Always on the lookout for new yield-producing products, commercial property investors have turned affordable housing into the latest hot alternative real estate asset. Backed by government subsidies and incentives, affordable housing investments provide the relative safety and income of a high-yield Treasury bond or net-lease investment, which is hard to pass up in the crowded field that has driven up conventional property prices.
“A lot of cash buyers and funds have come into the affordable housing market. They see it as a stable asset class,” says Heidi Burkhart, founder and president of New York-based Dane Real Estate, an affordable housing brokerage that has closed some $1.5 billion in transactions since 2008. “It’s a cool time to be in affordable housing; it’s a hot topic.”
It’s going to get hotter. Economic and cultural trends portend a shortage of the product for years to come as college debt, unpredictable job creation, high home prices, rising rents and other variables are blocking home ownership and weighing down renters, according to observers and Affordable Housing: Emerging Asset Class, Global Investment Possibilities, a report issued by CBRE in July.
In New York City, some 54 percent of renters in 2015 were “cost-burdened,” paying more than 30 percent of their incomes for housing. By comparison, the national average of cost-burdened renters at the time was 50.6 percent, according to research released in late 2016 by ApartmentList, a San Francisco-based apartment rental marketplace. Only 38 percent of renters were considered cost-burdened in 2000.
At the same time, the National Low Income Housing Coalition’s March 2017 report, The Gap: A Shortage of Affordable Homes, found that “extremely low income” households at 30 percent or less of the area median income (AMI) faced a shortage of 7.4 million affordable housing units in 2015, which equated to a supply of only 35 units for every 100 of the households. Similarly, only 55 units were available for every 100 households with “very low income,” or 50 percent of AMI.
“Since the recession, I would say tenant demand for affordable housing has gone up tremendously,” says John Gilmore IV, a vice president with Cleveland-based KeyBank who focuses on affordable housing finance in the Northeast. “It’s hard to build affordable housing, and you can’t build enough to stay in line with demand.”
Overcoming Challenges
Against that backdrop, concerns surrounding interest rates, rising construction prices, potential funding cuts to the U.S. Department of Housing and Urban Development (HUD), and future fiscal policies have generated caution in the space. According to the CBRE report, for example, the federal government allocates about $46 billion for affordable housing initiatives annually. One of those, the Low Income Housing Tax Credit program (LIHTC), has produced about half of the affordable units in the U.S.
In the LIHTC program, a certain number of credits are allocated to states each year, and investors buy the credits to fund development, rehabilitation and preservation of affordable housing. But uncertainty over tax policy has driven down the per-credit price to between 90 cents and $1 from a high of about $1.15 late last year, so individual projects require the sale of more credits to raise the same amount of equity that would have been achieved before the slide in value, explains Alex Viorst, a principal in the affordable lending arm of PGIM Real Estate Finance, which provided funding to preserve 3,142 affordable units last year. Subsequently, fewer deals get done, he says.
Still, the situation is serving as a catalyst for developers, lenders, states and local governments to craft new solutions, says Burkhart. For example, she’s pursuing new affordable housing projects on six sites in the New York metro area after launching a development division two years ago, and equity investors are showing interest, she says. But she’ll also use New York incentive programs, such as 421-a, to build a mix of around 70 percent market-rate and 30 percent affordable units. The 421-a program, which was renewed and revamped last year, provides a property tax exemption for 35 years for projects of at least 300 units that meet construction wage requirements.
“While budget cuts definitely would hurt, they’re going to create more opportunities for development to take different directions from what we’ve done in the past,” Burkhart says.
New and innovative state and local funding programs are critical to financing new development and preservation projects, Gilmore says. That’s particularly true as affordable housing demand continues to grow among not only low-income households, but also middle and moderate-income earners such as firefighters and teachers, he and Burkhart say.
“It is becoming a national issue now, but New York and the Northeast have had affordable housing needs for decades,” adds Gilmore, who is based in New York. “We have to figure out how to make the projects work, but at the same time, investors and sponsors must consider that the asset class offers a very attractive risk-adjusted return.”
In March, KeyBank’s Community Development Lending and Investment division provided $18.2 million to preserve and renovate the 46-year-old, 104-unit Martin Luther King Revitalization Apartments in Troy, N.Y. KeyBank made a $6.2 million construction loan and is investing up to $12 million in LIHTC to fund the first phase. The bank provided some $1.4 billion in affordable housing financing in 2016, and it plans to boost that to $8.8 billon over the next four years, Gilmore adds.
Cap Rate Compression
To date, growing investment demand for affordable housing has been the most pronounced in the project-based Section 8 properties. Created in the 1970s, the program directly subsidizes landlords, which typically rent to households with extremely low and very low incomes. Only about 23,000 of those properties exist nationwide, however, and were built in the 1970s and 1980s, says Gene Levental, a managing director with SVN Affordable |
Levental Realty, a Cincinnati-based brokerage that focuses on project-based Section 8 and Section 42 housing.
“You have a lot of old original developers who owned the majority of these assets, and we’re seeing new developers coming in and buying a lot of the existing inventory,” adds Jamie Renzenbrink, a senior advisor with SVN Affordable | Levental. In February the firm and Pryor Cashman brokered the $180 million sale of a 1,009-unit Section 8 portfolio owned by Kline Enterprises in Northern New Jersey. “Everyone wants the guaranteed subsidy,” she continues, “and they feel like there’s strength in the federal programs despite all the talk about budget cuts.”
But the demand for affordable housing over the last several months has fueled the same yield compression seen in conventional property segments, Levental explains. He estimates that cap rates for project-based Section 8 properties, which were around 10 percent to 12 percent nationally in 2011, are approaching those for Class A multifamily assets in any given submarket, or roughly 5.75 percent in New York or Northern New Jersey.
Evolving Dynamics
Traditionally, it has been common for developers who buy project-based Section 8 properties to spend about $40,000 to $60,000 per unit on a renovation and then repeat the process, observers say. Acting as general partner, for example, a developer will find a limited partner to fund the deal by buying tax credits. The developer then operates the building with income restrictions in place for 15 years, as required by tax code. At the end of the 15-year compliance period, the developer will often buy out the existing limited partner, secure another allocation of tax credits and then syndicate the deal to a new limited partner to fund the rehab. That re-starts the clock on a new 15-year period of income restrictions.
But today, aggressive pricing has interrupted that model to the extent that some long-time industry veterans have been shut out of the final round of bids for project-based Section 8 properties, even after putting as fine a financial pencil to their offers as possible, Viorst says.
“Non-traditional affordable housing investors have cash to spend, and they’re willing to invest at a relatively low yield for Section 8 properties given the certainty of cash flow from these assets,” Viorst says. “Some of the more traditional affordable housing developers are being crowded out. It’s overly frothy.”
The high prices also limit a developer’s ability to execute robust property renovations, and he and Gilmore maintain that preservation of the existing affordable housing stock remains essential to the market.
“There’s a risk that some buyers are doing just enough to keep the property running, and at the end of the day that may not be the best for the affordable housing space,” Viorst says. “It’s a small component of the market but something to keep an eye on.”
What’s more, the fervent demand is hastening an evolution of the project-based Section 8 transaction structures. A few years ago, some developers that didn’t want to wait for the 15-year compliance period to end began selling their general partnership interests in the properties after 10 years. Today, however, they’re selling those interests just a few years after rehabbing the properties, Levental and Renzenbrink say.
“Developers are trying to figure out how they can capitalize on the momentum in this market,” says Levental, whose firm is marketing 13,000 units, some of which are under contract, in 34 states. “Affordable housing is the sexiest space alive right now, and everybody wants in.”
— Joe Gose