The case for killing the Owner-Occupancy policy on backyard cottages.

The single greatest limiting factor in building more of the inherently affordable backyard cottages is not zoning restrictions, it’s not your neighbor’s NIMBY attitude, it’s the bank’s inability to appraise its value.  Kill the Owner-Occupancy policy and you solve that problem.

The Catch-22 of the appraisal
Today, we can create tens of thousands of inherently affordable housing units, simply by enabling homeowners to build ADUs.  Of the 124,000 eligible single-family lots in Seattle, less than 800 have a permitted ADU.  This is in part because of the cost: the average ADU costs roughly $185,000 — enough to require most to take out a loan.  But ADUs do not appraise; there are too few in the market so banks risk not recouping the value of their loan. It’s a Catch-22: to get a loan for an ADU, you must first have the equity you need to construct one or already have built one to appraise.

The single largest category of homeowners who could manage this Catch-22 are the investor home-owners who use their house(s) as a leveraged asset.  There are approximately 25,000 single-family homes in Seattle that are non-owner occupied.  An ADU on each of those lots would equate to 25% more than Seattle’s entire HALA goal for the next 10 years.  Yet our policy precludes construction and/or renting of an ADU on a property that is not occupied by its owner.

The fastest way to build more ADUs is to eliminate the one policy that is precluding the group most capable of side-stepping the cold lending market.  By doing so, we will have a magnifying effect by creating viable comps to appraise, thawing the loans giving average homeowners access to the capital to build more of them.

Background
ADUs are a massive opportunity for increasing density without the use of public funding. ADUs would add inventory to the housing market in the least densely developed areas, which comprise nearly two-thirds of our land area.  ADUs are inherently affordable simply given their small scale and they are low-impact, nestling into the character of our esteemed single-family neighborhoods.

Except a few neighborhoods within Vancouver and elsewhere in BC, few Cascadia cities have taken advantage of this opportunity.  Planners and policymakers here in Seattle and Portland recognize the opportunity and believe ADUs are a logical component of any housing solution.  Defining the opportunity itself is not the limiting factor.

Non-owner occupants are one of the single largest demographic of homeowners representing more than one-fifth of all single-family homeowners.  According to the US Census, 20% of detached single-family houses in Seattle alone are non-owner occupied.  That equates to roughly 25,000 houses or 125% of the HALA affordable housing goals.  According to First American Title, the number of non-owner-occupied units is even larger with 27,047 homes in Seattle (J Tamparo, Senior Commercial Sales, First American Title Insurance Company, December 2015).  If we remove the owner occupancy laws, we will remove a barrier that is limiting one of the largest proportions of likely ADU hosts who most likely have the financial means and skills to construct ADUs immediately.

The Magnifying Effect
Stimulating a small critical mass of ADUs will enable banks to assess their value in appraisals, unlocking loans to tens of thousands of homeowners who could not otherwise borrow the money necessary to build an ADU.  The minimum average cost to construct a backyard cottage in the Seattle market right now is about $185,000.  Few have that sort of liquidity and would look to borrow by leveraging the equity in their home with the exit strategy of refinancing their mortgage once construction was complete.  However, if the bank doesn’t believe that an ADU increase the value of their home, the refinancing exit doesn’t work and homeowners are left saddled with an increased mortgage payment.

This is the number one reason we are not seeing more ADUs currently.  It’s not land-use policy but financing.  We need a sufficient quantity of ADUs in the market for appraisers to draw comparable analyses when appraising other homes with ADUs.

The Second Opportunity
The average cost of a one-bedroom cottage is $185,000.  This is an enormous barrier in itself.  If one were to borrow 80% of that over a seven-year term at 4.5%, that’s a monthly payment of about $2,050.  There are few neighborhoods in Seattle where one guaranteed to clear that cost in rent for a one-bedroom (DADU or AADU), especially after deducting for vacancy, insurance, maintenance expenses, and taxes.  But construction costs are consistent across neighborhoods despite the fact that rents may vary as much as 75% within a mile.  Rainier Beach, for example, has an average rent of low $2.00PSF whereas parts of Capitol Hill is pushing $4.00PSF.

Why would we tax Seattle homeowners to fund construction of affordable housing when those same homeowners could make money by renting their own inherently affordable backyard cottages?

Ironically, the homeowners who most stand to benefit from having an ADU and the associated supplemental income do not live in the neighborhoods that can command this rent.  So even if we solve the appraisal problem and thaw the lending market, the underlying costs limit access, which suggests that after solving the appraisal issue, the next most valuable policy would reduce the total cost of construction and ownership of an ADU.

We have policies that do this already for large institutional multi-family projects: the MFTE and low-interest loan programs for affordable housing.  And what’s most exciting about these when applied to the ADU market is that they provide a triple benefit.  (1) They encourage construction of affordable housing in the form of ADUs; (2) they provide relief and supplemental income to lower-income homeowners, preserving homeownership and wealth accumulation for the lower half; and (3) they do all of this in the private sector rather than burdening OH and SHA to produce the lion’s share of affordable housing for our city.

The savings from a tax exemption program like MFTE and a low-interest loan are significant.  Considering that example of the 80% loan on the $185,000 cottage, if the rate were 2.0% and term 10-years, the monthly mortgage would be $1,360 or a nearly a $700/month savings.  Now a one-bedroom cottage in Rainier Beach starts to make a profit.  Then if we eliminate property taxes for the portion of the property devoted to the affordable ADU, given rough average property taxes and average size lots, that could easily equate to another $300 per month in savings.

If we want to stimulate the proliferation of ADUs, we need to make it more affordable for those who are thirstiest for them and who are most motivated to build them.  To do this, we first need to enable the market to build more cottages quickly to enable the appraisal.  In parallel, we need to offer qualifying homeowners the existing tools we’ve created for institutional scale housing development.  The existing volume of lots available to host inherently affordable cottages is enough to meet this decade’s goal of housing.  It seems foolish not to capitalize on this and, instead, tax homeowners to fund public housing programs when those same homeowners could be earning money for providing housing themselves.