1,000 Subscribers Special: Explaining the Missing Middle Housing Financing Gap

Why urbanists' favorite housing is tough to build even where regulation allows it

A triplex built in 1912 with an ADU out back, in Aurora Highlands, Arlington, VA

In 2012, I graduated college and moved to the DC area for what proved to be a short-lived journalism career. What endured was my occupancy of and affection for missing middle housing, which we will define as a structure of between two and 50 (more likely a dozen) residential units. Ranging from duplexes to small apartment buildings, this medium-density housing, in the middle ground between detached single-family homes and large multi-family, blends into any neighborhood but is now seldom built.

Without knowing what to call it, as a renter I noticed that missing middle was often cheaper than an apartment in a large building while offering perks like a small private yard. I did not want to feel isolated and split my utility bill with hundreds of people. After two stints in intern housing, I lived in the following places (with the year built):

• A room in a DC rowhouse, for only a month (1900)

• A room in a “single-family” gray market boarding house in Arlington, VA (1940)

• A room in a two-bedroom apartment in a fourplex in Arlington, VA (1940)

• My new wife’s one-bedroom garden apartment in Alexandria, VA (1925)

• The three-bedroom townhouse we now own in Alexandria, VA (2000)

YIMBYs of Northern Virginia, the volunteer advocacy group I founded, helped enact zoning reforms that legalized small multiplexes across Arlington County and Alexandria City, though a judge struck down Arlington’s reform. Whatever the final outcome of that legal challenge and another in Alexandria, these policy victories still marked a new chapter in our region’s local politics, shifting power away from NIMBYs and scarcity-minded homeowners. The reforms reflected the jurisdictions’ broadly pro-housing leadership, and subsequent elections have strengthened the pro-growth majorities on the Arlington County Board and Alexandria City Council.

As for actually building more missing middle housing, that would require additional specific zoning reforms: curtailing or eliminating rules around minimum parking requirements, lot coverage, setbacks, etc. Yet even where the law permits multiplexes and small apartment buildings, they tend to be old and otherwise rare. The story of why middle housing went missing in America over the past century and became difficult to build is legal and political, but also economic and, in particular, financial.

After digging into the missing middle housing financing gap for a year, I am ready to share what I have learned about the current landscape. This explanation draws from roughly 50 conversations with various real estate professionals, including developers who create middle housing today.

The Townhome Exception and Institutional Capital

Townhomes are the exception that proves the rule of missing middle, because they are still built in significant numbers. They are certainly popular here in the DC region. Amid the deepening housing crisis, townhomes are receiving well-deserved attention for being more attainable and scalable than detached single-family homes — a palatable compromise for American homebuyers.

Townhome is really just an upscale term for rowhome or, in Britain, terraced housing, meaning homes built in a row with shared side walls. My basic explanation for townhomes’ staying power is that they are easy to build en masse and thus finance.

The home we live in first sold in 2000 for about $400,000, less than half of what it is worth now. (I should mention that my dad bought us the home about six years ago, which has left me eternally grateful and slightly haunted by guilt.) There are about 150 homes like ours. We could pretend they were a stand-alone development worth about $60 million in 2000, almost $111 million in 2025. You might assume that financing gets more complicated as the numbers get bigger, but if anything, the opposite is true. In 2000 as now, finance was dominated by large institutions, which naturally prefer commodification and scale. A large bank or fund investing in real estate is deploying hundreds of millions or billions of dollars to assemble its portfolio. “The Birth of a Building” explains this well. A developer might need to be raising $100 million total to be worth an institutional investor’s time — there are only so many hours in a day. Under ordinary circumstances, missing middle is too small for institutional capital.

Townhomes are easy to construct in large numbers. Even with variations in floor plans and exterior design elements to spice things up for buyers, work crews are executing a fairly standard design for each unit. I feel so blessed to have a good home for my family, and I have to say, it was clearly built by guys churning stuff out.

“Just” Add Financing

Housing can be a luxury good, a commodity, or something in between, but at the end of the day, it is a product. It gets built by sweat, money, and calculated risk. To help us appreciate this harsh reality, imagine being a neighborhood developer, a passion-driven individual who has pulled together a solid missing middle project.

You have locked down control of a nice lot in a streetcar suburb neighborhood on the upswing. You have successfully executed a couple of fourplexes and want to do another one. You have a good architect. You have a strong relationship with a reliable GC (general contractor) who has a slate of subs (subcontractors) who you know do good work. You and the contractors have plans to deal with labor shortages and material cost spikes. And the local government is open to growth. Planning department and other staff are reasonable and efficient. But wait, there’s more!

Based on your prior experience, you are sure you can hit an IRR (internal rate of return) of 25%, a number that will grab prospective investors’ attention. With all of these stars lined up, you just need to find financing. “Just,” ha. You know you will end up spending half of your time chasing down money — friend and family money, country club money, maybe hard money. Historically, you would have gotten a community bank loan, but that sector tightened up over the past fifteen years.

If you are a developer and this story rings true, please reach out. I would love to talk.

If I got something wrong or you just want to share your take, please leave a comment.

Risk and — Maybe — Reward

A likely question from any potential investor or loan officer is, “Why not just do a big single-family home and call it a day?” That would certainly be easy to finance. If you find an affluent buyer who wants a custom home, they will not care about financial return, though they might take out a $1 million mortgage for tax reasons. Even if you are building on spec (speculation that you can hit a certain sale price), a large, luxurious single-family home caters to a wealthy clientele willing to pay a premium.

However, four or two or even twelve units are still more valuable than one big house. Spreading the cost of multiple units over the same land is still economically efficient. It can be tough because an infill lot in a nice neighborhood will have a high per-acre cost. Developers make or lose most of their money based on what they pay for land. Large multi-family projects either benefit from cheap land in the peripheral locations that dense housing is often limited to, or have the large-scale unit economics to cover the high cost of an expensive urban lot. This is another reason institutional capital might balk at missing middle. “The unit economics are just not there,” a big investor would complain from his corner office. “I have the same closing costs for a 150-unit building as for one of these little twelve-unit garden apartments. There is no secondary market for the debt if a building has fewer than 50 units. And what if your GC goes AWOL? ‘Congratulations,’ I own a half-finished fourplex, now what?”

That last question is on the mind of any prospective investor. Real estate is messy, complicated, and just plain risky. Some deals go sideways. And there are always contingencies. City officials might inexplicably delay an inspection for months, a subcontractor might do a shoddy job that needs rework, materials might be damaged in transit, on and on and on. Even a small real estate project feels like a miracle.

What happens if and when a project blows up is a serious matter the developer must account for and address up front with investors. Equity investors get an ownership stake with the understanding that they might not get their money back. Debt investors have more security because they can take possession of a property or maybe even go after the developer’s personal assets, but that means disposing of a half-finished build where corners were probably cut as things broke down. Coby Lefkowitz has a great explanation of that dynamic and broader financing issues:

Why small developers are getting squeezed out of the housing market

The basic answer here is that even small developers have ways of dealing with failure risk, from offering more generous terms to liability protection to girding themselves and signing a personal guarantee on a loan. This is a big reason why the traditional way that individuals get started in real estate development is drawing from significant family wealth. If you flame out, you will still be invited to Thanksgiving. (I wonder if some kind of apprenticeship arrangement would help more people enter development.)

Pitfalls of Conventional Financing Sources

Equipped with all of this context, we can delve into why traditional sources of capital balk at missing middle, and why developers might not find them attractive either.

I do need to touch on loan-to-value ratio (LTV). Things were looser pre-2008, but these days a developer can expect to get a loan for at most 65% of a project’s value from a bank or experienced investors, likely less. There are exceptions but the point is: the developer must raise equity, convincing investors to buy into a project. Developers are expected to put some of their own cash into a deal as equity too (skin in the game).

Community Banks

Historically, the primary financing option for neighborhood developers, these fairly small regional banks focus on a local market. They were a fairly reliable source of capital for missing middle until mergers and acquisitions significantly consolidated the sector in the past fifteen years, partially due to standards imposed by the 2010 Dodd–Frank Wall Street Reform and Consumer Protection Act. Many community banks and their loan officers were absorbed into institutions with bigger fish to fry.

Community banking is heavily relationship-driven, which made it a natural fit for neighborhood developers who need to explain so many aspects of missing middle, starting with what it is and why they want to pursue it at all. Local loan officers have local knowledge (what Hayek called tacit knowledge) that helps them assess whether the developer can sell for a certain price per square foot or charge a certain rent.

Trust is the one essential element that makes a missing middle deal work. Even for a rock-solid project with conservative assumptions, the lender or any other investor needs to take time to understand the numbers. Community banks are more likely than bigger players to give developers a bit of flexibility too. As a prime example, an infill developer told me he sticks with a loan officer he has developed a good relationship with, even though he could get a lower rate elsewhere, because he knows they will understand if he tells them that he wants to spend 7% more on windows.

Still, lending is all about managing risk, and any real estate deal is risky. It is always easy enough to just say no. And small banks are especially risk-averse. As a veteran grassroots developer explained to me, if a community bank has one bad loan on their balance sheet, their regulator is going to spot it during a regular exam, give them grief about it, and likely require that they increase their capital reserves, limiting how much money they can lend out and profit they can make, which is a big problem.

Much Ado About Comps

Underwriters are the financial professionals who formally assess the risk of a potential investment. Missing middle sets off alarm bells in their heads for a couple of reasons, captured in its name. This middle housing is more complex than a single-family home but without the scale of a commercial-scale residential project, which provides a certain kind of stability. One tenant not paying their rent in a 100-unit building is annoying; in a fourplex, it could be a disaster. On the other hand, the more expensive a project is, the bigger the financial fallout if it blows up, all else equal.

Middle housing properties, especially new ones, are also generally rare, making them “non-standard” in underwriter speak, which brings us to the issue of comps. Short for “comparables,” comps are the properties a prospective lender or investor uses as a reference point to evaluate the financial assumptions around a proposed project. A new single-family home in America has as many comps as you can shake a stick at, which, along with favorable federal policy, makes single-family mortgages easy to commoditize (as illustrated by the financial crisis that led to Dodd-Frank). Likewise, finding comps to validate the projections for a commercial-scale property is routine.

Even as they perform due diligence to ensure that risk is well-managed and carefully review comps, underwriters are used to viewing them as open-and-shut. Telling an underwriter, “Let me explain my comps to you,” will stop them in their tracks, leaving them confused, maybe even suspicious. Even if a developer has five comps they can point to in the same neighborhood or similar ones, all built in the past year or two, a loan officer might not have the patience to walk through each one. A critical issue for missing middle projects is that banks and underwriters systemically underestimate the price per square foot that they ultimately sell for. So a bank offers a higher interest rate, one that the developer may not even be able to accept.

All of this is surmountable. Neighborhood developers still can and do secure loans from community banks, often thanks to accumulated trust and goodwill. But at a macro level, the pairing broke down. Put simply, community banks lending to neighborhood developers worked reasonably well 15 or 20 years ago, but not anymore.

Bank loans also have some built-in limitations. Banks are, you may have noticed, tightly regulated and bureaucratic. The overhead costs they must cover put a floor on the interest rates they charge. And they may take multiple months to approve a loan.

I should briefly mention credit unions as well as community development financial institutions (CDFIs), which are more lightly regulated entities with a mandate to invest in local economic development. Though they might seem like appealing alternatives to community banks, they end up being fairly similar in practice, with the same broad limitations. So ideally a neighborhood developer can tap into …

Friend and Family Money

This is exactly what it sounds like: family members and friends of a developer who have the financial means and personal inclination to buy equity or lend. Having a rich dad to step in and personally guarantee a loan is unfair but also extremely helpful, especially for a developer early in their career. Just to acknowledge the elephant in the room, real estate, even at a small scale, favors individuals who have money, come from money, or know people with money. At the same time, it rewards scrappy self-starters who claw out a niche for themselves.

Hard Money

Hard money lending, backed by the “hard” or real property in a real estate deal, is a high-risk, high-reward sector specializing in short-term, high-interest loans. They traditionally focus on financing house flips (quickly buying, renovating, then selling a home). These private lenders or something like them could conceivably evolve into a source of capital for missing middle development. However, they charge a lot and have, depending on who you ask, a bruising reputation, but that is not a hard and fast rule. (I seem to have a few hard money lenders subscribing — thank you!)

Country Club Money

Similar to friend and family money, country club money is what it sounds like. I never got a sense that the name is a euphemism. These investors tend to be upper-middle class or simply upper-class professionals like doctors, lawyers, and dentists. They have something like $100,000 to spare that they want to “put to work” in an investment other than stocks, bonds, or even REITs (real estate investment trusts, typically with tradable shares). A few from the same profession may pool their capital into a fund.

High-net-worth-individuals (HNWI) invest in real estate for a few reasons. It tends to be a hedge against inflation and has tax advantages. Returns can be close to or even in excess of the stock market. And investing in a physical asset carries psychic value. There is also the appeal of investing in something that has a social benefit, though I have not found that missing middle generates mediocre financial returns.

The big question about affluent individual investors is whether a developer can find them.

A developer who networks effectively can become friendly with a family office, which is a private firm dedicated to managing the finances of a wealthy family. They can deploy lots of capital but are not (necessarily) too big for missing middle.

Affluent individual investors are difficult to generalize about. The big question is whether a developer can find them, then cultivate relationships and build trust. Developers view HNWIs as more easygoing and flexible than a bank. But a developer getting involved with high-agency people operating outside their domain of expertise may find that they are prone to interfere, micromanaging a project. Either way, the larger the average cheque size, the faster a developer can assemble capital.

Missing But Not Lost

Lest you get discouraged, remember that missing middle is still financially sound. Being a YIMBY makes it easier to see the overwhelming demand for missing middle, not merely because it is ‘another housing option.’ Forget affordability — missing middle housing is convenient and enables a community-oriented lifestyle. My wife and I brought our first child home to a structure that is now a full century old. New missing middle represents an extraordinary, exciting opportunity.

The puzzle of missing middle housing, from financing to the basic knowledge needed to efficiently build a fourplex with a shared stairwell, is somehow largely a matter of status quo bias, a Catch-22. A lack of comps limits financing, which limits comps.

As explained to me by Strong Towns Board Chair and Co-Founder Andrew Burleson, the Great Depression kicked off the long-term decline of middle housing in America. Many of the mom-and-pop developers who created missing middle were wiped out in waves by the depression and the Great Recession, or slowly died off. But the numbers still add up. Two or twelve is still more than one.

It is obvious how missing middle enriches neighborhoods. This is not a tragedy of the commons; it is a tangible product with willing buyers. We can revitalize the market.

The consistent refrain I heard in conversations about the missing middle housing financing gap is that it is “a real problem” because the projects make sense economically. Many folks went on to say that someone should do something about it.

Thanks to my 1,020 subscribers, especially my 16 paid subscribers. If you enjoy this blog or want to work together please contact lucagattonicelli@substack.com. I founded the grassroots pro-housing organization YIMBYs of Northern Virginia and live in Alexandria near DC.