The jury is in. The mechanism devised by the government in 1986 that leverages the know-how and agility of private real estate, investors interested in lightening their tax burden and the largess of the federal government has been fairly effective in delivering affordable housing. Since its inception, the Low Income Housing Tax Credit (LIHTC) program has provided millions with housing and has provided investors with attractive returns. However, the industry is entering a new phase.

Pricing from the investor standpoint is tighter. Margins are tighter for developers. Affordable-housing companies are consolidating.

With the industry maturing and pricing reaching unseen levels, the outlook for investors, developers and the end-users of affordable housing hinges on capital market dynamics, the future investors in tax credits and funding legislation.

Housing the poor, however, seems an intractable problem. The mechanism is sound, but there is still a long way to go. Despite the longest economic expansion in history, affordable housing is still beyond the reach of millions of Americans.

A recent report released by the National Low Income Housing Coalition (NLIHC) states that in order for a renter to afford a two-bedroom unit at the fair market rent (FMR), they would have to earn more than $11 per hour, or a full 215% of the federal minimum wage.

Affordable housing grows up By most accounts, the LIHTC program has been the most efficient of all the government initiatives aimed at providing housing to low- to middle-income renters. The apparent disconnect between the efficacy of the program and the current lack of housing is more a question of federal funding and the persistent low incomes of bottom-tier renters.

"I think the overall state of the affordable-housing-investment industry is reflective of the goals of the program," says Michael Novogradac, a partner of San Francisco-based Novogradac & Co. "If you introduce private competition into public financing, more public good is produced with the same amount of funds."

Since its inception in 1986, the LIHTC program has delivered more than 1 million affordable-apartment units, an average of approximately 100,000 per year. Tax credits have been a popular investment. "I think that you can argue that the program has never been more acceptable as an investment strategy for the institutional investor," states David Sebastian, president of Portland, Ore.-based Columbia Housing. "The movement of yields and the fact that virtually every tax credit allocated is ultimately sold to an investor is evidence of that." The Internal Revenue Service (IRS) recently announced that the carryover pool of unused LIHC credits was the smallest in the program's 13-year history.

Pricing of tax-credit investments, the investors and the sources of financing all reflect a more mature industry. The pricing of tax credits - the vehicles that drive the programs - is a clear sign that the industry has entered the mainstream. Corporations motivated by tax savings rushed to the market in the industry's early days to snap up $1 of tax relief for as little as $0.50. The laws of supply and demand have brought the industry to the point where that same $1 of tax relief now costs as much as $0.80. Tax yields that were historically in the 12% to 15% range have shrunk to 7.5% to 8%. "It is funny," says Sebastian. "Everyone says that prices can't rise any further, yet they do."

The maturation of the industry has been brought about by increased institutional activity. "Institutional involvement, particularly in the acquisition, due diligence and documentation of these investments, combined with the strong performance of the underlying real estate has created a relatively secure environment for investing," says Sebastian.

Sebastian explains how the risks associated with affordable-housing investments have eased over the years. "You do not see the same loss-rate associated with tax-credit investing today as there was ten years ago. Lower cost of capital and strong, consistent demand for the housing means that the industry has not seen significant loss of benefits due to the failing of the underlying real estate assets," he says.

The higher prices and lower yields that come with a more mature market have touched off a shift in the universe of investors in affordable-housing tax credits. This shift is similar to the dynamics experienced in other real estate investments as they mature. The investment baton is handed off from the high-yield investors all the way down the line until it reaches the lower-yield, risk-averse investor. The industry is now at the lower-yield stage.

"The market for these investments is still deep. There is a lot of capital, but the pool of investors has narrowed. The capital is concentrated in fewer hands," says Sebastian.

"You don't see the Eli Lillys, the RR Donnelleys or the manufacturing companies that have historically been big investors making new investments. Those players have either satisfied their appetite for tax credits, or yields do not achieve their internal hurdle rates."

Given the current yields and the specter of rising interest rates, it is difficult to predict that many of these traditional investors will return to the market. "Yields to investors in a rising interest-rate environment are reaching a point where there are significant concerns about more investors leaving the marketplace," says Sebastian.

Russ Kaney, director of housing investments with Heartland Properties in Madison, Wis., agrees. "The pricing has got to the point where big, direct buyers are beginning to choose between other investments, or they are looking at benefits other than rate of return," says Kaney.

"No one really knows to what extent financial institutions will accept lower yields on these investments," says Novogradac. "For years, there have always been buyers that were willing to accept lower yields, but the risk premium cannot go to zero.Except, perhaps, for Community Reinvestment Act (CRA) investors."

The CRA is playing a larger role in these investment decisions, especially as financial institutions position themselves for mergers following the repeal of the Glass-Steagall Act. Banks in particular will be interested in the alternative benefits of these investments since they have concrete CRA-related investment responsibilities.

"Banks will continue to be major investors as long as the balance between yield, CRA and the ability to generate additional product sales like construction financing remains favorable," says Sebastian. "Utilities have also been, and to a degree still are, prominent investors in this program due to the consistent earnings stream that tax-credit investments produce."

The current pricing of these investments is a bit confounding to some and may signal a change in the not-so-distant future. "The current state of the market for these investments is an anomaly. The pricing does not make much sense," says Sebastian. "We have rising interest rates, the cost of capital is going up, the returns on alternative investments are going up, and yields on tax credit investments are falling. At some point some key players may say, 'These deals don't make sense anymore,' and we will see less equity entering the market."

Pricing of the credits has had an effect on the developers as well. "I don't think people should expect the developer to not make money on these deals; there is risk involved for them," continues Sebastian. "The pricing and negotiation of terms is pretty aggressive right now. More deals need more money because of aggressive rent-skewing by state housing agencies and limitations on supplemental sources of financing in the market. Pricing should be trending down, not up."

Prices have not gone down. Equity has continued to enter the market and the competition between developers for these credits has been fierce. In most states, the demand for tax credits outpaces supply by around three to one. Texas is experiencing some of the most intense competition. In 1999, the state tax-credit allocation agency received 204 applications requesting more than $124 million in tax credits. Only 53 awards worth $21.4 million were awarded. In this case, demand outstripped supply by a factor of five to one.

The effects of this fierce competition have been favorable for the end-users of the housing. The state allocation agencies put a premium on applications that improve the housing for low-income renters. Developers have gone to great lengths to gain an advantage in the approval process. One factor that scores big points with the state agencies is subsidizing lower rents.

"The allocation process varies greatly from state to state, but one general trend that helps secure credit awards is the subsidizing of lower rents, or rent-skewing. Historically deals were secured at 60% of the median rent; now, we see more deals at lower rent levels," says Sebastian.

The downward skewing of rents is great for the renter in the short term, but there are some concerns about this practice. Lower rents mean smaller debt-service coverage and less margin for error. "It can be discouraging for developers that know what they are doing to have to keep skewing rents down to win a tax-credit award," Kaney points out. "This brings more affordable housing to the marketplace and that is great for the short term. Lower rents may not be in the best interest in the market for the long term, though."

Competition fosters consolidation The economics of the business have driven changes in the way business is done. Slim margins in a more competitive market force companies to consolidate and try to create partnerships to either achieve economies of scale or provide one-stop shopping for the investor. "It is challenging for companies to expand in a mature industry, especially when there is a finite nature to the product [credits]. Companies will grow their market share by enhancing product offerings to developers," says Sebastian.

Two of affordable housing's biggest players recently merged with large, well-capitalized companies: Pittsburgh-based PNC Bank acquired Columbia Housing and Atlanta-based Lend Lease Real Estate Investments Inc. acquired Boston-based Boston Financial. "The benefit of our marriage to PNC Bank and our relationship with [Kansas City, Mo.-based] Midland Loan Services is the ability to compete by providing additional services to developers rather than just pricing," says Sebastian. "It allows us to provide pre-development loans, tax-credit equity, construction debt and permanent debt."

On the financing side of the affordable-housing industry, the universe of lenders is limited to those with the lowest cost of capital: banks, insurance companies and government-sponsored entities like Fannie Mae and Freddie Mac.

Investors that choose to be in the market can benefit from well-capitalized companies created by consolidation. Companies like Columbia House can now acquire and warehouse affordable-housing investments for investors. This can increase the specificity of portfolios and provide for more timely delivery of tax benefits. "Being well-capitalized allows us to buy properties before the investors are put together," says Sebastian. "It improves the timing and certainty of returns for investors."

Pressure to expand the program The apparent success of the LIHTC program and the strong demand for credits have prompted most in the industry to call for an expansion of the program. States are currently limited to federal funding of $1.25 per capita for tax credits and $50 per capita for tax-exempt bond issues. Despite strong support from lawmakers, the increase has hit snags in Washington since the legislation is usually just one provision of much broader bills. Just this year, President Bill Clinton vetoed the tax-cut measure that included two LIHTC expansion items.

"The situation surrounding the expansion of tax-credit caps seems to change almost daily," says Sebastian. "The wild card continues to be the highly-politicized budget-and-appropriations process. Nonetheless, there is unparalleled support for this program in Washington. The tax-credit expansion, as well as some technical corrections to the program, are currently included in an omnibus appropriation bill sponsored by Congressman Rick Lazio (R-N.Y.) that addresses minimum-wage issues."

By all accounts, the program is due for an increase in funding. The program's funding levels have not been adjusted since 1996. "According to an internal study that we did on the funding levels of the program, we believe the expansion should be closer to 75% in order to return to the original funding levels," says Novogradac. "The need is so great for these credits. The current per-capita levels can't keep pace with the demand, let alone eliminate the lack of affordable housing. The measures being looked at in the legislature, however, outline a 40% increase. This increase would at least raise the caps to reflect inflation." A 40% increase would raise the tax credit level to $1.75 per capita and the tax-exempt bond allocation to $75 per capita.

While the amount of the proposed increase is all but decided, the manner in which it would be raised is not. The increase can take effect all at once or can be ramped up gradually. The effect on the pricing of the credits may differ depending on the method used to increase the caps.

Sebastian feels that the balance has tipped in the favor of a gradual increase. "What was once a one-fell-swoop expansion has been ratcheted back to a proposal to ramp it up over time," explains Sebastian. "The prospect of increasing the supply of credits all at once is not especially attractive in a way. An immediate 40% increase in the supply of product would have ramifications on pricing, or at least have an effect on the perception of where pricing should be. This could potentially impact the flow of capital to the industry. If investors believe yields should rise given the increased supply of credits, many might pull out of the market until yields actually rose."

Not opting for the 9% tax credit Many developers are avoiding the 9% tax credit to skirt the competition, and instead are opting for the combination of a 4% tax credit and tax-exempt bond financing. As the competition for tax credits has intensified, many developers have turned to the combination of tax credits and tax-exempt bonds to finance new projects. Instead of the 9% of qualified costs taken as a tax credit, the 4% deals reap only 4% of the qualified costs of the project.

The 4% tax credit combined with the tax-exempt bond structure can be attractive for a few reasons. "Different investors approach this from different ways," says Sebastian. "Some investors like the 4% transactions because they can achieve higher yields with the bond. However, more of the yield is comprised of losses, which are more sensitive to changes in the investor's effective tax rates. In general, this is more difficult to forecast consistently. Investors may be generally inclined to do some bond transactions, but not in abundance compared to 9% deals."

The bond route is also starting to look more attractive from the developer's perspective. "The straight 9% tax-credit deal has, in a way, become risky in many states as competition for the awards has risen," explains Bob Banks, CEO of Midland Mortgage Investment Corp. in Clearwater, Fla. "It can be costly for developers to go through the process of obtaining awards and have no projects approved. Some firms working in a good market have gone the tax-exempt bond route to eliminate the process of applying and awarding of 9% tax credits."

Tax-exempt bond deals avoid the substantial competition for 9% credits, though in some states the developer must also compete under the bond-volume cap. Developers must also meet state requirements for bonds as well as tax credits. According to some industry specialists, the 4% credit is no longer automatic.

The advantages of the bond-and-4% combination have increased since the early days of the program. These deals typically provide substantially lower permanent financing costs than conventional financing programs, and the favorably-priced leverage can result in higher-than-expected cash flows and more cushion or higher returns to investors and developers from bond-financed deals.

Ruth Theobald, senior vice president of Pewaukee, Wis.-based Affiliated Capital Corp. also sees increased interest in a 4% tax credit/tax-exempt bond financing combo. "We have seen a strong drive to tax-exempt bond deals," she says. "If you do a tax credit that is 50% financed with tax-exempt bonds, you are no longer under the tax credit allocation cap of $1.25 per capita, so you won't be competing as intensely for the credits."

There are some caveats, she adds. "The downside is that there is a loss-of-credit potential since the investor must draw on the 4% tax credit, not the 9%," says Theobald. "This pulls the value of the credits down, but the interest rate on the bond is typically lower. There is no hard and fast rule; each project has to be looked at individually."

They can also be considered riskier given the higher leverage. "These may also be considered to have a higher risk factor due to substantially higher amounts of leverage," adds Sebastian. "A typical 9% deal would be 50% debt/50% equity. A typical bond transaction might be 80% debt/20% equity."

In order to make the combination tax-exempt bond financing and 4% tax-credit deal pencil, there usually needs to be some form of credit enhancement. Fannie Mae has led the industry in providing enhancements for tax-exempt bond deals. "One of our roles in the affordable-housing industry has been to credit enhance, or guarantee the mortgage payments, for multifamily properties financed with tax-exempt bonds," says Daniel Cunningham, director of affordable-housing debt at Fannie Mae.

According to statistics from Securities Data Co., Fannie Mae was the largest provider of credit enhancement for multifamily tax-exempt bonds in 1998. Fannie Mae provided nearly $680 million in credit enhancements for 67 multifamily tax-exempt bond transactions. Over the last four years, the company has provided enhancement for almost $3 billion in tax-exempt bonds.The IRS comes calling The need to comply with IRS rules in order to obtain and hold on to tax credits puts a premium on the asset management of affordable-housing projects. "One cannot understate the importance of proactive management of these investments both on the real estate side as well as the tax-and-compliance side. Non-compliance with program parameters can materially impact the investor's return," says Sebastian.

"The compliance requirements make this program different," notes Theobald. "If the projects are not in compliance, the IRS can take back the credits, so there is real value at risk. For investors buying thousands of units for tax-credit purposes, compliance is crucial to success."

The risk of the IRS recapturing credits has kept the industry on their toes. "The structure of some of these tax-credit deals has put more stress on keeping these deals compliant," says Theobald. "In some deals there is a general partner that guarantees the delivery of credits to a limited partner. If the project doesn't comply, the risk is on the general partner. This has caused the industry to adopt a better understanding of the process."

The IRS has recently stepped up its compliance-monitoring standards, and the industry has taken notice. "The desire to step up the monitoring of the program originated with the General Accounting Office (GAO) reports in 1996 and 1997. The report's findings were favorable, but there was a sense that there were some compliance issues. The IRS decided that they wanted to increase the amount of review these projects receive," says Theobald.

At the outset of the program, states set a minimum yearly-review standard of 20% of the files for 20% of all tax-credit projects statewide. This meant that the entire universe of tax-credit housing would be reviewed every five years. The new minimum is 20% of the files for 33.3% of all projects. This will result in a three-year review cycle of tax credit projects instead of a five-year cycle.

"This is not necessarily a bad thing," says Theobald. "The Congress and the IRS want to ensure the success of this program in the future. Some of these measures, like more physical inspections, will curtail physical deterioration."

While the monitoring of these projects for compliance will take place more often, investors and those hired to manage the assets have come a long way in their handling of compliance. "We have seen the industry doing a much better job of compliance over the years," says Michael Sher, managing director of American Express Tax and Business Services. "Both the state and investors are keeping a close watch over these assets. This is attributable to a few things. There is more familiarity with the projects, we have history to look at, and the IRS has put the fear of God into those involved. It is no longer a question of if there is to be an audit, but when there will be an audit."

Signs of oversupply in some areas For many years, the dearth of affordable-housing units meant that there were few fears of overbuilding. Looking at the national supply of affordable housing, there is certainly little fear of classic overbuilding. There is evidence, however, that the delivery of affordable housing is less efficient in some markets across the country. Some areas are experiencing signs of oversupply; some areas are losing too much affordable-housing stock to conversion to market-rate units.

With the LIHTC program churning out between 75,000 units and 100,000 units per year, there has been more talk of overbuilding. "We have had to turn down some deals in areas where the demand for affordable housing had been filled," says Banks. "Due to the nature of the approval process, developers are at the mercy of the state allocation agency. Sometimes not all of the right areas are served."

"In general, there continues to be substantial demand for this product; there still appears to be more units going out of stock than entering," notes Sebastian. "But, any given market still operates under the same dynamics of supply and demand. There are risks of oversupply in select areas. The state allocating agencies determine where the projects go. These are political decisions based on the facts and data, but the system is not perfect."

"Certain states are having overbuilding issues," says Sher. "In some areas where demographic analysis is not done properly we are seeing lower-than-projected occupancy."

Theobald also sees softness in select affordable-housing markets. "In some areas tax-credit housing is beginning to compete with each other. There are some areas where a developer would build units with two beds and one bathroom; a few years later, they would build two beds and two bathrooms, and the rents are the same.

Internal competition is something that the state agencies are trying to curb," she says. "It is going to be increasingly important where these projects are placed. The basic laws of supply and demand do apply to affordable housing."

The cost of not filling vacancies in the affordable-housing world can be costly. Instead of just taking a hit to the bottom line, the investor in an affordable project that does not lease up surrenders credits. "There is a deadline to get these affordable units to comply. If there are too many units in the market and there are not enough affordable-income households to fill them, the investor will have a difficult time qualifying the project," says Theobald. "The key is to define the market and build for the future with an eye toward the design and amenities while being cost efficient."

The importance of knowing the demand-drivers of the market in this environment has increased the importance of market studies for developers. "Market analysis, particularly with regard to the availability of tenants at the income levels within the set-aside rent restrictions for the project, is critical," says Sebastian. "The adage of 'Build it and they will come because it is affordable housing' is inaccurate."

Embarking on a new era The affordable-housing industry has largely delivered on its objective: efficient production of affordable housing. However, the industry is entering uncharted waters as it matures. Continued success will rest on the balance of federal funding, the attractiveness of these projects as an investment and underlying capital market and economic cycles.

Michael Novogradac Partner Novogradac & Co. San Francisco

David Sebastian President Columbia Housing Portland, Ore.

Russ Kaney Director of Housing Investments Heartland Properties Madison, Wis.

Bob Banks CEO Midland Mortgage Investment Clearwater, Fla.

Ruth Theobald Senior Vice President Affilliated Capital Corp. Pewaukee, Wis.

Daniel Cunningham Dir. Affordable-Housing Debt Fannie Mae Washington D.C.

Michael Sher Managing Director American Express Tax and Business Services