CREJ - Multifamily Properties Quarterly - August 2016
Most of us have heard the statistics that we need more affordable housing in Colorado, period. A “housing cost-burdened household” is any household that spends more than 30 percent of its income on housing. It is estimated that one in four renters in Colorado pays more than 50 percent of her income on housing, and 325,000 are spending more than 30 percent of their income on rent, according to Housing Colorado, a statewide association. By 2025 it is estimated that Colorado’s population will increase by 1 million due to our continued growth. Many of the jobs created over the next 10 years will have annual salaries of less than $36,000, according to a report from the Colorado Department of Labor. That is well below the income required to afford the average two-bedroom apartment. With this lack of supply, the gap in current inventory would take over 100 years to catch up to the demand, said a Housing Colorado report. So, why are we not developing more affordable housing? Simple: money. When an affordable housing developer is asked to explain how he finances his developments, he may be apt to respond with the infamous Facebook relationship status indicator – “It’s complicated.” One reason for this is the prime equity markets demand market-rate returns and affordable housing, by its very design, offers below-market rents. Prime markets (investors seeking the best economic returns) outnumber the affordable markets (investors seeking tax credits and other forms of economic or social benefits). With fewer equity options, affordable developers must seek alternatives to their funding sources, also referred to as the capital stack. Available Programs There are multiple programs that provide grants such as the Community Development Block Grant program, which is allocated and managed by the U.S. Department of Housing and Urban Development to benefit low- and moderate-income persons, and HOME funds, which are federal grants to create affordable housing for low-income people. But even with these sources, developers often are stuck with a financing gap. Local municipalities are another potential gap-funding source. The Office of Economic Development for Denver hosted an affordable housing conference in May called Bridging the Gap with the goal of having community leaders help solve this critical funding issue. One innovative way OED approached the financing gap was by creating a new Revolving Affordable Housing Loan Fund in 2015, which has helped close the financing gap on several local developments with a commitment to fund more. The largest funding source, outside of the permanent debt, is federal and state low-income housing tax credits. There are 4 percent and 9 percent tax credits, which contribute roughly 30 to 70 percent, respectively, of the equity needed for the development. The 9 percent tax credit is very competitive, due to a limited supply. LIHTC incentivizes private investment in affordable development by providing reductions in state and federal tax liability for the tax credit investor. The Colorado Housing Finance Authority is the designated state-allocating agency for Colorado and is responsible for designing and implementing the program. As you already may have surmised, even with all the federal and state tax credits and municipal programs, there still remains a funding gap in many developments to breaking ground and delivering these much-needed housing units to the local community. An effective approach to decreasing the financing gap is to increase the size of the permanent mortgage. A larger mortgage may completely eliminate the gap and remove the need for an affordable developer to defer his fees as contributed equity. The Federal Housing Administration insured loan, in general, provides the largest loan amount for an affordable development. This is the case even compared to other loans specifically designed for affordable housing, such as the Freddie Tax Exempt Loan. Freddie TEL and FHA both have the same debt-service coverage requirement of 1.15 to 1, but FHA provides for a lower rate, generally by 0.50 basis points, and a longer amortization, 40 years versus up to 35 years. The combined effect creates a lower loan constant. The lower loan constant results in a larger qualifying loan. This is due to the fact that it is common for affordable developments to be debt-service constrained. After loan and lender fees, the FHA loan provides the lowest cost of capital for the senior debt. The 4 percent LIHTC creates the largest financing gap and is more readily available, compared to the competitive 9 percent; however, such bonds are not unlimited. In fact, the state is provided with a volume cap of tax-exempt bonds to be used to promote certain private activities for the public good. At least 50 percent of the development’s aggregate basis (land plus depreciable assets) must be financed by volume cap tax-exempt bonds to claim the 4 percent credits. Therefore, in the case of a $20 million total budget, at least $10 million would need to be funded by a private activity bond through the state to meet the 50 percent test needed for the 4 percent tax-exempt bonds. The term of the private-activity bond typically will mirror that of the construction period in the form of a short-term, cash-collateralized bond. After receiving the PAB, the proceeds would then be advanced pari passu, during construction draws with the FHA loan and account for half of the funding source. Once construction is completed, the investor redeems the PAB and the borrower is left with the FHA mortgage and 4 percent LIHTC credits he started with. As an analogy, we can think of the PAB as the red wine in a spaghetti sauce that is cooked off during the preparation (construction) process, leaving the original recipe (permanent mortgage and tax credits) intact. With less available capital, more intellectual capital is required to develop affordable housing.