In recent years, several cities have introduced zoning reforms to encourage higher density, with a focus on increasing “missing middle” apartment buildings in neighborhoods zoned for only single-family homes. These changes intend to increase the availability of small-scale apartment buildings—those with roughly 2 to 12 units—whose construction has largely disappeared nationwide despite the housing supply not keeping up with a growing population. Whereas roughly 7 percent of new housing construction in the mid-1980s was in buildings with 2 to 4 housing units, this share dropped to just 0.2 percent in 2021.
However, the results of the new zoning reforms have sometimes been modest. Minneapolis, which eliminated single-family zoning citywide in 2019 to allow triplex construction, has permitted only a few small apartment buildings, in part because restrictive floor area ratio requirements and height limits have made building duplexes and triplexes difficult.
Macroeconomic real estate conditions can also explain the limited effects of the recent zoning reforms. In this post, I test this explanation by modeling the costs of typical small-apartment projects in Washington, DC, amid the current economic environment. Notably, I do not test any for-sale real estate models, and my results may not apply to all circumstances.
My analysis shows that high costs of land and high loan rates are impeding construction of missing middle housing. With additional housing necessary to make up for supply shortages, I recommend that cities ensure zoning reforms allow for larger projects (such as buildings with 4, 5, or more units), identify new sources of low-cost loans, and enable landowners to renovate existing single-family homes into multiple units or to add small apartment buildings to those homes’ backyards without tearing them down.
High property values limit investment in small-scale apartments
First, I evaluated the feasibility of new rental development projects of 2 to 6 units, given current construction costs and rents in high-income neighborhoods in the Washington, DC, region. I estimated whether each development would face a financing gap—whether it would make enough money in rent to pay for the loan needed for property acquisition and construction.
I find that, in Washington, DC, newly built duplexes that replace single-family homes are infeasible unless the initial property acquisition costs are below $100,000. Triplexes, which can generate more rental revenues because of the additional unit, can be financed even in the context of higher property acquisition costs, but only if they are below $300,000.
Yet in Washington, DC, the median home is worth more than $600,000—and homes in high-income neighborhoods are typically worth a lot more. Properties in low-income neighborhoods are worth less, but developers have less incentive to acquire and reconstruct those homes as renters moving into new units will likely pay less in rent. Generally, apartment units are worth substantially less than single-family homes, with people willing to pay more to live in a unit that is separated from its neighbors on average. That’s good for potential renters—but bad for property investors.
In sum, investors—even with accommodating zoning—may not see much benefit in buying a single-family home, tearing it down, and replacing it with a new 2- or 3-unit apartment building. Bigger buildings, however, can handle higher property costs. I find that a developer investing in a newly built 6-unit building could handle initial acquisition costs of up to $800,000. Evidence from Portland (PDF) reaffirms this finding, showing that, after a zoning reform enabled missing middle housing, permits for fourplexes have far outnumbered those for duplexes and triplexes.
This is not to say, however, that duplexes or triplexes are impossible to build given today’s property values. I also tested the possibility of acquiring existing single-family homes, renovating them, and converting them to triplexes. I find that this type of investment—unlike new construction—is financially feasible.
Since high land costs are an obstacle to small apartment construction, another option is to keep existing single-family homes on site but add duplexes or triplexes to the backyard, which has become the norm in cities like San Diego. This approach can preserve the value of the existing single-family home while limiting the challenge presented by high land costs.
Small apartment projects in other cities could benefit from lower land costs, but those cities also have lower rents, limiting the ability to finance their construction. A 4-unit building in DC on a $600,000 site could be financially feasible with rents above $4 per square foot (standard for new buildings in DC). A similar project on a site costing half as much would still require rents of more than $3 per square foot to be feasible—and that’s a lot more than standard in lower-cost markets like Columbus, Ohio.
Today’s high-interest environment makes debt too expensive for many projects
Interest rates on mortgage debt fell after the Great Recession, reaching lows of less than 3 percent in late 2020. During and after the COVID-19 pandemic, however, rates increased and are now holding steady at about 7 percent. Those rates put a chill on homebuying.
Interest rates also affect the financial feasibility of small-scale apartment buildings. In our model, I evaluated whether hypothetical projects of different sizes would face a financing gap because of different loan interest rates. At rates of 3 percent or less, financing triplexes or larger projects would be feasible. But interest rates at their current levels make projects of up to 6 units financially infeasible—they all face a financing gap.
This situation, like high property acquisition costs, limits the potential for investment in small-scale apartment buildings.
Recommendations to speed the construction of small apartment buildings
High-cost cities that seek to generate additional low-density, infill housing construction may struggle to attract investment if their zoning policies are designed to allow the building of only duplexes or triplexes. To achieve financial feasibility in today’s market, local governments and states may need to enable the construction of 4, 5, 6, or even more units on previously single-family lots.
In lower-cost areas, such as many suburbs and cheaper metropolitan areas, smaller projects are likely more financially feasible, but allowances for higher-density development are still needed.
Land-use regulations legalizing multifamily construction should accommodate adequate density to make projects with 6 or more units possible. These accompanying regulations can include the following:
- reduced parking requirements, higher allowed lot coverage, and reduced setback requirements, all to make more land on each parcel available for construction
- higher allowed heights, to enable four-story buildings
- increased floor area ratios, to make it possible to build adequate density
Localities and states should also ease the conversion of existing single-family homes to multifamily homes while allowing landowners of single-family homes to add small apartment buildings to their backyards. Both these options are often more financially feasible than demolishing existing buildings before new construction.
Even with these changes, developers still face head winds because of high interest rates. Policymakers may consider developing new sources of low-interest loans to fill the gap, especially if units are designed to ensure affordability for households with low and moderate incomes.
Let’s build a future where everyone, everywhere has the opportunity and power to thrive
Urban is more determined than ever to partner with changemakers to unlock opportunities that give people across the country a fair shot at reaching their fullest potential. Invest in Urban to power this type of work.