Any zoning reform or form-based codes or conferences about designing cities for people and not cars is for naught if there are no means to finance all of it. If banks will only lend money for office parks, shopping centers, and clusters of single-family homes around cul-de-sacs, that’s what will mostly be built, even in towns that know better.
It’s a problem that has plagued builders of small-scale, incremental development for many decades. In the most famous book on urbanism, The Death and Life of Great American Cities, Jane Jacobs wrote about how banks refused to lend mortgages to people with property in the North End of Boston, Back-of-the-Yards in Chicago, and East Harlem in New York because they had been designated as slums at one point.
“A merchant with whom I am acquainted in the blacklisted district of East Harlem in New York, unable to get a $15,000 loan for expanding and modernizing his successful business there, had no difficulty getting $30,000 to build a house on Long Island,” she wrote. Similarly, “Consider, for example, the case of a small New England city … with an extensive and well-publicized redevelopment program … the redevelopment staff prepared a map that showed where … clearance was deemed necessary. After the map was made, the planners discovered that it coincided, exactly, with the maps prepared by the city’s bankers many years previously designating localities into which no loans would be made,” apart from one neighborhood served by a small, independent bank that had continued making loans in the neighborhood.
These days, the obstacle preventing small development from being financed isn’t so much where a building is located as it is just getting a loan at an affordable rate.
Cary Westerbeck is a planner turned architect in a small town outside Seattle. After taking one of Jonathan Segal’s “Architect as Developer” courses and others through the Incremental Development Alliance, he decided to develop one of his designs, a three-story, mixed-use building, with a small commercial space on the ground floor and two apartments, including a residence for him and his family above.
“It’s crazy,” Westerbeck says. “This kind of building is all around the world. It’s the building block of cities.”
But he couldn’t find a bank that would touch it.
He talked to local, regional banks, who balked at providing a residential homeowner loan for building a commercial unit in it or a commercial loan for a building Westerbeck intended to occupy. One bank would have done it, if Westerbeck could have provided a personal guarantee of $350,000 from a backer. What was most confusing was that, with multiple income sources, such a building ought to be a safer choice than just a small apartment building or small commercial building.
In the end, much of the financing had to come from hard money at an interest rate of 12 percent, when a regular loan would have been nine percent. After a year, his broker was able to convert it into a 203(b) loan from the Federal Housing Administration, which Westerbeck described as a “vanilla residential loan … [but] it was the only loan we could get.”
That said, a 203(b) is a loan for purchasing or refinancing a primary residence that’s of one to four units, which still made construction a problem. The financing solution also made it impossible for the broker to sell on Wall Street because it’s so unique, it can’t be packaged with others. Another problem is that it’s a home-ownership loan, so Westerbeck would be unable to build another like it until the loan was paid off.
“When you’re not large, you fall through the cracks,” he says. “Every developer I talked to said to go to local, regional banks.”
What made the banks’ rejections more puzzling was that they came at a time when money was very cheap.
The refusal of banks to lend to Westerbeck might not be isolated. Johns Hopkins University did a study several years ago that found that even well-established businesses in Baltimore had difficulties getting credit from banks, explaining some of the persistent economic problems in the city. More recently, The Atlantic published an article by Robinson Meyer about how U.S. manufacturing businesses could not get loans, preventing them from growing or buying state-of-the-art equipment.
In a talk given at an Urban Land Institute conference in San Antonio (available on YouTube), Jim Heid, author of the book Building Small, said that big developers have capital stacks, while small ones have capital cocktails.
Westerbeck had no problem renting the building, either, even during the pandemic. He said that the commercial space was very attractive to several small businesses, ultimately ending up as a barber shop, because it was much smaller than other new retail spaces in town, and smaller businesses often don’t need as much space as larger ones.
Under the best of circumstances, financing real estate development can be complex. The aforementioned capital stack, according to Realty Mogul, consists of senior debt, which is secured and would get repaid first; mezzanine debt, which is when an investor gets someone to loan them some of the money they want to invest into a project, making a hybrid of debt and equity; preferred equity, which is equity that’s prioritized for repayment; and common equity, which is the equity that’s left.
The senior debt is the least risky and has the lowest return–that’s most of what banks would contribute. Mezzanine debt is more risky and offers a comparatively higher return. Preferred and common equity offer higher levels of risk. Assembling the money for a project, therefore, involves different sources with different repayment schedules and rates, as well as getting the right money at the right time. Purchasing a property to develop, for example, requires less cash on hand than hiring a contractor or worker to build the project.
Small developers, working on small projects, must further contend with various regulations intended to protect ordinary investors from being misled into taking on more risk than they can handle. Although the Securities and Exchange Commission’s accredited investors rules were recently loosened, the requirements still restrict investors to people with a net worth of more than $1 million (not considering their primary residence) or an income of $200,000 per year.