Developers are finding it tougher than ever to finance affordable housing. And often, the biggest hurdle for the sector’s borrowers involves construction — either obtaining that initial loan at a manageable cost or qualifying for take-out financing after a protracted construction period — which has strained resources and delivery schedules for a number of developments.
Limitations on rent increases make the industry especially vulnerable to rising costs, and expenses today have risen precipitously across the board. Rents have also grown, but not on pace with construction and operating costs driven up by inflation, wage pressures, soaring insurance premiums and a series of interest rate hikes, observes Tracy Peters, a senior managing director on Lument’s affordable housing production team.
“Borrowers are squeezed by a number of things in this marketplace,” Peters says. “The fed funds rate climbing 5 percent over the last two years means the interest rates on construction loans have basically come up 5 percent or more over that time. Now folks who had budgeted for a much lower interest rate — if they are still in construction mode — are trying to figure out how to deal with these higher interest rates.”
At the same time, the rising interest rate environment has compelled project owners to accept lower prices on sales of low-income housing tax credits (LIHTC), an important source of equity in the sector. “What investors will pay for tax credits is decreasing because buyers are demanding higher yields,” Peters says. “That means less dollars as a source of funds for a project.”
On the positive side, the government-sponsored enterprises (GSEs) have committed billions of dollars to affordable housing lending, giving the sector a vital alternative to banks and other providers that have curtailed real estate lending. Even so, the forces weighing on affordable housing developers can weaken a project’s cash flow during construction and lease-up, thwarting the owner’s ability to qualify for the long-term GSE financing they need to replace a costly construction loan.
“As a lender, Lument is finding ways to minimize the financing costs on deals in the affordable housing world,” Peters says.
Before the rapid climb in interest rates, affordable housing developers would typically obtain a construction loan and simultaneously lock in a low interest rate on a future loan with Fannie Mae or Freddie Mac to replace the project’s financing after completion and lease-up, Peters says.
Today, however, delays from supply chain breakdowns and labor challenges may require borrowers to pay on their high-interest construction loans for months or years longer than expected. Some borrowers burn through equity reserves or find they must renew an expiring insurance policy at a much higher premium if insurance is even available. When it comes time to convert to a previously negotiated long-term loan, some applicants may fail to pass underwriting for the full amount of the take-out financing.
“We suggest that clients be as conservative as possible on construction schedules and to lock in insurance beyond their expected completion date,” Peters says. “Time is not your friend in these deals, and you want to get done as quickly as possible but give yourself some timing cushion in the financing models to minimize the uncertainties.”
The challenge for owners, developers and lenders is to structure financing that not only enables them to complete a project’s construction or conversion to affordable units but also provides a dependable path to long-term financing after stabilization.
Lument has identified two primary strategies to help its affordable housing clients achieve these goals. Each approach mitigates construction loan challenges and avoids the need for a second, post-construction round of underwriting:
Immediate loans provide permanent financing from Day 1. Neither Fannie Mae nor Freddie Mac will fund an affordable housing project without a rent stream, which is why developers must look elsewhere to finance entirely new construction. Yet both agencies offer immediate loans to acquire operating properties and allow for renovations with tenants in place.
“You might have 15 percent vacancy and renovate the vacant units, then move residents as you go along throughout the building and then fill it back up once all the units are renovated,” Peters says.
A Lument client recently combined a Fannie Mae immediate loan with a tax-credit transaction to acquire a cash-flowing residential complex in the Southeastern United States and complete a substantial renovation as it converted the units to affordable housing.
“This is a good example of a way to lock in a long-term rate and not have to worry about a higher-rate construction loan,” Peters says.
Long-term FHA 221(d)(4) loans include construction. Borrowers willing to accept a relatively longer application process, federal wage rules and other requirements may opt for this unique loan to fund new affordable housing developments. Insured by the Federal Housing Administration, 221(d)(4) loans include both construction financing and long-term financing, without subjecting the developer to additional underwriting following construction. In addition, the 221(d)(4) program is fixed rate, 40-year term and amortization, and it is non-recourse.
“The FHA loan process takes time, but if you can build that into your transaction, the 221(d)(4) program is a very good option today,” Peters says.
There are still good examples of borrowers developing affordable housing with a construction loan and agency financing, Peters says. For example, a Lument client in the Southwest recently completed an affordable housing community with construction financing and will likely convert to a Freddie Mac forward-structure loan several months ahead of schedule. Keys to its success included partnering with local organizations for funds and expedited approvals, as well as an experienced general contractor and financial team that streamlined the project and kept it moving forward.
“The project has gone extraordinarily well, and it is leasing up quicker than expected,” Peters says. “We’re really pleased with this deal because it was kept on track and on budget, and that just doesn’t happen often today.”
For more articles from and news about Lument, click here.
Lument is a Fannie Mae DUS®, Freddie Mac Optigo®, HUD/FHA, and USDA lender, and also offers a suite of proprietary commercial lending, real estate investment sales, investment banking, and investment management solutions. Lument is the #1 FHA Lender.
Lument is a subsidiary of ORIX Corporation USA. Securities, Investment Banking, and Advisory Services provided through Lument Securities, LLC, Member FINRA/SIPC. Investment advisory services are provided by Lument Investment Management, LLC, registered as an investment adviser with the U.S. Securities and Exchange Commission. For more information, visit www.lument.com.