When a new apartment development recently opened at 15th and Magnolia streets in Detroit, residents of the inner city applauded. The 88-unit, $8.8 million Heritage Place project boasts some luxury features — including high-speed Internet connections and an exercise room — yet monthly apartment rents are only about $450.

The affordable prices can be attributed to the Low-Income Housing Tax Credit (LIHTC) program. Under the federal effort, the government establishes rent ceilings and helps developers raise equity. Then Washington steps out of the way. Private developers are free to design and manage projects, deriving whatever profits they can.

“The tax-credit program makes it possible to earn a decent profit on a development like Heritage Place,” says Lance Swank, COO of the Sterling Group, the private developer that built the project in Detroit. (For more information on how tax credits work, see sidebar on p. 55.)

In recent years, the public-private tax program has thrived, becoming the leading source of capital for affordable housing. While public-owned projects in Chicago and other cities have deteriorated and been torn down, many tax-credit properties are in fine shape after two decades of use.

But the public-private program is not big enough to satisfy the country's needs. Each year, tax credits subsidize construction of about 125,000 housing units, according to the National Council of State Housing Agencies. But many aging units are constantly demolished, and the country loses more affordable units annually than are built.

Construction is becoming more difficult as developers struggle to cope with rising energy and material costs. As a result, millions of households are straining to pay their monthly rents. Many existing affordable projects have long waiting lists of prospective tenants. While poor households face the worst problems, many people who consider themselves middle class are lined up for new projects that are designed for households of modest means.

“We are not keeping pace with the need for affordable housing,” says Swank, who also is chairman of a committee on tax credits for the National Association of Home Builders. “There are many areas of the country that are way underserved.”

Locked out of housing boom

Over the last five years, the problem has become more acute. Costs of new homes have been rising at double-digit rates, while wages of many workers have remained flat. The Department of Housing and Urban Development recommends that households should not spend more than 30% of their income on housing.

But from 2001 to 2004, the number of households that spent more than half their income on housing increased by 2 million to 15.8 million, according to Harvard's Joint Center for Housing Studies. Today, one in three American households spends more than 30% of income on housing.

The problem is especially pronounced on the coasts where housing prices have skyrocketed, according to the National Housing Conference, an affordable housing advocacy group in Washington, D.C. A mortgage applicant needs an annual income of at least $120,000 to buy a median-priced house in Boston, more than double the average salaries of middle-class workers, such as teachers and police officers.

The result for many tenants is a squeezing effect: two or more families often are sharing one unit. In order to buy houses that they can afford, many employees live a considerable distance from their jobs, suffering through long commutes.

Seeking remedies

To overcome the shortages, developers and nonprofit groups have been lobbying Congress for more tax credits or other subsidies that can support affordable construction. But faced with budget deficits, Washington has been reluctant to increase the amount of money spent on housing. Many cities and states have tried to fill the gaps with subsidies or zoning variances that make it easier to develop affordable units.

Whatever programs eventually emerge, tax credits are likely to remain at the core of the housing efforts. Congress issues tax credits to state agencies, and developers bid for the credits. For example, if a developer wins $100,000 in tax credits, he can sell them to banks or other investors, who in turn can use the credits to reduce their federal income tax bills. A $1 credit lowers a tax bill by that amount. After selling the credits, the developer uses the proceeds as equity for the project.

To begin work on its Heritage Place project in Detroit, Sterling Group first obtained a vacant lot surrounded by subsidized single-family homes. “The area was gentrifying, and there was a clear need for more apartments,” says Swank of the Sterling Group.

Sterling received a tax credit of $798,328 that enabled construction. Occupants of the seniors housing complex began moving in during May. “We love doing seniors housing,” says Swank. “There are not a lot of rent delinquencies, and elderly people tend to take care of the property.”

Menu of incentives

Often developers get more bang for their buck by using state and city subsidies in addition to federal tax credits. The Related Cos. L.P., a major New York real estate firm, recently spent $34.6 million to purchase Ocean Park, a 602-unit project on Seagirt Boulevard in the Far Rockaway section of Queens. The company will spend $10 million to renovate the subsidized project, which was built in 1972.

About 25% of the purchase price came from tax credits. In addition, the developer lowered financing costs by using tax-exempt bonds issued by the New York State Housing Finance Agency. Under the developer's agreement with the state, at least 70% of the project's units must be rented to tenants whose income is 60% or less than the area's median level of $41,509.

In addition, the building must keep rents at affordable levels for 40 years. Some tenants will receive rent subsidies from HUD. “The deal only penciled out because we could put together several layers of subsidies,” says Mark Carbone, president of Related Apartment Preservation LLC.

Government intervention

To encourage affordable housing, some states allow developers to avoid complying with local zoning that often is a barrier to new construction. In Massachusetts, developers can qualify for favorable zoning if they offer at least 25% of the units in a project at affordable rents. Other state programs are less aggressive, requiring only 15% of units to be affordable.

In some cases, state officials overrule local zoning boards, permitting a project to go ahead. “Many municipalities have artificial restrictions that are designed to keep out low-income housing,” says Alberto Cardenas, a principal with the Boston-based architectural firm of Domenech, Hicks & Korckmalnic. “The required densities are way too low to permit affordable housing.”

To succeed with a project that includes a mix of market-rate and affordable housing, the developer must ensure that the market-rate units subsidize affordable apartments, says Cardenas. He currently is working on a 240-unit project that is in a middle-class neighborhood of Pembroke, Mass. The developer, Trammell Crow Residential, a national builder based in Atlanta, received favorable zoning by making 25% of the apartments affordable.

San Francisco, where the median cost of a home is $700,000, recently imposed tough new requirements on developers. Under the rules, any project with five or more units must offer at least 15% of the units at affordable rents.

New York ranks as a leader in promoting affordable housing, using zoning and financing subsidies. With immigration booming, the city has added 840,000 new residents since 1990. The spike in population has helped fuel a surge in housing prices. Now such formerly depressed neighborhoods as Harlem boast houses that sell for more than $1 million.

To help those tenants who have been priced out of markets, the city committed $3 billion to a five-year program, now nearly complete, aimed at building 65,000 affordable units. A $200 million city fund now finances small developers, and the city's Housing Development Corporation has been issuing tax-exempt bonds to support affordable units.

Soaring costs

No matter where they operate, all developers of affordable housing face severe problems with rising costs of building supplies and utilities. The cost spikes are a particular problem for developers using tax credits. Under the federal program, landlords can only raise rents when local wages climb, according to a measure used by HUD.

If wages are showing little or no gains — as is happening in many markets — the rents cannot be raised. “If utility costs are skyrocketing, that money has to come out of the owner's pocket,” says Barry Kahn, president of Hettig-Kahn Cos., a Houston-based developer.

To illustrate the problem, Kahn uses a hypothetical example of an apartment that had a maximum monthly rent of $500 in 2005. Of that amount, the state housing regulators budgeted $100 for utilities. After utilities were subtracted, the landlord received a net rent of $400. In 2006, regulators allowed the monthly rent to climb to $520. But monthly utility costs have climbed to $200. Now the landlord only collects a net rent of $320.

To protect owners, the National Association of Home Builders has proposed linking rent hikes with changes in the Consumer Price Index (CPI), instead of relying on the current benchmark, which is tied to local wage measures. In many markets, the CPI has been climbing much faster than HUD's system of measuring wages.

“HUD should find a fair system for setting rents,” says Swank of the Sterling Group. “That will strengthen the tax credit program and ensure that private developers will continue helping to relieve the housing shortage,” Swank adds.

Targeting the middle class

While most programs are geared toward assisting low-income residents, some developers are making special efforts to reach people of modest means who don't qualify for government aid. Phoenix Realty Group, a New York firm, recently raised $250 million for a fund that will invest in housing for middle-income residents in high-cost areas of Los Angeles and other cities. Investors in the fund include MetLife and Citibank.

The idea is to build small units with modest amenities on less costly land. The developers hope to earn annual returns in the mid-teens. That is less than the results that have been achieved by developers of luxury units. But at a time when demand for luxury units may be slowing, the cheaper apartments could have considerable appeal.

“We are seeing more middle-class households that are eager for affordable housing,” says Swank of the Sterling Group. “By being creative, developers can find ways to build what the customers want.”

Stan Luxenberg is a New York-based writer.

Turning tax credits into bricks and mortar

In recent years, developers have competed ferociously to win Low-Income Housing Tax Credits (LIHTC). The appeal is clear: With tax credits, affordable housing projects can turn a nice profit. Without the credits or some other subsidy, it is extremely difficult for profit-making developers to charge low rents.

“If they win the tax credits, developers can get about the same margins with affordable housing as you would get with market-rent properties,” says Gary Alex, who oversees tax-credit deals for KeyBank Real Estate Capital Markets.

The process starts each year when Congress allocates credits to every state. For example, Michigan recently received more than $6 million in tax credits. Developers put together proposals and bid for the credits.

In many states, there are three bids for every credit, according to the National Council of State Housing Agencies. State agencies score the proposals, giving more points to projects that meet certain criteria, such as offering very low rents or being located in underserved areas.

After obtaining the credits, the developer sells them to an investor such as a major bank. For each dollar worth of credit, the bank can lower its tax bill by one dollar.

The investor pays the cash up front and receives the credits in annual installments over 10 years. Investors own shares in the properties, and in hot markets those shares can sometimes be sold at big profits.

As recently as five years ago, investors typically paid about 75 cents for each dollar of credit; investors figured that the credits had lower value because they were paid out over a decade.

Lately the prices have been climbing, reaching more than $1.02 in some cases, as bidders expect that the properties will appreciate. “We have been seeing a feeding frenzy in the market for credits,” says Alex of KeyBank.

After selling the credits, developers take the cash and use it for equity. Then the builder must raise debt to cover the rest of the costs. A typical deal may include up to 50% equity and the rest in mortgage debt. Developers often have little trouble raising the debt.

Lenders are eager to participate in the program, which has recorded few defaults. Risks are limited, since the deals are heavy with equity, and at a time when affordable units are scarce, owners have little trouble filling any vacant apartments.
— Stan Luxenberg