Can the affordable housing industry sustain a further decline in yields to its Low-Income Housing Tax Credit investors? The answer is obviously, no. So what is the industry outlook for 1999? Not very bright if the United States Congress fails to expand the long overdue LIHTC cap.

With limited tax credit dollars since 1986, and the increasing demand for affordable housing nationwide, the gap in supply and demand will widen. This will further heighten competition for tax credits, resulting in higher prices and a further decline in yields to investors. The yields on low-income housing tax credit after taxes have dropped to about 7% from the high teens to the low 20s 10 years ago. Any further decline in returns will force investors to seek alternative investment vehicles.

"There are some investors, who, at these yields, are not going to invest," says Thomas J. Kemper, division president of Lennar Affordable Communities, a subsidy of Portland, Ore.-based LNR Property Corp. "In 1999, yields will stabilize."

Jenny Netzer, senior vice president for tax credit at Boston-based Boston Financial, one of the nation's top real estate investment firms with $6 billion in assets under management, expresses similar consent.

"1998 was a very strong year for tax credits because of a growing interest from corporate investors," Netzer says. "More and more financial, insurance and manufacturing companies continued to invest in tax credits even though yields have continued to drop. But we are getting very close to a bottom investors will accept."

Peter Dion, senior vice president and national director of acquisitions at Key Housing Capital, a division of the Investment Banking Group within Keybank, says the entry of a large number of players into the market has crowded the field. The result is more competition for credits and higher development costs, which causes a dramatic decline in return to investors.

"The yields were high at a time when there were not many players and when people didn't know if it would continue for another year," Dion says. "People also didn't know much about the low income housing tax credit."

However, he added, despite a decline in returns in recent years, yields on low-income housing tax credits are still good. Before taxes, returns on tax credits today average about 12%, an almost non-existent figure in the marketplace today.

Richard J. DeAgazio, senior vice president of Boston Capital, says returns on tax credits still remain stable compared with many other investment instruments.

"Turmoil in the financial market has helped us, and tax credit investment is providing a very stable yield," says DeAgazio, adding that the main challenge faced by the industry is obtaining more tax credit dollars for production of more affordable housing units. "In 1986, when the low-income housing tax program was first introduced, we were building 125,000 units per year," says DeAgazio. "Now it's down to 70,000 to 75,000 units a year, so we are expecting to bring down the original amount for production."

That monumental goal can be achieved only if lawmakers in Washington increase the low-income housing tax credit ceiling in 1999. Bipartisan legislation to increase the LIHTC cap from $1.25 per capita to an inflation-adjusted $1.75 was not adopted by the 105th Congress. Industry activists have argued that the static $1.25 cap has eaten away the LIHTC program's purchasing power and should at least be inflation-adjusted - if not increased - to $6 per capita to meet the growing demand for affordable housing.

There is a 50-50 chance that the LIHTC cap will be increased in 1999, says Kemper of Lennar Affordable Communities, a company that owns about 7,000 units of affordable housing developments in 15 states. "If that passes, it will really change the industry dynamics because we will have bigger production of credits, which will mean more deals," he adds.

A boost in the tax credit ceiling to $1.75 per capita would translate into an additional 150,000 to 180,000 affordable housing units over five years, according to Michael Novogradac, a managing partner with San Francisco-based Novogradac & Co., LLP, a national accounting firm specializing in affordable housing.

The increase also will ease pressure from the ongoing cut-throat competition for tax credit dollars nationwide. LIHTC demand, for example, outweighed supply this year by an average margin of 3-to-1, according to the company's recent survey of 50 state allocating agencies. The survey also revealed that in large states like California and Texas demand exceeded supply by 5-to-1.

The good news, adds Novogradac, is that Congress passed a tax-exempt bond cap increase, which was enacted by President Clinton in mid-October. Under the law, the cap on bonds will be increased by $5 per capita beginning in fiscal 2003 for a total increase of $25 per capita until 2007. Currently states can issue $50 per capita or a minimum of $150 million per year. In 2007, the amount of bond authority available will be $75 per capita or $225 million per state.

However, industry activists don't want to wait for five years for the tax-exempt bond cap increase. They are expected to lobby Congress in 1999, arguing that tax-exempt bond financing for affordable housing has proved effective in providing affordable housing, and its allocation for affordable housing has already been oversubscribed in most states.

"The industry was trying to get $75 per person yearly starting in 1999 and was disappointed that there wasn't a greater increase," Novogradac says. "Current expansion for 2003 is viewed as a down payment on a more rapid bond increase next year. The industry is cautiously optimistic, but has to remain vigilant."

The use of tax-exempt bond financing has become one of the affordable housing industry's hottest trends. As a result, many states are allocating more money from their bond volume caps to affordable multifamily projects. Tax-exempt bonds are seen as attractive finance mechanisms for the development of affordable rental housing because interest rates on such bonds are generally less than conventional long-term financing. In addition to the lower interest rates, such rental properties also are eligible for low-income housing tax credits.

To qualify for tax-exempt bond financing, rental housing developments must set aside a minimum number of units for use by low-income persons. Like the low-income housing tax credit program, at least 20% of the units must be rented to families at or below 50% of area median gross income, or 40% of the units must be rented to families at or below 60% of area median gross income.

"We have an ample supply of tax-exempt bond capacity," says Tim Kenny, executive director of Nebraska Investment Finance Authority. "Our cap is $150 million, and we will have a $30 million carry over, which will add up to a $180 million cap in 1999." He adds that tax-exempt bond allocation to multifamily housing in Nebraska is approximately $30 million, or 20% of the total bond ceiling.

According to industry officials, state housing agencies across the country have begun to take an active role in mixing various subsidy and affordable housing programs. They are working closely with affordable housing developers to structure projects that meet the needs of the market and are joining hands with non-profit developers.

J. Michael Fried, president and CEO of New York-based Related Capital Co., the nation's largest tax credit syndicator with an acquired real estate portfolio valued in excess of $8.7 billion, says involvement of states in LIHTC and tax-exempt bond financing for affordable housing has increased significantly.

"States are becoming more and more involved in underwriting transactions, and they have a detailed understanding," Fried says. "More detailed market studies have led to increased jobs for syndicators and lenders."

This greater state involvement in allocating tax credits and tax-exempt bonds for housing projects has resulted in two major trends. First, projects are no longer concentrated in any one particular area of the state, but are distributed geographically. And second, the size of the projects has become smaller.

"In the beginning, we had 150 to 300 units per property, and now we are looking at 40 to 120 units per project," Fried says. "More and more developers are getting involved in these smaller projects."

Fried adds that these changes are providing tremendous opportunities for smaller developers, and projects are being spread out in small to mid-size communities. However, the industry overall is headed toward bigger players. Smaller companies are trying to form alliances with major institutions to obtain the necessary financial resources to survive in the fiercely competitive affordable housing market.

Pittsburgh, Pa.-based PNC Bank Corp. recently acquired the Arcand Co., a leading investor in affordable housing nationwide. Portland, Ore.-based Arcand was renamed Columbia Housing Corp. and is one of the 50 largest U.S. owners of multifamily properties, managing more than 22,000 units in 43 states.

Late last year, Boston Capital entered an agreement with BankAmerica to market low-income housing tax credit investment funds to corporate investors. Banc One Capital Corp., the investment and merchant banking arm of Columbus, Ohio-based Banc One Corp. and Boston Financial also have formed a strategic alliance. Under the agreement, Banc One Capital will make a non-voting investment in Boston Financial to provide it with additional working capital to expand its business. Both parties also intend to explore the possibility of leveraging their real estate and investment banking competencies.

Novogradac says recent mergers of several financial giants will also have some impact on the affordable housing industry. Cleveland-based KeyCorp. recently acquired McDonald & Co. Inc. Related functions at McDonald and Key are being combined into a newly configured Key Capital Partners organization. New York-based American International Group (AIG) is acquiring SunAmerica Inc.

"Consolidation is taking place," Novogradac says, adding that no one knows how these reorganized institutions will respond to the affordable housing market. "In mergers, all sorts of things can happen."

"Business is going to stay with big companies because that's where corporations put their money," says Fried. He also adds that companies wanting to maintain their market shares and have an edge in the marketplace have to become more service-oriented and respond quicker to customer needs.

Kemper says the growing competition among industry players will lead to more consolidation and formation of strategic alliances in the industry. "Syndicators like Boston Capital, Boston Financial and Related Capital are hooking up to large bases of capital," he says. "Since 1995, competition has dramatically increased, and some transactions that cost 40 cents a few years ago are now worth 70 cents for credit."

Novogradac says prices and yields should stabilize at the current range. "Prices have risen to a point where investors are discriminating product- and price-type and are attaching terms to the deals," he says. "This is good for the industry because it means there is more money per transaction and, ultimately, more housing will be built."

Industry figures forecast that the unmet need for affordable housing in the U.S. is expected to climb to 8 million families by the year 2000 from 5 million in 1996.

IRS is drafting new audit guideline on LIHTC program Since the Low-Income Housing Tax Credit program's introduction in 1986, the industry has matured and become more organized. There are now clearer rules and regulations, smoother underwriting procedures and most industry players - from tax credit syndicators to developers to state agencies - have become more sophisticated and knowledgeable about the program.

What about the IRS? The IRS has also done a good job in dealing with the complexities of the LIHTC program, but new issues emerge from time to time and seek interpretations from IRS auditors. To solve this problem, the IRS is expected to issue its much-awaited Audit Guidelines for Low-Income Housing Tax Credit.

"I hope they're going to be fair," says Michael A. Costa, president of Long Beach, Calif.-based Kaufman and Broad Multi-Housing Group Inc. "There are always questions that come back for the IRS. It's 10 years old, but it's still a new program."

Michael J. Novogradac, a managing partner of San Francisco-based Novogradac & Co., LLP, a national accounting firm specializing in affordable housing, says the draft of Audit Guidelines for Low-Income Housing Tax Credit Projects circulated earlier this year among industry professionals is already controversial because of its conservative position on several issues.

Watch out for the following in the upcoming IRS guidelines:

* Greater scrutiny of developer fees and soft costs.

* Definition of the developer fee.

* Closer review of closing documents, including all loan documents and related expenses.

* Compliance with the next available unit and tax credit calculation.

* Tax credit calculations for mixed- income projects.

* Qualified non-profit organizations.