Apartment developers and municipalities are increasingly turning to modular (prefabricated) multifamily design and construction to address the affordable housing crisis. Cost savings and an accelerated development timetable translate to renters spending less on monthly rent. But before we examine exactly how and why modular development works, let’s quickly recap on the state of affordability within the apartment market.

The Rise of Cost-Burdened Renters

In spite of recent increases in take-home pay, nearly half of today’s renters remain cost-burdened – meaning that more than 30 percent of their household income goes towards rent. Close to a quarter of renters are now severely cost-burdened, contributing a staggering 50 percent or more of household income towards rent. As the interactive map below shows, this problem is not just isolated to the gateway markets.

This burgeoning issue can be distilled down to the fact that rent growth has outpaced income growth. Rents have increased 3% annually from 2001–2015, while median household incomes decreased 0.1% annually over the same period after adjusting for inflation. Put another way, the national median rent has risen 20 percent faster than inflation from 1990–2016, while the median home price rose 41 percent faster. Going back a little further, we see that the median rent payment increased 61 percent between 1960–2016, while median renter income grew only 5 percent. This should serve as some food for thought the next time someone complains that millennials aren’t buying homes because they spend too much money on avocado toast.

While there are numerous economic and demographic factors contributing to the affordable housing crisis, the type of apartment product built during this recovery cycle certainly plays a role. Nearly one million Class A apartments have opened their doors to greet new tenants between 2013 and 2017. Developers built less than 20,000 Class B/C units during that same time frame. The rising costs of land, construction materials, and labor have led to luxury being the only type of development that pencils out as financially viable in most urban areas. Construction costs have increased at a faster clip for Class B/C assets as well. We find that the cost per square foot for developing a high-rise (eight to 24 stories) increased 20% from 2013 to 2017, while low-rise construction costs increased 30%. A rise in value-add investors repositioning the existing Class B/C inventory to Class A-/B+ exacerbates the affordable supply side issue as well.

The demand side of the equation presents additional challenges. Population growth and an ongoing bias towards an urban lifestyle have fueled demand for apartments. California, for example, saw 544,000 new households emerge between 2009 to 2014, with only 467,000 net housing units built. The overall housing shortfall in the state has expanded to an estimated 2 million units. It’s no surprise then that California is one of four states – the others being Florida, New York, and Colorado – where more than half of the renter population is cost burdened.

With no traditional solution to this problem in their tool bag, cities across the U.S. are looking at creative ways to deliver new apartment units that are affordable for the working class. Modular multifamily construction – which involves prefabricating apartment units in a remote factory and then assembling the building on site – is proving to be one way to get this done.

Benefits of Modular Rental Housing

Most real estate professionals wouldn’t be able to discern whether or not a new low- or mid-rise apartment community was built modularly from an exterior examination. The same holds true for the interior. If the different rooms of a unit were built separately off-site, close inspection would reveal thresholds between rooms concealing the connections. If the entire apartment was built as a single unit – as might be the case with a studio – you’d be hard-pressed to find evidence that the residence was fabricated elsewhere.

(Left: Conventionally built apartment complex. Right: Modular construction project. Image courtesy Terner Center for Housing Innovation at UC Berkeley.)
 

While it’s hard to discern differences in the end product, modular housing has some definite benefits over traditional construction methods. The most obvious is cost savings.

Cost

Current off-site construction practices save approximately 20% in cost for a three- to four-story wood frame multifamily building. Reduced labor costs, production efficiencies and economies of scale in the procurement of materials combine to achieve this discount. Standardization of design components across projects also means that material orders can be made with increased consistency and without intermediaries, further reducing costs.

Time

Excluding time for planning approval and entitlements, the average construction time for a 20+ unit apartment community exceeds 14 months. Modular building practices can reduce that by 40% to 50% because several construction processes can occur at the same time. Unit manufacture and foundation preparation can take place concurrently with modular construction. Enclosed production assembly lines mean no weather delays or need for costly subcontractors.

A quicker construction time also means a shorter construction loan term – that translates to reduced interest and a fast track to stabilized rent rolls. One Bay Area developer, for example, saved 2% of total construction costs – about $500,000 – just by paying less interest thanks to the expedited timeframe offered by modular construction.

These costs savings can ultimately be passed on to the renter. Another Bay Area casestudy saw that the 20% in construction cost savings translated to $338 less in monthly rent per unit needed to cover the cost of construction compared to traditional development methods.

Cities Take Action

The U.S. has not been a traditional leader on the modular housing front – that designation would fall on countries like Norway, Japan, and Sweden. However, that’s not to say we haven’t explored the concept. With the rise of suburbia is post-WWII America, some builders experimented with transitioning wartime industrial facilities into home factories. A Swedish-born Chicago businessman named Carl Strandlund repurposed the Curtiss-Wright warplane plant in Columbus, Ohio, to construct prefabricated homes made of porcelain-enameled steel panels. Though production delays, zoning laws and purported subterfuge from the housing industry would lead Strandlund’s firm to declare bankruptcy, nearly 2,000 ‘Lustron Homes’still exist today. With more than five television shows currently dedicated to small prefabricated homes, the idea of small, cost-effective housing remains popular.

Multifamily developers and municipalities have taken note of the advantages associated with prefabricated building as well. I recently had the pleasure of assisting a joint venture land $16.4 million in permanent Freddie Mac financing for a 110-unit mixed-income modular housing development adjacent to the Coliseum BART station in Oakland, Calif. Units for that project were built in Boise, Idaho, trucked to Oakland and set in place this past June. The first tenants are expected to move in in January 2019. Oakland will also soon be home to the two tallest modular high-rises in North America with RAD Urban’s 200-unit towers rising in the uptown and downtown districts.

California is also home to a startup called Katerra that is looking to disrupt the entire development process. The firm, which currently has factories in Phoenix and Spokane, Wash., delivers end-to-end prefabricated-focused construction services starting with design and finishing with on-site assembly. Materials for everything from door frames to countertops are sourced from a global supply chain, fabricated in the factories, shipped to the development site and assembled. This novel approach has earned Katerra an $865 million investment from Japan’s SoftBank, which puts the value of the 2015-founded company at over $3 billion.

(A quick video exploring Katerra’s end-to-end process.)
 

Of course, the modular housing trend is not limited to California. The City of New York is currently incorporating modular housing as part of its Housing New York (HNY) plan, which, as the most aggressive housing plan in the country, is on track to create and preserve 300,000 affordable homes and apartments by 2026. The NYC Department of Housing Preservation and Development will focus modular development in areas approved for low-rise and mid-rise projects to accelerate unit deliveries. In May, the agency issued the city’s first RFP to require modular construction, soliciting bids for a mixed-use, mixed-income 100% affordable development located on a vacant parcel of land adjacent to the Grant Avenue A-train station in the Brooklyn neighborhood of East New York.

Overcoming Hurdles

Given the cost and time savings associated with modular construction, we can only expect to see an increase in similar initiatives across the U.S. Yet there are some elements to modular housing that must be overcome to spur widespread adoption. With construction shifting from building sites to factories, many trade unions perceive modular building methods as a threat, especially with imported unit modules. Modular construction firms with local or regional factories employing union workers will likely find greater acceptance in the long run, with negligible impact on the final cost of the finished product.

There is also sometimes a perception that modular construction is a substandard product compared to traditional methods based on cost. This stigma will likely clear over the next few years as the current round of modular development proves itself. The standardization of materials and quality afforded by factory assembly should mean that modularly-built projects will hold up just as well as traditional apartment construction, if not better.

Finally, not all financial institutions are familiar with supporting this type of product. While some construction lenders want to lend in small draws, modular construction often requires 30% upfront. However, arranging permanent financing or refinancing a prefabricated community is no different from that with a traditionally built community after accounting for the accelerated delivery timeframe.


About the Author

John McAlister is Managing Director and the West Coast Team Leader in the Affordable Housing Debt unit of Hunt Real Estate Capital. For over 20 years, McAlister has served as a consultant, advisor and underwriter on more than 250 different tax-exempt or taxable bond transactions. In addition, he has extensive experience with many conventional financings and the refinancing of multifamily housing projects. McAlister is a graduate of UC Davis and the Peter F. Drucker Graduate School of Management at the Claremont Graduate School.

Questions about financing? Contact John McAlister at (626) 263-9666 or john.mcalister@huntcompanies.com.