Apartment lending is on a historic run as property values and rent prices are near all-time highs, while vacancy rates are near all-time lows. In turn, multifamily-loan default rates are close to record lows. Banks, government-sponsored enterprises and conduit lenders compete for this “safe space” of property types.

When an economic downturn inevitably arrives, however, the market will reveal which apartment types renters prefer. Changes in technology, workforce composition, infrastructure and lifestyle have fundamentally reshaped housing demand. Commercial mortgage brokers should be aware of these factors, too, so they can understand an apartment lender’s blueprint for keeping default rates low.

Imagine a world where you walk to work, the gym, restaurants, coffee shops and home. You don’t own a car, allowing you to eliminate expenses for gas, parking, registration, insurance and repairs. Plus, you no longer waste an hour a day sitting in traffic. Some would call this paradise. It is not a far-off vision — it is modern-day Seattle.

Ten years ago, Seattle-area developer Jim Potter created micro housing, a new apartment type based on walkability. Since then, his model has been copied and refined across the U.S., and not just in downtown neighborhoods. Many projects were successful, but some were not.

Understanding how lenders safely invest in micro housing — generally defined as small studio units between ISO and ASO square feet — requires a clear understanding of modern tenant demand. Why do tenants live where they do?

Tenant demand
Modern renters have far different priorities today versus 30 years ago. Big-screen TVs, oversized couches and dining rooms are out. Connectivity, walkability and common areas are in. Americans watch an average of five hours of TV per day, but much of this content is now delivered via phone, tablet or laptop, which frees the tenant from the living room.

In a similar trend, Americans are cooking at home less each year, allowing renters to do away with much of their kitchen paraphernalia. A third trend is a delay in getting married. The median age for marriage has steadily risen since bottoming out in the 1950s and 1960s. Combining these trends forms a picture of a person sitting alone, eating food prepared by someone else and binge-watching their favorite shows, all of which can be done virtually anywhere.

This does not mean tenant demand is expanding everywhere. In fact, the opposite is true. In the book “The New Geography of Jobs,” economist Enrico Moretti says job growth is increasingly concentrated in innovation hubs like San Francisco; Seattle; San Diego; and Portland, Oregon. Every new Amazon or Google job creates several others in the area, while increasing density, and higher incomes drive average rental prices to record highs. High-income renters can afford the latest luxury high-rise, but most other renters face an affordability crisis.

Consider a hypothetical example: Joe, a 28-year-old barista living in a Seattle suburb and working downtown. He earns about $33,000 per year, the median income for a rental household, and spends half of that on housing and transportation. Joe scans the local listings on Craigslist and discovers that standard studio apartments in Seattle cost $1,200 a month or more — well above his budget. He could find a roommate, which would save some money but likely expose him to the myriad issues of living with non-relatives.

Joe also could have his own place far outside the city at a more affordable price, but part of that savings would be offset by increased fuel and maintenance costs due to the long drives, as well as the daily loss of time. Faced with this choice — to overpay, crowd in with roommates or commute from afar — what can a barista do?

Modern housing
Seattle-area developer Potter’s solution was to build very small studio apartments, or micro units, near employment centers. Each location had a high “walk score,” enabling tenants to walk to daily destinations like work, shops and entertainment.

Consequently, the vast majority of tenants do not own cars, allowing micro-apartment developers to build more units while replacing costly parking garages with bike storage and common rooms. With home cooking on the decline, units include kitchenettes. Full-size, common-area kitchens may supplement a tenant’s needs. Units also typically include a shower, toilet, sink, desk, chair and bed, minimizing move-in time and costs.

The new design proved popular with a wide variety of tenants, even some with higher incomes. With near-zero transportation costs and rent prices far below the local average, even Joe the barista can save a good portion of his earnings for weekend trips, tuition costs or a future downpayment on a house. Fueled by pent-up demand, micro apartments have sprung up across many cities, like Seattle, leasing quickly and staying full.

Before he died, Potter described the advent of micro units as the most exciting phenomenon in his lifetime. One visionary micro-unit project, designed by Robert Pantley and located in the Seattle area, was the U.S. Green Building Council award winner for outstanding multifamily project. For the residents of these innovative properties, the future is an amazing place to live.

The micro-apartment product faces many challenges as it grows and expands, from city council regulations and transportation infrastructure, to the natural learning curve of developers and lenders. Demand for the product should remain robust and might even increase during economic downturns.

Lenders and developers — and consequently, mortgage brokers who serve as intermediaries — must ask which tenant they would rather rely upon: Joe the barista, saving much of his paycheck while living and serving up lattes downtown, or Joan the department store manager, commuting from a suburban garden-style complex to her retail job.

Market dynamics
Micro apartments may well be the future of rental housing. There are plenty of pitfalls for developers and lenders, however, that commercial mortgage brokers should understand.

Having your own bathroom is necessary, as owners of single-room occupancy (SRO) hotels discovered long ago. Even more critical, from a lender-risk perspective, is what type of cooking units can be used. The wrong type of hot plate can spark a fire, which is much more dangerous in these densely-inhabited, wood-frame buildings.

Experienced property management is important, too, because common kitchens require regular cleaning, even with responsible tenants. Staffing, maintenance and other operating costs can be very different from standard apartments, complicating a lender’s underwriting task. Overall, developers and lenders must have higher standards for experience, building quality, location and property management.

Operational challenges aside, the largest impediments to the budding micro-apartment industry are cities themselves. Cities are starving for affordable housing, but they hold fast to 20th-century requirements around density and parking, which can push costs so high that developers can only afford to build luxury housing.

San Diego, for instance, ranks as one of the least-affordable rental markets in the country, but new development consists of luxury-type units in the trendy Little Italy and East Village neighborhoods. In Seattle, a surge of restrictions stifled the pipeline of planned projects and construction lending has dried up for all but the most experienced developers. Denver has experienced mixed results with transit-oriented development as some transit stations lack the requisite infrastructure to make these areas walkable.

From a lender’s perspective, the arbitrary requirements of cities raise a host of issues, from renovations and zoning compliance, to property-tax treatment and sewer-capacity charges. This exemplifies the old adage that real estate is a local business. What works in a Seattle suburb may not work in Southern California and vice versa.

Not surprisingly, many lenders shy away from micro-apartment financing. Some have worked for years to obtain agency-based financing from Fannie Mae and Freddie Mac. The agencies support these transactions, provided they meet the different, higher standards regarding project quality. A few regional banks compete in this sector but, again, with the same higher standards. For out-of-state lenders, avoidance might be the wisest approach.

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Lenders may worry that micro units are a fad, but will the centripetal forces causing urban job growth suddenly reverse, causing demand for affordable urban housing to fall out of favor? Sure, people move out when they get married and have children, but that happens across all apartment types.

Regardless of the mindset of city leaders or lenders, developers and commercial mortgage brokers should know about the burgeoning demand for small studio apartments in walkable areas. Whether you’re a part of it or not, the future of rental housing is here.


This article originally appeared in Scotsman Guide