Tiny Spaces, but Lots of Room for Pace-Type Financing

Move over mortgages – there’s a new kind of real estate that could benefit from a new type of funding. As higher interest rates and rising prices are making affordable housing a challenge in many markets, cities can fight the problem with a small-scale solution – accessory dwelling units (ADUs).

What’s an ADU?

ADUs are additions (attached or detached) to homes or converted spaces within already existing buildings that can be used as rental units. Local governments on the west coast have become friendlier to the development of ADUs as a new housing option for strapped markets. In San Francisco, underused areas in multi-family dwellings (laundry rooms, basements, storage rooms, utility rooms) are being converted into apartments. In other places, “granny flats” or “in-law apartments” are being added to the backyard of single-family homes. Cities have been making building code and zoning changes to encourage this construction and make these new living spaces safe and legal.

Given the cash needed by existing property owners to finance the modifications, a Property Assessed Clean Energy (PACE)-style financial product – where funding is provided by a PACE provider in partnership with a municipality and repaid through tax assessments on the subject property over time – could be the way to fund a potential boom.

ADUs in Action

Where government support exists, ADU growth has followed. For example, in Portland in 2000, just 24 ADU permits were issued, but that number climbed to 615 in 2016. In Los Angeles, after permitting reforms were implemented, ADUs leaped from 90 permit applications in 2015 to 1,980 in 2017. And in San Francisco, where just 200 ADUs were added annually from 2014 to 2017, there were already 1,200 new ADUs planned as of March 2018.

Adieu to Traditional Financing

Despite the growth, ADUs probably won’t meet their full potential to satisfy unmet housing needs until financing options become more widely available. Although local banks in areas of ADU growth have tried to offer creative solutions beyond a home equity line of credit (HELOC), borrowing against the future value of the improvement would be a sensible possibility.

And it wouldn’t be the first time PACE-type financing has expanded beyond energy efficiency issues: San Francisco is using PACE financing for seismic retrofits (including buildings which add ADUs), Florida is permitting hurricane-resistant impact windows, roof replacements, and storm retrofits using PACE liens and California recently passed a law to allow PACE liens for wildfire safety protections.

Making PACE-type financing available for ADUs could be a big win all around – from homeowners looking to supplement their income with a rental property to politicians seeking to address a lack of affordable housing without government funding to lenders seeking new opportunities.

Nicole Serratore, an Attorney in the Insolvency, Creditors’ Rights & Financial Products Practice Group of Davis & Gilbert, contributed to this post.