Financing and Appraisal
“In the last four years, lenders have done a complete 180 as far as how they treat the product type,” says Anderson. “When we started, there were definitely some misconceptions among the lending and appraisal communities. [They thought] micro expenses would be just as high as market rate, and that was a major miss. These operate sometimes for less than half a market rate per unit. Once appraisers had more comparable appraisals and sales to justify the lower expense numbers and lenders saw that they actually operate around the same exact occupancy rate, if not lower than market rate, they got more comfortable with it.
“We don’t see any spread on interest rates over what the local lenders can offer for these buildings over market rate. Furthermore, we have several micro buildings in the city and surrounding area that have agency financing; for Freddie Mac, it fits in its affordable umbrella, and it’s an uncapped line of business, so they are, as often as possible, trying to underwrite and place very attractive debt on these properties.”
“The buyer pool [for microunit buildings] was very small initially,” says Anderson, “But it’s growing. When you take a traditional investor, who’s used to looking at traditional one- and two-bedroom apartments, and take them into 200 square feet, if they’re not prepared for it, it can be shocking.” In Anderson’s case, focus made a difference. In the last four years, his team has marketed more than a dozen micro properties. They’ve produced market studies and hosted four micro-specific events. “We’ve been able to get a large number of investors through these buildings, explaining the benefits and allowing the buildings to speak for themselves,” he says. “They’re maintaining high occupancy rates, quick turnovers, and frankly, just better cash flow than a lot of the market-rate apartments in the area.”
Building and Operating
Unfortunately, says Hewlett, national data on microunit construction and operating costs is lacking. “The hypothesis is that both of those things are higher. Yes, you get higher rents, so you get better dollar per square-foot/value ratios. But you still have to build a kitchen and a bathroom. The difference between a 350-sf unit and a 500-sf studio is building a living room and a bedroom – it’s only drywall – so the base costs of the unit are similar.
“And for operating costs, turnover tends to be higher, and the wear and tear tends to be a little higher. The supposition is that when you look at a contribution margin for these units, it might not be as attractive as a conventional studio.” “We have clients who have everything that you’d expect in a traditional apartment – a full-sized washer and dryer, air-conditioning, and different creature comforts in the unit,” says Anderson. “Those are very expensive units to build relative to their size, and for their pro forma to work, they need to achieve a much higher rent per foot. When micros rent for near the same price as a studio, they’ve had trouble stabilizing those buildings. Our experience has been you must right-size the finishes so you can still offer an affordable unit. What we’d expect is hard surface flooring, hard surface countertops, mid-grade cabinets, and mid-grade bathroom improvements, while not going above and beyond in appliance quality or even appliance offerings.”
For example, he says, some individual apartments may only have a microwave or countertop burner, and each floor might have a full-sized kitchen that tenants can share. Hewlett says he knows instances of communities that have eliminated one unit per floor and turned that area into a communal gathering and entertainment space. Correct rental pricing is key. “As long as the asking price for the units is approximately $250 less than the next-most affordable studio, they do very well,” says Anderson. “In Seattle, if studios are around $1,500 per month, and micros are running for about $1,250, they do fine. If someone builds the nicest micros and asks $1,400 per month, they don’t do as well.” Hewlett notes a similar figure – the rent sweet spot, he says, is around 20 to 25 percent below a conventional studio.
With a young and often-transient market for microunits, leasing and turnover can be a concern. “They definitely have a higher turnover rate,” says Anderson. “We’ve talked to dozens of owners. Some near the University of Washington have experienced as much as 100 percent turnover, while other in markets with fewer affordable options have seen turnover as low as 40 percent. We’ve gravitated to about 70 to 75 percent turnover as what you can expect. Most management companies and owners are signing nine- to 12-month leases, making sure they’re staggered, just as you would in a market-rate building.” But, he adds, the demand for the units means that they lease quickly. “The drawback is you have higher leasing staff expense,” he says. “The benefit: When you do lease, you can usually turn the unit within a day and sign a lease within a week.”
“In good locations, and with a good economy, I think the depth of the market for a certain percentage of these is very robust,” says Hewlett. “I haven’t heard of any problems that any communities have had in good locations renting microunits.” At the same time, he has observed one notable piece of planning. Some developers are building flexibility into their communities. One building in Washington, D.C., for example, features a mix of microunits along with conventional apartments. The micros are built in separate bays of the buildings. “If the market was moving away from these smaller units in 10 or 20 years, they could break through the wall between two microunits and turn the space it into a conventional one-bedroom unit.” Hewlett says. “They would lose the investment of one of the bathrooms and one of the kitchens, but they wouldn’t have two units that they couldn’t rent. Forward thinking and smart design professionals and developers are looking at how to create flexibility into their design so that if that market moves away, they can convert.”
Anderson’s advice for those considering getting involved in microunits: “Get out and see them. When you see a 250-square-foot unit, well designed, with nice large windows, hard-surface flooring, new appliances – it shows and lives really well. It’s easy on paper to think that this thing is uninhabitable and smaller than a mousetrap, but you get in it and see how – at various points in your life – you easily could live in one of these units and save quite a bit of money.”