February 15, 2023 | The Small Deal Survey: What We Learned | By: Patrice Frey, Senior Advisor at Main Street America |
As readers of the MSA Blog will know, I’m excited to lead Main Street America’s Small Deal Initiative. This project explores barriers to small-scale real estate development projects across our Main Streets and identifies ways to help our Network overcome these challenges. We define small deals as those under $5M in total project costs, though we recognize many Main Street projects fall well below that threshold.
At one time or another, nearly all Main Streets will encounter real estate development projects that are difficult (if not impossible) to get off the ground. In communities of color, where assets may be artificially devalued, rehabilitation work is even more difficult as it’s extremely difficult to obtain financing to cover the real costs of repositioning a building. Beyond this devaluation of assets, owners and developers of color continue to face other systemic barriers to accessing capital.
Rural communities face challenges as well, both because asset values are often depressed – meaning it’s not possible to qualify for a loan that will cover a substantial portion of rehabilitation costs – and because small towns have fewer lenders from which to seek investment.
About the Survey
In Fall 2022, MSA partnered with infill developer and small-deal guru Jim Heid and the Incremental Development Alliance to conduct surveys on the barriers to small-scale real estate projects across the United States. We were thrilled to have more than 500 Main Street leaders, small-scale developers and other interested folks participate in this research. To our knowledge, ours was the first such national survey to identify the challenges that stand in the way of repositioning smaller-scale buildings or adding small-scale infill development to downtowns and districts. Huge thanks to Jim Heid of the Building Small empire and Sherry Early at IncDev for their partnership, to Mike Powe (MSA’s Senior Director of Research) and Emi Morita (MSA’s Research Analyst) for their execution and analysis of the surveys, and to those of you who participated.
Let’s dig into what we learned.
Inability to Develop Small-Scale Real Estate Holds Back the Revitalization of Main Streets
Our respondents indicate that challenges in rehabilitating small buildings and advancing infill development impede economic progress in downtowns and districts. Fully 70 percent of Main Street America local leaders reported that the lack of built-out space holds back economic development in their downtowns or district. Anecdotal evidence from Main Street America’s Field Services Team suggests that “easier” buildings have been renovated in many places. New business starts and existing business growth is hindered by the inability to reposition more complex structures.
Uncooperative Building Owners, Capital Inaccessibility, and Local Capacity Challenges Hinder Small Deals
Various factors make it difficult to adaptively reuse existing buildings and put vacant lots back into service. While the survey identified many obstacles, uncooperative building owners, a lack of financing options, and a lack of local developer capacity as the top three obstacles to reuse and infill development.
Uncooperative Building Owners - Identified as a top obstacle by 72 percent of Main Street respondents.
Hindsight is 20-20, and if we were re-designing our small-deal survey today, we would have asked for a lot more detail on the topic of uncooperative building owners. Anecdotally, we know that owners of buildings can pose challenges for several reasons. Certainly, one of the most frequent complaints I hear is that owners often have very unreasonable expectations about the value of their buildings, either thinking the building is worth more today than the comps would suggest or believing that their town is on the cusp of a resurgence and they should hold onto their building because valuations will increase dramatically in the future. Other property owners sometimes hold on to buildings purely for the tax benefits, and still others are simply absentee owners and difficult to reach.
Capital-Related Challenges - Identified as a top obstacle by 45 percent of Main Street respondents.
A myriad of challenges accessing capital can stand in the way of small deals.
Pre-development Funds: In our survey of small-scale developers, 80 percent of respondents report that securing pre-development funding is a difficulty in development, particularly for smaller-scale, more locally serving development projects. Pre-development costs include architectural fees, engineering fees, legal fees, preliminary financial applications, and other expenses incurred in the very early stage of project development. Our survey also indicated that pre-development funds often come from sources that may be scarce for first-time or otherwise inexperienced developers, including personal funds, friends and family, and club investors.
Acquisition Capital: Our survey also found that sources of acquisition capital are also likely to be scarce among women or BIPOC developers;’ typical sources include personal funds, friends and family, CDFIs, and high net-worth investors. 80 percent of developers of color respondents and 79 percent of non-male respondents indicate that acquisition funding is a difficulty in development, compared to 68 percent of all male developer respondents and 69 percent of all white respondents.
Construction Capital: Survey respondents similarly report considerable difficulty in securing construction financing. About 80 percent of developer respondents say securing construction financing was “difficult,” “very difficult,” or “extremely difficult.”
Thin Project Margins: Our survey seems to suggest a final capital-related challenge. While there are high-quality small deals that meet investors’ typical expectations of financial return, many small-scale projects -especially in communities that have experienced significant disinvestment - simply don’t pencil at conventional rates of return
To re-appropriate a phrase from the world of politics, all real estate is local. While clear themes emerged in the data – for example, the specific and significant challenge of obtaining pre-development funding – this research suggests that the needs of Main Street projects vary widely and are project specific. The need for flexible sources of capital at all stages of the redevelopment process is clear, as is the need for low-cost or even no-cost capital.
Our survey indicates that small-scale development is hindered not just by access to capital but also by a lack of experienced developers to lead these projects. More than forty percent of Main Street leaders reported that their communities lack real estate developers to take on rehabilitation or infill projects. Several interviewees noted that even when communities are fortunate to have local developers, these professionals eventually “move up the chain,” taking on larger buildings because these projects typically offer better returns.
There is an even greater lack of representation of women and BIPOC-developers, who traditionally have faced substantial barriers in the field. Those with ambitions to become developers find a fragmented and chaotic ecosystem, encountering difficulties with everything from the acquisition of property, to the local entitlement process, to construction financing, to the construction process. There is a clear need for capacity building and systems to support emerging developers throughout the Main Street America Network.
Other Zoning, Code, and Regulatory Barriers Stand in the Way of Adaptive Reuse and Infill Development
Other difficulties related to small scale-development include a multitude of zoning, building code, and other regulatory barriers. Multiple survey participants wrote in responses indicating that parking minimums impede small-scale projects and that there are difficulties associated with navigating historic landmark commission review processes. Meeting building code requirements can be prohibitively expensive, with respondents noting that required fire suppression systems, grease traps, ADA upgrades, and asbestos abatement are particularly costly. Fiber, sewer, water, and electrical hookups are also significant expenses. Finally, permitting processes were reported as “needlessly difficult,” with rules and regulations that are sometimes contradictory, complicated, and/or confusing. A lack of trained municipal staff and politicized permitting processes were also identified as barriers.
The Path Ahead
While it can feel overwhelming to read that (very long list) of challenges standing in the way of such important development projects, this research helps to illuminate the path forward: we must find new sources of capital to connect to small deals, especially from investors willing to take a reduced rate of return and offer flexible lending terms. Building on the important work of Jim Heid, the Incremental Development Alliance, the National Development Council and others, we must also redouble our effort to support emerging developers – especially women and people of color – through training, mentorship and a range of other offerings to help smooth the path for these new developers.
In the longer term, we must wrangle with the myriad other issues that stand in the way of small deals, including identifying creative and effective strategies for engaging reluctant or uncooperative building owners. This area is challenging, however, because few legal tools are available to address this issue, and the tools that do exist can vary state-by-state. Because our Main Streets are rich with other good potential projects in which owners are engaged – or can be engaged – and we’re turning our attention to these first.
Join me at the Main Street Now conference in Boston to learn about our new pilot project to attract investment capital to small deals (hold a space on your calendar for our session on the Small Deal Initiative on Monday, March 27th from 2:45 -3:30 p.m.) I look forward to seeing you and sharing more soon!