The Math of “Missing Middle” Upzoning
It adds up to Gentrification
By Andrew Dobbs
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There are few facts as valuable for understanding housing markets and gentrification as knowing how to value commercial real estate. It’s a fact that takes you a long way towards understanding why the terms of the present housing debates in many US cities are so completely fucked up and why a massive investment in public housing is our only healthy way out of the present conundrum.
Specifically, it shows why an obsession with heedless rezoning residential neighborhoods for so-called “Missing Middle” housing poses a real risk of making a bad situation even worse.
The whole thing really is very simple: commercial real estate is valuable because it makes the people that own it money. This money comes from the rent paid by tenants, and this determines the value of the property. The more rent they can get, the more money they make, and the more valuable the property.
There are essentially two ways of going from this scenario to a final value — one called direct capitalization, the other called discounted cash flow. These are technical terms but they are actually very easy to understand. Direct capitalization is the easiest to lay out: you take the income generated by the property — the rent you can collect — and subtract all the costs of running the place to identify the property’s net operating income. This income divided by the total value of the property is known as the capitalization (or just “cap”) rate for that property.
But we don’t know the value of the property — that’s the whole question we are answering here. Thing is, cap rates are not set at random, they are set by the market at large and closely related to US Treasury bond yields. Once you know the typical cap rate in a market you can use that information and the rent you know you are collecting to figure out the value of the property.
Here’s an example of what we mean, one that actually shows how upzoning single-family properties for small apartment buildings, duplexes, “granny flats” (or Auxillary Dwelling Units — ADUs), and other properties referred to by the consultant trademark “Missing Middle” housing can actually promote gentrification and displacement.
Pretend that we have a house in the Pecan Springs/Springdale neighborhood of East Austin, an area that is one of the more affordable remaining areas of town, if still gentrifying. Taking the average sales price there and the average size of a starter home in Austin, an “entry level” house in this neighborhood would be valued at $344,148. Homeowners value their property differently because they aren’t buying their home as an income source.
Now let’s say that we rezone this house to allow for some of this “Missing Middle” housing and it becomes eligible to be redeveloped into apartments. Let’s say that between the main house and an ADU in the back we get 3 units out of the thing, and that each unit rents for Austin’s current average one-bedroom rent of $1,244 a month.
So how does this affect the value of the house we just upzoned? Well, three apartments at that rent times twelve months and cut in half to take out operating expenses (the nation-wide historic average is actually only about 45%), gives us an annual net operating income of $22,392. Austin’s local cap rate is about 5.5%, and dividing that into the net income for these apartments gives us a final valuation of $407,127. Just by taking an average starter home, at an average value in an especially affordable neighborhood and rezoning it for apartments we’ve increased its value more than 18%.
The family in the home now will see such a value increase whether they actually build the apartments or not, and at Austin’s 2017 all-in property tax rate of 2.213985% the annual tax increase associated with this one zoning action is $1,394.35, or $116.20 a month. For a working income family such an increase just may not be possible to foot, and while yes we have provided housing for three new households, what we’ve likely done is displace a family in order to make way for three one-bedroom dwellers. We’ve displaced traditional residents, changed the character of the neighborhood, and traded out middle income families for young professionals. In short, we’ve gentrified the neighborhood.
This is why canards like allowing “all forms of neighborhood scale housing in all neighborhoods” sound great in principle, but in practice will destroy what remains of many communities of color and working class neighborhoods in Austin. To the extent CodeNEXT allows such developments, it will be responsible for displacing Austin families, especially the thousands of people living in rental houses. These folks won’t just have to pay the $116 a month in extra taxes — which would be enough to displace many of them — but rather the full potential rent increase on the property as a whole.
How many households can handle an 18%+ increase in rent? For an average rental unit in Austin — which is likely cheaper than a full rental house — this amounts to $254 a month. Maybe the landlord will be nice and leave money on the table to not force their tenants out, but nobody ever got rich betting on landlords being cool. Upzoning single-family neighborhoods for so-called “Missing Middle” housing benefits them and screws their working class tenants.
It is at this point that supply-siders point out that this very displacement will lead to an increase in vacancy and therefore drop rents and values altogether. Such a glut is unlikely to happen, however, because of the OTHER means of valuing commercial property, the discounted cash flow model. Discounted cash flow is more complex than direct capitalization, but the basic process involves predicting a rate of rent growth and a discount rate that takes the cost of maintaining the investment into account. It then uses these figures to arrive at a present valuation.
Among the most important factors in determining this discount rate: predicted vacancies. This means that any sudden, unaccounted for increase in vacancies can wreck past calculations and strip properties of their value. This costs investors big money and if the property is leveraged it may now be under water. The lenders and capitalists facing these risks are the ones that finance new commercial properties, and any project that is likely to create such a problem for their past investments by driving up vacancies won’t find any cash to get off the ground.
Bottom line: extending entitlements to property owners and developers won’t create that much more supply; it will simply add value to their assets on the one hand while increasing their flexibility on the other. Families get screwed and the landlords make out like bandits.
Now despite my scare quotes and passive aggressive capitalization of “Missing Middle” housing, a strategy for building those extra units and getting the vacancy rate high enough to stick it to landlords would no doubt benefit renters. The one thing we know, however, is that as long as this is being attempted on a commercial basis it is guaranteed to benefit the owning class — and we don’t mean middle class homeowners here. Hoping that the market will solve this problem is depending on the culprits to turn themselves in — it just won’t happen.
Taxing authorities, the landlord class, the most powerful developers, or even a lot of well-to-do homeowners all benefit from people being in the dark about how housing is really built, bought, and sold. That means that knowing a little bit more can make a big difference in holding them accountable. In the end correct-sounding neoliberal talking points are no match for a little simple math, so here’s hoping the folks making the final votes don’t just make speeches, let’s hope they do just a little algebra too.