After spending the past two years scrambling to find financing for affordable housing projects, developers are welcoming the return of investors for their low-income housing tax credits. Still, the industry faces challenges that could once again stem the flow of capital, including the loss of a key government funding program and rising prices for tax credits that may curb investors' appetite.

High yields coupled with increasing stability in the banking sector are luring the buyers back to the affordable housing sector. Tax credits are generating pre-tax returns between 13.8% and 15.5%. Not only are those returns nearly triple the 5% returns tax credits were generating back in 2007, but they also are well above the returns in alternative investments such as corporate bonds. The pre-tax return on the 10-year Treasury, for example, is hovering around 2.7%.

The spreads are pulling sidelined investors — largely banks and insurance companies — back into the market. “You have very healthy spreads that exist between tax credits and alternative investments — probably the highest spreads that have existed since 1993,” says Kevin Costello, an executive vice president and principal at Boston Capital.

The Boston-based investment firm has acted as a syndicator of tax credits since the mid-1980s. The firm expects to sell $600 million in tax credits this year, double the $300 million Boston Capital syndicated in 2009.

Tax credits are the lifeblood of the affordable housing industry, which is expected to attract more than $1 billion in investment this year alone. Tax credits are awarded to developers at the state level, and those credits are then sold to investors to raise capital. Depending on the individual project, tax credits are used to fund anywhere from 25% to nearly 100% of a project's total cost.

Prices are rising

The surge in investor demand is evident in the spike in syndication activity and rising prices. “As 2010 has progressed, we have seen a return of many of the banks and financial institutions, and today the investor market is very robust,” says Todd Crow, executive vice president at Pittsburgh-based PNC Real Estate.

In addition to serving as an affordable housing investor and lender, PNC also is one of the largest tax credit syndicators in the country. The company expects to syndicate between $700 and $800 million in tax credits this year.

PNC recently introduced a large tax credit fund that was over-subscribed almost immediately by about a dozen investors that include both banks and insurance companies. Although insurance companies are motivated by returns, banks typically purchase tax credits as a means to fulfill community investment obligations as established by the Community Reinvestment Act of 1977.

Such deals sell out quickly because the investor returns that ballooned into the double digits in 2009 are starting to fall. “We have seen a dramatic increase in tax-credit prices since the beginning of the year. In some cases, prices have increased by as much as 15 to 18 cents,” says Crow.

Pricing currently ranges between 70 and 80 cents, with prices dipping as low as 60 cents for less desirable projects and climbing as high as 90 cents for projects in top markets such as New York and Los Angeles. Although tax credit prices often fluctuate with supply and demand, tax credits typically sell at a discount — less than $1 per credit to make them more appealing to investors.

Demand outweighs supply

The tax credit funds PNC is now syndicating were originated six months to a year ago. “The perception among investors is that prices are going up and yields are coming down significantly,” says Crow.

“That has created a real sense of urgency among investors to snatch up those funds if they're available.” Another reason funds are selling out quickly is the scarcity of tax credits, something that could not have been predicted a year ago, adds Crow.

When investors were sidelined, Congress introduced affordable housing financing tools as part of the American Recovery and Reinvestment Act in 2009. Many developers and state allocating agencies relied heavily on those programs to fund new projects, namely the Tax Credit Assistance Program and the Tax Credit Exchange.

Both programs expired at the end of 2009, but proposed legislation could extend the exchange program through 2010. Uncertainty over whether that program will be available is creating a delay in the flow of tax-credit projects to the investment market. Funding sources for many programs are still in limbo, says Crow. (See related article on page 78.)

Based on historical increases, nearly 1 billion in low-income housing tax credits is projected to be awarded in 2010. Although government data is not yet available for 2009 or 2010, there were nearly 906 million tax credits awarded for new construction and rehab projects in 2008, according to the National Council of State Housing Finance Agencies.

Syndicators at the door

Developers who survived the financial crisis have been rewarded with a surge in demand and a hike in tax-credit prices in recent months. The capital crunch has funneled more business to developers with strong balance sheets and proven experience.

“We are more active due to some of the changes in the market,” says Dan Markson, a senior vice president of development for the NRP Group in San Antonio. NRP has 40 affordable housing projects underway across the country, including six in Texas.

The financial meltdown sidelined tax-credit buyers across the board, including the two largest investors — Fannie Mae and Freddie Mac. Combined, the two agencies were responsible for buying 25% to 30% of the tax credits on the market.

Some developers were forced to give back credits they had been awarded by state agencies because they could not find financing to make their projects work. Other developers were able to parcel together deals by tapping new sources of equity, such as local banks and new government programs, to keep construction moving ahead.

Michaels Development Co., based in Marlton, N.J., is busier than ever with more than 4,000 units under construction and another 10,000 units in the pipeline. Part of the surge in activity is due to the fact that the firm was able to rely more heavily on its own syndication company, Prestige Affordable Housing Equity Partners. Prestige has raised more than $250 million in equity for the firm's developments since it was founded in 1982.

Now that equity is returning to the tax-credit housing market, Michaels Development is faced with a big decision — whether to continue to use Prestige, or shift that business to other third-party companies.

“Now all of a sudden we have syndicators coming back and knocking on our door,” says Robert Greer, president of Michaels Development. “We're comparing their numbers to our numbers to see if we will be working with them or not.”

Michaels Development, for example, was awarded a 748-unit housing project by the Hawaii Public Housing Authority to redevelop the Kuhio Park Terrace and Kuhio Homes public housing projects in Honolulu. Construction on the proposed $316 million redevelopment is expected to start in early 2011.

“We are now in our final stages of drawings, and we are in the process of seeking final proposals for investors to compare to our own ability to sell the credits,” says Greer. Michaels Development has typically been pricing its tax credits around 75 cents with returns between 7% and 9%.

City lights attract buyers

Despite the renewed appetite for tax-credit projects, investors are selective. Most buyers are gravitating toward developments in major markets where there is a guaranteed demand for the product.

“It feels like the country is beginning to recover from the recession, but I don't think that all 50 states are participating in the recovery equally,” says Crow. The states that are lagging a bit in demographics, employment growth, income growth and market-rate housing are having the most difficulties attracting investors, he adds.

The disparity in demand for projects in a major metro such as New York or Chicago compared with secondary and tertiary markets such as a Waco, Texas or Davenport, Iowa is evident in investor demand and tax-credit pricing.

Tax credits for projects in Los Angeles, for example, are currently being syndicated for 90 cents, while projects in smaller markets are seeing prices slip below 70 cents.

Those pennies translate into millions of dollars in lost financing for developers.

For example, a typical tax-credit housing deal with a $1 million credit reservation over 10 years represents a $10 million deal. Every penny in the price of the credit equals $100,000 over the life of the credit. So selling credits at 90 cents compared with 60 cents per credit translates into a difference of $3 million in project funding.

NRP takes action

Developers that have struggled to attract syndicators and investor interest have opted to sell the tax credits themselves. For example, the NRP Group recently syndicated the tax credits for the 252-unit Cevallos Lofts in San Antonio.

The developer used its own money, and also pulled together a small group of private investors to buy the tax credits. “We are not in the tax-credit investment business, but we believe in the development,” says Markson.

The project is located in a vibrant arts and entertainment district about two blocks from downtown. NRP Group is partnering with the San Antonio Housing Trust Fund Finance Corp. on the project that combines city, state and federal funds, as well as 25% in tax-credit financing.

The mixed-income project allows for 10% unrestricted income units, 25% tax-credit units, and then the remainder of units will vary between 80% to 200% of the median area income. The project is under construction and should be completed in 18 months.

The project was a tough sell to syndicators and banks due to the mixed-income component. Most investors are seeking 100% tax-credit properties and don't want to assume the market rate or moderate rate rent risk, says Markson.

Although NRP expects to continue to syndicate a couple of deals each year, that activity is due to necessity rather than choice. “We're in the building and development business. We're not in the financial services business,” says Markson. “It's a whole different mentality when you are providing investor due diligence on the lending side versus the borrowing side, and very few shops around the country are equipped to take it on.”

Yields set to dip

As the tax-credit market adjusts to compensate for the rise in investor demand, returns will inevitably fall. “I think yields are going to step down as the demand continues to increase,” says Costello. Given the absence of Fannie Mae and Freddie Mac, the demand from banks is not large enough to push yield investors out.

However, there likely will be investment “tiers” that develop with high-demand urban projects garnering top prices and lower-demand projects — oftentimes smaller projects in more rural areas — commanding lower prices.

Ultimately, the fact that syndicators are returning to the market is a positive sign in that there is more equity flowing into the market. Yet developers are still waiting for resolution from Congress on the exchange program, and they remain wary about a sustained demand for tax credits.

“As the returns begin to fall and the pricing comes up,” says Greer of Michaels Development, “we're worried that these insurance companies are going to step out of the business and are not going to be there in 2011.”

But the view from investors is that they have no intention of exiting the market — especially given the lack of competition from alternative investments. “The performance of the tax-credit properties has been very strong,” notes Costello. “That's why investors have continued to invest in tax credits. The risk-adjusted rate of return in the tax-credit program has been consistently very high.”

Beth Mattson-Teig is based in Minneapolis.

STATES WITH THE LARGEST TAX-CREDIT ALLOCATIONS

More than 905 million low-income housing tax credits were awarded in 2008. The states that allocated the largest number of tax credits included Louisiana at 88.5 million and California at 82.6 million.

Agency name Total 2008 Allocations
Louisiana Housing Finance Agency 88,535,292
California Tax Credit Allocation Committee 82,594,947
Florida Housing Finance Corp. 49,453,920
Chicago Department of Housing and the Illinois Housing Development Authority 46,657,159
Texas Department of Housing and Community Affairs 45,534,564
New York State Division of Housing and Community Renewal 43,792,289
Mississippi Home Corp. 43,328,780

Source: National Council of State Housing Finance Agencies

Stalled legislation puts tax credits in limbo

Uncertainty regarding whether the U.S. Congress will extend a key tax-credit financing program is hanging over the affordable housing industry like a dark cloud. Stalled legislation to extend the Tax Credit Exchange Program has major implications for both developers and investors.

On the investment side, it has delayed the release of low-income housing tax credit allocations, and produced fewer financially feasible transactions, notes Todd Crow, executive vice president and manager of Tax Credit Capital at Pittsburgh-based PNC Real Estate.

Many states have structured their tax-credit allocation plans on the presumption that government money would be available as a partial funding source for these affordable housing projects.

But there is a growing industry consensus that the legislation will not be extended due to mounting pressure to control government spending. So, many states are retooling their allocations.

“It is just not clear what is going to happen, and how many of these transactions are going to be able to move forward and close,” says Crow. “That has created a scarcity of tax credits, and that is part of the reason that the investor demand feels so robust.”

On the development side, the exchange program has proved an important financing tool. Rather than selling tax credits to banks or insurance company buyers, the program lets qualified projects swap housing credits for cash backed by government funds.

For example, the exchange program provided crucial equity for an 80-unit affordable housing development under construction in Karnes City, Texas. The community of 3,500 residents near San Antonio is experiencing a boom from gas and oil drilling and a subsequent shortage of affordable housing.

“You're not going to get a lot of investors excited about that submarket,” says Dan Markson, a senior vice president at the NRP Group in San Antonio.

The NRP Group is developing the $10.7 million project with its non-profit partner, Merced Housing Texas. The exchange program provided $8.5 million in funds. Without the program, the project, which broke ground in January, would not have had funds to proceed.

The exchange program was introduced in 2009 as part of the American Recovery and Reinvestment Act to help fill the financing gap created by the credit crisis and the loss of key investors such as Fannie Mae and Freddie Mac.

However, legislation to extend the program, included with other expiring tax provisions in the Small Business Jobs Tax Act (H.R. 5297) was pulled in July because Democrats lacked the votes to overcome Republican objections.

It remains to be seen whether extension legislation will be reintroduced after Congress reconvenes this fall.