After decades of tightening land-use requirements, cities and towns across the country are taking a hard look at their zoning laws and restrictions on where and how densely housing can be built.

This should come as no surprise, as housing costs are outpacing incomes across the country, and mounting evidence suggests that local land-use regulations suppress housing supply and drive up costs.

Communities are rethinking their zoning laws to meet growing demand and improve affordability. But without innovation in financing, zoning reforms are unlikely to close our nation’s growing housing supply gap. After all, if you can’t finance new types of permitted housing, they are unlikely to be built.

Accessory dwelling units (ADUs) in particular can help expand the affordable housing supply, and many communities are rewriting their local zoning laws to allow them. Financing ADUs, however, has been limited. Without developing and scaling innovative financing for ADUs, zoning reforms alone won’t unleash supply.

Step one: Allow ADUs

ADUs are small second housing units on the same grounds as a single-family home. They can include backyard cottages, basement apartments, or garage conversions. 

Historically, most single-family residential zones in the US prohibited ADU construction. But today, cities and states are increasingly permitting ADUs to be built in single-family zones.

Seattle recently made it easier for more homeowners to build up to two small ADUs on certain properties zoned for single-family residences, and California adopted a similar law statewide.

Some places that already permit ADUs are also improving their policies to boost production: Arlington, Virginia, adopted an ordinance in 2009 allowing homeowners to build ADUs inside their house by converting an existing structure.

But after seeing few units produced, the county updated its standards last year to allow homeowners to build new detached ADUs on their property without first seeking county permission.

Step two: Finance ADUs

Allowing ADUs is a critical first step, but financing can be an additional obstacle. Existing mortgage products are poorly tailored for ADUs. The only current options for financing ADUs are a cash-out refinance, a home equity loan or line of credit, and renovation financing.

Cash-out refinancing and home equity loans and lines of credit allow the borrower to tap into the equity of their existing home. The government agencies and government-sponsored enterprises that back most loans in the country—Fannie Mae, Freddie Mac, and the Federal Housing Administration—limit loans that allow the borrower to refinance and extract equity—so-called cash-out refinancing—to 80 percent of the home’s value.

For many homeowners who already have a mortgage on the property, this limitation would mean they cannot take out enough to build an ADU.

Banks could theoretically make mortgages allowing the borrower to take out more equity relative to their home value than is permitted by the government or government-sponsored enterprises and hold these loans in their portfolio, but they don’t. Bank portfolios tend to be used primarily for high-balance loans to pristine borrowers.

Home equity loans and lines of credit are also offered by banks and held in portfolio. These instruments can be used regardless of the borrower having a first mortgage on the property, but they have strict limitations on the maximum amount of credit that can be drawn in relation to the home value, and they tend to require very high credit scores, limiting the reach of these products.

Fannie Mae and Freddie Mac provide renovation financing, which could be an alternative lending source for ADUs. For a renovation, the borrower can borrow against the after-repair market value of the property, based on their current income.

This suite of available financing techniques is not well suited to ADUs for two reasons.

1. Cash-out refinances and home equity extraction tools consider only the current value of the property.

Renovation financing does look at the after-repair market value of the property, but this may increase only marginally because of the addition of an ADU.

The after-repair market value is based on comparable sales in a limited geographic area within a recent time frame, and to the extent there are no comparable properties with ADUs, the additional value of the ADU may be close to zero. Over time, we would expect the value of homes with ADUs to appreciate more rapidly than units without.

2. None of these financing techniques consider the income the ADU will generate.

Mortgages for one-to-four-family residences are based on the amount of debt relative to the income of the borrower, not the income from the property. The income from an additional unit can be added to the borrower’s income to determine mortgage eligibility only if the unit is already rented and there is proof of sustained rental income.

For example, Fannie Mae requires two years of rental income before it is willing to count this income toward the mortgage payment.  

Thus, there is no major mortgage product from the government or government-sponsored enterprises that considers both after-repair market value and potential rental income generated from a new ADU.

Government institutions need to step up

A handful of community-based lenders, foundations, and local governments are stepping up to help fill this void by developing products geared toward the ADU market:

• The Backyard Homes Project in Los Angeles will finance and build ADUs for homeowners who agree to rent the new units to housing choice voucher holders. It includes a construction loan and considers 75 percent of the projected rental income as qualifying income.
• The Additional Dwelling Unit Loan Pilot in Boston allows low- and moderate-income homeowners to receive a zero-interest loan of up to $30,000 for an ADU remodeling project.
• The City of Napa provides a forgivable loan of up to $50,000 to create a junior unit. The payments are deferred, and the loan is forgiven 5 percent per year as long as the unit is rented to a low-income tenant at an affordable rent.

Although these local initiatives are promising, each rely on scarce public and philanthropic dollars. To get to scale, we’ll need to see the government agencies and government-sponsored enterprises—which currently back 63 percent of all outstanding mortgages—develop mortgage products tailored toward ADU financing.

Banks and other mortgage providers tend to follow the lead of the government-sponsored enterprises. Unless these new products are developed, we are likely to see more permissive laws passed with few units being built.

In short, we need more responsible and innovative financing by banks and government-related institutions to keep up with zoning reforms to address a range of pressing public policy issues, from housing affordability to wealth building. ADU financing is a good place to start.