Missing Middle Housing Is A Huge Opportunity Offering Resilient Investment And High Demand

Dallas and Houston are both seen as low-cost housing markets, but when you start to pull back the curtain, you begin to see that while more affordable than some markets, there still remains a large gap in what is affordable for the middle class.

This creates an opportunity for developers to supply product in that range, and to benefit from the fact that it promises strong returns in any kind of market conditions.

The 2020 State of Housing in Harris County and Houston published by the Kinder Institute for Urban Research at Rice University reports that in 2018, 47% of total renter households in Harris County paid more than 30% of their income toward housing, classifying them as cost-burdened.

Plus, the affordability gap in Houston, or the difference between a home affordable to a household making the median income and the median home sales price, has grown. In 2018, a household with a median income of $60,146 could afford a $186,256 home, but median home prices were at $220,000.

Residents of Houston have to earn $21.02 an hour to pay for an average two-bedroom, market-rate rental. The minimum hourly wage in Texas is $7.25 and a minimum-wage worker would have to work 115 hours a week to afford this rent—nearly three full-time jobs.

Two hundred and forty miles north, in Dallas, a similar report revealed a shortage of nearly 20,000 affordable units. Almost 58% of home sales in 2017 were priced between $300,000 and $1 million and 60% of Dallas residents spent more than a third of their income on rent. Despite the fact that the city committed to building thousands of affordable homes each year for the next three years, only 320 qualifying homes were built in the next fiscal year.

Solutions With Impact

Ricardo Pagan, founder of 100% minority-owned real estate investment and development firm Claridge Properties, noticed the changes in both markets and how each had different contributors. 

“The Houston market was down due to the oil slump and COVID, so it was hit twice,” Pagan said. “Also, Houston has had a glut of Class A housing built in the last three years that has slumped its pipeline a bit, where Dallas has not. The oil glut has slowed and slowly Houston is returning to normalcy, otherwise, the need for affordable housing in Houston is huge.”

Pagan looks at Dallas differently. It has seen the most growth of almost any city outside of Austin in Texas, and given Austin’s tremendous growth, a lot of jobs are migrating to Dallas.

This gap in housing supply for a large portion of both city’s populations presents an opportunity to create more affordable housing through ground up development and through value add that will not only drive a positive return, but a return that is sustainable through any market condition. Pagan says that the return on the projects that he is involved in would be around 14% after a five-to-seven-year hold, even though Claridge is planning on a longer-term hold.

“The reality is that affordable housing is probably one of the safest asset classes,” Pagan said. “Given the need for it and the low availability, these assets usually remain stable even through tough times. For example, portfolio-wide, we have kept up an average 93% occupancy through the entire pandemic, whereas luxury has taken hits on occupancy. So, we understand that in the long run, this asset class will perform generally in a stable manner.”

Bob Simpson, founder, of housing finance and public policy firm Simpson Impact Strategies, is seeing the same returns on this high-demand, unique asset class. He also sees investors leveraging technology in ways to improve returns and create more housing and economic stability for renters as well. 

“There is a convergence of investor interest and motivation on the NOI side that also creates social impact for the renter,” Simpson said. “The challenging thing is that rent growth has outpaced income growth for a number of years – which is unsustainable. As a result, investors are finding more sustainable ways to improve NOI by focusing on the long term stability of their renters.  By investing in property improvements and resident service programming that lower utility costs, increase length of stay, and reduce vacancy costs at the property – investors can generate stronger returns and increase the stability of their renters. Technology is making it more cost effective to provide these services, especially those that make it easier to pay rent on time, provides access to rental assistance programs, and help renters build their credit by reporting on-time rental payments to the credit bureaus.”

Pagan is currently involved in one project in Houston and one just outside of Dallas in Arlington, that will add a total of 1,097 units to those cities. Claridge acquired the projects with regular long-term debt financing at 65% of the cost from HUD and the balance is all personal equity, with no investors or partners involved. 

“I acquired them fee simple,” Pagan said. “The properties are in dire need of repair. I avoided the credits as these assets already had credits issued to them when they were first built years ago. That way I made sure not to use them again, and was able to obtain the asset at an attractive enough basis price to make financial sense of it without the use of credits. Since the assets were in disrepair, we used that as the leverage to obtain a better basis that would allow us to buy it and retain its affordability.”

These acquisitions are undergoing renovations, and have attractive locations located near public transportation. Part of the renovations is a healthy remodel of the leasing centers.

“For the leasing center in East Houston, we will replace all flooring and ceiling, the bathroom, replace all computers and other back-office items,” Pagan said. “We are adding services like computers, and a copier for tenants as well as a BBQ area in the pool area, and a community room, all new pool area furniture and landscaping. Plus, we apply all the new color scheme guided by a new design for the community.”

These upgrades add up quickly for a total of $3.7 million on the two properties, and $2.2 million in the Houston project in year one. In addition to the leasing center updates, that money is invested in mini-parks for child recreation, family gathering areas, security cameras, carport and roof repairs, and specific unit remodels, including replacing flooring and cabinetry.

Due to the nature of these projects being affordable buildings governed by area median income, rent will remain stabilized at around $800. Pagan says that rents will not rise for the first 16 to 18 months. 

As another strong indicator of the demand for housing at this price point, there is a four-year approved waitlist on the Houston asset. 

The Need Continues To Increase

While Pagan tells Matt Slepin in a Leading Voices in Real Estate podcast interview that he’s currently part of a group selected by the Los Angeles City Council to acquire and develop Angels Landing, a $1.2 billion project that will offer a mix of residential options, the Texas markets’ needs continue to grow.

The trade publication Multifamily Executive, recently reported on the swell of tech companies set to relocate to Texas from California, including Tesla, Oracle, and HPE. A RENTCafé report that uses Yardi Matrix data shows that a total of 126,900 new apartments are under construction across the state of Texas—49,000 in the Dallas metro and 28,600 in Houston.

A two-bedroom, two-bathroom apartment in a high-end Texas city building rents at about $1,600 per month on average, while a three-bedroom, two-bathroom apartment rents for $1,800 on average. The Dallas area has 389,600 apartments classified as high end, followed by 303,800 in the Houston area.

The average rent across all apartment sizes and types was $2,355 in Los Angeles and $2,998 in San Francisco in December, according to RENTCafé. At the same time, the average rent across all apartment sizes and types was $1,249 in Dallas and $1,102 in Houston. While those rents are lower than California, they are still much higher than what is deemed affordable for the median income in both markets.

Despite the strong demand, the work still has many challenges. Claridge had to deal with how the pandemic was impacting the communities, including trying to stay staffed when replacing key employees was very difficult.

“Lending institutions also are shying away from these opportunities because they are perceived as higher risk,” Pagan said. “After funding is secured, the buying process is complicated because appraisers or inspectors were slow to get onsite for due diligence. We entered the contract in April and closed end of December. The largest issue was that HUD, due to the situation, just couldn’t move fast enough given all the issues they had to handle within.”

Kyle Shelton, deputy director at the Kinder Institute for Urban Research at Rice University, was heavily involved in Houston’s housing report and notes other challenges, such as the city being able to leverage land use regulations.

“We have been so dominated with single family and massive multifamily and we struggle to overlap other things on top of it,” Shelton said. “Missing middle is a flexible piece of the system and a key cog in the system as a whole. We need to determine what attributes we want from it and how to find the right balance for investors to make money.”

It takes all kinds—cities need a spectrum of housing options to address multiple issues, and missing middle projects not only provide a much needed price point, but tend to be smaller in size giving them the ability to provide more sensitivity to neighborhood context.

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