The future of (development) finance

An unmet need, and an opportunity to meet it

I believe we’re near the tipping point of a new, post-suburban development pattern emerging due to changes in transportation, land use, and finance. In the past two essays I explained how transportation and land use are evolving, and why it matters. Today we’ll take a look at finance.

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I’ll start today with a disclaimer. The previous two essays (1, 2) were mostly summaries of major innovations that are already real, or big changes that are unfolding as we speak. This essay is more of a question; as the rest of the world around real estate development shifts, how will finance change?

Specifically, I ended the last post with a prediction that there’s going to be a generational opportunity for incremental development to address our housing shortage. But there’s a dilemma: this kind of stuff is harder to finance, and without financing it isn’t going to scale up.

So how do development projects get funded today, and what other options are there?

How development projects get financed

Every development project is different, but most of them flow through a similar lifecycle. There are two main categories:

• Residential (Development for sale, ie, build a house and sell it)

• Commercial (Development for income, ie, build an office building and then lease it out to businesses).

Note that “residential” buildings like apartments that are more than 5 units are generally considered “commercial” property, because they’re built and operated primarily for the rental income they generate.

Normally the developer starts a project by buying a site and doing all the pre-work to get building permits -- a long a painful journey we might explore another time.

Once a developer has a site and permission to do something with it, they need to bring in the rest of the money to build. The most common source of funds is a construction loan, and the most common construction lender is a community bank.

Why community banks? I asked Seth Zeren (a developer), and here’s what he said:

The reason we use smaller banks is they tend to have lending officers who know us, who know our neighborhood, they aren’t just looking at a spreadsheet, they’ll come on a tour with us. That’s helpful when you’re doing something a little weird — which is most commercial development.

When things get rough there’s someone you can call, you’re not in the call center line at Bank of America. And they’re less likely to crush you when things go wrong.

Construction loans are short-term, require high loan-to-value ratios, and carry a higher interest rate, because they’re financing something risky: a building that doesn’t exist yet. Things can and do go wrong during construction.

A bank’s willingness to take on these loans is driven by several factors, including:

• How risky is the project? It’s less risky when the development team has done similar projects before, and when lots of similar projects exist nearby.

• How easy will it be to exit the loan? Ie. at the end of the project the property will be sold (and the loan paid off), or the project will be refinanced (via a long-term loan). How hard will that be?

Given these concerns, it’s not hard to see why banks prefer “cookie-cutter” projects. It’s a lot less risky to build ordinary things that there are a lot of. There are a lot of people around who know how to do these projects, and if things go wrong with the project it’s more likely that a third party could be brought in to take over. For residential, this shows there’s a market to sell into. For commercial, a large number of existing “comparables” will make it easier to get long-term financing.

By contrast, smaller scale, bespoke projects without many comparables; or, especially, new developers without a track record... those are a hard sell.

But there’s one even bigger factor that looms over the entire community banking sector: how much room does the bank have on its balance sheet? If the bank has large reserves and plenty of deposits they need to invest, they’re more willing to take risk. But if banks don’t have the deposits then it doesn’t matter how much they’d like to fund a project, they simply can’t.

This is a problem today. Quoting Zeren again, “The local guys have gotten super tight trying to maintain deposit balance. I don’t know what’s really going on but they are all jammed, they have no capacity to make loans even if they’d like to.”

And I think may become an even bigger problem in the future.

Headwinds on community banks

The US is an outlier in the number of banks we have compared to peer countries, but the number of banks is in secular decline, and has been since the Great Depression. The decline is largely the result of consolidation, as small “community” banks merge or are bought by larger competitors. For a number of reasons, I think this decline will continue and may even accelerate.

First we have the unintuitive dynamic of interest rate pressure. We know that banks make money off interest, so when interest rates are higher, it seems like banks could make more money. But in practice what matters for the bank is not so much the current interest rate, but the difference between the current rate and the past rate. The decade of ZIRP was challenging for banks, but what’s even harder is having ten-years worth of very low interest loans on the banks books when interest rates have finally come back up to historic norms. Customers now expect more interest on their deposits than banks are earning on many of their loans, and banks have to survive until those loans can be rolled over and the funds lent again at higher rates.

Making matters worse, depositors have proven to be more fickle than banks have historically assumed. In 1990, having a specific local banker who you could easily stop in to talk with, or call and reach directly by phone, mattered a lot. This convenience and relationship was one of the biggest selling points for regular people to use a local community bank. But in 2024, being able to handle all your money from your phone 24/7 is even more convenient for most people, so the industry has seen a substantial movement of deposits out of community banks and into fintech platforms that offer the nicest apps and highest yields, as well as the largest (GSIB) banks.

Community bankers are hard working, innovating, and adaptable, and I am sure that many of them will figure out ways to provide new and valuable services that retain depositors and keep their business healthy. But the headwinds are strong.

I’m not confident that community banks will have the deposits or lending appetite to serve as the primary funding source for a new generation of development projects. So if we want to scale up infill and incremental development, we’re going to need a new ecosystem of funding sources.

What might that look like?

Alternatives to community banks

The ability to pool money for investment is highly regulated. Oversimplifying a bit, we can think of the two extremes as creating a limited partnership as the easiest but least liquid way to do this, and creating a bank as the hardest but most liquid way to do it. There’s a large space in between that’s easiest to think of as variations on crowdfunding.

Investor-Focused

The original, most established way to do this is via a REIT, or Real Estate Investment Trust. A REIT is a company that owns, operates, or finances income-generating real estate. REITs allow individual investors to earn dividends from real estate investments without having to buy, manage, or finance properties themselves. They’re required to distribute at least 90% of their taxable income to shareholders annually in the form of dividends. Shares of REITs are often listed on public stock exchanges, which make them highly liquid.

Traditional REITs are highly focused on investors, people who are buying and selling stocks generally, and looking to have some exposure to real estate within their investment portfolio. The largest REITs tend to focus on single, specific, conventional product types (things like “Apartments” or “Data Centers”), and then invest in that product nationally.

Smaller, specialty REITs exist that focus on more niche investment types or locales. There are a lot of these, you can browse the Nareit directory to get a sense of all the sizes and flavors.

But one thing these investor-focused REITs have in common: they prefer economies of scale. Once they’ve done the work to raise a large pool of capital, it’s less work for them to invest in a smaller number of large projects, than to invest in a large number of the smaller scale projects that community banks would typically finance.

Consumer-focused

Since 2010 a new wave of consumer-focused REITs have emerged for individuals who like the idea of investing in real estate, but want something in between joining a single developer’s fund and buying generic REIT shares on the stock exchange. The original pioneer of this model is Fundrise, and a number of similar offerings have followed (1,2,3).

These platforms are generally leveraging technology to make it feasible for consumers to participate (with very low investment minimums), and to match people to specific buildings (because the consumers are looking for that concrete understanding of what they’re investing in).

Product-focused

The next generation of funding may be product-focused platforms. I connected with Alexander Billy, who is starting a company called MidFill¹ to specifically target Missing Middle housing (they define missing middle as residential buildings with between two and 50 units, including ADUs, duplexes, larger multiplexes, and small apartment buildings).

“We realized that even though missing middle zoning reforms are starting to take hold across the country, there are still significant barriers to financing medium-density housing,” Billy said. “There are already thousands of developers in the U.S. trying to do this kind of work, but many spend half of their time wrangling financing. Good deals are out there. Investors just need a way to find them.”

MidFill seeks to solve this by building a platform that brings together developers and specific projects seeking funding, with a network of real estate investors who are seeking opportunities to invest in this new generation of infill development.

Note: Billy and his team are very early in this endeavor, he offered his email for anyone interested in connecting and engaging more.

Building on the previous two posts, I think “missing middle” development is going to be a substantial portion of what gets built in the next generation or two. The unmet demand for financing emerging categories of development represents an real opportunity, and while I think it’s still early, I wouldn’t be surprised to see a number of companies like MidFill emerge to try and meet the need.

Neighborhood-focused?

Closing out the variations on crowdfunding, I think there may be potential for another variation, specifically small, consumer-friendly investment platforms like Fundrise focused on investing in specific neighborhoods. When Seth and I were talking he suggested there might be demand for something to fill the role that community banks have traditionally filled (local investment), but without actually being a bank. The local bank model, borrowing short to lend long, is fundamentally risky. But if, instead of offering demand deposits, a fund issued shares (like a REIT), then it could better manage term risk. There could be a lot of people excited to invest in the total economic activity of a particular town or neighborhood, instead of a particular product category.

Afterwards Seth pointed me to one pioneer, Local Return. Local Return is starting with a $3.5M fund to invest in local communities in the state. Their focus will be “locally-owned, community-driven real estate projects and small businesses,” targeting “neighborhoods that have been historically excluded from traditional financial investment.”

Government-led

While I think we’ll need the private sector to provide the bulk of development funding, there are also options for cities that want to help get the flywheel spinning. A few pioneering communities have already taken first steps. In Escaping the Housing Trap, Chuck Marohn identifies a few promising strategies for cities to help get small projects off the ground:

• Infill TIF: Cities can use Tax Increment Financing to make small loans for infill projects. Muskegon, MI has pioneered this technique to fund housing projects on vacant lots.

• Special assessments: In many states, cities have the power to issue debt that is repaid by special assessments -- a fee added to the property taxes of nearby properties. This mechanism could be used to fund backyard cottages or accessory apartment conversions at no risk to the city, since property taxes have higher precedence than even a mortgage lien.

• Co-signing loans: When community banks are interested in a project, but the developer doesn’t have a long enough track record, or there aren’t enough comparables for underwriting, cities could step in as co-signers on the construction loan. While there’s some risk to the city, there’s also upside: successful projects costs the city nothing and result in added value on the local tax role. Cities could start with a small budget for insurance, and the proceeds of early projects could be used to cover the foreclosure risk of subsequent projects.

Conclusion

New forms of transportation are already here, and land-use regulation is quickly evolving around us, but to capitalize on the opportunity this represents we’ll have to figure out easier financing. We have some hints as to what might work, and some ideas to try, but I think this space is still largely open for discovery. Until we figure this out, most infill projects will be more expensive than conventional suburban development, and these new product types will be slow to scale up.

But I’m optimistic. Finance doesn’t require any new technology or fundamentally discoveries, nor is it so constrained by regulation that change is impractical. And historically, the finance sector has been extremely responsive to demand, so I think we’ll work this out.

1. Alexander Billy and the MidFill team gave me a lot more detail on their plans than I could fit into this specific article, so I’m considering writing a deeper dive on the MidFill concept in the future. If that’s the kind of content you’d like to see, let me know in the comments. And thank you, Alexander, for sharing so generously!