The Net Net
- LA is suffering from a major housing shortage.
- New regulation aimed at increasing the allowable density of new home development has the potential to help combat this problem.
- Fundrise has become a leading investor in this space with an aim to both address the housing crisis and generate strong returns for investors.
A Crisis of Monumental Proportions
Across the country, major urban areas are facing a housing crisis of monumental proportions, driven by a growing preference to live in major cities, increased population density, and lagging supply. There are few markets in the country where the housing affordability crisis is as acute as in California.
According to a report by the McKinsey Global Institute (MGI), California suffers from a $50-60B annual housing affordability gap, with housing price growth outstripping median income growth threefold over the past seven years. This has resulted in dire consequences for the state. According to MGI, the state loses $140B per year in GDP due to its severe housing shortage.
Meanwhile, the problem is particularly severe in Los Angeles. Trulia finds that buyers in Los Angeles would need to spend nearly 92% of their income to purchase the median starter home. Among major US cities, only San Francisco ranks worse on this affordability metric.
No wonder more than 40% of Millennials in LA are still living with their parents.
No Reprieve in the City of Angels
Meanwhile, the crisis is likely to worsen in the coming years. We have found that major cities across the country are expected to face a combined shortfall of more than 3.6 million starter homes within the next year—sufficient to meet less than 6% of projected demand. Using raw data from Trulia and the U.S. Census Bureau 2016 American Community Survey (ACS), we estimate that Los Angeles’ situation is even worse, with starter home inventory positioned to satisfy only around 3% of projected demand over the next year.1
The problem stems from two elemental factors: supply and demand. In Los Angeles, prospective homebuilders are stymied by regulations ranging from state-level laws such as CEQA (the California Environmental Quality Assurance Act) and municipal zoning codes that have rendered building homes so time-consuming, uncertain, and costly that the risk-return frequently fails to pencil out. According to ACS data, from 2010-15 LA’s population grew twice as fast as its housing stock. Forbes reports that LA has added less than one new housing unit per 7 new residents since 2010.
Meanwhile, the city is facing an avalanche of new demand. As The Wall Street Journal reports, the nation’s homeownership rate rose last year for the first time in over a decade, thanks largely to older Millennials. Fundrise’s proprietary survey revealed that nearly two-thirds of Millennials want to buy a home in the next 5 years, and nearly one-quarter are looking to purchase within one year. The survey results are in line with CoreLogic projections that housing demand will reach a peak in 2023.
Finding Creative Solutions, and Generating Robust Investment Returns
All that said, the situation is not hopeless, and the city is taking important strides to tackle its housing affordability issues. For instance, in 2005 the City Planning Commission passed legislation enabling builders to construct high-density single-family home developments on parcels that are not developed to their highest and best use – the Small Lot Ordinance.
The Small Lot Ordinance allows developers to bypass typical lot size requirements and thereby construct high-density housing on parcels that would otherwise remain underutilized. The idea is that if you can take a lot on which a single home has been built, demolish it, and build several smaller but efficiently designed homes in its stead, you can boost residential density in neighborhoods that are starved for it, and thereby improve affordability.
There’s a reason one blog even calls this law the “sexiest city ordinance.” Not only is it helping bring desperately needed residential density to a market hungry for supply, it’s also creating intriguing opportunities for investors looking to meet demand from an extremely underserved segment of the market – first time homebuyers.
Why Small Lots Can Mean Big Returns
Fundrise anticipates robust demand for small lot homes in Los Angeles, and expects that this demand will not only help ease the city’s housing crisis, but also translate into sizable returns for investors. Our expectations of strong demand are predicated on several factors:
- Small lot homes appeal to a segment of LA’s housing market that is starved for new supply. In addition, small lot homes are generally priced to sell below the median price of existing homes in the neighborhood, while still achieving a strong return.
- These detached homes bear less risk of competition from condos due to relatively low fees and more favorable financing requirements. Moreover, they are also more desirable to build from a developer’s perspective due to the reduced risk of litigation.
- Many small lot home developments are strategically located on infill lots in burgeoning neighborhoods popular among Millennials. They also feature efficient and modern layouts designed to appeal to Millennial aesthetic sensibilities.
Limited Risk of Competition
There are several factors that make detached small lot homes inherently more attractive to prospective first-time buyers than condos. For one, condo fees in LA typically run over $400/month, compared with $60-80 for small lot homes, according to the Urban Land Institute (ULI). For another, townhomes share no common walls or foundations, and thus offer buyers greater privacy, and freedom from shared decision making. Small lot homes may also be easier to purchase, since fee-simple homes typically enjoy more favorable financing and credit requirements than condos.
Another benefit of small lot homes over condos from a developer’s perspective stems from their relatively low risk of engendering lawsuits. In LA, lawsuits pertaining to construction defects have driven up the costs of condo insurance to levels that have rendered many condo projects non-financeable. By contrast, small lot homes offer a way to capitalize on the provision of housing for a high-demand segment of an underserved market, with comparatively low risk of litigation and concomitant insurance premiums.
Strategic Location & Aesthetics
Small lot homes are typically designed and built using innovative architecture and construction techniques designed to maximize space and privacy. Modative – a Fundrise partner and architect of nearly 100 small lot projects since 2006 – is known for crafting streamlined, modern designs that make these relatively compact homes feel spacious. As the firm’s cofounder Christian Navar told The Los Angeles Times, small lot homes are akin to “the iPhone or Prius of homes.”
Moreover, most of the small lot projects we invest in are strategically located in hip, up-and-coming urban neighborhoods, such as Silver Lake, which previously topped Forbes’ rankings of America’s Best Hipster Neighborhoods. According to a developer who spoke with ULI, small-lot homes “will appeal to a discerning market of 25-to-50-year-old urban professionals [..] who seek a more urbane lifestyle in a walkable neighborhood close to cafes, restaurants, and […] other services.”
The Fundrise Case Study
Across our various eREIT and eFunds, Fundrise has committed over $50M for the development of more than 280 small lot homes in Los Angeles, rendering us among the most prolific developers of these homes in the country. As we seek to leverage our granular knowledge of the LA market to create opportunities for our investors to earn outsized profits, we have focused specifically on investing in assets with a cost basis well below typical sales for comparable properties. We anticipate that this strategy will minimize our downside risk while preserving significant upside potential for our investors, and also enable us to breathe fresh air into a market where reasonably priced entry-level homes are few and far between.
Our intent is to bring homes to market at a price point well in excess of our acquisition and construction costs, but still below the median price for existing inventory in the surrounding neighborhoods. We believe such a strategy should limit our competition and potentially reduce marketing costs and time to sale, while still offering respite for area residents. As an example, we recently purchased a 1,850 SF home in the Los Feliz neighborhood of Los Angeles. We intend to complete a small lot entitlement process that would enable us (or another developer) to replace the existing older home with five new ones. Our thesis is that by leveraging our operational advantage in procuring entitlements through the Small Lot Ordinance, we can dramatically increase the value of the site by boosting its allowable density by 5x.
Once entitlements have been procured, we then have two options – we can sell the lots to a developer, or construct the small lot homes ourselves. We believe that should we choose the former option, we could achieve a sellout price more than 25% above our anticipated all-in costs. This should enable us to earn a healthy profit for our investors of around 17%, although there can be no guarantee that we will be able to achieve such returns. Alternatively, using construction estimates of similar projects we are invested in or have reviewed, we believe we could build the homes ourselves and bring them to market at a price well below that of existing inventory, creating a measure of safety in the investment, while also helping to supply more affordably priced homes to an underserved market.
To further illustrate this strategy, we compare the cost basis for a sampling of our small lot investments with the anticipated sale price per entitled lot/appraised value per lot at stabilization, and the median price for existing single-family homes in each neighborhood (per Zillow):
Given the dearth of entry-level supply in LA and particularly in the neighborhoods we are targeting, we expect robust demand for assets in this segment, which should support our pro forma return projections. At the same time, these homes should offer some much needed reprieve for households looking to purchase in these neighborhoods but grappling with a lack of reasonably priced options.
Celebrating the Small (Lot) Wins
While new SLO developments may not solve California’s housing affordability problem entirely, or single-handedly deliver the death knell to the seemingly intractable regulatory encumbrances at its root, they can still make a significant dent. Adding density to underutilized parcels through the construction of starter homes that young families can actually afford is helping to chip away at the problem. It may not be the whole solution, but it’s shifting the needle. Moreover, creating opportunities for first-time buyers – even those at the higher end of the income spectrum – to purchase takes pressure off of the Class A rental market, which in turn takes pressure off of Class B rentals, and so on. And the more affordable the rents in those segments, the sooner those renters may be able to purchase themselves.
Here at Fundrise, we’re drawn to investment strategies that address broader social and economic challenges while also maximizing risk-adjusted returns for our investors. By investing in the development of small lot homes, we believe we’ve found another opportunity to support an important cause, while helping our investors potentially generate better, more stable returns.