Leveling the Field: Reforming Land Use for “Missing Middle” Homes
In housing construction, new homes are said to “pencil out” – or be financially feasible – when the expected rental income or sales price is high enough to cover construction costs plus a reasonable return on investment. A project that doesn’t cover its own costs, and deliver a competitive return, “doesn’t pencil” — and so, does not get built.
Understanding housing finance is critical to making good housing policy, which is why the UC Berkeley Terner Center for Housing Innovation has an ongoing “Making It Pencil” series that analyzes the housing construction finance environment in California.
In the most recent installation, Making Missing Middle Pencil: The Math Behind Small Scale Housing Development, David Garcia shifts the focus from large, midrise “five over one” projects to four types of “missing middle” projects: for-sale duplexes, for-rent fourplexes, for-sale fourplexes, and for-rent tenplexes.
Key Takeaways:
- California’s recent efforts to encourage small-scale, “missing middle” infill housing in urban areas have not been successful, because building this type of housing is not financially feasible in most markets.
- Right now, the only types of infill, multifamily housing that reach the minimum rates of return are for-sale duplexes in the East Bay and Sacramento. Everywhere else, builders are better off building large, luxury single-family homes.
- While policy reforms like impact fee relief and building code changes will make certain projects more financially feasible in some markets, missing middle housing will not truly scale without fundamental changes to both land use and building code regulations, and finance.
To examine the financial feasibility of missing middle housing, researchers constructed mock financial analyses of duplexes, fourplexes, and tenplexes in four urban areas: the East Bay, the South Bay, Sacramento, and the westside of Los Angeles.
Even when relying on optimistic assumptions about location, price, financing, labor, and local restrictions, the only missing middle projects that “penciled” were for-sale duplexes in the East Bay and Sacramento. Fourplexes, both for-sale and for-rent, and rental tenxplexes did not meet the internal rate of return in any of the markets the researchers analyzed.
They then ran the analysis with two changes: They reduced impact fees from $40,000 to $10,000 per home, and allowed fourplexes and tenplexes to be built under the residential building code, rather than the more costly and complex commercial building code. The result: The combined changes made for-sale fourplexes in the East Bay financially feasible, and brought for-sale duplexes in Los Angeles close to viability.
Builders interviewed for the report noted that “a fundamental shift in the marketplace would be required for missing middle development to truly scale,” and emphasized the need for multiple reforms: Better financing terms; land use codes that explicitly favored multifamily over single-family development; simplified lot-splitting for townhome development; and predictable permitting timelines.
Going further, the authors identified other policy changes that could bend the cost curve: exempting smaller units from impact fees; shifting the timing of impact fee payment; eliminating parking mandates; legalizing “single stair” buildings; reforming construction defect liability laws; and reforming minimum lot sizes.