The preferences and concerns of pre-industrial Venetians were different from the preferences that you or I might have when envisioning a "nice place to live," and this impacted the way the city's inhabitants planned their city. But another important thing to keep in mind is that the Realtine Islands, where modern center of the city we know as Venice is located, would have been nearly unrecognizable to us for the first several centuries of its existence.

While St. Marks’ square was paved in the 13th century, the other squares in the city (appropriately called “Campi”) would remain mostly unpaved well into the 18th century. While certain neighborhoods, like St. Mark’s, along with the areas adjoining the Grand Canal, the Ghetto, and the Arsenal, were indeed very densely built-up, other more peripheral parts of the city were much less dense, with unpaved streets and muddy canal banks, where homes separated by orchard groves and vegetable gardens. In fact, much of the dense apartment blocks on city’s northern and eastern edges are relatively new compared to the rest of the city, having been built-up as middle-and-working-class housing after the unification of Italy (the furthest east part of the city in particular was built-up most recently, principally in the 1920s as public or subsidized housing).

And it is not, strictly speaking, accurate to say that the Realtine Islands are the only densely inhabited parts of the lagoon. Murano, Burano, Chioggia, the Lido, and Malamocco are all densely built-up communities located on Lagoon islands some ways away from the Realtine center.

In fact, the earliest inhabitants of the lagoon ignored the Rialto! Originally, the Venetian community was very much spread across the lagoon, with settlements in Torcello, Eraclea, and Malamocco much more important than the community on the Realtine Islands. It is only in the tenth century, after two hundred or so years of Republican rule, that the Venetians began migrating to the center of the lagoon.

Indeed, the largest early settlements were in the northern lagoon, notably Torcello. The landscape here is characterized by shallow canals, wide mud flats, and numerous islands. While the damp and loamy soil of the islands is not particularly well-suited for agriculture or pasture, for the mercantile early Venetians this was of relatively little importance. Small flat-bottomed working boats connected island communities, and while galleys had a bit of a tougher time (especially if burdened with goods) most seagoing ships below a certain size could loaded and unloaded while run aground at low tide.

The impetus to move from the northern lagoon to the Rialto certainly had practical connotations. An important factor was the location of the Doge’s first official residence (and Venice's first public building): an imposing castle on the eastern end of the Realtine Islands (today, unfortunately, all that survives is the neighborhood’s namesake “Castello”). While the choice of a central position overlooking one of the lagoon’s lanes to the sea was in part driven by security concerns, mercantile concerns also played a big part. The early Venetians had settled in the shallow northern lagoon because islands there are larger and more numerous, but by the tenth century merchants found they couldn't accommodate increasingly large merchant galleys, while on the other hand the wide basin in front of the Realtine Islands most certainly could. Lastly, diseases (principally malaria) also pushed the Venetians away from the northern lagoon and towards the Rialto.

You see, the shallow stagnant water of the northern lagoon (isolated from the stronger tides and currents of the deeper basins to the south) breeds diseases, especially where there are people living in close proximity to each other (and to animals) without modern plumbing and garbage disposal systems. The Realtine Islands, more exposed to tides and sea-currents, are naturally more sanitary (although as time went on, the Venetians would eventually have to dredge canals and redirect the rivers to safeguard the Realtine Islands too).

But why were people living so close together to begin with? To conceptualize an answer to this question, we have to envision a society that is immeasurably different from our own. This is a society with no rapid communication, and where personal connections are a vital resource. Networks of artisans, bankers, and merchants needed to be close together in order to maximize interactions. Business needed to be overseen largely in-person, or by agents who had earned trust through close in-person relationships. Both literal and figurative marketplaces were difficult to navigate, with buyers and sellers haggling in ever-shifting networks of trust and mistrust. In a society where news and business spread by word-of-mouth, proximity was vital as artisans competed to secure the best raw materials at the cheapest price, while financiers strived to participate in lucrative expeditions, and sailors sought to get hired by increasingly shrewd captains.

The value of proximity is important to any pre-industrial city. While Venice was particularly large for its time, the very same needs influenced most of the world’s urban planners (such as they existed) prior to the invention of the automobile: any pre-industrial city street grid is a web of largely organic narrow streets allowing for tight-knit neighborhoods. Venice is probably most striking in that no other city to have reached its size (anything between a quarter million to a half million residents at its height) experienced such a dramatic subsequent decline, leading the city to be largely ignored by the urban planning trends of the industrial age.

Indeed, even before the invention of the automobile an important byproduct of the earliest industrial age is the desire to streamline city streets for wheel-cart and trolley traffic. While Baron Haussmann’s plans for Paris are probably the most famous intervention of this kind, similarly-minded planners intervened in all of Italy’s major cities, demolishing old medieval fortifications and cutting through ancient neighborhoods to lay down wide boulevards (this is why, when strolling in the quaint neighborhoods of Italian cities like Rome or Florence, you can turn a corner and find yourself unexpectedly in front of a six-lane avenue; Milan in particular is notable for all but one of its main thoroughfares and every single one of its main squares being carved out after the turn of the 19th century). But no such transformation occurred in the declining city Venice. It's true that small efforts at "modern" renewal were made: in the Napoleonic period green spaces were expanded, and notably a public park was built in the "Castello" neighborhood the eastern end of the city, while in the subsequent Austrian period a canal was interred to create a wide boulevard in that same neighborhood. An analogous intervention took place in Milan, also planned by the Austrians-by-way-of-Napoleon, but while the Milanese upper classes did relocate to the new boulevard along the new gardens (the modern Corso Venezia, go figure) the smaller and less dynamic Venetian aristocracy and bourgeoisie never really cared for these interventions and the "Castello" neighborhood remained largely working-class.

The Venetian’s indifference to interventions in the city was also in part due to the fact that the city’s most vital traffic artery would always remain the Grand Canal. At the city's height, patrician dynasties jockeyed to outdo each other in building increasingly grandiose palaces along the Canal’s waterline. Their location along the Canal allowed the Venetian patricians to easily oversee their ships and warehouses, visit collaborators, and spy on competitors, all the while watching over their ships traveling in and out of the harbor in real-time. In earlier periods, palaces along the Grand Canal could also double as warehouses, with goods unloaded directly to and from their wide doorways opening onto the water. In short, the Venetian upper class were very interested in being in the thick of things.

One important phenomenon to point out is that as Mediterranean commerce declined, the Venetian dynasties did turn away from trade and built comfortable estates outside the city. However, they weren't interested in other islands of the lagoon, but rather intermarriage with dynasties from the mainland saw venetian aristocrats increasingly invested in agricultural estates, with grand palatial homes built overseeing the fertile lands along the roads leading from the Lagoon to the cities of Padua and Treviso. I actually wrote about venetian country homes and how they came to define "Palatial" (from the architect Andrea Palladio) here, in an admittedly tedious and overenthusiastic answer.

You might also be interested a couple of posts touching on quality of life in historic Venice: this post about venetian food security, and this other post about drinking water availability in Venice. There is also this other post you might be interested in about aspects of urban planning in 19th century Italy.