The affordable housing industry seeks to balance the goals of public policy and private investors.

It is a basic fact of life in the affordable housing industry that the supply of low-income apartments comes nowhere close to meeting the demand. The U.S. Census Bureau estimates that approximately 20 million such units are needed to meet the housing demands of those U.S. households that are earning less than $30,000 a year.

In 1998, there were roughly 5 million low-income apartments, the products of the federal Low-Income Housing Tax Credit (LIHTC) program and other federally subsidized rental housing initiatives, according to the Washington, D.C.-based National Low Income Housing Coalition (NLIHC).

Also consider the fact that each year, 100,000 low-cost apartments are demolished, abandoned or converted to market-rate use, according to the Washington, D.C.-based National Council of State Housing Agencies (NCSHA). On the other hand, approximately 70,000 affordable apartments are completed every year, suggesting an annual net decline in the stock.

As a result, the state housing agencies that administer the LIHTC program have begun to feel pressure to stretch their tax-credit programs to produce more units. In turn, this has put pressure on private investors who purchase LIHTCs.

While not considered a serious problem right now, the players in this field have begun to think about managing the tensions that exist between the public policy goal of providing housing and the private investment goal of generating acceptable returns.

"There is a growing tension," says Dave Sebastian, president and CEO of Portland, Ore.-based Columbia Housing Partners, which is a subsidiary of the Pittsburgh-based PNC Financial Services Group and has a portfolio of 750 affordable multifamily properties.

This tension stems from two sources. First, the popularity of LIHTCs among investors has produced a supply crunch that has raised prices and reduced yields. Second, state housing agencies interested in stretching tax credits sometimes encourage developers who apply for credits to meet underwriting standards that raise investor risk.

Increasing risks When affordable housing agencies first went to the private markets in the early 1980s, they garnered most of their funds from high net-worth individuals. However, the introduction of the LIHTC program in 1986 brought institutional investors into the market. "Institutions were clearly more capable of buying large chunks of tax credits than individual investors," says Sebastian.

By 1994, institutional investors were the primary source of dollars for this market, adds Sebastian. The amount of institutional money available began to drive up the price of tax credits and reduce the yields.

"In addition, states administering these programs have been trying to stretch their assets to meet growing housing needs," says Sebastian. "Sometimes, though certainly not as a rule, this has been done at the expense of real estate feasibility."

This trend creates an unusual investment environment. As investor yields decline, risk increases. "Obviously that doesn't connect," says Sebastian. "You would expect to see yields rising in the face of more risk. I think this is where the tension lies right now."

What does the combination of high investor interest, falling yields and rising risk portend?

"I've been involved in this program since 1993," says Sebastian. "For the first time, I'm seeing yields begin to creep back up, as investors on occasion say `no' to certain transactions.

"In some cases, this is creating a differentiation between assets in this class. Historically speaking, a tax-credit transaction on a 12-unit deal in a rural area would effectively drive the same kind of pricing as a 250-unit deal in a major city," he adds. "But today, people are willing to pay a slightly higher price for the larger deal, which might come with a more sophisticated and more experienced developer."

Firms such as Columbia Housing consider this tension when selling tax credits to investors and when purchasing tax credits for their own accounts. In practice, this development has led to the emergence of small, but nevertheless perceptible, spreads between the price of tax credits associated with different projects.

"If you would pay 79 cents for each dollar of tax credits on a two-story, garden-style suburban development awarded to a well-established developer who has done 10 such projects, you might be willing to pay only 77 cents for each dollar of tax credits for a smaller deal in a rural area awarded to a new developer," says Sebastian.

Goals may create concerns "Investors like fairly conservative underwriting by states," says Jenny Netzer, principal and head of housing and community investing for New York-based Lend Lease Real Estate Investments Inc.

State housing agencies often award LIHTC projects to developers using point systems to rate proposals. Sometimes, the goals promoted by these point systems give investors pause.

At one time, for example, some states awarded points for projects with low debt-coverage ratios, such as 1.0 or just more than 1.0. From the state's point of view, a low debt coverage reduced the number of tax credits that would have to be spent on one project, thus leaving more credits available for additional projects.

But investors objected. "The higher the debt-service coverage, the better," says Netzer. "Typically our deals are 1.10 to 1.15. When states ask for lower coverage by saying the less cash in the deal, the more points you get, that's a recipe for more risk for investors."

By and large, the practice of awarding points for a 1.0 debt-service coverage has been eliminated. The NCSHA recommends that states require a minimum debt-service coverage ratio of 1.10 and warns against rewarding proposals with the lowest possible debt-service coverage.

Other practices can create debt-service concerns as well. Some states offer points to developers who defer development fees. Suppose a $10 million project qualifies for tax credits equal to $5 million in equity but can only meet underwriting requirements for $4 million in debt. The project will still cost $10 million, but may receive approval because the developer agrees to collect its development fee later from cash flow instead of earlier from the debt and equity provision for the deal.

"Some states like to see this, viewing it as a form of capital that the developer puts into the project," says Will Cooper Jr., president and COO of Costa Mesa, Calif.-based WNC & Associates. "We look at this as a negative. Suppose the cost of material and labor go up, for whatever reason, during construction. By the time we get to the Certificate of Occupancy stage, the project may have added costs of $200,000."

Mixed-use enters the picture While state housing agencies want to spread tax-credit benefits to increase affordable housing supplies as much as possible, they do not want to award projects that will not satisfy the LIHTC program requirement that the units will be maintained as affordable housing for 15 years.

The pressure to make a limited supply of tax credits go further has produced other state strategies as well. According to Netzer, some states have been exploring the use of tax credits with mixed-income projects. Some are doing this to spread the tax credits over more projects, but others aim to satisfy social policy objectives such as promoting the development of mixed-income communities.

In either case, the resulting project will carry a requirement for renting only a portion of the units, say 60%, at affordable housing rates, while the other 40% of the units will carry market-rate rents.

This practice also complicates the debt-service picture. When a portion of the rents is set at market rates considerably above the rental rates of tax-credit units, the question of sufficient rental income arises, says Netzer. The units will attract renters, but will the developer be able to get the full market-rate for all of the market-rate units during the entire 15-year compliance period?

"If your debt-service calculations assume market rate income for 40% of the units, you now have more risk in terms of being able to cover debt service," says Netzer.

This issue, in particular, draws differing opinions. "I think mixed-income projects are good," says Stephen Fayne, a managing director in the San Francisco office of Calabasas Hills, Calif.-based ARCS Commercial Mortgage Co. "I don't like the idea of segregating low-income people from market-rate people."

Michael Novogradac, managing partner and principal of San Francisco-based Novogradac & Co. LLP, offers still another view of mixed-income projects. "Suppose a state awards an affordable housing project with 50 market-rate units," he says. "Then 50 families will go without affordable housing. On the other hand, what if the state places smaller affordable housing projects in communities that have market-rate housing. If they are next door to each other, it's possible to achieve the investor's underwriting goal as well as the public policy goal."

Smaller deals can create reluctance among investors as well. Certain states set a cap on the amount of tax-exempt bond money that can be allocated to an individual project, says Fayne. "A $5 million limit, for example, keeps a project small. From an investor's perspective, a small project may not be worth the time and effort required."

State housing agencies, developers and the investment community have lobbied the federal government for several years to expand the tax-credit program that has proved so successful in producing affordable housing.

Tax-credit legislation As of press time, legislation to increase both the 9% tax-credit cap and the tax-exempt private activity bond cap, which governs 4% housing tax-credit programs, has been passed by the U.S. House of Representatives and awaits Senate approval.

The current proposals would raise the 9% program cap from $1.25 to $1.75 per capita per year and the private-activity bond cap from $50 to $75 per capita.

Observers believe there is broad bipartisan support behind this effort. "The delays have to do with the details of overall tax legislation and not the proposal to raise the housing tax-credit and bond caps," says Novogradac.

Assuming this proposal becomes law, will it relieve the tensions that have built up in the system? In some states, maybe. In other states, maybe not.

The problem is that the need for affordable housing will continue to outweigh the resources to build this housing, despite the increased caps.

State housing agencies will likely view the expanded pool of tax credits as a way to produce more projects, while investors will likely view the increases as a way to satisfy sturdier underwriting. The tensions will likely persist.

Depending on the state, new tensions may arise. For example, affordable housing in rural areas is an issue in many areas of the country, but one that many states have not addressed. More tax credits may make it possible to direct development to rural areas. But rural projects tend to be small, and investors, especially on the tax-exempt bond side, prefer large deals.

"Every state will look at this new pool of money and feel drawn down one available path or another," says Novogradac.

"Some might use the money to allow more stringent underwriting," adds Novogradac. "Others might decide to rehab aging tax-credit projects and old Department of Housing and Urban Development [HUD] projects that are at risk of being switched to market-rate housing. Still others might decide to address problems of urban sprawl with new developments in the cities."

Surely, more money will ease the tensions that have appeared in affordable housing. Chances are, however, it will not eliminate them.

The affordable housing tax-credit program, created by the federal Tax Reform Act of 1986, provides tax credits for affordable housing investors in two ways.

First, there is a 9% LIHTC program, which the federal government funds through an annual allocation to every state at the rate of $1.25 per capita. So a state with a population of 10 million people can distribute $12.5 million in LIHTCs per year. This is generally done through the state housing agency.

A developer receives a certain number of tax credits for a project receiving state housing agency approval. Investors purchase the credits for cash that serves as equity in the deal. Suppose, for example, an LIHTC project will cost $5 million. Approximately 9%, or $450,000, will represent the annual tax credit available to equity investors over a period of 10 years. Overall, investors would receive tax credits worth $4.5 million.

The developer sells the tax credits to investors at a discount. Today's per-credit prices range from the high 70-cent area to the low 80-cent area. In this example, an investor might pay 80 cents on the dollar, or $3.6 million, to get the $4.5 million in available credits. The cash becomes the equity, leaving $1.4 million of the project's cost to be covered by debt. The tax credits pay back the equity investors with interest over 10 years, and the low loan-to-value ratio makes an attractive deal for a lender.

Many affordable housing lenders prefer another program created by the 1986 Tax Reform Act. Under this program, the federal government authorizes states to issue tax-exempt, private-activity bonds at a $50-per-capita rate.

Tax-exempt bonds provide the debt for a project, usually in an 80-20 or 90-10 debt-to-equity ratio. Then, 4% of the project costs qualify for tax credits, again taken annually for 10 years.