Why is the Middle Missing (A Housing Mystery)?

Seeking an Alternative

As the residents of District 19 grapple with building permit applications for multifamily apartment buildings, opponents of those projects, (most notably the Stone House Development proposal for 6610-6706 Old Sauk Rd), often propose a less dense development similar to the many two- and four-unit condominium developments in the area built in the 1980’s through early 2000’s. This is an excellent and appropriate question. Madison’s city government sees the low production of this category of housing as an urgent problem. Two- and four-unit buildings and townhomes and even some larger condominium developments are an historical first step to home ownership. After nearly two decades without significant new construction of this category of housing across the US, the absence is mourned and is now often referred to as “the missing middle”.

I serve on a subcommittee of the Housing Strategy Committee which has been tasked with seeking out tools that Madison might employ to encourage more development of “missing middle” housing. To that end the subcommittee has taken testimony from Madison builders, developers, architects, and financial institutions, and reviewed numerous studies of the problem. The subcommittee concluded that the obstacles are formidable and almost completely beyond Madison’s ability to incentivize. The subcommittee is now searching for creative tools and ideas for chipping away at those few obstacles within the City’s control. While Madison is focusing on how to incentivize “missing middle” housing that would comprise that affordable first-step to home ownership, the findings of the subcommittee apply for the most part to the entire range of home prices. In the balance of this blog, I’ll try to describe the obstacles and even offer a rather radical suggestion to residents who would prefer missing middle owned housing to larger rental projects.

Legacy of the Great Recession

The primary spark for the Great Recession of 2007 to 2009 was a near mindless explosion of real estate debt, which, when the poor quality of the collateral became apparent, led to an equally sudden implosion of the financial institutions that had provided the funding. The Federal Reserve stepped forward to take radical actions to avoid the evaporation of credit and the money supply that prompted the Great Depression of the 1930’s. While not well known, the construction industry, especially in the Midwest, actually suffered an even greater contraction than during the Great Depression. Congress and the regulatory agencies for banking and mortgage finance (FDIC, FNMA, FHLMC, FHA, VA) responded with new regulations and vastly more intensive inspections of bank assets.

Regulators noted that construction lending to developers of condos and other forms of “missing middle” housing were a particular source of bad loans. Regulators required a virtual halt to any construction lending for such projects. I remember bankers telling me at the time that at least one regulator was in their office every day telling loan officers what they could and couldn’t approve. FNMA and FHLMC, the principal underwriters of mortgages, dramatically increased the number of condo units that had to be presold before they would approve any mortgages in a project. This regulatory noose around construction lending has only relaxed slightly in the intervening 1-1/2 decades.

Construction and mortgage lending are necessary oxygen for residential development. An essential lubricant is the construction period and related insurance, including liability insurance for related architectural and engineering services. Another dramatic casualty of the Great Recession was AIG, the insurance giant, which had underwritten a huge portion of development period coverage. AIG abandoned such coverage entirely. Other insurance giants did not rush in, noting that another result of the Great Recession was an acceleration of the trend of condo associations suing every entity involved in the development and condo residents suing their association. Court decisions that allowed condo associations to bring suit against the developer and other parties many years after construction, exploded premiums, and caused more insurers to leave the market. Again, this continues. For me, it’s personal. I consult nationally on various aspects of construction technology, and my insurer will not permit me to consult on condo projects. I’m sure if I sought special coverage for a condo project, the sky-high premium would essentially rule out my participation.

In 2022, condominium development in Madison was 1/7 of the 2007 volume.

The Inflation of all Components

Disruption of long-standing supply-chain arrangements by US tariff policy, further damaged by the supply-chain impact of the COVID-19 pandemic and subsequent monetary and fiscal policy reactions resulted is hyperinflation of building materials, which has only partially receded. The long-expected retirement of “Boomers”, who comprised an over-sized proportion of the construction trades, followed by the pandemic-related exit of construction workers, and an apparent growing aversion of younger cohorts to construction jobs have combined to create a labor shortage and inflation in construction wages.

Separate from material and labor inflation is the trend toward enhancing building codes to increase safety and especially to improve energy efficiency and less reliance on fossil fuels. The impact of greater economies-of-scale with increased use of sustainable materials has helped reduce the costs of sustainable buildings, but the overall effect is still an increase in up-front costs, fortunately often offset by long-term energy savings.

In summary, it costs much more to build any kind of housing today compared to a decade or two ago, and particularly more expensive to build missing middle housing.

Obstacles Peculiar to Wisconsin and Madison 

Wisconsin is the only remaining state that has not adopted some version of the International Residential Code. Wisconsin did finally adopt a version of the International Building Code for commercial and larger multi-family structures, but it has clung to its Uniform Dwelling Code for one-and-two-family residences. Moreover, the International Residential Code covers one-and-two-family residences and townhouses, a favorite for of condominium development. Interpretations of Wisconsin’s residential code push townhouses into the commercial code and its tougher requirements for all kinds of costly features including sprinkler systems.

Wisconsin also has a relatively tough statute for the creation of condominiums, adding time and investment to generating an acceptable document set.

Madison’s permit approval process is infamous as a gauntlet that adds multiple layers of risk for the developer and frequent redesigns, at least compared to other cities and states. Multiple staff departments and various committees, boards, and commissions evaluate every aspect of a building proposal. This includes the intense civil engineering exercise of meeting Madison’s stormwater ordinance that was toughened after the 2018 flood event. Then there is the frequent uprising of concerned residents that any kind of development in their neighborhood should be avoided as negatively impacting the character of the neighborhood. Famously, developers and contractors who work in multiple Dane County municipalities say they add 15% to 30% to their bids for projects to compensate for the extra difficulty and risk of doing business in Madison.  That may not be exactly true, but it is probably partially true, despite some concerted efforts by the City to streamline the permitting process.

Bottom Line

A developer of apartment buildings which plans to hold the project in its portfolio, can amortize the high costs over 30 or 40 years. A developer of for-sale (ownership) housing needs to charge enough to generate a profit immediately. The bottom line of the testimony taken by the Housing Strategy subcommittee on owned housing is that the risks are too high and the assurance of a reasonable return on the effort too low to attract developers and contractors to missing middle housing. It’s just too hard.

The Housing Strategy Committee will probably make some recommendations on a few things the City might do to incentivize missing middle housing at the affordable end of the scale, such as pre-approved repetitive plans. Its suggestions will take time to evaluate and implement, and may or may not be effective.

What Happens if a Rental Development is Thwarted?

The eruptions of objections to multi-family rental projects in historically low-density single-family neighborhoods is not new, but appears to be more frequent and more boisterous, garnering news coverage. The forces pushing for more housing and more density are enormous, much broader than just a small group within the Planning Department. Advocates note that it isn’t just a matter of boosting supply to meet demand and provide affordable housing, it’s also a matter of reducing urban sprawl and reducing the carbon footprint of housing development. It’s easy to conclude from social media posts that advocates of greater density are at least as energized and boisterous as the opponents.

What would happen, if an energetic citizens’ effort persuaded a developer of a large multi-family project to withdraw its application? We can only speculate.

Based on our Housing Strategy study, one of the least likely results would be a developer stepping forward to propose a “missing middle” project. Even less likely in this moment of municipal austerity would be Madison’s acquisition of the property as a park, given the costs of development and ongoing maintenance. Perhaps more likely is the possibility that mounting pressure for development would encourage a developer to come forward for an even larger project with even less responsiveness to neighborhood desires.

The Linden Experience

There is an exception to this grim prognosis for the missing middle. Linden Cohousing was successfully completed just a few years ago on Madison’s East Side. Located at 107 Linden Court, it contains 45 one-to-three-bedroom units in a particular form of condominium in which the owners not only share common ownerships of the building’s basic structure and exterior amenities, but also some interior common amenities such as kitchen and dining. The project faced all of the other obstacles of missing middle projects, especially condominiums. Yet, it’s complete and successful. Madison’s Housing Strategy Committee wanted to understand the source of that success. The solution was “de-risking”.

De-risking is a process in which some parties in a project (or even an outside but interested party) find ways to reduce the risk for the other necessary parties to the project, thus eliminating the obstacles to moving forward. In the case of Linden Cohousing, most of the ultimate purchasers were motivated to live in a cohousing environment and effectively guaranteed the purchase of the units. That eliminated the risk of the construction lender and the mortgage providers, and provided assurance to the developing contractor that the project would be completed.

A Radical Thought Experiment

Could a group of neighbors concerned about a large multifamily rental project proposed for their neighborhood (such as the project proposed for Old Sauk Road) effectively substitute a lower density missing middle project using de-risking? From the perspective of my personal experience in housing and development over decades I would say it’s at least theoretically possible. It would take a heavy dose of courage by the neighbors and perhaps an excessive level of financial foolhardiness. I think it would look something like this:

1. The neighbors would form a corporation, each diverting some of their current investments or even mortgaging their homes to raise a substantial fund.
2. Their corporation would make a competitive offer to the current property owner, taking it off the market.
3. The corporation would engage architects and engineers knowledgeable of Madison’s codes and zoning to design a project that was acceptable to the neighbors.
4. The corporation would engage an experienced Madison developer, to generate realistic cost estimates, and commit to the general contractor to de-risk its involvement.
5. The corporation, with the assistance of the general contractor, would then seek construction financing and ultimate mortgage lenders, again making any necessary commitments to de-risk the lenders.
6. This de-risking could include some of the neighbors committing to purchase some of the living units. After all, they may have already been considering downsizing, thwarted by the lack of availability of such units in Madison, and with the added incentive of spending more years in the neighborhood they love.

I’m guessing this isn’t likely to happen either for the Old Sauk project or similar projects that will continue to come forth in Madison in coming years. I wouldn’t personally invest in anything like this. Nevertheless, it’s at least one possible solution. I hardly possess all the expertise to address every aspect of the missing middle, so gladly encourage others to correct any errors I have made and propose other potentially viable solutions.

Stay tuned. I’m working on a blog titled “Why are there ‘No Rezoning’ yard signs on Old Sauk Road”?