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Roots of the Housing Crisis: Part 2


Today only 20% of US households are traditional families, 80% are a combination of individuals living alone, couples with no children, single-parents with children part-time or full-time, or households of unrelated adults. When surveyed about 73% of the people in these groups express a strong preference for walkability as a top value. But so little of the US housing stock is walkable, and land use, zoning, and building codes actively prevent walkable real estate development in many cases. So builders keep building large homes that are unattainable financially for many small households and even if they were attainable, they are the wrong fit for the preferences of households.

How does this change?

It would be easy to start with regulatory (zoning, building codes) and finance (lender programs both for construction and home ownership) changes that need to be made to facilitate this type of housing, but then we would be paralyzed as we wait for these slow institutions to adopt change. We will discuss the changes happening on the regulatory and finance front in future articles, but they are largely out of our control so there is a better place to start. The only way this changes is if developers take action despite the hurdles in the regulatory and finance arenas. How do investors take action without the ‘blessing’ of the regulators?

Enter the investor to save the day!

Investors can facilitate the initial series of prototype neighborhoods and, if the projects are successful, earn outsized returns on their capital for taking the risk of being an early mover in the emerging space. They can also lose their investment, so it cuts both ways. If you have the money, you can do almost anything. For real estate developers attempting to create a new type of housing space the way they overcome the hurdles is by having the money and since debt and financing always trail innovation, the way projects get down is with equity capital from investors.

It is common today to talk about ‘voting with our dollars’ as consumers. The idea being if we buy things that we believe in, it creates demand for those things, and the companies that make them make more of those things. What is less common is thinking about voting with our capital and our investment portfolio. What is critical to realize is that before the consumer even has a chance to ‘vote with their dollars’ an investor had to put up the capital to fund the creation of the product in the first place. If the product did not sell, they are likely to lose their investment; but if the product sold well, they are likely to earn a pretty good return.

Investing in missing middle housing is an example. In 2016 Hiatus started our first Missing Middle neighborhood development. It was a risk as there was no proven demand for small-footprint homes. These homes were about 500 square feet and arranged in clusters around common areas with no garage and parking around the perimeter of the development. The project required $1 million in equity to acquire the land, pay for the entitlements, and pay for the infrastructure development including utilities and roads. It took a year to raise the capital and find twenty investors willing to risk between $25,000 and $150,000 each on a new housing concept. We projected that these units would sell for at least $200,000 but there were no comparables in the market of this size and price point to prove it. The investors had to believe. Two years later, the first units sold for $230,000 and it started going up from there. In the end, the twenty-second unit sold for $330,000. These prices resulted in outstanding project profitability and were driven by the demand for this new type of housing.

The investors that took the risk and put up the capital to launch the project were rewarded by earning between 19% and 29% annualized IRRs depending on the timing of when they made their investment. An outstanding return by any measure!

Investors placing their capital at risk into new ideas that have promising, but not proven, demand is step 1 of the virtuous cycle. Once the demand begins to prove out more investors come to the table, cities begin to make regulatory changes, and construction and homeowner financing begins to adapt to the new and growing market. To grow beyond the prototype stage where one-off, unique Missing Middle Housing developments begin to be so prolific that they become just-another-type-of-housing-development it is going to require some major shifts in the regulatory and financing arenas. But step 1 is investors willing to invest their dollars into this type of project in the hope that the demand is truly there at a growing scale.

We will cover some of the hurdles and innovations in the regulatory and financing world in future discussions. But one final note on who these “investors” are. Investment managers often talk about investors as if they are all one flavor, but this is not even remotely the case. I break down investors into 4 strata:

1) Friends and family

2) Individual accredited investors that are connected to the industry

3) High net-worth individuals and families

4) Professional and institutional investors

Let’s break it down.

Friends and family are the first investors that place capital into a new concept. They always invest in someone they know, hence the term ‘friends and family’. In most cases, they know very little about the industry or technology they are investing in, but they believe in their nephew, niece, son, daughter, cousin, friend, or former colleague. These investments are made based strictly on relationships and are made in trusted closed groups. This is how Hiatus funded the equity on the Hiatus Benham project for example. Most of the investors were family, friends, or friends of friends of Hiatus Founder Jesse Russell.

After one or two prototypes have shown some promise or early success. Entrepreneurs begin to attract individual accredited investors. These early investors have some net worth and some experience in investing, by definition an accredited investor typically has at least $1 million of net worth outside their primary residence. But they are not the ultra-wealthy or institutional investors. Different than the friends and family group, the early accredited investors typically ARE connected to the idea or concept. For example, Hiatus attracted several of our vendors as early investors including subcontractors, architects, engineers, real estate agents, and others connected to the trends in real estate that, when presented with the opportunity to participate in a new type of housing believed that it would certainly pan out. These investors often invest in the sectors that they work in or know and thereby have a competitive advantage of being able to asses opportunities.

The next group is the high-net-worth individuals and families. These investors look at the track record (hopefully) generated by the capital deployed by the first two investor types and seek to make similar returns but at a lower risk profile because the prototype is now proven to a degree. They don’t have to go through committees and are investing their own money, but the check sizes are usually larger. Instead of $25,000 - $100,000 checks, these groups make investments in the hundreds of thousands or millions.

Lastly, a company or idea attracts professional investors and institutional investors. These groups are making huge amounts of capital but it is not their own and so their risk tolerance is much lower and they go through committees and engage in thorough due diligence. Ultimately this is where large amounts of capital exist to scale up truly big ideas.


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