By Taylor Williams
In an era in which land and construction costs are perpetually on the rise, developers of affordable housing must be able to navigate a complex web of federal, state and local programs in order to secure gap financing — the capital that covers the delta between total development costs and those covered by tax credit equity, municipal bonds or other types of subsidies.
Understanding and effectively utilizing the various initiatives and incentives — density bonuses, private activity bonds, tax increment reinvestment zones, energy efficiency compliance — is no easy task. Time and manpower aside, this process is further complicated by the fact that state and municipalities have their own laws and regulations when it comes to these programs.
But successfully navigating them is key to eliminating development costs not covered by tax credits — the critical piece of financing that lies at the heart of virtually every affordable housing project in Texas. For without these subsidies, the economics of paying market-rate land prices and record-high construction costs to develop housing in which rent levels are capped simply doesn’t work.
“As developers that want to build high-quality affordable housing that’s basically indistinguishable from market-rate product, what we need is capital that’s designed to integrate with affordable housing,” says Ryan Wilson, senior vice president at San Antonio-based Franklin Development Co. “Our construction costs are the same as those of market-rate developers, but our rents are significantly lower, so to cover that gap, we need more money.”
“As we artificially lower our rents to be affordable to the segment of the population earning 60 percent or less of the area median income (AMI), the ability to raise capital on permanent financing is reduced,” he continues.
Jason Arechiga, senior vice president in the Texas office of national developer The NRP Group, observes that construction costs were about 33 percent cheaper five years ago than they are today on a per-unit basis.
“Affordable housing developers face the same rising construction costs as market-rate developers, the difference being that market-rate developers can adjust rents,” says Arechiga. “Our rents are capped based on AMI, which forces us to find other avenues to fill that gap.”
According to the latest data from the Associated General Contractors of America (AGC), the supply of construction labor continues to trail demand, with the industry losing 20,000 jobs between April and May. Nationwide, nonresidential and residential builders had approximately 357,000 job openings at the end of April.
Price escalation for construction materials has been equally rough on developers. Though many projects experienced delays due to the COVID-19 pandemic, construction was generally deemed essential business and moved forward at regular clips once job sites were deemed safe and secure.
In addition, the bevy of shelter-in-place orders in 2020 prompted many citizens to undertake home improvement projects, creating a spike in demand for materials. According to the AGC, the price of iron and steel scrap metal rose 76.6 percent between May 2020 and 2021, while the average price of lumber and plywood skyrocketed by 111 percent during that period.
Arechiga notes that affordable housing developers also compete with market-rate developers for land. Land sellers, as owners of a precious and scarce resource, are always going to ask for top dollar, regardless of what the buyer plans to do with the dirt, he points out.
Despite ballooning land prices, affordable housing developers in Central Texas remain committed to competing for sites in areas that provide access to employment clusters, public transportation and good school systems. Why? Because it’s what their residents deserve, according to Wilson.
“Clustering housing that’s far removed from those services doesn’t do anybody any good,” he says. “So we’re faced with the challenge of providing housing with a finite budget in those areas that need it but may not be as affordable as a site outside of an urban center. In order to give our residents the best housing possible while juggling the economics of the real world, it’s critical that we have those programs to help bridge the gaps in our financing structures.”
“Our goal is to provide residents with a true community that is comparable to the market-rate development across the street,” concurs Arechiga. “For example, NRP is utilizing granite countertops at our communities not only because they are easier to maintain than laminate, but because they are nicer. The same applies with vinyl plank flooring — yes, it’s easier to switch out than carpet, but it’s also more aesthetically pleasing and provides a more modern-looking unit, which is something our residents appreciate.”
Institutional Interest
Across the spectrum of investment, demand for multifamily assets and raw land that is zoned for multifamily development is especially strong right now, sources say. Various forms of federal aid to renters, from rental relief programs to the Centers for Disease Control’s (CDC) national eviction moratorium, has kept cash flowing throughout the space and drawn the attention of institutional investors that like the reliability of the asset class during a recessionary period. This demand for multifamily has penetrated all subclasses of the property type, including affordable housing.
At the time of this writing, the eviction moratorium was scheduled to expire on June 30, but numerous political outlets reported that the Biden administration would extend the moratorium for another month.
“Traditionally, the affordable housing space has not seen heavy capital flows from institutional investors, but the size of the market and general demand for the product has always been strong,” says Daryl Carter, chairman and CEO of California-based owner-operator Avanath Capital. “But as occupancies and collections remained strong in many portfolios throughout 2020, investors demonstrated a bigger appetite due to the defensive nature of the asset class.”
In September 2019, Avanath Capital Management acquired Canvas Apartments, a 255-unit property in Austin that was built in 1983 and renovated in 2016. The firm is actively looking to expand its footprint of affordable housing in the fast-growing state capital.
“Investors take in lower yields on affordable deals relative to market-rate deals, but those yields are driven by the lower risk that the assets carry due to demand for affordable housing,” adds Hector Zuniga, vice president and senior relationship manager at KeyBank Real Estate Capital. “As a result, we’ve seen continued appetite from institutional investors who target the space even during the pandemic.”
Zuniga says that he saw some hesitancy among institutional investors to deploy capital into the affordable space during the second and third quarters of 2020 as these capital sources wrestled with how tenants who’d lost their jobs would be able to pay rent. However, subsequent measures like stimulus relief checks and the CDC eviction moratorium assuaged those concerns. Now, with the U.S. economy and society rapidly returning to pre-pandemic modes of operating, investment demand for affordable assets is back to where it was in early 2020.
Avanath Capital currently owns two affordable communities totaling about 600 units in Austin. Carter says that Avanath is looking to expand in the state capital — ultimately aiming to grow its Austin portfolio to 1,500 to 2,000 units — and recently closed a $760 million affordable housing fund to facilitate that goal. Carter notes that the fund’s original target was $550 million, and that it could likely have exceeded $1 billion had the firm pushed for investors to oversubscribe.
“A lot of investors are interested in Austin in general because it has such strong job growth, and there are a lot of capital flows targeting the affordable space as well, especially with regard to Class A rent-regulated product,” he says. “In addition to major institutional employers like University of Texas, Austin is landing a lot of high-paying jobs from major companies. It’s really important that we’re able to provide affordable, quality housing for the people who support those industries behind the scenes.”
Carter notes that as the need for affordable housing — in Texas and beyond — has grown more pronounced and become a higher priority among city planners and administrators, more data on the product type has become available. Better information on the performance of affordable housing properties has in turn made institutional investors more comfortable with the asset class.
Consequently, when affordable developers do win land deals, they’re coming into the next phase of the development at an economic disadvantage because their revenue streams have hard ceilings. Effectively mitigating that disadvantage is the essence of successful gap financing, and that task is accomplished by finding and leveraging incentives from the public sector.
“At the end of the day, we find our gap financing by understanding local, state and federal funds and how they are administered,” says Arechiga. “For example, a city may put money toward infrastructure improvements like streets, sidewalks and public right of ways.”
“The question for us then becomes, ‘How do we dovetail that with affordable housing?’ We take care of vertical construction if the city helps improve infrastructure or other parts of the project that would typically be borne by the developer,” he continues.
Cities Address Need
As one of the fastest-growing cities of the last decade, Austin is undoubtedly supply-constrained. To address this, some city leaders have pushed for a repeal of the state law that forbids inclusionary zoning — a practice in which cities and municipalities require developers to designate a certain percentage of units in a new project as affordable. Thus far, these efforts have been unsuccessful.
However, that doesn’t mean that officials aren’t acutely aware of the supply-demand imbalance within the affordable housing space. The City of Austin rewrote its development code in 2019 with the primary intent of creating more avenues by which to encourage affordable housing development, says Patrick Howard, CEO and executive director of the Housing Authority of Travis County.
“The initial rewrite of the development code failed to secure approval, so it was followed by a second iteration that was designed to encourage more affordable housing development,” says Howard, who notes that AMI across the Austin metro area has risen by about 20 percent over the last few years. For a family of four, the current AMI in Austin is $97,600, up from about $81,000 several years ago.
“The city commissioned a strategic analysis of the problem and found that based on current growth rates, we’re going to need between 48,000 and 60,000 new units of affordable housing in the next 10 years,” he says.
One aspect of the revised code that promoted more supply growth was an expansion of the areas within which developers can secure density bonuses to save money on their projects. As legal tools, density bonuses allow developers to put more units on a site than would normally be allowed under the municipal code in exchange for helping the community achieve a policy goal, such as providing more affordable housing.
Howard says that developers that have experience in the Austin market have wised up to the fact that voluntarily including an affordable housing component in their projects can go a long way in facilitating the approval process.
“The buzzword right now is ‘community benefit,’ and affordable housing fits the bill for that,” Howard says. “Every multifamily project that has come through in the last two years has had some mention of including affordable uses because informed developers know it’s a priority for the city.”
San Antonio has undertaken similar quantitative analyses to better understand and attack its affordable housing problem. A few years ago, Mayor Ron Nirenberg’s office appointed various leaders within the industry to assess and identify the scope of the problem.
The task force found that about 250,000 households in the Alamo City met qualifications to be considered “overburdened,” meaning they spent about 50 percent or more of their disposable incomes on housing. The U.S. Department of Housing & Urban Development (HUD) takes that income threshold a step further, defining it as “severely rent burdened.”
“There’s a huge portion of the population here that has jobs and families but can’t find housing that’s affordable to them because they make 60 percent or less of AMI,” says Wilson of Franklin Development. “Based on the findings of the task force, the city has identified the ability to provide affordable housing as one of, if not its top priority. The city realizes that if it doesn’t prioritize workforce and affordable housing in its budget, it’s going to lose the battle to provide residents with the vibrant communities that everyone wants.”
More recently, the Alamo City voted to approve Proposition A, an initiative that amended the city charter to allow bond financing to be applied to a wider range of public works projects, including affordable housing.
Critical Credits
Amid the numerous financial and bureaucratic struggles that affordable housing developers face in their efforts to deliver quality product, there is at least one silver lining: Demand for tax credits among banks and syndicators is very strong.
Developers sell their tax credits to lending institutions, a liquidation process that enables them to nab much-needed equity for development. Because tax credits are secured by properties for which tenant demand is incredibly strong and supply low, the price of these subsidies remains high.
“Because there are a finite number of tax credits that are allocated to each state every year, and there are numerous buyers for them, pricing is very attractive,” says Zuniga. “Investors are happy to put these tax credits on their balance sheets because these properties typically remain stabilized throughout the life of the compliance period.”
Zuniga adds that since the federal tax credit program was created as part of the Tax Reform Act of 1986, the default rate on loans backed by these subsidies is less than 1 percent. In addition, the Community Reinvestment Act, passed in 1977, requires major lenders to invest in low- and moderate-income areas within the markets in which they’re active. Being in possession of tax credits enables big banks to meet this obligation in the form of financing more affordable or workforce housing.
— This article originally appeared in the June 2021 issue of Texas Real Estate Business magazine.