Household rent burdens increased in every segment of the multifamily market in 2022, but no group felt the squeeze of rising costs more than middle-income households. The “missing middle,” defined as households earning between 60% and 120% of the area median income (AMI), earn too much to benefit from traditional affordable housing programs but not enough to afford more readily available luxury apartments.
Indeed, housing affordability for middle-income renters plummeted during the past two years. In the 24 months ended December 2022, rents for Class C and B apartments rose by 20.1%, roughly twice the increase in the average hourly wage (10.4%) and personal income per capita (11.3%), adding meaningfully to the percentage of moderate- and middle-income renter households paying more than 30% of their household incomes in rent and utilities.
Stock of Attainable Rental Housing Lags Demand
The rising rent burden of America’s working families is attributable to a host of reasons, none more so than a chronic shortfall of new middle-income housing. Although multifamily construction is proceeding at the fastest pace since the 1980s, most properties in the pipeline are targeted toward higher-income households or, to a much lesser degree, renters qualifying for housing subsidies or restricted rents, leaving reduced stock of attainable rental housing.
Without tax credits or subsidies, developers find it difficult to make middle-income project numbers work. As a result, only 4% of the 1.325 million market-rate units added to primary and secondary market inventories since 2018 are rated below grade B+, according to commercial real estate data provider Yardi Matrix. By contrast, Yardi describes nearly 50% of its coverage universe as lower mid-range and workforce housing. Much of the workforce housing activity it tracked was limited to value-add transactions, which did not address the supply problem or reduce cost burdens. In fact, many of those value-add renovations resulted in rent increases.
Rising to the challenge, developers, investors, and communities are developing replicable models that can create new attainable housing without direct federal government subsidies, and lenders are offering new incentives to conventional sponsors prepared to restrict rents for missing-middle renters.
An Increase in State and Municipal Programs
The shortage of attainable housing also hinders municipalities seeking to recruit essential workers and is cause for businesses to locate in lower-cost markets. Consequently, an increasing number of states, cities, and community organizations are working to develop public/private partnerships to bring more housing to market that is affordable to more of the workforce and deed-restricted to ensure that it will remain affordable for decades to come.
At the local level, municipalities are extending real estate tax exemptions and waiving density limits to encourage middle-income housing construction. States have also begun to provide financial incentives to build or set aside more attainable units. For example, the Michigan State Housing Development Authority recently launched a program providing grants to middle-income housing developers. The Missing Middle Housing Program will employ $50 million of unused American Rescue Plan (ARP) funds to boost housing for households with incomes as high as 300% of federal poverty guidelines. Massachusetts and Rhode Island have implemented similar programs, which will likely become more common as more jurisdictions leverage available ARP funds.
Essential Function and Other Types of Tax-Exempt Bonds
Various public-sector groups in California are creating government entities and partnering with for-profit operators to use tax-exempt bonds that can be issued for such purposes as acquiring market-rate properties, which are subsequently converted to middle-income housing with rent restrictions and annual rent caps without using private-activity bonds and low-income housing tax credits (LIHTCs). In this arrangement, a municipality issues social impact revenue bonds through a state development authority in an amount sufficient to purchase an apartment community and pay transaction expenses. In many instances, little to no equity investment is required, although municipalities typically forego real estate tax collections so long as government entities are the owners of the properties.
The bonds qualify for state and federal tax exemptions because the financed asset serves a defined essential purpose under a local, county, or state ordinance. The bonds are sold at interest rates that are below conventional mortgage loan rates to institutional investors who typically buy municipal bonds. As market-rate tenants relocate, they are replaced by income-eligible tenants paying restricted rents not exceeding 35% of household income. The municipality becomes the sole owner of the property and can sell it after a defined holding period.
Tax-exempt bonds aren’t always the tool for such housing. In some instances, real estate tax exemptions may be available through ground lease or other structures and those tax savings can be used to make up for the lower rent collected when units are set aside for moderate-income residents.
Private Middle-Income and Workforce Housing Investment Funds
Several investment managers have found success with middle-income and workforce housing focused equity funds. Middle-income tenants tend to be “stickier” than renters by choice and therefore have longer tenures and lower turnover rates, particularly during periods of economic weakness. Moreover, workforce community occupancy tends to be slightly higher than that of luxury-tier properties in all markets and is more resilient in more challenging economic times. As a result, institutional investors find them attractive despite rent restrictions. In addition, such housing funds appeal to investors with environmental, social, and governance (ESG) or social impact objectives.
Consequently, investors may accept lower target yields from a workforce fund or partnership opportunity than for core-plus or value-add multifamily fund options. For example, fully subscribed middle-income and workforce funds floated since 2021 targeted levered internal rates of return in the 10% to 14% range and net equity multiples from 1.8x to 2x, moderately lower in each instance than most comparable core-plus funds. The results suggest that equity for attainable housing acquisitions may be less costly than comparable stabilized or value-add multifamily assets, regardless of applied rent restrictions.
Attainable Housing by Design
Increasingly, multifamily developers are constructing purpose-built attainable housing, leveraging their ability to economize on construction costs to deliver product affordable to the missing middle.
Developers focused on the missing middle share some common strategies and business models. Most build in suburban settings where land costs are lower and at higher density than luxury alternatives to reduce land costs per unit. Designs featuring clusters of mid-rise buildings separated by on-street parking rather than green space are other common ways of reducing land and operating expenses.
Designs are simplified with standardized floor plans that can be readily replicated on other sites with only cosmetic changes to fit local preferences. Kitchens and bathrooms often are prefabricated and assembled on-site to provide for economies of scale, and landscaping and property amenities are downsized to economize on expenses. Large-scale operators employ reinforced concrete construction to support higher building elevations, longer useful lives, and greater unit per acre density.
Preferential Financing
Lenders are also contributing to the creation and preservation of middle-income housing. Government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac have increased their focus on mission-driven business, a category that consists in large part of properties renting to households earning 60% or less of the AMI but that now includes a discrete middle-income housing component.
One relevant change is the expansion of both Fannie Mae and Freddie Mac’s authority to provide preferential financing in the form of forward mortgage commitments to non-LIHTC properties. It is now possible to obtain forward commitments for middle-income projects that commit to cap rents on properties with as few as 20% of their units at affordability levels around 80% of the AMI. The agencies have demonstrated some flexibility for transactions in higher-cost markets and have been willing to discuss transactions with various affordable restrictions. Some developers see these forward commitments as a way to mitigate their interest rate exposure once their properties reach stabilization.
Both GSEs are also offering incentives for market-rate borrowers. Fannie Mae’s Sponsor Initiated Affordability (SIA) program offers conventional borrowers interest rate discounts (in some cases as much as 30 basis points) when they agree to set rents for at least 20% of units at levels affordable to households earning less than 80% of the AMI, adjusted for household size, for the life of the loan. (See Fannie Mae Introduces Sponsor-Initiated Affordability Incentives.) Freddie Mac recently added a Workforce Housing Preservation “Prez” program to its offerings, building on its Tenant Advancement Commitment product. Both can be used by sponsors willing to voluntarily set aside units at moderate-income levels.
Looking Forward
Although an inadequate supply of B and C apartments has meant that middle-income renters have been disproportionately impacted by rent increases since the pandemic, efforts by governments, private investors, developers, and lenders have the potential to narrow the gap.
State and local governments are taking steps to mobilize financial and regulatory resources to address workforce housing needs. Private developers are employing new designs and methods to facilitate construction of economical middle-income product. Investors are actively seeking opportunities to put equity to work in the space, albeit in a limited fashion, and lenders are encouraging borrowers to agree to preserve affordability within the market-rate context. Much work remains to be done to overcome the housing deficit, but templates to success are increasingly visible.
