Why Microapartments Are Expensive
There has been a lot of debate about NYC’s first microapartment project, which opened earlier this summer in Murray Hill. The cost of these units — which is roughly on par with full-sized studio apartments in the neighborhood — has generated a mix of confusion, disgust, and concern.
It’s logical to think that if you’re getting less space, you should pay less money. Unlike coliving, microapartments don’t have access to nicer shared spaces than residents would be able to afford otherwise — they’re just smaller. So naturally, many people are confused when microapartments cost the same as a studio apartment down the street. Microunits in Carmel Place run from $2,570 (for 265 square feet) to $2,920 (for 360 square feet), while a studio in the neighborhood averages $2,400 according to StreetEasy.
So why are microapartments so expensive?
One, construction costs don’t scale down linearly as the residential unit shrinks. A kitchen the most expensive part of an apartment to build, and each microapartment is legally required to have its own private kitchen. Same story with the bathroom. The space that you lose by going from a studio to a microapartment — open in-unit space that people use for seating and storage — is the cheapest to build.
Also, many microapartments come furnished, including most of the Carmel Place units. The specific furniture needed to make microapartments “work” can be difficult to find and arrange, so most developers supply it. Whatever savings earned by shrinking the unit are easily lost with custom furniture — Murphy beds aren’t cheap.
The second and biggest reason is the cost of debt. Understanding why this matters requires knowing a bit about how real estate developers make money.
Developers live and die by the cost of their debt financing. Without a construction loan, a project won’t get off the ground. But just as important is access to “permanent” capital — a long-term loan against the income generated by a finished building. The higher the interest rate charged by the lender, the costlier the debt financing to the developer. The costlier the debt financing, the more income — rent — the property will need to generate to cover the debt and provide investors with a return.
So what can change the interest rate developers are forced to pay? Perceived risk will increase the cost of debt capital. Traditional apartment buildings are generally seen as a very low-risk asset class, so almost any deviation from the standard layout and business plan will increase the perceived risk and therefore the interest rate that banks will charge.
Microapartments are certainly a deviation from the “standard” apartment layout. Keep in mind that most loan officers are middle-aged men who live in the suburbs, not the audience targeted by microapartments. So the “I don’t want to live in this, so I don’t see why anyone else would” effect has a real impact on the loan terms and therefore the income a building must generate to perform at least as well as traditional apartments.
Given that most residential projects operate at 60–80% leverage once permanent capital is in place, the impact on even a small increase in interest rates can be huge. For instance, a banker may assess a 50 basis point “risk premium” on a microapartment project. If a typical residential project can secure financing at 2.75%, this means that a micro project will be financed at 3.25% annual interest rate.
This increase has a massive impact: the microapartment project needs to generate almost 20% more rent in order to perform at least as well as a traditional building. If a microapartment is only 30% smaller than a typical studio — say 315 square feet rather than 450 — it’s easy to see how the cost of the developer’s debt alone could erase almost all cost savings.
Debt financing is a local business, and the higher cost of debt capital can come down as microapartments become more accepted in any given market. For instance, Seattle and Washington DC both have robust development and financing ecosystems for small units — although Seattle’s city government has done its best to quash theirs.
But for the moment — at least in cities where micros are a relatively new phenomenon like New York — construction costs and the risk premium on debt capital combine to make microapartments a pricey option for consumers.