The following post examines a U.S. housing market split between market-rate and affordable housing, highlighting the differences in their development processes and explaining why equity is the common currency of all real estate.
Housing development must be the strangest business in the world. Where else would you find a chronically undersupplied multi-trillion-dollar market for a product that literally every single human needs to survive? How is it that housing continues to be delivered by a fragmented industry that has for decades been unable to meet demand, yet we do not see massive amounts of capital pouring into the market to finance innovation to challenge the incumbents? Why is it that very few people would be able to name an incumbent? The answer can be found in the development process itself — a process that is fully understood by a very small group given the size of the housing market. What these people fully understand is the unique value creation inherent to real estate. They know that the dirt itself appreciates in value, and anything legally attached to the dirt appreciates with it. And they, more than anyone, understand that the currency of this value creation is equity.
Surely housing, of all markets, would be considered ripe for disruption. Zillow estimates that housing in the U.S. is a $33.6 trillion market. The U.S. housing market gained $11.3 trillion in value over the last 10 years. California, with 12% of the U.S. population, represents 21% of the market. California alone is a $7 trillion housing market, with major cities like Los Angeles and San Francisco each worth more than $1 trillion. Nearly $5 trillion or 14% of the value of the U.S. housing market is from new housing stock entering the market.
All this means that no matter how you think about it, the opportunity to deliver new housing and break the supply deadlock is enormous. So how can it be that California, the home of technology and business model innovation, and the birthplace of venture capital, is 3.4 million units short of housing?
A split market: Market-rate and affordable
Part of the answer is that there is not one but two housing markets. One market builds for buyers and renters who pay market prices based on supply and demand. Another market builds for the millions of people who can’t afford market prices. Each market works very differently, but ultimately represents the value and equity created when housing and land are put together to create real estate.
The split housing market can be seen most clearly in the process of development financing. To build housing, a developer must raise money to buy the land and pay for project architecture, engineering, development, and construction. A developer can only attract financing if they can demonstrate that the rents will be high enough to pay back the building costs. Therefore, it is the relationship between market rents and build costs that drives the world of real estate finance. So far, this seems like a normal market where a producer can borrow money based on their ability to repay, which is dependent on enough customers paying full price to purchase the product when production is complete.
For projects where the developer will charge full market rents, some mix of debt and equity financing will provide 100% of the money necessary to complete the project. But not everyone can afford market rents. In fact, full-time minimum wage workers cannot afford rent for a 2-bedroom apartment anywhere in the U.S. If tens of millions of renters could not afford full market rents and developers could only finance projects that would pay back lenders based on full market rents, then there would be tens of millions of homeless people in the U.S. When tens of millions of citizens cannot afford the market price of a necessity, the government steps in with subsidies for “affordable housing.”
A market dependent on subsidy
A significant portion of the financing for affordable housing development comes in the form of low-income housing tax credits (LIHTC). Under a highly complex set of rules, requirements, and allocations, developers may apply for LIHTC financing to offset the financing shortfall to develop housing for people who make less than the area median income (AMI). The level of subsidy necessary to finance a new housing development grows in inverse proportion to the income level of renters to be served. The lower the resident income relative to the area median, the less money will be available for the developer to repay their debt, and the greater the required subsidy. The LIHTC system is highly bureaucratic and, as such, an entire market has emerged to develop projects that utilize this source of financing.
Affordable housing developers are like market-rate developers in terms of the product they build and the industry that they employ to deliver the housing, but the affordable housing finance and regulatory processes are very different. A new housing development must be clearly conceived and designed as affordable from the start, and it will follow prescriptive development paths and timelines. To secure LIHTC financing, an affordable housing developer must develop their project within constraints, competing with other affordable housing developers for a fixed pool of available money. The rules of who may develop, where a project is developed, and for whom a project is developed, are completely different for affordable housing development than they are for market-rate development. This layer of complexity makes affordable housing more expensive to develop than market-rate, though without subsidy this much-needed housing would not be developed at all.
Equity is the currency of all development
Though market rate and affordable housing development processes follow very different paths, they share in the currency that is used to describe their value: equity. Equity is that unique attribute that marries the physical housing product with the dirt, the real estate. Equity is ownership, whether it is real estate, a business, or any asset that has associated liabilities. In housing, equity is the goal and is also the reason why housing works so differently from other industries. If you own the equity, you participate in the appreciation of the real estate and benefit from the fact that no one is manufacturing more land. Those who own the real estate own the equity; those who participate in the industry or rent the product do not.
A clear illustration of the importance of equity can be seen in the difference between mobile homes and permanent housing. A mobile home is unattached to the ground by law and by code, meaning that it cannot be financed or located as real estate. Mobile homes are like cars, boats, and bicycles, in that they are not tied to any site and, as a result, depreciate as soon as they leave the factory. People who live in mobile homes rarely own real estate and generally lease the land, and sometimes the mobile home itself, from a mobile home park owner. The mobile park owner owns the real estate and captures the land appreciation and the rents. The building, the mobile home, depreciates in value over time regardless of its location, because it is not legally considered real estate.
Real estate is defined as property of land and any buildings or resources on that land. Permanent housing, whether it’s an accessory dwelling unit (ADU), a single-family home, or an apartment building, is connected to the dirt by law and by code, and as such, can be financed and owned as real estate. Most of the land in the U.S. is reserved by law and zoned for permanent construction, meaning only permanent real estate may exist or be built.
Real estate ownership, like ownership in a business, is recorded as equity, and it is the equity ownership that is the goal of real estate development. The architects, engineers, contractors, and regulatory agencies work for hire, but are not typically compensated in the form of equity. They work on each project, get paid, then move on to the next. It is real estate developers and their finance partners who own the equity, and who pay fees to the different service providers necessary to complete a new build.
The split housing market depends on the housing industry to create physical equity. In previous posts we have discussed how conventional housing development is highly fragmented among different players whose primary goal is to maximize profits while transferring risk to someone else. Housing is pre-industrialized in its design and manufacturing, resulting in an endless series of one-off builds. At the core, housing is dis-incentivized to address the fundamental mismatch between housing supply and demand in a split market. Because it is the currency of both market-rate and affordable housing, equity is the only sword that will cut through the Gordian Knot that is strangling our housing supply. New sources and methods of investment are required to break the current financing deadlock and unlock the supply. What’s needed is an integrated solution, which will be the subject of our next post.