Understanding housing policy, finance, and regulation can be daunting, requiring us to wade through a sea of acronyms, untangle public and private interests, trace knotty financial flows, and decrypt complex bureaucracies. In our new Housing Brass Tacks series, we’re going back to basics to get a grasp on this unwieldy topic.
In the third Housing Brass Tacks discussion, we asked: What’s the math of affordable housing? Where does the money come from and what’s it used for? Mark Willis, the Senior Policy Fellow at NYU’s Furman Center, took us through the structure of affordable housing finance. From AMI to LIHTC, the CRA, and MIH, the process is as complex as the supply is scarce.
Housing is generally considered “affordable” if a family pays no more than 30 percent of their income on housing costs. If they spend more, they are considered “rent burdened.” But what actually qualifies as affordable housing can be a moving target.
Affordable for whom? Generally in New York City, affordable housing has been targeted toward households whose income is 60 percent or less of the Area Median Income (AMI). AMI is a figure released by HUD annually for each metropolitan area in the country. In 2016, AMI in New York City was $90,600 for a family of four. This number is a little haphazard, but it plays a big role: Income requirements for publicly-subsidized affordable housing units are pegged to a percentage of AMI, as are the rents that landlords can charge and the amount and kind of subsidies a developer can receive. A family of four making 60 percent of AMI would have an income of $54,360 and would pay $1,121 (approximately 30 percent of after-tax income) for two-bedroom affordable apartment — not too bad! However, there are not enough units available at these prices. Government can help renters with sky-high market rents through demand-side programs like Housing Choice Vouchers (Section 8), in which the government pays the difference between the rent and 30 percent of the tenant’s income (although there's not nearly enough vouchers to go around and only about one in four eligible households receive one). Still, there’s a great need for supply-side programs that increase the overall number of affordable units. Almost all new affordable housing in New York City consists of rental apartments created with subsidies from federal, state, and local governments through programs with various income, use, and occupancy restrictions (programs may be specifically targeted toward the elderly, formerly homeless, and so on).
For roughly the last four decades, the development of affordable housing in the US has been almost exclusively in the hands of the private market (both for-profit and non-profit). The financing for these developments is complex and can come from myriad (and sometimes surprising) sources, such as funds for disaster recovery, historic preservation, or energy efficiency. However, most financing relies on various common forms of debt and equity; the economics of affordable housing don’t add up on their own. Rents for affordable units in New York City can generally cover maintenance and operation costs, according to Willis, which average around $600 per unit per month. However, the developer will need a Net Operating Income that exceeds her expenses and debt payments (known as the debt service coverage ratio). Subsidies and incentives are therefore critical to a project’s financial feasibility. Developers put together a “sources and uses” statement for construction, a budget that shows where the money is coming from and how it will be spent.
How the sausage gets made The major sources of affordable housing finance are debt, equity, and grants. Debts are any sorts of loans taken out, whether a conventional bank loan or a government-insured one, and equity is any sort of capital raised for the project, which can include money raised from tax credit investments as well as small amounts of capital put up by the developer as “skin in the game.” Grants might come from government (such as federal Community Development Block Grants or HOME funds) or through private foundations or charitable organizations. The basic process of financing an affordable development involves a two-part loan: the first is the short-term construction loan, used to build or rehab the property, followed by the “take-out” loan, the long-term permanent financing that’s used to repay the construction loan and serve as the mortgage going forward. A developer needs to arrange the take-out (such as a Federal Housing Administration loan) in order to be an attractive candidate for a construction loan. Loans are underwritten based on how much profit the building is expected to make after completion, also known as the Net Operating Income (NOI, essentially gross income minus operating expenses and debt servicing). Government provides five primary categories of funding: direct appropriation or subsidy (such as a grant or loan), in-kind subsidy (including donated land), tax-exempt bond financing, tax benefits (which come in various forms of incentives, deductions, credits, and exemptions), and inducements for private sector funding (such as guarantees or insurance). Property tax exemptions reduce a developer’s tax burden, thereby increasing her NOI and allowing her to borrow more money. In New York, local tax incentives for affordable housing include 420-c, 421-a, J-51, and Article XI, among others. But where does the money go? Primarily to acquisition (of land and/or an existing building) and construction. But don’t forget the “soft costs”: contingency, architectural and engineering fees, legal and accounting fees, bank financing fees, insurance during construction, real estate taxes, developer’s fee, title and recording, partnership fees, marketing, and so on.
Created through the Tax Reform Act of 1986 and codified in Section 42 of the Internal Revenue Code, the Low-Income Housing Tax Credit (LIHTC) is the largest federal program producing affordable housing today. Between 1987 and 2014, the LIHTC program produced nearly 2.8 million housing units, about 122,000 of those in New York City. The program has thrived partly because, as an indirect subsidy, it is relatively invisible, and as a tax expenditure, it is not subject to Congressional appropriation, both of which make it less of a political target.
Low-Income What Now? LIHTC (pronounced “lie-tech”) is an economic incentive for the private sector to invest in affordable housing. Investors (individuals or, more likely, corporations) can reduce their federal tax bill dollar-for-dollar by the amount of tax credits they hold over a ten-year period. Tax credits are allocated by formula to states based on population — each state receives $2.35 in credits per capita currently — that are then doled out by the state based on its own Qualified Application Plan (QAP). (In New York City, federal credits are actually allocated by the city’s Housing Preservation and Development agency; the state also has its own tax credit program, SLIHC.) LIHTC funds must support low- or mixed-income developments: either 40 percent of the units must be for renters earning up to 60 percent of Area Median Income (the so-called 40/60 test) or 20 percent must be for renters under 50 percent of AMI (20/50 test). Affordability restrictions must remain in place for at least 30 years. Without getting too much into the weeds, there are two types of credits: The more valuable nine percent credits are granted through a competitive process, while four percent credits are available as-of-right to developers who are receiving federal subsidies, generally tax-exempt bonds. Once awarded LIHTCs, a developer uses a syndicator (essentially a broker) to sell the credits to investors to raise equity used to finance the project. Normally, the involved parties create a limited-partnership ownership structure in which the developer has only a 0.01 percent ownership stake and investors hold the rest (and therefore receive nearly all the profits). An entire industry has sprung up to manage these deals: syndicators, intermediaries (groups that provide technical assistance and training to community development organizations, like Enterprise and LISC), lawyers, accountants, development consultants, and more. As a program of the IRS, the appeal of LIHTC investments will depend on the (yet unknown) new federal tax rates, which could significantly change the value of the tax deductions received by investors. (And of course, a brief reminder that not all subsidized housing is affordable: the IRS also administers the mortgage interest deduction, which overwhelmingly benefits wealthy homeowners.)
Most affordable housing funding comes through LIHTC, and banks are the predominant buyers of the credits. There are a few reasons that commercial banks may want to invest in and offer loans for affordable housing, according to Willis.
What’s in it for them? Banks are often eager to invest in LIHTC because they need to meet the regulatory obligations of the 1977 Community Reinvestment Act (CRA). The CRA requires that large banks (with over $1 billion in assets) meet the credit needs of the places where they accept deposits, meaning that they need to make community development investments in low- and moderate-income communities. Investing in affordable housing meets one of the CRA’s required “tests.” In addition, banks may offer loans for affordable housing in order to issue the mortgages as Commercial Mortgage Backed Securities (CMBS) into the capital markets. (If the 2008 subprime mortgage crisis didn’t make it clear, housing is not merely a shelter but a debt-financed commodity to be traded on the international capital markets.) Finally, while affordable housing may not offer the returns of market-rate housing, it is inherently less risky, since there is always demand in markets like New York City for affordable units, and the vetting and insurance of government backing means these projects don't often fail.
Historically, “we’ve had time-limited affordability requirements and those eventually expire,” said Willis. After that, landlords can raise the rent to whatever the market will bear. A typical affordability regulation lasts 30 years. If the city wants to preserve units as affordable after those restrictions lapse, it has to offer subsidies to entice owners, particularly in high-rent areas, not to convert to market-rate.
Keep it cheap. In 2015, Mayor de Blasio triumphantly proclaimed an affordable housing victory with the $5.3 billion sale of the traditionally middle-class Manhattan enclave Stuyvesant Town to the Blackstone Group, an investment firm. The terms of the sale required affordability protections for the complex’s 5,000 remaining rent-stabilized units (of 11,232 units total). For $221 million, the city got 20 additional years of affordability for about 45 percent of Stuy Town’s middle-class households, and added 5,000 units to the win column toward de Blasio’s goal of 200,000 affordable units constructed or preserved by 2024. Twenty or 30 years of affordability may sound like a lot at first first blush, but life expectancy in New York City is about 81 years — meaning the average New Yorker could outlive her affordable apartment three or four times over. There are 750 federally-subsidized buildings in New York City set to expire by 2030. The good news is that there are two very significant sources of permanently affordable housing in New York: 180,000 units of public housing, as well as all units created through the city’s inclusionary zoning programs. Only a few thousand affordable units have been created through inclusionary zoning thus far, but that number will grow as the city increasingly relies on cross-subsidizing affordable housing production in market-rate developments, including through the new Mandatory Inclusionary Housing (MIH) program.