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Reference
Understanding affordable housing finance
Renewed Affordability
A Paradigm for Existing Affordable Housing
by David A. Smith
This paper is posted with the permission of the National Housing Conference.
Summary What properties are at risk? The concept of renewed affordability What is 'affordable'? What makes a preserving entity? How do we get there? Experimentation Conclusion
With mark-to-market and the Federal government's inexorable march away from renewing current Section 8 contracts on affordable housing, more and more properties have not only the legal right but the financial motivation to exit from HUD regulation. Since April, 1996, just under 100,000 apartments have gone market, and if trends continue, that number could more than double in the next three years.
Leaving HUD, however, need not mean leaving affordability – and it should not. A few transactions are creating a third path of renewed affordability which levers available resources – Federal, state, and local – to capture the same property that opts out of HUD to opt in to a new paradigm, one where the property is recapitalized and healthy but preserved for a long term.
Renewed affordability demands active financial intervention, usually at the state level, by entities and governments who will put a little of their own money into the mix to make the difference. It takes work but the results are rewarding.
Renewed affordability should be the wave of the future.
Existing HUD properties are at risk in three ways:
1. Prepayment of older assisted properties. Under the nine years of preservation (1988-96), about 90,000 apartments were preserved. Since restoration of the prepayment right three years ago, 60,000 have prepaid, and the rate continues steady.
2. Opt out of newer assisted Section 8 AAF properties. With Section 8 contract expiration and mark-to-market, about 28,000 apartments have already opted out. This rate is likely to climb as the apartments with expiring Section 8 contracts peak in FY 2000.
3. Deterioration, principally of older assisted properties that can no longer fund their renovation needs within their budget-based rents. Many of these properties are 28-30 years old and the upgrades they need simply cannot be sourced from available rents.
Most significantly, Federal policy is largely set for the next several years. The Multifamily Assisted Housing Reform and Affordability (MAHRA) Act, the mark-to-market legislation, was enacted 15 months ago and is just now coming into permanent effect. Even if Congress were suddenly to reverse course – and there is no evidence that this is likely, let alone imminent – and enact new legislation, putting it into effect will take 2-4 years … by which time most of the best properties will already have recapitalized.
In the next few years, most HUD properties will be recapitalized somehow, either to
take out equity or bring in new capital to fund renovations. Either way, the status quo is
unsustainable. Most of these apartments will be lost to the affordable inventory unless
there is a rapid response in new renewed-affordability alternatives.
The concept of renewed affordability
As we conceive it, renewed affordability means a transaction with these characteristics:
1. Exit from HUD. The property leaves HUD regulation (although HUD subsidies may continue, either property-based or resident-based).
2. Entry into non-HUD affordability. The property enters into a new, more robust affordability paradigm.
3. New financial resources. Making affordability as attractive as market conversion means, for a good property, that someone brings new resources to the table. These may be Federal (Section 8 enhanced vouchers, tax deferral via UPREIT or 501(c)(3) tax-exempt bonds), state (exception-rent vouchers, allocated tax-exempt bonds, allocated LIHTC's, HOME or CDBG, or legislature-appropriated funds), or local (real estate tax abatement or exemption). Whatever their source, they are tied to renewed affordability according to some definition.
4. Long-duration preservation. The new transaction has a long duration – at least 15 years, longer if the finances sustain it.
5. Preserving entity ownership. The property is owned by a preserving entity – non-profit or for-profit, private or quasi-public) whose mission is tied to long-term affordability preservation. What makes a preserving entity is amplified below.
6. 'Affordable' redefined. 'Affordability' will be defined in some internally sensible manner that will probably differ from HUD's definition. It might track LIHTC affordability, tiered affordability (30% of some fraction of median income), or rent-proxy affordability (e.g. at some percentage of FMR). As discussed below, alternate affordability can be quite meaningful and still sustain a reasonable amount of debt.
7. Economic viability. The property will be internally self-sustaining and economically viable even if Federal subsidy is withdrawn or modified. This is critical because no one can bind Congress' future actions and virtually no one can predict them.
8. Protection for current residents. Saving the property but making all the residents move would be a hollow preservation indeed.
9. Likely income mixing. To achieve the preceding objectives, more than
likely the property will drift gradually into a broader income mix with a deconcentration
of the very poorest families.
Every program has originally defined 'affordable' to mean (i) an income limitation on eligible residents, and/or (ii) a rent formula that derives a rent affordable to the target population. As HUD properties evolved over 20-25 years, inherent affordability has typically drifted downward (that is, toward deeper income targeting). This slow windfall has been insidious, necessitating ever greater subsidy flows with no opportunity to take stock and ask questions like:
- Is this cost-effective?
- Is this good for the property and the community?
- Are some beneficiaries being over-subsidized?
Renewed affordability means resetting the standard to a sustainable level, and then redesigning rent change mechanisms so that affordability does not drift later on. This second condition is critical – without it, we will redo the exercise again in ten or fifteen years.
As an illustration, consider a property reasonably close to the national average through the lens of a typical two-bedroom apartment in a marketplace with a $45,000 median income for a family of four. The resulting affordable rents and sustainable debt are as follows:
| Income category | Percent of median | Income limit |
Affordable rent º | Sustainable debt ¹ |
| Median | 100% |
45,000 |
1,125 |
99,600 |
| Low | 80% |
36,000 |
900 |
69,700 |
| LIHTC | 60% |
27,000 |
675 |
39,700 |
| Very low | 50% |
22,500 |
563 |
24,800 |
| Lowest full-time job ² | 27% |
12,100 |
304 |
Negative |
| Typical Section 8 recipient | 18% |
8,100 |
203 |
Negative |
º Assuming 30% of income for rent at the income limit.
¹ Based on 93% occupancy, $4,200 per apartment per year operating expenses, 75%
leverage, 7.5% interest rate, 30-year term.
² Using $6.00 per hour against a 40-hour work week, 50-week paid year.
This little thought experiment has several profound consequences:
1. Tax credit rents will fuel many acquisitions of existing HUD property. Rents at the LIHTC ceiling (30% of 60% of median income) support about $40,000 per apartment of debt, to say nothing of equity that can be raised. The supportable debt increases significantly if tax-exempt financing is brought to bear even if LIHTC's themselves are unavailable.
2. Housing people at or below the minimum wage requires income supplement. At $6 per hour, which is about 27% of national median income, a family can afford $304 a month, less than the $350 a month it takes to run the property. There is no way to make a property self-sustaining if its income mix falls below this line – it will always need outside sources.
3. The current income mix is unsustainable without ongoing Section 8. At 18% of median income – which is the level of the typical Section 8 recipient and the typical public housing resident – the 'affordable' rent is $203, far short of the $350 per apartment per month it takes just to run the property.
And the major conclusion:
4. Redefining affordability is both necessary and sufficient:
- a. Necessary. Without redefined affordability, properties will always be subsidy-dependent, and therefore vulnerable.
- b. Sufficient. With it, the property can sustain NOI, so that if the remaining price can be funded with capital sources, then the property can be self-sustaining over the long term.
What makes a preserving entity?
A preserving entity will be an owner who will be a faithful trustee of the
property over a long affordability period. This means that the ideal preserving entity
should have these attributes:
1. Commitment to affordability. The preserving entity must be committed to maintaining affordability as a primary goal. (This does not mean forswearing profitability or economic return, but rather that sacrificing affordability is non-negotiable except to protect the property's health.)
2. Capacity. The preserving entity must be able to run its property, which means it must have, or be reliably able to secure, operational capacity in many areas:
- a. Market knowledge and responsiveness. To paraphrase Tip O'Neill, all markets are local markets. Owners must know their markets and react quickly to market changes.
- b. Renting at market. As current Section 8 contracts expire, properties will be exposed to market forces, either directly (because they have been vouchered out) or indirectly (through comparable-rent tests). Either way, ability to rent vacant apartments will always be a critical skill.
- c. Renovation. Older properties need periodic and systematic renovation which goes beyond mere replacement to upgrading and preventing or correcting functional obsolescence. In a 25-year-old property, as much as one-quarter of the operating budget goes into continuous renovation lest its market competitiveness and financial viability atrophy.
- d. Repositioning. Subsidy-dependent properties will wean to market only slowly. As they do, they must be repositioned – physically, operationally, and in market perception.
- e. Property management. In the long run, no one manages as intensively as an owner, for the simple reason that no one else cares as much. Preserving entities who contract all their property management risk too much.
- f. Resident services. As residents age in place, affordable properties should (and usually do) become a nexus of social services – such as medical or wellness programs for the elderly, or job training and family counseling for families – that are brought to the residents rather than making the residents travel to the service provider.
- g. Finance. Finance is a property's lifeblood. Without regular circulation and recirculation, usually every 5-7 years or so, the property becomes anemic.
- h. Asset management. Often overlooked but critical when a preserving entity plans to hold a property twenty to thirty years, a time period in which the only thing certain is that some major totally unexpected event will happen … usually more than once.
3. Financial resources. It thus follows that the preserving entity must have the wherewithal to buy, operate, and fund properties when they need capitalization. Under-capitalization inevitably leads to default, usually at an inconvenient time when new resources are scarce or expensive.
4. Financial commitment. To assure that a preserving entity is motivated to rescue a faltering property, it should be exposed to financial downside itself if a property fails.
5. Business enterprise. The preserving entity must approach the property as a business that deserves to be supported and protected. If it teaches nothing else, the failure of public housing proves that properties must pay their own way. The revenue they earn (through rents) must cover their expenses, pay their scheduled debt service, and fund renovation and replacement. A property cannot be perpetually hat in hand for grant funding.
6. Organizational viability. In the same way, the sponsoring preserving entity must itself be a viable business if it wants to attract and retain the best people … and this business demands the best people.
Although many resource providers automatically assume that preserving entities must be non-profit, nothing in this list requires it, and the business discipline – at both the property and organizational level – is more often found in for-profit entities, who have financial downside exposure. Critical is finding that magic combination of genuine commitment to affordability and robust business enterprise.
Today only a handful of organizations meet all these tests. If renewed affordability is to become a reality, the nation will need more of them.
Inevitably, moving a huge undifferentiated inventory out of its current but untenable complacency and into custom-designed post-recapitalization affordability will be difficult. New approaches have to be conceptualized, developed, tested, codified, and then replicated. Fortunately, the last two years have witnessed an explosion of experimentation throughout the country, from which we are gleaning some conclusions:
Putting properties in the hands of preservers. When it comes to a property's long-term viability, the capacity and orientation of its ownership entity are as important as its location or construction. When the dust settles, properties being preserved for the long term should be owned by preserving entities with the capacities already discussed.
By itself, this principle does not mandate transfer, nor should transfer necessarily be encouraged. Instead, resources should be allocated if and only if the ownership entity is a genuine preserver meeting the credentials listed above. Some owners are born preservers, some evolve into being preservers, and some will never be preservers. Incentivizing the desired ownership format will both motivate owners to improve and provide the financial lubrication to enable transfer when appropriate.
Structuring long-term viable affordability. There is always an inherent tension between property viability and resident affordability – affordability means lower rents, viability means higher ones. Rent structures should provide meaningful affordability across broad income ranges but also provide ample NOI and net cash flow.
Rent increases and downstream flexibility. Like initial rents, rent increase structures should provide rapid and ample responses that echo inflation so that properties that begin healthy are not driven into default by overly tight circumscription.
The tax credit program provides a useful and successful example of easily-implemented rent increases; each time area median income rises, so do rent ceilings, which means that not only do the rents stay within a well-defined affordability range, they also rise differently in different markets. While there can be asynchronicity – rents spike up through supply shortage even if incomes are not quite keeping pace – in general, income drives rents because rents represent what people will pay. So an external, automatic paradigm that shadows CPI should be robust and genuinely affordable on a long-term basis.
Use restrictions: term and capitalization. Similarly, use restrictions can be more lengthy if they also allow ample financial breathing room so that properties can flow cash (for internal reinvestment) and fund new debt (either refinanced first loans or new second loans). Alternatively, since this is so hard to structure, the use restriction could have a mixture of escape hatches and renewal options, an escape hatch if the government does not want to continue affordability, a renewal option (probably tied to unregulated market value derived at the time) if it does.
The paradigms of renewed affordability are being created through experiments as individual property situations stimulate local response and sponsor creativity. At least seven variations have so far been tried:
1. LIHTC acquisition/ rehab. Older assisted prepayment eligible properties are bought by new sponsors who secured Low Income Housing Tax Credits (LIHTC's) via either direct allocation or volume-cap bonds. Normally these transactions involve moderate to substantial rehab.
2. Tax-exempt bond acquisition. Entities who can access tax-exempt bonds – either for-profit in states where allocations can be secured, or non-profits with their own 501(c)(3) issuance capacity – have been levering their access to inexpensive debt into acquisitions which can be free-standing or combined with LIHTC's.
3. Restructuring Flexible Subsidy properties. Under Flexible Subsidy, HUD provided an up-front payment (with an owner match) but required the property to sign a Use Agreement preserving it as affordable for the remaining original term of the HUD loan (typically, until 2010 to 2015). Although successful as a preservation strategy, the Use Agreement has choked off new capitalization so the properties are deteriorating. In a few cases, HUD has been approving – and even facilitating – transactions which pay off the HUD loan but keep a restated post-payoff Use Agreement in place
4. Friendly prepayments. State housing finance agencies (HFA's) recognizing a major prepayment threat in their jurisdiction have in some cases developed their own affordability-oriented prepayments that recapitalize the property, finance an owner equity takeout, protect all current residents, and provide a gradual transition to a mixed-income, less subsidy-dependent configuration. These transactions are often also fueled by local participation through real estate tax abatements.
5. State HFA Section 8 recapitalizations. HFA's with Section 8 AAF are facing owners who opt out of expiring Section 8 contracts or leave the Section 8 in place but refinance out from under bond-financing dividend limitations or operating restrictions. Many of these HFA's – notably Illinois, Minnesota, Michigan, Massachusetts, Rhode Island and Wisconsin – have developed programs (either sale or refinancing) to provide owners with equity takeouts in exchange for ongoing affordability. Several have been remarkably successful.
6. Section 236 IRP decoupling. Owners or buyers of aging Section 236 properties unzip the two halves of a Section 236 loan – they refinance the first mortgage (sometimes having it acquired by a state HFA and then wrapped with new HFA financing) to lever a lower gross interest rate but keep the Section 236 interest reduction payment (IRP) in place. A few pathbreaking transactions have been completed, notably in California (but even in unlikely places such as Montana). The same concept underlies Section 531 of the MAHRA Act, which so far HUD has yet to implement.
7. HOPE 6 revitalization. Renewed affordability is finding a purchase even in public housing. Even though HOPE 6 provides huge new block-grant funds to housing authorities to renovate (or demolish and rebuild) deeply troubled properties, these new funds must be levered with other resources (most commonly, LIHTC's or tax-exempt volume-cap bonds), and in that process affordability is redefined and the property's income mix is improved.
The exodus of HUD properties from HUD regulation is now inevitable, but that exodus need not imply losing affordability entirely. Instead, properly designed incentive programs can attract owners back into renewed affordability that achieves the core objectives – availability of housing for low income households and rents those households can afford – under a different construct than today.
To accomplish this, groups interested in renewed affordability preservation – state and local governments, state HFA's, regional partnerships, local non-profits, and others – must be nimble to design, promulgate, negotiate, and close programs and transactions tailored to their markets and their inventory.
Renewed affordability can be done and is being done in a host of isolated examples. But, if the inventory is to be saved before most of it goes conventional, these small experiments must swiftly expand into programs at the state, regional, or national level.
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