Affordable Housing – High Leverage vs. Complexity
Affordable housing projects provide the sponsor (e.g., developer) incentive in the form of subsidies – the most active of which for new supply nationwide are Low Income Housing Tax Credits (LIHTC). Other subsidies (e.g., property tax abatements, inclusionary zoning, state tax credits, 80/20) may be used in conjunction.
BACKGROUND ON LIHTC
Introduced via the 1986 Tax Reform Act, LIHTC are federal credits which state and local housing agencies allocate. While providing significant monetary incentive, they are also one of the most complicated programs for housing development.
LIHTC effectively streamlines affordable housing by cutting out the federal government as the middleman – the private market provides capital up-front and monitors compliance.
The tax credit is a dollar-for-dollar reduction in one’s tax liability (as opposed to a tax deduction).
Up-front investment is required (only 4%) to finance land acquisition and housing construction/rehab. The tax credit is claimed over 10 years by the property owner (LP or LLC); cash flow runs to the GP developer, and tax credits & losses run to the LP syndicator.
Rent restrictions are imposed for a 15 year ‘compliance period’ and a 15 year ‘extended use period’. Non-compliance (e.g., qualifying a tenant that has too much income) can lead to tax credit “recapture” by the Treasury.
Eligible for the tax credit are a significant portion of the total project expenses (e.g., hard costs, construction financing). Ineligible expenses include those associated with land acquisition, permanent financing, commercial space and legal.
2 types of LIHTC based on annual % of eligible basis claimed over 10 years:
-competitive scoring system ranking sponsor based on value they bring to the project (e.g., lower rents, green elements, experience, site control)
-low financing fees
-tax-exempt bonds promoting private activity for public purpose
-credit enhancement – a financial institution guarantees repayment of bonds/interest
-involves an issuer, underwriter, investment banker, credit enhancer, servicer, trustee and all their legal counsels
-supports acquisition costs
Developer – a for-profit or non-profit entity that identifies the project and applies for funding, lines up the architect, engineers and general contractor, and coordinates with city and local government.
Low income tenants – tenants with gross income less than a certain percentage of the area median income (AMI) for households of equal size. A portion of the property can have market rate residential tenants and commercial space.
Syndicator – the syndicator acts as an intermediary between the developer and investor(s). He/she receives up-front fees to identify and underwrite investments, and nominal ongoing fees to manage assets and funds. An investor is a limited partner providing a private equity investment in a fund which essentially purchases 99.9% of the property and receives 99.9% of tax credits as well as other passive benefits.
Investor(s) – LIHTC investors include (1) Community Reinvestment Act (CRA) investors: bank holding companies with regulatory requirements to reinvest into communities where they hold deposits (e.g., Citi, Goldman, JPMorgan); and (2) Yield investors: large corporate institutions with steady annual cash flow and a long term investment horizon (e.g., Verizon, Google, MetLife). Pre-credit crisis, 25 of these investors made up 85% of the affordable housing market; Fannie Mae and Freddie Mac alone were 50%. Eligible investors have to be in the 35% corporate tax bracket. Individuals can’t invest; however, there is legislation before congress to consider expanding the investor market. Today investors are seeking a 9-10% IRR; included in the return are equity installments, tax credits, depreciation, interest deductions and other losses/expenses.
Construction and permanent lender – provide financing for the construction phase and permanent financing. Construction lending is typically provided by banks. Permanent financing comes from banks, state and local agencies, FNMA, Freddie Mac and other sources. Standard underwriting includes a 5% vacancy factor and 4-6% for management.
Agencies – although LIHTC are federal credits regulated by the US Dept of Housing and Urban Development (HUD), state and local housing agencies are responsible for their allocation. Below are the agencies involved in New York (NY has the most and is the most complicated).
State - Division of Housing and Community Renewal (DHCR)
State - NYS Housing Finance Agency (NY Homes or HFA)
City - Dept of Housing Preservation and Development (HPD)
City - NYC Housing Development Corp (HDC)
City - New York City Housing Authority (NYCHA)
Let’s look at an actual affordable housing project utilizing LIHTC and the 421A tax abatement.
Parkview Commons, East 161st Street, Bronx NY – mixed use / mixed income
Housing built to target low income tenants – 87 new units; rent restrictions for 30 years. Construction began in 05; stabilized in 08. Project involved coordination between 4 subsidy sources, plus the real estate development process.
Developer (for-profit) L+M Development Partners
Developer (non-profit) Nos Quedamos
Tenants 60% of AMI
Construction Lender Citibank
Permanent Lender Citibank
Agencies HDC, DHCR, HPD (4% LIHTC)
Hard costs 15,163,827
Soft costs 3,396,816
Developer fee 2,601,054
SOURCES – CONSTRUCTION:
HDC tax exempt bonds 10,900,000
HDC subsidy – 2nd mortgage 3,960,000
Developer’s fee 2,601,054
Tax credit equity 3,702,669
SOURCES – PERMANENT:
HDC tax exempt bonds 4,255,000
HDC subsidy – 2nd mortgage 3,960,000
DHCR HTF – 3rd mortgage 3,079,000
Developer’s fee 771,954
Tax credit equity 9,091,811
Cash equity 3,933
Note the sponsor’s (i.e., joint-venture developer) upfront investment of $771,954 is 4% allowing for 96% leverage (LTC) after all financing/subsidies; however, at the end of the day upon project completion the leverage increases to ~105% as LIHTC tax credits are claimed over a 10 year period.
Affordable housing is not a cash flow business due to downward pressure on rent required to qualify for subsidies. Yield benefits come from (1) annual receipt of tax credit; (2) depreciation of real property (27.5 years), site work (15 years), and personal property (5 years); and (3) deductible expenses from interest and amortization. Note that secondary/distressed markets won’t qualify for maximum tax credits (as opposed to markets like NY).
As we see, leverage for this commercial real estate sector from a financing standpoint can be quite attractive; however, the process is far from simple requiring significant timing, legal and regulatory coordination among many parties. Success requires significant experience from the sponsor which is why joint-ventures are common.
Affordable housing is considered one of the most stable sectors in commercial real estate. All of the heat that FNMA and Freddie Mac received in the wake of the credit crisis has been due to their single family programs. Their multifamily programs have been very successful with default rates of less than 1%. Note that there is some secondary market activity where developers with tax credits unable to complete projects are selling portfolios at a discount.
This article was written based on a presentation at a Urban Land Institute (ULI) Young Leaders Group Peer to Peer breakfast with the following panelists:
Anne Carson Blair, L+M Development Partners
Drew Foster, Raymond James Tax Credit Funds
D. Hara Sherman, Goulston & Storrs
Evan Williams, Prudential Mortgage Capital Co.
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