Affordable Gold

Brave the arcane--but potentially lucrative--world of buying and selling affordable rental housing projects.

April 1, 2000

The last time John Stone looked over his shoulder, he had a commercial niche practically to himself.

But as word gets around his Clearwater, Fla., market area that there’s opportunity in helping developers secure land, projects, and management contracts for affordable rental housing, the crowd behind him might grow a bit thicker.

“The barriers to entry are high,” says Stone, CCIM, an associate with Colliers Arnold who’s been working on apartment deals for more than 10 years and on affordable deals for the past seven. “But I’ve been preaching since 1992 that there are opportunities in this sector.”

What makes the wall so difficult to scale, even for commercial practitioners who specialize in the apartment market, is the complexity of deals that can involve a dozen local, state, and federal assistance programs. All those programs raise timing and underwriting issues that must be sorted out before a deal can close. That means you can work on one deal for a year or more before seeing a paycheck.

It’s also not uncommon to be thrust in the middle of sticky tenant or neighborhood disputes, which can derail projects for reasons having nothing to do with financing or project feasibility.

But practitioners say the rewards are worth the effort. “It’s definitely a complicated business, but it’s fun and there’s a lot of business there,” says James Henry, CCIM, of JHL Commercial Properties, Fairfield, Calif. “It’s particularly good when the economy’s in the tank. When apartment rents in the conventional market don’t support new apartments, affordable housing does very well in a countercyclical kind of way because of its different financing.”

In with the new

The greatest opportunities, affordable specialists say, lie in helping investors acquire existing market-rate apartment complexes, which their clients then convert to affordable housing using a mix of assistance to bring down development and operating costs. The programs that developers most commonly tap for assistance these days for development, acquisition, or rehab of affordable apartments are

  • Federal low-income housing tax credits
  • Tax-exempt bond financing
  • Federal HOME grants and loans
  • State trust funds
  • Local tax abatements

The federal tax credits, bond financing, and HOME program are administered at the state level by housing finance agencies.

By using these programs to bring down their costs, the new owners can charge rents below the market rate, enabling low- and moderate-income households to secure housing without paying more than 30 percent of their income for rent. In general, low-income households earn up to 80 percent of an area’s median income. Moderate-income households earn up to 100 percent of the median.

Many affordable housing developers these days are nonprofit community development corporations that are high on intention but low on experience and need the expertise of real estate pros to make deals happen for them, say practitioners.

“You need to know the market and have enough credibility with sellers to convince them that these buyers can do the deals in a timely manner,” says Henry. “When sellers bring deals to these inexperienced buyers, the sellers need to have a real estate practitioner standing by, because it takes months to get through the due diligence.”

“There are a million buyers out there for every apartment project that comes on the market,” says Stone. “The sellers want the highest and best price in a reasonable amount of time, and they don’t believe these [mission-oriented buyers] can get the deal closed. The practitioner brings to the table the credibility the sellers are looking for. I’ve spent most of my time telling sellers to give these buyers a chance. I’ve had pretty good results.”

Stone is shopping for properties for several Florida public housing authorities that are acquiring properties to expand their stock of affordable housing. Drastic cuts in federal public housing funds over the past several years have made it necessary for public housing authorities to act more like conventional apartment owners and developers if they’re going to make enough revenue to pay their costs, Stone says.

As a result, public housing authorities in every part of the country are sticking their toes into the local market, often for the very first time. Practitioners who want to tap into this potentially huge market (there are more than 3,200 public housing authorities around the country, and at least as many private nonprofit developers) can expect to spend a good chunk of their time just educating these agencies and developers on how to act nimbly, rather than as a bureaucracy, says Stone.

At the same time, these buyers bring a card to the table that practitioners can play to enable them to land a deal over the competition: a higher purchase offer. Because of the tax-exempt financing and grants they can bring to a deal, they can sometimes offer a price slightly above a conventional buyer’s offer and still build an affordable component into the project.

Private for-profit developers are getting into affordable housing in a big way as well, primarily by tapping low-income housing tax credits and tax-exempt private-activity bonds. But they tend to concentrate on new construction, so there are fewer opportunities on the acquisition and sales sides, practitioners say.

Out with the old

There’s another market that’s on the verge of exploding, but the deals are even more complicated. These are deals in which a buyer acquires an existing affordable housing project either to maintain the project as affordable by bringing in a new round of subsidy or to convert the project to market-rate use by refinancing the old use-restricted financing.

The market is poised to explode because the owners of hundreds of affordable projects built in the 1970s with FHA financing are becoming eligible to prepay their financing, so many owners are looking for deals. Some want to prepay and convert the project to market-rate use, which opens up opportunities for practitioners experienced at doing feasibility studies. And others want to sell, which opens up opportunities in the sales market.

So far, deal making is at a trickle, because the federal government is still wrestling with complex policy issues that have made it difficult for owners to do anything--either sell or refinance--even though they have the right to do so.

But that trickle is expected to become a flood once enough of these early deals get done, and 2000 is the year industry observers expect the explosion to hit.

Paul Wright, CCIM, principal of Paul A. Wright Investment Co., Austin, Texas, was tapped to work on one of these early deals because of his experience in doing feasibility studies. Now almost a year and a half later, he still hasn’t closed the transaction, but he’s acquired so much knowledge about the programs involved--FHA Section 221(d)(3), 221(d)(4), and 236 insurance, low-income housing tax credits, and tax-exempt bond financing--that he’s looking for more such deals.

The tricky part of these transactions is setting the purchase price, because there are so many more variables that go into the equation than in the conventional market, says Wright. Many of the older FHA-financed projects have little or no net operating income, so the finance providers must underwrite the financing on the basis of highly speculative projections of the project’s value after rehab and a new tenant mix, says Wright.

In the deal he’s working on, the buyers have applied for an allocation of low-income housing tax credits, which is critical to making the deal work financially. But that has created a catch-22 situation, because to be considered for the credits, the buyers have to put the deal under contract, and that contract presupposes they’ll get the credits. If the credits fall through, the buyers will have to scramble to fill in the gap.

“It really is specialized,” Wright says. “When you go into a market area, you have to know everything about the tax credit allocations in the state, any HUD programs that are involved, and so on.”

On the other side of the deal, many owners of the old FHA projects face high tax hits if they sell, even though the projects haven’t given them any income for years. That’s because of depreciation rules they’ve had to follow, says Allan Foster, CCIM, CRE®, of Foster Appraisal and Consulting, Leominster, Mass. “Sellers want these deals to make them whole somehow,” he says.

Despite the headaches, practitioners say they find the affordable rental housing market uniquely gratifying. “The reason I got into this business was to do adaptive reuse of existing buildings for affordable housing,” says Robert Keller, a residential sales associate with Columbia Cos., North Hollywood, Calif.

Keller tried to get his first affordable apartment deal done last year, but the nonprofit housing provider he courted wasn’t interested in a tract of land Keller thought was ideally situated for a new tax credit project.

To keep his finger in the affordable area, he helps low- and moderate-income households on the residential homeownership side, but he always has his eye out for the deal that will get him into the commercial side of the market. “It’s really the thing I want to do,” he says.

What’s affordable housing, and how’s it made?

In areas where there’s plenty of market-rate housing for households earning less than 80 percent of the area median income (generally the separation point between low- and moderate-income households), conventional housing and affordable housing are one and the same. These markets are scattered throughout the country, with some concentration in the Midwest.

Affordable housing as a separate market comes into play only in areas where households earning less than 80 percent of the median income can’t find conventional housing without paying more than 30 percent of their income for rent. In those markets, developers can tap assistance from two sides--the development side and the rental side--to create affordability.

On the development side, they can tap equity, below-market loans, grants, and tax abatements to bring down development or operating costs or both. On the rental side, they can attach rental subsidies to their project units. Few new federal rental subsidies are issued now, compared with the 1970s and 1980s. Most new so-called project-based subsidies are tied to specific needs, such as preservation of existing affordable housing.

More common now are so-called tenant-based subsidies, which are issued to households and travel with them as they rent housing in the conventional market. A market-rate project can become “affordable” if a tenant uses a rental subsidy voucher or certificate to cover the gap between 30 percent of the tenant’s monthly income and the rent.

Opportunities for residential practitioners

The growth of affordable rental housing development has spawned a growing market niche on the residential side of the business.

To increase their chances of winning low-income housing tax credit or tax-exempt bond authority allocations, which are tied to priority state housing needs, developers are increasingly proposing “mixed-income, mixed-use” projects. Those projects offer residential practitioners the opportunity to sell houses to both market-rate and low- and moderate-income buyers.

The jury is still out on how well the projects will work over the long term, because of the uncertainties involved in mixing in a single neighborhood tenants and homeowners of vastly different income levels, but two things are clear, practitioners say. One, mixed-income, mixed-use projects are top priorities in many states, so expect to see a lot more of them. And two, the for-sale units in early projects are selling like hot cakes.

David Fleischaker of Housing Associates in Louisville, Ky., started selling single-family lots last year as part of the massive Park Duvall project in that city. As of early 2000, almost all of the 150 lots in the project’s first phase had been sold.

The Park Duvall project is a massive undertaking by the Louisville public housing authority that involves the demolition of about 1,600 highly concentrated public housing units. The units are being replaced with low-density, low-income rental housing units and scattered-site single-family homeownership units.

The fast-selling lots are in what was, just a few years ago, one of Louisville’s most decaying neighborhoods. The buyers are from all income levels, says Fleischaker.

Buyers--high-income as well as low-income--were originally attracted by the $27,000 in forgivable secondary financing that was available on each lot, but interest has been so high that the incentive money has been dropped to $10,000, Fleischaker says.

Why the success? “The housing authority succeeded in creating communitywide buzz about what it was doing in this area,” he says. “The houses being built are attractive and use ‘new urbanism’ design principles. They have porches, picket fences around the yards, no front garages, and lots of alleys. The whole thing was marketed to the local real estate community before any lots were sold.”

Other big projects involving the replacement of concentrated public housing units have met with similar success, say practitioners. The Chicago Dwelling Associates has been selling market-rate units in town houses located just outside one of Chicago’s most notorious public housing zones, as part of the revamping of that city’s public housing. And in Atlanta, McCormack Baron and Associates of St. Louis, Mo., blazed the mixed-income, mixed-use trail, turning around obsolete public housing there.

What are low-income housing tax credits, and why does everyone love them?

Since Congress changed the tax laws to spur affordable housing development 11 years ago, the low-income housing tax credit has been the financing engine behind the development of more than a million apartment units. That’s made it one of the biggest drivers of apartment development in the country. In high-priced markets, it’s been the engine behind virtually all the new apartment development in the past few years.

States receive an annual allocation of credit authority from the federal government based on the number of people in the state. The states allocate the credits to developers on the basis of how well the developers’ project plans meet state housing priorities. Developers that win an allocation can use the credits to offset their federal income tax liabilities for 10 years, but more commonly they pass the credits on to investors who become limited partners in the project. The funds the investors use to “pay” for the credits constitute the project equity. That equity makes it easier for developers to obtain debt financing. In areas where the median income is very low, extra subsidy funds can be added through other federal, state, or local programs to get rental affordability down low enough to help tenants.

With more than a decade of performance to look at, investors are comfortable that the projects are safe investments. That’s because they, and the lenders, are motivated to make sure the general partners (the developers) maintain the projects in an economically sound way. If a project runs into trouble, the investors and the lenders have tools--financial leverage, the authority to demand changes in project operation--to help the general partner get back on track.

Investors are also motivated to make sure the general partner maintains project affordability, because if the project fails to maintain affordability, the investors can lose their tax credits.

Robert Freedman

Robert Freedman is the former director of multimedia communications at NAR.

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