Nine years after first being introduced by Congress, the low income tax credit program has become the catalyst for one of the hottest segments of the real estate industry -- affordable housing -- as well as a darling of the investment community.

One of the few beneficial measures intended to encourage investment in real estate that emerged from the Tax Reform Act of 1986, the low income tax credit program has been responsible for producing between 70,000 and 100,000 units a year nationally, and about 50 percent of the total apartment units produced in 1992 and 1993. In 1994, approximately one-third of all new apartment construction was financed by tax credits.

Although the program had been effectively used since its creation in 1986, its credibility and viability were boosted significantly in 1993, when Congress passed the Revenue Reconciliation Act, making the tax credit program permanent after years of short-term extensions.

"In 1993, the market for investors just exploded, and there was a tremendous demand," says Jack P. Manning, president and CEO of Boston Capital, which specializes in providing both equity and debt financing for the development of affordable rental housing, and is the fifth largest owner of apartments in the country, with 67,000 affordable units in its portfolio.

"Corporations had been looking at this program since it was first started," explains Manning, "but the permanent enactment in 1993 gave the program the credibility that was needed for [those corporations] to commit." Manning says that 1993 was the biggest year ever for the industry, with $1.5 billion invested by major corporations. Although competition in the market has driven yields down somewhat, Manning says 1994 was still a "very good year," and "the future looks just as promising as more and more corporations consider investing in these types of funds." In addition, the demand for affordable housing continues to outstrip the supply, even with 700,000 new affordable units coming online since the beginning of the program in 1986.

The tax credit encourages the creation of low income rental apartments by offering investors a credit against their income taxes for part of the cost of developing such housing. Investors receive an income tax credit each year for 10 years equal to approximately 4 percent of total eligible project costs for acquisition-rehabilitation projects and 9 percent for substantial rehabilitation and new construction.

Both corporations and private individuals may use tax credits for investments in low income housing, although individuals are now subject to a cap of $10,000 annually. Since the cap was put into effect, the typical real estate investor in affordable housing has evolved from an individual investing from $5,000 to $50,000, to large corporations that invest between $1 million and $25 million. This evolution is responsible for the virtual tidalwave of capital that has flowed into the affordable housing arena over the last two years.

"With respect to the production level of affordable units, the 1993 act had no effect, since the credit has been fully utilized since the 1980s," says Michael Fried, president of Related Capital, a real estate financial services firm that provides debt and equity capital as well as other investment opportunities to institutional real estate investors. "But what it has created is a shift in the nature of the investors -- prior to 1992 and '93, the predominant investment vehicle was public real estate partnerships with investments by individuals; subsequent to the permanence of the credit, there has been a significant shift from individual investors to corporate investors to institutional investors," says Fried, He notes, by way of example, that in 1992, approximately 80 percent of Related's product was purchased by individual investors. In 1994, 75 percent was represented by corporate investors.

Fried believes this evolution is healthy for the industry. "I think what it means is that it continues to be a viable marketplace, because the individual investor was waning -- there was a cap on the number of tax credits the individual could use each year, and there was a natural limit to the number of investors who could invest in the program," he says. "With the expansion into the corporate market, an unlimited pool of investors was created."

First Financial Management Corp., Boston, is considered one of the pioneers in marketing low income housing tax credits to corporations, having represented corporate investors exclusively since the Tax Reform Act of 1986. Since that time, First Financial has participated in the placement of partnerships representing more than 7,000 units of low-and mixed-income housing with equity of approximately $250 million. So it comes as no surprise to this company that the corporate investor is achieving dominance in the market. According to Bernie Husser, vice president of the company, corporations have been involved with purchasing low income housing tax credits since the credit was established, although the level of involvement has increased steadily with each successive year. "So even though the inclusion in August 1993 of the low income housing tax credit as a permanent part of the tax code induced even more corporations to make these investments, we believe this really just speeded up an inevitable process whereby corporations were already beginning to dominate the market."

Alan Hirmes, senior managing director of Related Capital, and the president of the industry trade group, The Affordable Housing Tax Credit Coalition, notes that "corporations have the ability to use an unlimited amount of tax credits against business income as well as passive liability generated on an unlimited basis." As such, he says, "in 1995, you will find that a significant amount of corporate budgets include anywhere from $10 million to upward of $100 million allocated for investment in affordable housing tax credits." Hirmes notes that of the $246 million Related Capital raised for affordable housing in 1994, $40 million was from one corporation.

According to First Financial's Husser, the prevalence of corporate investors in the market is the result of many different factors. Because corporations are capable of investing millions of dollars at a time, says Husser, developers and syndicators can work more efficiently, not just in raising the initial equity, but in servicing these investors over time as well. "First Financial represents-investors that will purchase the entire limited partnership interest of a specified transaction," says Husser. "This makes the equity financing much more efficient for a developer than trying to appeal to large numbers of investors."

Also, regular C corporations are not subject to passive loss restrictions as are individuals, Husser continues. "This enables corporations to use all the benefits of this investment in offsetting their tax liability, and because corporations can use losses as well as tax credits generated by a project, this can result in higher payments to the sponsor."

Big-name corporations that have purchased low income tax credits include The Walt Disney Co., Chevron, Campbell Soup Co., Weyerhaeuser Co., and Trans-america Corp. Fannie Mae and Freddie Mac also have had substantial involvement.

According to Jack Casey, senior vice president of Meridian Investments Inc., the largest originator of tax credit equity in the United States, now that the market has proven viable, it's attracting a new wave of investors that includes utilities, retailers, insurance companies and banks.

"The market is changing," says Casey, "in addition to getting tax benefits, banks can also get CRA [Community Reinvestment Act] credit's," which makes the investment even more attractive. In addition, Casey says traditional buyers of leveraged leases are entering the market in a big way right now.

"You can go in on a tax credit deal today, and get a credit-enhanced basis of 8.25 percent after tax, with no residual risk," he says, "so, it's better than 300 basis points over other types of investments, which in the world of finance means a lot of money," says Casey.

With the market maturing considerably over the past two years, however, competition has increased and yields have flattened. Casey notes that when Meridian first started doing these investments in 1987, the yield was 18 percent after tax. Now the yields are more likely to be between 12 percent and 13 percent after tax, which still compares favorably with alternative investment vehicles.

In addition to increased competition, fluctuations in interest rates contributed to the decline in yields in 1994. "As interest rates rise, the mortgage balances are reduced and it requires more equity to be invested," explains Jack Manning. Because the tax credits are a flat rate, there is a decline in the internal rate of return. However, with interest rates stabilizing, yields should either remain where they are or even improve slightly in 1995.

Elizabeth Bluhm, vice president of Banc One Capital Corporation, believes that yields will stabilize somewhere between 12 percent and 14 percent. "Otherwise you'll hit a point where investors lose interest, and you can't sell," she says. Bluhm points out that the low income tax credit is one of the few ways available for a corporation to manage its tax liability and that's why so many corporations have come into the market. "The corporations look at it compared to their cost of capital and it needs to exceed that and exceed their basis return hurdle for their main business," she says. Most of the corporations that tend to invest in low income tax credits have internal costs of capital below 12 percent.

Bluhm notes that the lower yields have caused some of the largest investors in tax credits who have been involved for several years to back off somewhat, but at the same time, interest continues to be high among the newer entrants to the market.

Banc One Capital Corporation had one fund in the fourth quarter of 1994, through which it raised $30 million in equity; it's currently in the market with its second fund, which will raise $40 million. Bluhm says there will be a third fund placed before the end of the year.

Some of the hesitation among investors during 1994 and the first quarter of 1995 may have been due to a forthcoming change in rules from the Financial Accounting Standards Board (FASB), whose Emerging Issues Task Force was considering a ruling that would have required investors in the low income tax credit to amortize their investments down to zero. However, concern about such a ruling has been subsiding, and it's expected that FASB will issue some kind of compromise because depreciating everything down to zero would deflate investor interest considerably.

"The ruling is probably going to result in a little bit less income being able to be reported from tax credit investments in the short-term," says Michael J. Novogradac, a partner with Novogradac, Fortenbach & Co., an accounting, tax and consulting services firm to the affordable housing industry. "Some corporations will find that their investment in tax credits won't generate as much book income as it did before the FASB change, but its impact should be fairly minor," says Novogradac.

The FASB issue did generate interest in the residual value of the real estate, according to Douglas Koch, director of the Affordable Housing Group of Cushman & Wakefield. Where in the past investors' interest was predicated on yield alone, Koch says now consideration also is being given to the residual value of the projects.

"Interest in affordable housing has been growing," says Koch. "People are starting to understand that underlying all this is the real estate."

Koch says investors are now becoming more aware that there has to be some kind of residual return. "Investors interested in holding real estate on their books will continue to be interested, and that's who has been interested anyway -- it's not only a tax shelter," says Koch. The Affordable Housing Group at Cushman Wakefield, which was created about one year ago, has done about 130 affordable housing assignments. The group does market feasibility studies and due diligence for corporations investing in tax credit projects, as well as provide valuation and appraisal services.

"Because the properties need to be affordable and have set leasing requirements, it's necessary to ensure that the properties are developed in areas where the demographics work," notes Koch. "There is a fine line because people need to earn income, but the rents have to be set at the right levels, and you have to understand how to ensure compliance as you rent up and operate," notes Koch. The program differs substantially from other types of subsidized housing because there is no deep subsidy. According to Elliot Bernold, president of Edgewood Management Corp., which has been involved in all aspects of the affordable housing arena for years, knowing the local market is crucial when developing low income tax credit projects.

"It's a difficult program in the sense that you have a cap on the income of the individuals that are allowed to move in -- they have to be able to afford the rent, but their incomes cannot exceed a certain amount," says Bernold. "Depending on how much financing you need in a property, the spread is only a few thousand dollars, so you're looking at a sliver." This is different from properties built under Section 8, where you were guaranteed a market. "Now that the subsidy has been eliminated, it's imperative that you know there are enough people in your piece of the market to fill up the property," he says. Bernold also notes that like all real estate ventures, some tax credit projects will have residual value, others will not.

Because the program requires that properties be held by the developer for at least 15 years, no project has been through the entire cycle yet. However, people in the industry expect that most projects will either be able to convert to market rate properties, or will be purchased by the state or a non-profit organization that will maintain it as affordable housing, Under the program, the first opportunity to buy the project belongs to the state housing agencies. It's conceivable that some states may issue further credits allowing original investors to cash out.

"From what we can see," says Boston Capital's Jack Manning, "there is value at the end of the line. Most of these transactions today have amortizing conventional mortgages so they can service their debt and at the end of 15 years, when the tax credits have been used, they can refinance to get a return. The real world number of what we're seeing with some of these transactions indicates that the internal rate of return upon which these offerings are being sold is highly conservative."

Manning also points to a new trend in the market known as a guaranteed return. "What you have is corporate buyers in the market who don't want to do due diligence on the properties themselves, they just want to buy rated paper, and so what's happening is that some companies have come forward and credit-enhanced the tax credit flows that these properties provide." Manning notes that Sun America, which is based in California, is currently doing such transactions. "It's a positive trend that will bring more timid investors into the marketplace," says Manning.

Stan Cheslock, president of Cheslock Bakker & Associates, says, "I think in a lot of the syndicated deals that had an array of investors, most were looking at it only from a tax point of view, but newer investors are looking at the residual value and certainly the developer is looking at the residual value." Cheslock adds, "The people investing now are thoughtful, intelligent investors who are looking at the full breadth of the program." Because the projects must be properly maintained, many will be able to transform to conventional product after the holding period expires. "That's what I like about the program," he says, "it's not creating future slums like Section 236 and Section 8 did, these are beautiful projects that have to provide good, safe, adequate housing and operate in good order."

Cheslock Bakker is a permanent finance lender, which provided approximately $60 million for affordable housing in 1992 and $70 million in 1993. The company packages the loans and securitizes them; they are then serviced by outside companies.

"I think the outlook for the future is that the securitized mortgage product will become more recognized for its value and spreads will start to narrow," says Cheslock, noting that until now the equity side has done a much better job of defining the value of tax credit investments than has the debt side. That is starting to change however.

In fact, the outlook for debt financing continues to improve. Lenders see it as a way to comply with community lending requirements under the CRA, and are realizing that the projects are sound credit risks due to the amount of equity that is brought to the table up front.

Fannie Mae, which has been a corporate investor since the inception of the program in 1986 -- averaging more than $100 million annually for the past two years -- also is involved on the debt side in a number of ways. According to Wendell Johns, Fannie Mae's vice president for housing and investments, the company is currently working on a forward commitment program in which developers can lock in their interest rate at the time of closing on the construction loan, even though permanent financing would be done later. The program is available only through Fannie Mae approved lenders to projects that supply low and moderate income housing, the majority of which are financed by tax credits.

"If you look at the production of low income housing today, most, if not all of it, is the result of low income tax credits being available," says Johns. "On the equity side, there is no secondary market right now, although the industry would love to come up with some way to make equity investment more debt-like or more bond-like, and they're getting closer," he says. "On the debt side, the secondary market does work and there are pools of mortgages backed by properties that are eligible for low income tax credits." Johns notes that Fannie Mae is catching up dramatically on the debt side to where it is on the equity side. "Our multifamily has produced debt of $5 billion, and a significant amount of that was tax credit projects," he says.

GE Capital can also now provide forward commitments for permanent loans for a period of 12 to 24 months, if certain occupancy requirements are maintained and net operating income is achieved. The forward commitment program is part of GE Capital's new "one-stop shopping" for affordable housing program, in which it can act as a single source of funds for equity, construction and permanent debt financing for tax-credit projects. The program was started in mid-1994, with a commitment to provide between $250 and $300 million annually for affordable multifamily rental housing.

Multi Family Capital Markets, Inc., of Richmond, Va., has also been one of the most active lenders on the debt side.

"In the last year, we've done new construction as well as rehabilitation loans," says Michael Sugrue, the firm's senior vice president. "We did 39 of these projects last year before we ran into a lull; there was a pent-up demand during the temporary stage [of the program], and now that it's permanent more lenders are involved." Sugrue says he believes the demand will continue to be strong; he notes that 40 states used all of their tax credit allocations last year.

Multi Family Capital Markets deals strictly in low income tax credit properties, including multifamily, townhouses and even some single family homes that are being developed under the program. Sugrue says that the developers of these projects have "owners in waiting." Because all tax credit projects must be held for 15 years, Sugrue says most lenders offer loans of either 25 or 30 years. "Any permanent debt less than 15 years is very risky, because you have a refinance risk prior to validating the credits -- the term must exceed that 15 years for the safety of the investors," he says.

Although it's a federal program, low income tax credits are administrated by the states, all of which receive tax credits annually in the amount of $1.25 times the state's population. To qualify for the credits, projects must include a set-aside of at least 20 percent of the units for households earning no more than 50 percent of the area's median income, or at least 40 percent of the units for persons earning no more than 60 percent of the area's median income. Projects often have 100 percent of the units set aside, however, because the credit is taken only on those units designated for low income use.

Just as more lenders and investors have come into the market in recent years, so have more developers. Right now, the demand for tax credit allocation currently outpaces supply -- most states have two to four times as many applications than tax credits available. As such, it's become a very competitive program and the application criteria is quite strict.

Georgia Murray, vice president of Boston Financial, which has raised over a billion dollars in equity since introducing its first corporate fund in 1987, believes that, like investors, developers became significantly more interested in tax credit projects after Congress extended the program permanently. "I think it had even more of an effect on the developer market than on the investor," she says, because it takes years for developers to find land, get their plans and spec done, get zoning, get financing and complete construction. "When they thought they might only have a window of a year to do the program, they were much less willing," notes Murray.

Although some developers may have been attracted to the program because the credit crunch of the early '90s made it difficult to finance conventional, market rate properties, activity has not decreased in the affordable housing arena, even now that the crunch has eased. Many of the developers traditionally doing affordable housing have been local entities, but the past year has witnessed the entry of some national development firms as well. Trammell Crow Residential, for example, has done some tax credit projects.

Most in the industry agree that the future will continue to see a strong market -- both in terms of investor and developer interest -- for affordable housing. It has proven to be an efficient and extremely successful method of creating affordable housing -- virtually the only low income housing production program available, even though it was not created as a production program.

Some projects developed under the auspices of the low income tax credit program may even lead to the eventual ownership of the apartment in a coop-type arrangement or in the single-family homes being produced with tax credit.

"We have seen single-family subdivisions where the houses are going to be rented for the holding periods, and then will be available for purchase by the tenant," notes Cliff B. Hardy, president of First Housing, which provides financing for low and moderate income housing in the state of Florida. Hardy says projects also have been developed for senior citizens, although these are somewhat more complicated to do, given the array of services that are often provided, especially in assisted living facilities.

With all the talk of deficit reduction on Capitol Hill, however, is the tax credit safe? Most in the industry believe it is -- although no one is willing to say "never" when it comes to Congress.

"I can't make a prediction about what the president or Congress may do, but I think that if there was ever a good Republican program, this is it," says Cushman & Wakefield's Koch. "It is regulated by the IRS, ifs totally in the private sector, it's at the state level, and there is tremendous incentive for the developers not to fail because there is a 100 percent recapture of tax credits if they do."

Michael Fried of Related Capital agrees: "This is a program that is steeped in the public/private tradition of joining together the private industry with public incentives to fulfill a public need."

That need continues to be great. Fried notes that the disparity between the affordable housing being produced by the program and what is needed in America is at least a 20:1 ratio. The proposed dismantling of HUD and many of the subsidized programs in which funds were allocated up front should enhance the importance of the tax credit program, which has been lauded across the board as a successful and efficient way of raising capital for the development of affordable housing in the United States.