Incremental Development: How to Avoid the Bust by Avoiding the Boom
If you’re among the large number of Americans who want to see rents come down and stay down, then recent trends in apartment construction should concern you. I follow enough real estate folks online, both actual developers and analysts, that it’s been impossible to miss a pervasive pessimism about the short-term outlook for building…well, nearly anything.
The developers I follow who build apartment buildings and generally have good insights into that process are almost all saying things like this:
“If you are out there doing real estate deals right now, especially ground-up multifamily development, you are making unrealistic (and ridiculous) assumptions and your risk/reward ratio is completely out of whack.” That’s according to Minneapolis developer Sean Sweeney, who has developed over $200 million in projects since 2017.
“In Los Angeles, across a wide range of assets suitable for value-add strategies: At current rent levels, the price of buildings needs to come down by ~30% to make deals pencil,” Moses Kagan, a Los Angeles developer, wrote last summer on X (formerly Twitter).
“We had a 200-unit entitled, zoned and ready to rock in a market that desperately needs it. Was ready to break ground. And yet, interest rates + build costs + unwilling city to do a tax abatement = no longer pencils. And now the supply issue will worsen for this market.” That’s from Robbie Hendricks, a principal in a large real-estate firm in Cincinnati.
The top 25 apartment developers in the U.S. started 27% fewer units in 2023 than in 2022, according to a National Multifamily Housing Council (NMHC) report cited by real estate analyst Jay Parsons. It’s been predicted that multifamily starts (that is, the number of new apartment projects commencing) will be even more depressed in 2024 and maybe into 2025. In turn, this suggests that rents will escalate strongly in 2026 and 2027, as fewer buildings are completed in those years and available supply is squeezed.
Of course, a lot can happen to the broader economy between now and then, but the essential prediction here is that the supply shortage isn’t showing signs of going away — in fact, it's showing signs of getting worse.
To a bystander whose training is not in real estate, finance or urban economics, this must be befuddling on a basic, common-sense level. Here is a consumer good — housing — that is a core necessity for literally everybody. We know how to build it and millions of people desperately need it and will pay a lot for it. Yet many of the people who build it are saying that it’s currently not economical to produce this consumer good in almost any context.
Why is multifamily construction such a difficult proposition right now? The answer lies in the boom-and-bust dynamics that drive modern development finance. This can be understood as a four-step process:
As rents increase, investors put more money into financing development projects, allowing more projects to start.
When those projects are finished a few years later, the demand for housing decreases, forcing rents lower in a bust.
As rents decrease, investors put less money into financing development projects, so fewer projects start.
A few years later, the lack of new buildings increases demand for housing, forcing rents higher in a boom.
Jay Parsons explains that we are in stage two of this cycle:
Apartment construction starts are rapidly declining … Rents are falling in many markets — especially for new construction. Once-in-a-generation rent spikes of 2021-22 unquestionably helped trigger the once-in-a-generation supply surge of 2023-24, which then put downward pressure on rents. But those days are gone, and rising costs + slowing rents (and, in turn, falling property values/higher cap rates) make it less likely projects can pencil out.
He adds that people who are able to start building projects during this stage “will be well positioned for growth in 2026-27 — when new supply will certainly be dramatically less and (barring a recession or black swan event), demand should top supply and rents could be growing at a solid clip again.”
In addition to low rents, several factors combine to make projects that might have gotten financing in 2021 non-starters today:
Consistently high construction costs.
Labor shortages.
High land costs for a scarcity of good developable sites
Escalating costs of insurance.
Escalating costs of debt (that is, interest payments on construction loans).
Escalating costs of debt is a particularly significant part of this story. Development projects take a long time to plan and execute. Developers who planned a building based on low pre-2022 interest rates today face rates that are double or higher, as well as lower construction loan-to-value ratios (the percent of the project costs they can borrow). These developers have to make up the difference by raising more money from equity partners (investors that finance development in exchange for a financial stake in the profits). And it’s getting harder and harder to generate the rate of return that will bring those partners to the table.
The broader picture here is that almost all new construction is financed in the same way: with a lot of debt. Coby Lefkowitz wrote a brilliant essay explaining why debt is so central to the development process, and he also discussed it on our Upzoned podcast on March 20. Large apartment buildings require large-scale financing, and they all get it from the same kinds of sources: big national banks, pension funds and university endowments. These institutional investors demand a return, and real estate is only one of several places they might go looking for one.
Under that status quo, when the returns available to new apartment construction start to soften even a little, the math breaks. The tide of investment capital eager to fund these projects can quickly disappear.
In all the YIMBY success stories you’ve heard in the past year, the gains are real — such as in Austin, Texas, where rents fell 7% in the past year as a surge of new buildings opened; in Minneapolis, where rents have been effectively flat even as they rose in the rest of Minnesota; or in Oakland, California, where new supply is credited with triggering rent declines. However, these benefits will be short lived if falling rents then tank the construction of new apartments.
There is a fundamental challenge here to a basic YIMBY premise: By allowing and encouraging more housing development, we can drop rents to broadly affordable levels. If modestly falling rents actually cause a steep drop-off in housing starts — an automatic brake applied by those who finance apartment construction — then we’ll never achieve more than modest declines through this model.
Incremental Development as a Release Valve
If we want a true housing supply glut — enough to fundamentally alter the contours of a housing shortage totals at least six or seven million homes, by most estimates — who is going to build it?
A key part of our answer at Strong Towns is small-scale, incremental developers.
Let me be clear: Incremental developers aren’t going to swarm out of nowhere to do this singlehandedly. Large apartment buildings aren’t going away. Our cities won’t stop needing them. In fact, we need a lot of them.
But incremental development adds an incredibly important pressure-release valve to the mix. And I suspect it will prove far more resilient than the boom-and-bust nature of big-time housing development.
This is crucial because, unlike housing supply, housing demand does not usually boom and bust. People keep having babies. People keep graduating from college and moving out of their parents’ houses. Life goes on, and as long as life goes on, we need to be building homes.
Incremental development is different because it gets resources off the sidelines. It’s not asking established developers to increase the rate of their current business model. It’s taking people who would have never been developers at all and turning them into developers. And it’s putting land that hasn’t been developable into play.
I can walk around my neighborhood right now and go up and down the alleys. I can count garages by the dozens. One or two of them have Accessory Dwelling Units (ADUs) — a small apartment built above the garage. Most don’t. What if even a quarter of them did? What if we could begin to finance that, in neighborhood after neighborhood?
The 5-over-1 apartment developer isn’t interested in this. The institutional investors that they partner with aren’t interested. They want a large site where they can do a large project while investing a large sum of money.
But what about the relatively cash-poor but land-rich homeowner? Someone who has a resource — a yard which local regulations like minimum lot sizes probably required them to own — that may provide them some use value, but isn’t currently providing them a financial return. What if it could provide a financial return? How many would take that deal?
A cash-poor, land-rich homeowner probably won't be able to finance that accessory apartment. But cities can help them do it. They don’t have to vacate their home. They just need to qualify for a loan to build the ADU and make the down payment on that loan.
In "Escaping the Housing Trap,” — my book with Strong Towns founder Charles Marohn, which was released yesterday — we discuss how this can be a win-win proposition for a local government, which can establish a revolving loan fund to help finance these projects, offer the kind of tax abatement that cities commonly offer large developers as a matter of course, and work with banks to buy down interest rates. Cities can borrow at the lowest rates out there. They can afford to be long-term, patient capital. Out of that deal, they get more local wealth and more residents paying taxes, for virtually no marginal investment in infrastructure because the neighborhood already has streets, water and sewer pipes with excess capacity.
This kind of development isn’t some magic formula. If backyard cottages were an easy financial win everywhere, we’d already see a lot more of them, and we’d see institutional arrangements to finance them at scale. There are still constraints imposed by math here: An ADU, like any new home, needs to bring in enough rent to cover construction costs. In many neighborhoods, at current costs, it won’t.
But there are many places it will. We see the pent-up demand for this kind of thing in city after city. The ADU revolution is well underway in California. It seems to be on the verge of surging in Boise.
And if we do commit to encouraging incremental development, we’ll find that it won’t be as boom-and-bust prone as the large-scale development that has been slowing to a halt in city after city.
This is because homeowners who want to build on their own property (and, to a lesser extent, small-scale developers who want to acquire property in their neighborhood to build on) have a much more diverse range of motivations and investment criteria than large-scale developers. Financial return matters, but the kinds of people who will do these jobs aren’t strict return maximizers the way a pension fund is. You downsize because you’re getting older or your youngest child went to college. You build that mother-in-law cottage because your literal mother-in-law is moving in.
Incremental infill development — the kind that activates land and resources that are under the radar of the mainstream development industry — is not likely to provide the majority of new units in any American city any time soon. But it has an extremely crucial role to play in making the housing market more responsive, elastic and less subject to busts that undermine the benefit of any boom.
Daniel Herriges has been a regular contributor to Strong Towns since 2015 and is a founding member of the Strong Towns movement. He is the co-author of Escaping the Housing Trap: The Strong Towns Response to the Housing Crisis, with Charles Marohn. Daniel now works as the Policy Director at the Parking Reform Network, an organization which seeks to accelerate the reform of harmful parking policies by educating the public about these policies and serving as a connecting hub for advocates and policy makers. Daniel’s work reflects a lifelong fascination with cities and how they work. When he’s not perusing maps (for work or pleasure), he can be found exploring out-of-the-way neighborhoods on foot or bicycle. Daniel has lived in Northern California and Southwest Florida, and he now resides back in his hometown of St. Paul, Minnesota, along with his wife and two children. Daniel has a Masters in Urban and Regional Planning from the University of Minnesota.