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In tight housing market, lenders get creative to finance garage apartments

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It’s uneconomical to build affordable homes on a large scale. So people in some of the nation’s most crowded housing markets are thinking small.

Accessory dwelling units — small separate dwellings on single-family properties — are gaining increased attention as a way to quickly increase the supply of rental housing and also provide income that can keep current owners in their homes. A number of cities and states have passed legislation easing zoning and permitting regulations for homeowners who want to build infill housing in their backyards.

Yet so far, these efforts are not helping those who could benefit the most. A lack of dedicated financing means that people who build ADUs to date either have money or a lot of equity in their homes.

Portland, Oregon, is one of the most mature ADUs markets in the U.S.; the city holds regular tours for people interested in meeting the homeowners, builders and designers who built them. Yet even in Portland ADUs are primarily “a luxury thing for wealthy homeowners and early adopters like architects,” said Patrick Quinton, a former executive director of Portland’s development commission, Prosper Portland.

Quinton co-founded a company called Dweller that builds and installs more utilitarian ADUs. For homeowners who can’t get financing, Dweller offers to lease space on the property in exchange for a share of the rent. It’s one of a number of start-ups coming up with innovative ways to finance construction.

There’s clearly a need.

“We’re not seeing the scale that we would expect from homeowners seeking to maximize their income,” Quinton said. The industry as a whole, he said, needs "to get to the point where people have options to minimize the investment required to get product that’s attractive and rent it out. That’s where we’re headed, we’re just not there yet.”

Portland, Seattle and Vancouver were some of the earliest cities in the U.S. and Canada to adopt zoning reforms, sometimes combined with financial incentives, resulting in a spike in construction in recent years. But many other cities and states are promoting ADUs as a way to increase the supply of affordable housing, too.

California faces a housing shortage that is projected to reach over 3.5 million units by 2025. The McKinsey Global Institute estimates that as many as 790,000 of these units could be created by allowing homeowners to build garage apartments, basement apartments and backyard cottages. This is a conservative estimate, because the 2016 report examined only three counties — Sacramento, San Bernardino and Contra Costa. It notes that in San Francisco and Los Angeles, 93% of the residential land area is dedicated to single-family housing.

McKinsey recommended changing local zoning codes to make it easier for homeowners to build ADUs. And over the past two years, there has been a lot of progress on this front, much of it at the state level. A 2016 law set statewide standards for ADUs, preempting many local rules. Additional legislation passed last year further reduced barriers, streamlining approval and expanding capacity for development.

“We started by looking at the principal impediments homeowners face if they decide to build,” said Matt Regan, senior vice president of housing policy at the Bay Area Council, a business-sponsored, public policy advocacy group that has been working on ADUs going on four years. “The low-hanging fruit are impact fees set by local jurisdictions. Some require additional off-street parking, for example.”

However, “permits are only half the battle,” Regan said. “Homeowners in many instances don’t get that far; the financial alternatives for some are lacking.”

There are of course traditional methods such as cash-out refinancing and home equity lines of credit. “Those work for most homeowners, particularly in the Bay Area,” he said. “In this housing market, anybody who purchased a home other than in the past few years probably has equity. Home prices have risen so much they could finance an ADU just using equity. Others will use personal savings or other things. The gap lies in the communities where equity financing or cash-out refinancing doesn’t exist.”

Option 1: Borrow local

Local and regional lenders may be more comfortable financing ADUs than larger banks. The Terner Center for Housing Innovation at UC Berkeley surveyed 414 homeowners in Portland, Seattle and Vancouver who built ADUs; the majority either borrowed against existing home equity (40%) or used cash (30%) for funding. Just 4% reported borrowing, at least in part, against the future expected value of the unbuilt ADU to help finance its construction.

Of the 91 respondents who reported getting a loan of some type and who indicated what type of institution made the loan, 60% reported borrowing either from a credit union or a local or regional bank. Only 34% reported receiving a loan from a national bank.

“This suggests that efforts to encourage or create innovative financing products to ease ADU financing might most productively focus on partnerships with locally-focused lending institutions that already understand the local real estate market in general and ADUs in particular,” says the report, which was published in April 2017.

Even if larger banks aren't providing construction or plan loans on their own, some are providing grants to organizations that do. Last year, JPMorgan Chase awarded a $3.5 million grant to a pair of nonprofit lenders: Housing Trust Silicon Valley, based in San Jose, and Genesis LA Economic Development Corp., based in Los Angeles. The two agencies will oversee construction and technical assistance loans for low income homeowners who want to build ADUs.

The Bay Area Council has also been working with Alameda County on using some of the affordable housing bond they passed to help fund ADUs as a homeownership preservation tactic. "This could be used to help stabilize communities such as West Oakland, where people are struggling to pay the mortgage and are being offered large cash offers to move away," said Rachele Trigueros, a senior policy manager for the advocacy group.

Option 2: Piggyback on PACE

One business model for nonbank lenders is to rely on contractors to suggest their loans to homeowners, as do providers of Property Assessed Clean Energy financing, which is used to finance energy and water efficiency projects and is repaid via an assessment on property tax bills.

Daniel Passage, a partner at Winston & Strawn and co-chair of the law firm’s structured finance practice, thinks that financing for ADUs shares some characteristics with PACE that make it a compelling opportunity. “PACE is exciting to lot people because of two factors: there’s compelling public interest — it encourages water, energy conservation, which are public goods — and it uses private funding,” he said.

Similarly, ADUs serve a public interest: affordable housing.

Winston & Strawn has a client, Solar Capital Solutions, that recently started offering ADU loans. It was formed in the last few months, and demand for loans is already outstripping available capital. The average loan size is $150,000 to $200,000. The loans are often suggested to homeowners by contractors, another similarity to PACE.

The financing that Solar Capital provides is not identical to PACE; it does not have the status of a tax lien and there is no government agency involved. As with PACE, however, the interest rates are higher than a mortgage, but not dramatically. And there’s a direct benefit to the homeowners, namely rental income and higher property values.

Passage said there’s already significant demand for ADU loans from banks, which can use them to comply with Community Reinvestment Act requirements. There’s also demand from capital markets investors amid expectations that these eventually the loans will be bundled into collateral for bonds, similar to PACE.

Greg Saunders, CEO of CleanFund, a provider of PACE financing for commercial property, thinks that there’s a case for using PACE itself to finance ADUs. There’s already some latitude to use PACE for the kinds of improvements you’d normally make on new construction, such as efficiency-related measures, for ADUs, he said.

CleanFund would be interested in supporting legislation that would broaden the scope of commercial PACE to include 100% of the costs associated with constructing ADUs. Building ADUs “is a public good, it achieves a community benefit, which is the cornerstone of PACE,” Saunders said. This could be done with an amendment to existing PACE legislation that would enable all local PACE providers to automatically provide financing for ADUs.

Working with policymakers to amend PACE legislation is “a very methodical and collaborative process,” however. "It would require PACE providers to coordinate efforts to win over Realtors and other constituents that, in the past, have opposed residential PACE," he said. Nevertheless, PACE has become increasingly applicable to things that matter to communities, especially seismic strengthening, storm-proofing and, more recently, fire-proofing.

To meet the criteria for achieving a community benefit, legislation might have to stipulate that an ADU is eligible for PACE financing on the condition that the ADU is immediately available for a long-term rental, for example, in order to satisfy the affordable housing needs of local communities.

Option 3: Vendor financing

Another business model is for a builder to provide financing, as Dweller does. The company retains ownership of the ADUs it finances and pays a share of the rent to the property owners each month. A property owner has the choice of identifying qualified tenants for the ADU or leaving that to Dweller. The property owner can purchase the ADU at any time, based on a declining buyout payment; at the end of a 25-year lease, the property owner will own the unit outright.

Dweller works with a factory builder, Champion Home Builders; the entire ADU is built at the company’s Idaho factory, including cabinets, flooring and appliances. When the unit arrives at the site, Dweller drops it in. “We do very little on-site construction. Most of what happens on-site is prep and installation, pouring the foundation, hooking up to existing utilities and landscaping,” Quinton said.

Each Dweller ADU is approximately 450 square feet and has a living space, a kitchen with full-size appliances, a bathroom and a bedroom.

Quinton said ground leasing has not been as tough of a sell as the founders anticipated. “There’s a whole generation in their 30s and 40s now that understands that [their backyard] is an asset to be monetized. It makes complete sense for them.”

To date, the company has been funding the ADUs it owns itself, though it is in the process of obtaining a bank line of credit. It’s also raising equity.

While boosting property values is part of the sales pitch, Quinton said views on this are “evolving.” Despite demand for properties with ADUs, “we need appraisers to build up enough experience and see enough transactions that can justify increasing property values," he said. "Then ADU lenders will follow suit.”

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