It’s Not the Code but Lack of Financing the Prevents DADUs

The latest big social media buzz in and around City Hall is the fight between some angry neighbors and the City over the last round of regulations on Detached Accessory Dwelling Units or DADUs and also called back yard cottages. The recent regulation was appealed by the neighbors and was bogged down in an additional required environmental analysis on the impacts. If you read the headlines, some of the breathless, and scanned the articles and posts you might come away believing that this legislation would determine whether or not DADUs would be allowed. But here’s the thing, DADUs are already allowed by the code and this legislation won’t do anything to make them more prevalent as rental housing. The reason is the lack of a market for DADUs and an absence of financing because of the limits in the existing code.

If you want the arcane details of the latest feud you can look at Sightline’s recent letter on the City’s Environmental Impact Statement (EIS). I have been writing about cottages and DADUs for more than a decade, and it was about ten years ago when the City finally permitted detached dwelling units; previously they had only been allowed as attached to the main house. Then in 2006, the City allowed 50 units to be built just in the southeast sector of the city. Then they subsequently allowed them everywhere. Over the period of time since then, about 159 units have been built or permitted all over the city, or roughly a dozen a year. Yes, a dozen.

Is that modest production the result of onerous regulation? The regulation doesn’t help. But the bigger problem is the absence of money to pay for cottages and the irregular nature of lots that might be eligible. I worked with an internet start up to figure out how many eligible lots there might be under the existing code, and we found hundreds. Are all those households jumping up and down wanting to build rental housing in their backyard. Not really. Not every single-family lot owner that could fit a DADU in their back yard wants to, and often, we found, their motivations aren’t rental housing but providing a place for a family member who is rolling out of a sale of their existing house; grandma and grandpa sold their house in Peoria and want to live in Seattle next to the kids and grandkids.

How do you pay for a backyard cottage? The answer is typically from the sale of grandma and grandpa’s home. But that doesn’t lead to a rental unit. The other is a home equity loan, essentially a second mortgage on the existing home and land with those assets as collateral. The going price for a cottage is around $150,000 or so. But that can vary. And equity varies as well. Not everyone who is paying a mortgage or even owns their home can or wants to take out yet another loan. Also, each and every single-family site is different. Some don’t have alley access and some have other issues with utilities. So all those hundreds of eligible lots winnows down to a very small number of people who are willing to take on a project. Architects and builders don’t like to do one off projects. They’re expensive, hard to manage, and take up a lot of time.

So today, there just isn’t a market for DADU construction for rental housing. There isn’t a lot of demand for building it and builders and architects don’t really have a product or service ready to go if there was a surge in demand. What’s the answer? Exactly what the neighbors and the City don’t want, professionals coming in and building lots of DADUs.

First, anyway you slice the money, the biggest incentive for motivating DADU construction would be financing that would be based on rent revenue from the cottage. Banks simply don’t lend money this way for a cottage. They need collateral in the form of the existing house which often already has a mortgage. Additionally, for regulatory reasons, mortgages have to be for a house, not a rental property. There simply isn’t a product that would lend money to a homeowner based on the rent that would be collected. Lots of people hand wave this, but to really accelerate people making the jump from homeowner to landlord would require dividing the lot to allow the cottage to be financed separately, just like a speculative housing unit. Banks know how to lend for that.

If this happened, the cottage could pay for itself with rent revenue. If something went wrong, the bank would have the cottage as collateral and could sell the home to get it’s money back. The homeowner wouldn’t lose their existing home. This kind of financing could generate a market for design and architectural services to create stock designs and a scale for builders that could turn out lots of cottages. Builders and entrepreneurs could pitch homeowners with a lot to buy a service with loan, design, construction, and property management all together for one price paid for by rents from the cottage. This could catch on and create many more rental units.

But we’ve been here before. Remember the small-lot housing battles of 2013 and 2014? Probably not. We lost. Essentially the City Council outlawed building single-family housing on lots smaller than standard 5000 square foot lots. The reason? Too many people, parking, and yes, greedy developers and others making money. The DADU challenge is the same. Unless there is a motive to make a return on investment of time and money by architects, builders, and others in real estate there simply isn’t scale to sustain a business model that produces cottages. And homeowners are unlikely to take a big financial risk unless there is easy and less risky financing to buy those services. And the financing won’t happen unless there is a return on the banks investment.

This is why markets are good things. Tweaking the existing rules on DADUs simply doesn’t matter and won’t create a waterfall of new rental housing in single-family neighborhoods. What would accomplish a big spike in DADU production is allowing property owners to divide their property, create a new asset that can support a loan and thus the money to buy the professional services at a scale that makes business sense. And yes, the details of the code (i.e. setbacks, height, etc) limits a lot of potential too, but fixing those won’t spark new rental housing. Homeowners, the Council, and neighbors need to see the business opportunity in their backyard. Until that happens, DADUs will remain a largely theoretical land use debate with little benefit to people who need housing.

 

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