Affordable Housing Lenders, Investors in New York City Face Underwriting Challenges
By Taylor Williams
For lenders and investors in New York City’s affordable housing market, accurately underwriting rent growth, operating costs and long-term asset appreciation can be a tricky proposition in today’s economic environment.
To be fair, buyers and financiers of affordable housing properties in many U.S. markets are being forced to adjust and recalculate their metrics due to forces they can’t control. Yet macroeconomic factors like rising inflation, which puts heavy pressure on construction and operating costs, can often seem more acute in the Big Apple, where the cost of living and doing business is already higher than virtually anywhere else in the country.
The labor and materials costs for the renovations and rehabilitations that many affordable housing communities need are rising. According to Producer Price Index data supplied by the U.S. Bureau of Labor Statistics, for the month of August, the latest report available at the time of this writing, the aggregate cost of construction materials had risen by 19 percent from August 2019.
Much of this rise in materials costs is due to disruption of the global supply chain via COVID-19, causing developers of much-needed housing stock to incur heftier budgets and longer construction timelines on ground-up and rehabilitation projects.
Despite these pressures on development and operating costs, which are hardly unique to the affordable housing space, owners within this asset class have seen stable rent collection rates from tenants amid the pandemic. According to data from RealPage, the national affordable housing collection rate in July was roughly 88 percent, relatively unchanged from the pre-COVID average of 89 percent.
Yet that too could potentially change in the coming months. The demise of enhanced federal unemployment benefits that were enacted to combat COVID-19, as well as the expiration of the federal eviction moratorium, could both impact renters. Both programs officially ended at the beginning of September.
“The impacts of the enhanced federal unemployment benefits expiration are happening in real time — it’s a wait-and-see environment right now,” says Eric Steinberg, senior vice president in KeyBank’s New York City office. “Some rent relief programs have started to trickle down to developers, who are making sure that those in need can get that relief. So, we’re hopeful there won’t be a major drag on payment, collection or occupancy rates.”
“With regard to the expired benefits and moratorium, at least on the affordable side, there was already a lot more stability there,” notes Josh Reiss, a director at New York City-based Lument who specializes in affordable housing deals. “Most collections that were reliant on any form of subsidy, like Section 8 housing, continued to flow through.”
Within New York City’s market-rate multifamily sector, the moratorium expiration is generally being used as a tool to encourage renters to pay back rent as opposed to going through the full eviction process, according to Reiss.
Lastly, despite rampant economic disruption over the last 18 months, New York City’s area median income (AMI) is on the rise. According to the New York Department of Housing Preservation and Development (HPD), the current AMI for a family of four is approximately $119,300, up more than 5 percent from $113,700 in 2020.
A natural increase in AMI should translate to more revenue for owners of income-restricted properties due to the simple fact that rental thresholds are based on various percentages of AMI. When one goes up, the other should follow. But the higher costs of building and operating in an inflationary environment also works to offset some of these gains in revenue.
All of the moving parts add complexity to the owners’ and lenders’ efforts to construct accurate models for future revenues and costs.
Other Influencing Factors
On another level, New York City has been a hotbed of experimental rent-control laws and policies in recent years, a trend that culminated with the Housing Stability and Tenant Protection Act of 2019. This sweeping, pro-tenant piece of legislation shields renters of rent-controlled properties from excessive security deposit demands, industry blacklisting and even eviction under certain conditions.
Lastly, the general growth of impact investing by institutional capital sources, as well as lenders’ obligation to meet requirements of the Community Reinvestment Act (CRA) has led to an influx of debt and equity into the affordable space. As drivers of investment activity, these factors have shown a tendency to throw some kinks into the traditional underwriting system.
“Because there’s so much institutional capital in the affordable housing space that’s eager to deploy, pricing has become more frothy,” explains Victor Sozio, executive vice president of investment sales at New York City-based Ariel Property Advisors.
“A lot of institutions are willing to underwrite lower returns than what they’ve historically targeted because they’re motivated by mission-driven capital placement and a need for CRA credits.”
The CRA encourages lenders to provide credit to the communities in which they operate, including low-income and moderate-income neighborhoods. Banks can receive favorable CRA consideration for community development activities, including ones related to the Low-Income Housing Tax Credit (LIHTC), new markets tax credit (NMTC), historic rehabilitation tax credit and renewable energy tax credits.
Sozio adds that in his hometown market, these social and legal obligations often lead institutional investors to underwrite returns of 10 to 12 percent on 10-year holds. These double-digit yields — if actualized — may sound like major paydays. But they often pale in comparison to the returns that institutional investors could get on market-rate deals in markets with lower costs of doing business and fewer barriers to entry, such as those in the Sun Belt region.
“A lot of our clients are looking at deals in Texas and the Southeast because it’s hard to compare returns on market-rate deals in those regions to the 10 to 12 percent that many investors are settling for with prime affordable investment opportunities in New York City,” he says.
Steinberg of KeyBank concurs that returns on affordable housing investments are softening due to more players chasing yield and driving up prices. While that scenario may not be great for investors, Steinberg points out that this growth in demand has brought more financing partners into the mix — a tailwind for a widely recognized, major social problem.
“The acquisitions market for stabilized properties has become more competitive, as have development and lending spaces,” says Steinberg. “Lenders are getting more aggressive and competitive on leverage points. We’ve seen cost ratios go higher for acquisitions. It’s exciting to see capital commitments from lenders and investors going up, because affordable housing is a major need across the country that has only been exacerbated by the pandemic.”
KeyBank recently provided $16.3 million in financing — a $12.8 million construction loan and a $3.5 million Freddie Mac permanent loan — for the development of a 51-unit affordable housing project in Harlem that exclusively serves members of the lesbian, gay, bisexual, transgender and queer (LGBTQ) community. The capital stack also includes $14.3 million in LIHTC equity, as well as a $2.5 million subsidy through the state’s Supportive Housing Opportunity Program and a $1.8 million grant from Enterprise Community Partners.
“This project speaks to the need for subsidies and rental assistance in such a high-cost-of-living market like New York City,” says Steinberg. “Even before the pandemic, projects in this market required a good amount of subsidies that trickled down from the state level. The state and city have gotten creative in deploying subordinate financing in addition to private capital sources to provide the most competitive financing they can.”
In addition to more private lenders getting into the affordable housing game, government-sponsored enterprises Fannie Mae and Freddie Mac have adjusted some of their basic loan parameters to help more projects get developed, says Reiss of Lument.
“In terms of underwriting, projects in New York City are unique because they historically have a high number of predevelopment costs associated with them,” he says. “Lately, we’ve seen that both Fannie and Freddie have been more willing to be a little more flexible for certain projects, such as those in particular submarkets and those that qualify for subsidies.”
“We’ve also seen Fannie and Freddie increasingly offer 40-year amortization schedules instead of 35 years on new construction projects,” continues Reiss. “That has helped a number of projects pencil out better and be less reliant on subsidies. Further, we’ve seen Fannie and Freddie team up with the city and state to offer developers risk-sharing products that effectively break down the cost of capital.”
Sozio of Ariel Property Advisors says that he’s also advised investor clients, particularly those who don’t need to close on their loans immediately, to consider agency products due to the favorable underwriting terms they can offer.
“The gold standard for debt for many affordable housing developers and operators is still FHA/HUD financing — if they have the time and patience for it,” he says. “If it’s a project that almost entirely qualifies for rental assistance, lenders can get to a 1.1 debt service ratio with an FHA/HUD 223(f) loan with up to 85 percent loan-to-value (LTV) and a 35-year amortization schedule.”
Investor competition for properties in New York City that are largely covered by rental assistance programs can be fierce, says Sozio. But many investors want to move fast on these deals and avoid the uncertainty of execution and lengthy timelines for closing that FHA/HUD loans typically require. By going the agency route, they can avoid those obstacles and still typically get banks to underwrite similar terms — 1.2 debt service coverage and 80 percent LTV at 30 years of amortization, he explains.
— This article originally appeared in the October 2021 issue of Northeast Real Estate Business magazine.