Competition for low-income housing tax credits has affordable housing players turning to tax-exempt bonds to generate tax credits in a less competitive environment.

Just a couple of years ago it was very difficult to combine tax credits and tax-exempt bonds to finance affordable housing," says Michael J. Novogradac, a managing partner of San Francisco, Calif.-based Novogradac & Co. LLP, a national accounting firm specializing in affordable housing.

Not anymore. "There is a beauty contest for low-income housing tax credits. The credit is getting extremely competitive and, as a consequence, developers are increasingly turning their attention to tax-exempt bonds because tax-exempt bonds automatically have tax credit," Novogradac says. "As a result of increased attention to tax-exempt bonds, there is more bond volume going toward multifamily rental housing. There is an excess demand for tax-exempt bonds for multifamily rental housing."

Richard Thornton, executive vice president of Washington Capital, a Washington, D.C.-based mortgage banking firm that has financed more than 45,000 apartment units nationwide, says his firm has provided $100 million in financing to six projects during the last 18 months, and all of them have involved tax-exempt bonds.

"Almost all of our projects have been coupled with tax-exempt bonds. We have also done five forward commitments, all of them jointly with bond financing," Thornton says. "Tax-exempt bond financing has become a major player. It is easier to get bonds in many states and, when you get bonds, you automatically get credits."

Deneice Jordan-Walker, president and chief executive officer of Aries Affordable Capital Corp., an affiliate of Chicago-based Aries Capital, says there is already a scarcity for tax-exempt bonds for financing affordable multifamily rental housing.

"This is becoming a scarce commodity as tax credits. You will run into the same situation as you are running into low-income housing tax credits," says Jordan-Walker, who focuses on structuring tax-exempt and taxable bonds and mortgage loan facilities utilizing tax credit as well as other equity sources for commercial and affordable-housing transactions. "There is a growing demand for tax-exempt bond projects for affordable housing. We are looking to tap and use and are already tapping bond markets to facilitate affordable housing."

Tax-exempt bonds are issued by state and local governments, municipalities and other organizations and governmental units that are qualified by the Internal Revenue Code of 1986. Tax-exempt bond holders are exempt from federal taxation and generally from local taxation if the obligations are issued within the state of residence.

There are two types of bonds that can be used to facilitate affordable housing: affordable multifamily rental housing bonds and 501(C )(3) bonds for nonprofit developers. There is a limitation on the total amount of tax-exempt multifamily rental housing bonds. Each state may issue tax-exempt bonds annually at a maximum of $50 per capita or $150 million for smaller states.

Increasing bond volume Given the phenomenal demand for these bonds, a broad range of affordable housing interest groups in California, including the California Housing Finance Agency and California State Treasurer Matt Fong, have launched a federal lobbying effort to increase private-activity bond volume from $50 to $75 per capita. Multifamily rental housing tax-exempt bonds are a type of private-activity bonds.

In response, House Ways and Means Committee members B. Kennelly (D-Connecticut) and A. Houghton (R-New York) recently joined the private-activity bond volume cap effort and introduced legislation (H.R. 979) that would restore the state maximum to $75 per person or $250 million for smaller states and index the cap for inflation.

"It is not a new issue. It has been around since 1987 when the bond volume authority was reduced to $50 from $75. But now it's getting a big push," says Novogradac, who also sits on the board of directors of the Affordable Housing Tax Credit Coalition, a Washington, D.C.-based industry organization that has been pushing the increase in bond allocation. "The decision will be part of the budget agreement with the president of the United States. We believe it is good for the country."

There is also a cap of $150 million on 501(C )(3) bonds that can be used by not-for-profit developers, says Jordan-Walker of Aries Affordable, a mortgage banking firm specializing in Wall Street mortgage pools secured by multifamily and commercial loans.

The 501(C)(3) bonds, however, can be used for profit, Jordan-Walker says.

"The challenge to these bonds will be equity positions. We have come up with a mechanism to address that equity gap," says Jordan-Walker, adding that strong alliances among management, contractors, developers and others involved in such projects can be an alternative to meet the growing demand for tax-exempt bond financing for affordable housing in most states where demand exceeds supply. "We are being very innovative in this respect."

Credit enhancements With a robust tax-exempt bond market, there is also a boom in ways to raise money from the tax-exempt bonds from the standpoint of either credit enhancements or noncredit enhancements. Credit enhancements -- which are provided by a few companies such as General Electric Capital Commercial Real Estate Financing and Services, Fannie Mae, state housing finance agencies and bank letter of credits -- support tax-exempt bonds and guarantee bonds will be repaid. Nonenhanced bonds fall into either rated or nonrated categories.

Analysts expect that more than $4.2 billion in credit enhancements will expire by early 1999.

"It is still a narrow specialty, but the core business of credit enhancement is very strong. The market is quite robust," says Edward Marson, president and chief executive officer of New York-based CentRE Mortgage Capital LLC, which arranges credit enhancements for tax-exempt bonds. "We continue to be very active in the credit-enhancement business."

Mike Silver, director of the national affordable housing practice in the Portland, Ore., office of Deloitte & Touche LLP, a national accounting and consulting firm, says more and more people are getting educated about the tax-exempt bond financing and the low-income housing tax credits and want to do affordable housing projects.

"Definitely we are seeing more and more tax-exempt bond financing. There are not enough low-income housing tax credits, and tax-exempt bond is a way to build these projects," Silver says. "You still need someone to issue the bond. You have to get allocation of private-activity volume cap. You cannot have unlimited volume of bond. It is limited by state -- limited just like tax credits."

Alan P. Hirmes, a senior managing director of New York-based Related Capital Co., says that for every dollar available for low-income housing tax credits in most states, there are applications for at least two to three dollars worth of tax credits.

"This is the only program that is providing affordable housing stock in the country," says Hirmes, whose firm has raised nearly $2 billion in equity for the construction and rehabilitation of 48,000 apartment units nationwide since 1987."

Hirmes says tough competition for limited tax credit dollars is already forcing many developers of affordable housing to the tax-exempt bond market.

H. L. Van Varick, vice president of McClain, Va.-based Freddie Mac, says his organization has been heavily involved in the financing of affordable housing projects but has not paid much attention to tax-exempt bonds. "We have not been very active in tax-exempt bonds, but we do feel that we need to get more into this area," Varick says.

He says Freddie Mac remains a major contributor to the affordable housing industry, but mainly through the federal Low-Income Housing Tax Credit (LIHTC) program. "We feel comfortable with the fact that here is a program supported by the government that provides affordable housing and the fact that the marketplace is being able to deal with it."

The LIHTC is currently the largest federal program to fund the development and rehabilitation of housing for households with incomes at or below specified income levels. Under the program, states are authorized to allocate federal tax credits as an incentive to the private sector to develop rental housing for low-income households. Tax credits awarded may be taken annually for 10 years by both corporate and individual investors in low-income housing projects to offset federal taxes otherwise owed on their income.

GAO report on LIHTC The LIHTC program got a major boost in April from a study on the low-income housing tax credits by the U.S. government's General Accounting Office (GAO). The report shows the program has exceeded the goals Congress expected of it in helping meet growing low-income rental housing needs nationwide.

The GAO report, which was released in April by Congressman Bill Archer, chairman of the Committee on Ways and Means, shows that, while the credit appears to be helping those who need it, the administrative oversight of the credits needs to be improved.

"After reviewing the GAO report, it appears that the housing projects using the credit are benefiting the right people -- households with very low incomes -- but we have also learned that compliance and enforcement need to be strengthened," says Archer, who once tried to sunset the tax-credit program.

"The GAO report is viewed as positive for the affordable housing industry," says Silver of Deloitte & Touche. "It seems to be a general consensus that there is no immediate threat now and in the near future to the low-income housing tax credit program."

Richard J. DeAgazio -- president of Boston-based Boston Capital Services Inc., a major player in the affordable housing industry -- says the GAO report has not only provided a big relief to the industry, but it has also educated members of Congress who have been skeptical about the effectiveness of the LIHTC program.

"Chairman Archer started to soften his stance as he became more educated about the low-income housing tax credits. There was a lot of effort undertaken by the industry to educate him and his staff and other members of Congress," DeAgazio says. "We have found a lot of supporters at Capitol Hill now because they now know what it is all about."

DeAgazio says although it's too early to say what the new Congress is thinking about affordable housing, it is likely to view LIHTC positively.

"You have to look at what current leadership is saying," DeAgazio says. "Leadership of Congress has not changed and, thus, we anticipate positive impact. I define positive as no-change -- status quo."

However, despite the favorable GAO report on the LIHTC program, Related Capital Co.'s Hirmes says that Congressman Archer may again be trying to sunset the program.

"It could be just political, but he has put it on the table as a potential revenue raiser. That is one of the things, he thinks, can help balance the budget," Hirmes says. "Tax credits is one of the programs that could be cut, but it is a program that should not be touched. The whole program has been very effective."

Congressman Archer could not be reached for further comment before press time.

Industry wish list The industry, however, does have a wish list and would like congressional leadership to fulfill them, DeAgazio says.

"One of the things we would like to have is an increase in the amount of fund allocation to the low-income housing tax credit program. When the program was launched in 1986, fund allocation was set at $1.25 per capita. That came to $3.3 billion a year in tax credits paid out over a 10-year period," DeAgazio says. "Ten years later, we still have the same amount."

In 1986, the program was creating between 120,000 and 125,000 apartments units per year, DeAgazio says. In 1996, the same amount of dollars created only 76,000 units because of higher land and development costs and a 10-year accumulated inflation, among other factors.

An increase in the amount of even the 10-year inflation adjusted figure to $1.60 per capita will be welcome by the industry, DeAgazio says.

"From an investor's viewpoint, the amount of tax credit an individual investor can take should also be increased," DeAgazio says. "Individuals in the highest income bracket (39.6%) can only take $9,900 a year in tax credits. That individual is the one most likely to make the investment, and the individual amount should be increased to $20,000."

Industry analysts say fierce competition for tax credits and rising costs have also brought down overall returns on investments in affordable housing projects and funds in recent years. They say return on funds has declined to 10% to 13% at present from 18% in the early-1990s. Yields on affordable housing projects have declined to 12% to 18% from 21% in the early-1990s.

Bill Haynsworth, senior vice president of acquisitions and tax-credit business leadership team of Boston-based Boston Financial, says Fortune 500 corporations, which began investing in the low-income housing tax-credit program in 1992 with a big bang, still remain a dominant investor in the industry. Yield on their investments, however, has also declined in recent years because of the high price to developers.

He says total rate of return on corporate investments has fallen to the high-8s and low-9s as compared with a peak 15% to 16% return in 1992.

"If interest rates go up substantially, that could further affect yields. So far, I don't think it has affected anything," he says. "You are always concerned about higher interest rates."

Thornton of Washington Capital says the cost of developing affordable housing, especially in inner cities, is very high. "It's very difficult to make an inner-city project work because cost is so high," says Thornton. "Most of the projects are being concentrated in a few geographical areas. That is a problem in a lot of states. They are not looking for geographical diversity."

Upendra Mishra is a Randolph, Mass.-based freelance writer who covers real estate issues and is a former real estate editor of the Boston Business Journal.

As a part of the committee's oversight of the tax-credit program, the chairman of the House Committee on Ways and Means asked the General Accounting Office (GAO) to determine the characteristics of the residents and properties that have benefited from tax credits, as well as to assess the controls the Internal Revenue Service and states have to ensure that:

Priority housing needs are met; Housing project costs, including tax-credit costs, are reasonable; and States and project owners comply with program requirements.

"The GAO report dramatically demonstrates the housing credit's runaway success, unequalled by any other federal housing effort ever undertaken," says Jim Logue, president of the National Council of State Housing Agencies, a Washington, D.C.-based national nonprofit organization of state housing agencies. "The GAO report also helps make the case for increasing the amount of housing credits available nationwide."

He cites the following highlights from the GAO report:

The average housing credit apartment renter earns only 37% of the local median income, even though the law allows such renters to earn up to 60%.

More than three of every four housing-credit apartment renters have incomes lower than 50% of their area's median income.

Average housing-credit rents are well below market rents, as much as 23% below the maximum legally permitted rents and 25% below HUD's national Fair Market Rent.

States are giving preference to apartments set aside to serve low-income tenants much longer than the law requires.

Housing-credit apartment development costs are reasonable. They average less than $60,000 per unit.

The states have developed voluntary "best practice" for housing-credit administration, including limitations on developer and builder fees.

The GAO report does says that the administrative oversight of the credit needs to be improved. The GAO recommends the following initiatives:

Independent verification of information on sources and uses of funds submitted by developers.

Requiring on-site inspections to assure that projects are habitable.

Better verification so that states do not overspend their share of the credit.

Subjecting the LIHTC program to the Single Audit Act, which requires that state operations be audited for compliance with federal laws.

Copies of the report can be obtained by calling GAO at (202) 512-6000.

Editor's note: On the occasion of the 10th anniversary of the low-income housing tax-credit program this year, NREI asked Dr. Michael A. Stegman, HUD Assistant Secretary for Policy Development & Research, about the Clinton Administration's position on the state of tax credits and affordable housing in the country.

NREI: Is your administration willing to push Congress to increase tax credits that have remained flat at $1.25 per capita for the last 10 years?

Stegman: The Clinton Administration has been a strong supporter of the housing tax credit. The first large budget package in this administration contained the permanent extension of the credit. The administration has also withstood subsequent Republican efforts to scale back or eliminate the housing tax credit.

The administration has not yet taken a position on increasing the per capita cap. We have studied the issue at HUD and believe a good case can be made for increasing the allocation rate. Inflation has eroded the real value of the annual per capita authority of the states to allocate the LIHTC. Between 1987 and the third quarter of 1996, the chain-type price index for the Residential Fixed Investment Component of Gross Domestic Product (a measure of construction costs) grew from 88.3 to 112.5. This suggests that to retain the 1987 value of the $1.25 per capita, LIHTC authority should be raised to $1.59 per capita. Similarly, the price of a constant quality home grew from $127,700 in 1987 to $164,900 in the fourth quarter of 1996. This suggests that per capita LIHTC authority be raised to $1.61 to regain the 1987 value of the LIHTC program. Notice that, even ignoring the unmet need for affordable housing, one could argue to raise the cap to approximately $1.60 just to keep pace with inflation.

NREI: What steps is your administration taking to improve the affordable housing situation?

Stegman: In this context of severe needs for increased rental assistance, the scheduled FY 98 expiration of Section 8 rental assistance for 4.4 million people poses an ominous threat. If these contracts are not renewed, an enormous loss of affordable housing and widespread evictions could result. The department has proposed a comprehensive solution, seeking both full renewal and cost continuing reforms such as reducing excessive subsidies and tightening income-verification procedures. At the same time, Secretary Cuomo has also proposed legislation to continue deregulating well-performing housing agencies while cracking down on those that are troubled.

More generally, HUD's FY 1998 budget also proposes funding that would help create tens of thousands of new affordable housing and homeownership opportunities. These would include replacing the nation's worst 100,000 public-housing units with modest new townhouse and Section 8 certificates, providing 50,000 new Section 8 certificates targeted to help implement welfare reform and stepping up assistance to first-time homebuyers, especially in underserved areas of the country.