The “What”: the Monoculture Chicken-Egg Problem
There are a handful of standard loan products that offer low interest rates, preferential terms, and a straightforward, streamlined process to qualify. These tend to exclude the kinds of projects that many incremental developers want to do—urban infill buildings that are often mixed use, usually rental properties, and often denser and with less parking than has been the norm for the last 70 years.
A key reason is the lack of a secondary market in such loans. The secondary markets are where banks resell loans they have issued to third parties. There is a massive secondary market for home mortgages, dominated by Fannie Mae and Freddie Mac, which buy home mortgages and bundle them into mortgage-backed securities. There is no equivalent for mixed-use loans. A report called “The Unintended Consequences of Housing Finance,” published in 2016 by the Regional Plan Association, explains the significance of this fact:
In practice these projects would be good investments, but require time and openness from the lender, and an interest in supporting the local community. Yet as there is no secondary market for mixed use loans, they are held on the bank’s balance sheets, keeping the bank from “reusing” the funds for other loans and collecting more fees. Including these opportunity costs, the loans are notably more expensive for the bank, and thus expensive to the developer. Banks prefer “cookie cutter” conforming loans and sell them easily, but non-conforming loans are relatively rare, expensive, and unsalable. Generally the loans simply are not made, and without financing opportunities many mixed use projects, especially in older areas, aren’t conceived.
How did it get this way? One interpretation, offered by Stephen Smith, is that “finance problems are actually zoning problems.” Because land-use regulation restricts the vast majority of urban land in the U.S. to single-use structures, and in the case of residential areas, typically 80% or more to single-family homes, banks don’t find it worthwhile to create loan products for building types that are uncommon.
On some level, though, the problem is almost certainly a chicken-egg one. At times, it’s lenders, not regulators, restricting development practices. Accessory dwelling units (ADUs) are often poorly served by existing loan products, even in cities where they are allowed and encouraged by the planning department. And for commercial buildings, it’s not uncommon that a loan officer will insist on more parking than the zoning itself requires. Banks have acquired their own ideas about what is high or low-risk in development.
These ideas may have little empirical grounding, but they have a long history. Many date to the Federal Housing Administration’s original sin, in the 1930s, of defining mixed-use buildings and apartments, and urban areas with many of them, as “hazardous” for the purpose of insuring loans, a key component of mortgage redlining. This belief was baseless at the time, let alone now, yet its legacy is still present in our banking system.
There is some momentum for federal reform. 2016 changes to FHA loan guidelines allowed up to 49% of a property to be commercial, up from the previous 25%. More work needs to be done to democratize these standard, easy-to-access loan products, though. One low-hanging possibility is to adjust the 203(K) program, which provides a loan for rehabilitation of a home that then becomes a conventional mortgage, to more easily finance the construction of ADUs, by letting borrowers borrow against the future rental income stream from the ADU. Combined with Kronberg’s suggested policy of allowing fee-simple ADUs (essentially dividing a residential lot in two), there would be a straightforward source of financing to take virtually any single-family home to the next increment of development: two homes.
Two Paths for Developers: Form Follows Finance, or Find a Better Bank (If You Can)
From the perspective of an individual developer, you can’t do much to fix the system, but you can work within it in one of two ways.
One is to embrace the principle of “Form Follows Finance,” a catch phrase I learned from the Incremental Development Alliance. This is another way of saying what Eric Kronberg told me: “Feed the lenders and appraisers what they eat.”
For a small developer, there are a few templates that fit within the strictures of well-established loan products—if your situation and goals are compatible. One is a standard FHA loan which converts to a federally-insured 30-year mortgage upon completion of the building. You can use this on a house of up to four units, as long as one of them is your primary residence. Up to 49% of the building can also be commercial space, but a number of other issues surrounding appraisal can still present roadblocks. Another option, pointed out to me by Monte Anderson, is a Small Business Administration (SBA) loan, which can cover the construction of a building in which your business occupies at least 60% of the space. The remaining 40% can be turned into rental apartments providing an income stream.
The other path is to find a lender who “gets” it and build a good working relationship with them. Here, local banks and CDFIs shine. This has been a big part of the story in South Bend’s small developer ecosystem. I spoke with Gary Benedix of Northwest Bank, which has been a key factor in that ecosystem. Benedix told me it’s common for individual banks to specialize in certain kinds of loans or refrain from others. In the case of Northwest, the small business program is particularly flexible, and the bank has a longstanding commitment to working with neighborhoods to promote local investment.
Benedix’s biography, in some ways, illustrates why he is the exception rather than the rule. “I worked my way through college as a county commissioner up in Michigan,” he told me, “and the liaison to the regional economic development commission, so I learned things through osmosis. My senior VP was the director of a downtown development corporation in Buffalo.” Northwest Bank has sponsored a local arts fair, and talked with the Near Northwest Neighborhood about a revolving loan fund to help home renovators overcome appraisal gaps.
The knowledge required to evaluate the strength of a small development opportunity is often hyper local. It includes not just the usual factors like the presence of experienced developers on the team and an investor backer with some collateral, but also things like the relationship the developers have with the city and the neighborhood, and context about other in-progress efforts that might affect that neighborhood’s trajectory. (This is the whole “farm” concept again.)
This is one of many reasons that consolidation in the U.S. banking sector is a worrisome long-term trend; very often it takes a local bank to even entertain working with a small local developer. It will be very difficult to scale up the number of lenders who “get it,” and thus small developers who get the loans they need, without robust local banks.
Even with the Gary Benedixes of the world playing a vital role, educating bankers about community development is hardly a comprehensive answer to the system’s tilt in favor of large enterprises and standardized development products. Reform at that broader, systemic scale—likely starting with the FHA, Fannie, and Freddie, is beyond the scope of this essay or my expertise, but it starts with recognizing the role that federal mortgage policy and the derivatives market have played in putting a very, very heavy thumb on the scale.
The IDA’s Monte Anderson has a plea: for federal changes that would allow for more flexible terms on smaller loans—under, say, $2 million. “I’m not saying no regulation. But it’s very rigid right now. If you want to build a mixed-use building, it’s 30% down.”
“It’s a double whammy on small developers: financing is strict, the code doesn’t work, and you can’t get any of the incentives that you get as a big developer. Cities create these complicated capital stacks and tax credit nightmares that cause odd things to be upon the earth. All we’re asking for is cheap equity and cheap finance.”