Current Practices for Financing Affordable Housing in the United States

Transcription

1 Current Practices for Financing Affordable Housing in the United States Cambridge, MA Lexington, MA Hadley, MA Bethesda, MD Washington, DC Chicago, IL Cairo, Egypt Johannesburg, South Africa 1996 Prepared for Fannie Mae Foundation Office of Housing Research 1996 Tri-Country Conference on Housing and Urban Issues Prepared by Michael J. Lea Cardiff Consulting Services James E. Wallace Abt Associates Inc.

2 Current Practices for Financing Affordable Housing in the United States * Michael J. Lea Cardiff Consulting Services James E. Wallace Abt Associates Inc. Abstract This article first sets a context for reviewing affordable housing finance in the U.S. by addressing the need for subsidy and the risks involved to private suppliers of funds for affordable housing. U.S. tools for financing affordable housing include capture of equity for rental housing in the low-income housing tax credit (LIHTC), a housing block grant (the HOME program), effective interest subsidies provided through tax-exempt bonds and below-market-interest funds provided to members of the Federal Home Loan Bank (FHLB) system, mortgage insurance and guarantees, regulatory influences on mortgage capital through the Community Reinvestment Act and through housing goals of the major secondary mortgage market entities (Fannie Mae and Freddie Mac), and state and local devices such as housing trust funds. The current options for financing affordable housing in the United States provide housing affordable to moderateincome home purchasers and to renters in the range of 50 to 60 percent of local median income. Assistance beyond that provided in the housing finance system is necessary to reach households at lower income levels. The diffusion of incentives to state, local, and private sources of financing and the use of implicit or explicit tax devices make it very difficult to assess their overall impact or cost effectiveness. Introduction Affordable finance of housing has been a concern of government policy since the creation of the FHA in Over the years there has been considerable experimentation with different techniques including mortgage instrument design, interest rate subsidies, down payment grants, insurance and guarantee programs and tax incentives to lenders, builders and buyers. Today the U.S. does not rely on a particular approach or program. Affordable housing finance programs exist on the federal, state, and local level, and incorporate a wide variety of techniques to reduce financing costs. * This research was supported by the Fannie Mae Foundation Office of Housing Research. The Foundation has agreed to permit publication of the paper.

3 2 Michael J. Lea and James E. Wallace This situation has arisen in part because of government budgetary constraints and in part from a desire to de-centralize the provision of housing programs. In recognition of declining government support for affordable housing, there has been an increased emphasis on stimulating private sector finance for affordable housing in the form of goals and requirements and through linking of regulatory approvals to lender performance. This approach has both strengths and weaknesses. On one hand, the use of multiple techniques by multiple different organizations has led to innovative programs and flexibility in design. On the other hand, this approach has created a bewildering array of programs and program features that increase the cost of provision and monitoring. Furthermore, many of the programs offer relatively shallow subsidies (reflecting the limited resources provided by different levels of government), which frequently necessitates combining several different programs to finance one project. This article provides an overview of the main approaches to the provision of affordable housing finance in the U.S. today. In the next section we provide a definition of affordable housing and identify the major barriers that exist to the private sector provision of finance for both owneroccupied and rental housing. We then review the major approaches that can be used to assist in the finance of housing including subsidization and risk-reallocation. Finally, we review the major government programs, and in the concluding section we provide an assessment of the current approaches to the finance of affordable housing. What is Affordable Housing? Need for Subsidy We define affordable housing as housing for low-income households (incomes at or below 80 percent of local median income, adjusted for family size), and very low income households (incomes at or below 50 percent of local median income, adjusted for family size). 1 In 1993 there were 26.5 million households with incomes under 50 percent of U.S. Department of Housing and Urban Development (HUD) defined adjusted area median income (14.7 million renters and 11.8 million owners), and an additional 16 million households with incomes between 50 and 80 percent of HUD adjusted area median income (6.4 million renters and 9.7 million owners) (HUD 1996a A-2). Affordable housing can either be owner-occupied or rental tenure. Current federal programs and private sector incentives do not directly address those households in what HUD and the U.S. Congress have defined as worst-case housing. 1 See Wallace 1995 for a more comprehensive discussion of the definition of affordable housing. Both the LIHTC and the GSE affordable housing goals (which will be discussed extensively in this article) use a definition of 60 percent of local median income.

4 Current Practices for Financing Affordable Housing in the United States 3 As a measure of housing need, HUD annually produces a congressionally-mandated report on worst case housing needs. Worst case renters are those not receiving federal housing assistance; with incomes below 50 percent of median family income in their area, as adjusted by HUD for family size; who pay more than half of their income for rent and utilities; or who live in severely substandard housing. The number of worst case renters had reached an all time high of 5.3 million in Almost 2 million of these have a working member of the household. Despite large and growing needs for housing affordable to worst case renters with extremely low incomes (under 30 percent of median area income), housing markets are not supplying units affordable for them. Affordability of Owner-Occupied Housing From the borrower s perspective there are two dimensions of affordability: the ability to service the loan (the payment burden) and the ability to provide the down payment. As reported by Harvard s Joint Center for Housing Studies (1995), the average first-time buyer (household income of $24,265) buying the average-priced ($67,959) house in 1994 had an after-tax cash burden of approximately 30.4 percent of income, the lowest level recorded since 1986 (figure 1). 2 This buyer, however, had a ratio of up-front costs (down payment plus closing costs) to income of 58 percent. Lowering the down payment requirement to 10 percent reduces the up-front cash payment from $14,200 to $7,600, or 31.3 percent of annual income. 2 After-tax cash cost is the ratio of after-tax housing costs (mortgage payment, property tax, insurance, fuel, utilities, and maintenance) assuming a 30-year fixed-rate conforming mortgage with a 20 percent down payment for the American Housing Survey median value house purchased by a first-time home buyer aged 25 to 29 divided by the average income of young renters (married couple renters aged 25 to 29 in 1989 dollars). Down Payment/ Closing Cost is the ratio of down payment (20 percent of the median value house) plus average closing costs divided by the average income of young renters. The average income of all renters ($15,814) is considerably less than the average income of young renters ($24,265). See Table A-1 in the Joint Center study for more detail.

5 4 Michael J. Lea and James E. Wallace Figure 1. Home Ownership Cost Burdens Source: Joint Center for Housing Studies These data suggest that the down payment constraint is the major obstacle facing first-time home buyers today. 3 One solution is the provision of higher LTV loans. A household can get a 95 percent loan with private mortgage insurance. (A 5 percent down payment requirement would lower the household s up-front savings requirement to $3,398, or 14 percent of annual income. The annual premium for mortgage insurance would increase the after-tax cash burden to 29.9 percent of income.) The median net wealth of young renters, however, is less than $2,500, suggesting that a majority of these households would be rationed out of the market even with 95 percent loans. 3 There is obviously a great deal of regional variability in these numbers. In high cost areas (e.g., New England, coastal California) these ratios are considerably higher.

6 Current Practices for Financing Affordable Housing in the United States 5 Of course, the average first-time buyer does not have to purchase the average house. If the household purchased a house with a value of only 75 percent of the average with a 95 percent down payment, the required down payment would fall to $2, Moving down the income scale, however, the situation becomes more problematic. For a low- to moderate-income firsttime home buyer with income at 80 percent of average, the down payment burden for a house that is 80 percent of median is 15.6 percent of annual income. The ratios for this class of home buyer are likely to be a bit higher than those of the average-income household, reflecting the fact that some of the home ownership costs are fixed and not a function of house value (e.g., maintenance, utilities). Although 95 percent LTV loans are available in the U.S., they are not available from all lenders or to a large proportion of borrowers. The reason is that such loans are considerably more risky than lower LTV loans. 5 Affordable owner-occupied housing default risk is likely to be higher than other types of single-family mortgage loans due to lower down payments as well as less stable incomes. Research by Freddie Mac indicates that default rates on conventional 95 percent loan-to-value (LTV) loans are more than 15 times greater than on loans with LTVs of 80 percent or less (Van Order 1995). Default losses from the higher LTV loans are more than seven times those with the lower LTVs. Van Order and Schnare (1994) analyzed the relative default experience of affordable owneroccupied housing loans with loans to higher income households in Freddie Mac s portfolio. As shown in table 1, default rates rise substantially with LTV. Default rates for both low-income (51 to 80 percent of metropolitan statistical area [MSA] median) and high-income (120 percent or more of MSA median) borrowers are about 20 percent higher than default rates for moderateincome borrowers. Low-income borrowers with LTVs between 91 and 95 percent experience the highest default rates of these groups. Loan losses (as a percent of the outstanding balance before mortgage insurance reimbursement) for the different income groups are compared in table 2. Loans to low-income households have the highest severity of default loss, which also rises with LTV. As noted by the authors, these results are similar to the Federal Housing Administration (FHA) experience. 4 As discussed by Bradley and Zorn (1996) there are many non-financial factors that also deter young renters from becoming homeowners. These include the fear of rejection and complexity in the loan application process, the fear of purchasing the wrong house, and concerns over employment stability. 5 Affordable housing loans are also smaller and more costly to service.

7 6 Michael J. Lea and James E. Wallace Table 1. Probability of Ever Defaulting Household Income as LTV Percent of MSA Median 0-60% 61-80% 81-90% 91-95% All 51-80% 0.1% 1.2% 3.3% 8.8% 2.8% % % All Household Income as Percent of MSA Median Table 2. Loss Severity LTV 0-60% 61-80% 81-90% 91-95% All 51-80% 59% 47% 57% 67% 60% % % All Source: Van Order and Schnare There are several approaches to improving the affordability of owner-occupied housing. These include programs to lower the interest cost of mortgages (e.g., interest rate subsidies or buydowns), lowering the risk of granting mortgages to low- and moderate-income home buyers (and thus indirectly lowering the interest cost) through guarantees or insurance, or lowering the down payment requirement through granting of higher LTV loans (typically combined with insurance). Interestingly, the provision of lump-sum grants to home buyers, conditioned by savings behavior, has not been extensively used in the U.S. 6 The difficulties in providing mortgage loans on affordable terms to lower-income households suggests that programs to lower housing cost and encourage savings could be significant in improving the affordability of owner-occupied housing for first-time home buyer households. The President s Commission on Affordable Housing (1983) detailed a number of ways to reduce the cost of new housing, primarily through relaxation of land use regulations, building codes, and local taxes. Encouraging savings for housing has not been tried in the U.S. A number of countries have well-established contract savings programs for housing. These programs have been shown to be effective in stimulating aggregate savings as well as creating a pool of long-term 6 Economists have long extolled the efficiency of such grants, and they are extensively used in developing countries. For a review of the Latin American experience, see Ferguson et al

8 Current Practices for Financing Affordable Housing in the United States 7 funds for housing. 7 They typically combine a tax exemption on interest earned, a cash bonus paid by the government, and in some cases the availability of a low-interest second mortgage when the savings target is reached. Affordability of Rental Housing The economics of affordable rental housing finance is based on the cash flows produced by a project, the discount rates used by lenders and investors in assessing project feasibility, and the cost of debt and equity. The example shown in table 3 illustrates the parameters the developer and lender would look at to determine the feasibility of investment in affordable multifamily rental housing. The numbers are for illustration only, but are meant to be broadly representative of this type of investment. 8 In this example, the developer is assumed to reserve 20 percent of units for households earning 60 percent of U.S. median income, reserve 20 percent of units for households earning 80 percent of median income, and rent the rest of the units to households earning 120 percent of median income. Total project development cost is $85,000 per unit for a 100-unit project. Households are assumed to pay 25 percent of their monthly income in rent after allowance for utilities of $120 per month. As shown in the second section of table 3, the project generates an annual gross rental income of $846,000 and a net operating income of $543,700. The calculations at the bottom of table 3 show the maximum loan this project could support, assuming all of the net operating income is applied to debt service, or $5.4 million. This would be 63.7 percent of development cost in this example. This leaves the developer with a financing gap that must be covered by equity, subsidies, or non-interest-bearing loans. In reality, the developer is unlikely to get a first mortgage for this amount. The debt-service coverage ratio (DSCR) in this example is only 1.0 (all of the net operating income is dedicated to debt service), well below the usual minimum acceptable ratio of 1.2. A DSCR of 1.2 implies a loan of $4.5 million at the 8 percent interest rate, which leaves a financing gap of $4 million, or 47 percent of project cost. Another reason why the developer is unlikely to get a loan of $5.4 million is that the lender will not appraise the project value at the development cost. Rather, the lender will use a discounted cash flow valuation or apply a capitalization rate to the first year (or stabilized) net income stream. Assuming a capitalization rate of 9 percent, the project appraised value would only be $6 million (in part reflecting the effects of the affordable units on the project s net income stream). A 7 International experience with targeted contract savings for housing programs suggests that they do increase aggregate savings. See Lea and Renaud (1994) for a discussion of European experience, and Engelhardt (1994) for a discussion of the Canadian experience. 8 From Miles, Haney, and Berens (1996, F307-8), Figure The typical terms for apartment loans made by life insurance companies in 1995 were for 10 to 15 years at yields with fees around 8 percent at LTVs of 70 percent, debt-service coverage ratio of 1.5, and capitalization rates around 9 percent (American Council of Life Insurance, 1996).

9 8 Michael J. Lea and James E. Wallace lender using an 80 percent LTV ratio would lend $4.8 million, except that the DSCR approach would limit the loan to $4.5 million in any case. Assumptions Loan Term Loan Rate Table 3. Economics of an Affordable Multifamily Rental Project Inputs Total Units 100 Project Development Cost 240 months 8.00% annual $8,500,000 Total Vacancy % 5.00% Per Unit Annual Op Exp ($2,600) per unit Median Income $39,600 % of Total Units (Input) 60% 0% 20% 20% 0% Number of Units % of Median Income (Input) 120% 100% 80% 60% 25% Monthly Income $3,960 $3,300 $2,640 $1,980 $825 25% of Monthly $990 $825 $660 $495 $206 Utility Allowance $120 $120 $120 $120 $120 Rent Income Available $870 $705 $540 $375 $86 Total Monthly Rent $52,200 $0 $10,800 $7,500 $0 Total Annual Rent $626,400 $0 $129,600 $90,000 $0 Gross Annual Rent $846,000 Vacancy ($42,300) Total Annual Operating Expense ($260,000) Net Annual Rent Available $543,700 Max Loan Given Net Rent $5,416,806 Mortgage Payment ($543,700) Loan as % of Development Cost 63.73% Financing Gap $3,083,194 Financing Gap/Unit $30,832 Financing Gap % of Devlp. Cost 36.27%

10 Current Practices for Financing Affordable Housing in the United States 9 This example shows why there is little unsubsidized private market financing of affordable newlyconstructed rental housing. Quite simply, at the income levels for these households, costs of development and market mortgage interest rates, the numbers do not work. The developer is unlikely to find $3.9 million of private equity capital for this project, which generates an internal rate of return of only 8.5 percent on investor capital (assuming the standard depreciation allowance). Although the unassisted mortgage insurance programs have no income targeting requirements, they do typically have per-unit dollar caps that target them toward the lower cost end of the market. From data provided in the 1991 national sample of the American Housing Survey, one can estimate the percentage of rental units that would be affordable (at 30 percent of income) to households of various incomes relative to the area median. The percentage of households at median income that could afford rents can be estimated by type of structure and whether existing or new, as shown in table 4. Table4. Percentage of Affordable Units by Property Type and Income Level Rental Unit Type Affordable by Tenants with Incomes Under 50 Percent of Area Median Income Affordable by Tenants with Incomes Under Area Median Income Existing 1 4 Unit(s) NA 80% New 1 4 Unit(s) 20% 66% Existing 5+ Units 41% 78% New 5+ Units 9% 87% Source: Tabulations of the 1991 American Housing Survey Note: New is defined as units constructed within the three years prior to the survey. The economics of affordable rental housing are further complicated by the fact that investors view multifamily housing as more difficult and risky to manage than other forms of commercial real estate. As noted by DiPasquale and Cummings (1992), the management of rental housing is less of a business relationship than commercial real estate. There are complex legal relationships governing leases and tenant eviction protections, as well as the possibility of government regulatory restrictions on the rents that can be charged and the ability to convert the property into condominiums. The upside of rental housing investment is often limited by the location of the properties and the ability to raise rents in line with expectations and market developments.

11 10 Michael J. Lea and James E. Wallace Multifamily loans are viewed as more risky than single-family loans, reflecting the fact that they are investment properties in which both the probability of default and the loss per default is higher. 9 American Council of Life Insurance data show much higher delinquency and foreclosure rates on multifamily than on single-family loans. Nothaft (1994) notes that the spread between commercial (including multifamily) and residential single-family loans increased from negative spreads of 20 to 60 basis points in the time period to positive spreads of 50 to 60 basis points in the period, an increase he attributes to increased default risk. The negative spread in the 1980s reflects the value of the call protection common in multifamily mortgages. This measure is imprecise because the prepayment and liquidity aspects of commercial and residential loans also differ. It is less clear whether affordable rental housing projects have more or less risk than purely market rate projects. DiPasquale and Cummings provide a number of reasons why such loans may be less risky. These include lower vacancy rates reflecting the tightness in the affordable housing market, the presence of income subsidies that create more rent payment stability, and more intense and specialized management of such projects by specialized managers. There are, however, several potential offsetting risk factors. If the project is located in a poor neighborhood, the maintenance and security expenses may be higher and more variable and the project may have less upside potential. The affordability of rental housing finance can be improved through programs to lower the interest cost of debt finance. As with owner-occupied housing, this can be accomplished through interest rate subsidies, buydowns, and insurance. Because equity is an important component of rental housing finance, programs that lower the cost of equity (e.g., through tax incentives) are also a source of government assistance. Affordability can also be improved through reductions in the cost of inputs (e.g., land use regulations) and enhancements in rental income (e.g., through direct tenant assistance). Government Role in Affordable Housing The federal role in affordable housing encompasses programs of tenant-based rental assistance, a tax credit program to capture equity capital for low-income rental housing, interest rate subsidies, insurance and guarantee programs, and providing incentives to private lenders to provide mortgage capital in all markets. Before reviewing categories of current federal involvement, it is useful to set the context of existing affordable housing programs. As summarized in Rental Housing Assistance at a Crossroads, a recent document by the U.S. Department of Housing and 9 Research by Vandell et al. (1993) has shown that construction and development loans are significantly more risky than standing project loans. Among property types, multifamily loans are less risky than hotel and office projects, and more risky than retail and warehouse lending.

12 Current Practices for Financing Affordable Housing in the United States 11 Urban Development (HUD 1996a, 4), affordable housing supported by the federal government includes: Tenant-based assisted housing. Direct rental assistance to 1.4 million renter households to enable them to find their own housing on the open market. Begun in 1974, this type of assistance has accounted for by far the greatest portion of the incremental units, or additions to assisted housing, since the mid-1980s. Public housing, 1.25 million units. Owned by local public agencies. Begun in 1937, heavily used to produce assisted housing units until the mid-1980s. New production is now limited to partial replacement of units lost to demolition. Project-based assisted private housing. Construction and rehabilitation of 1.8 million rental units for low-income households developed from 1968 until the early 1980s. Deep rent subsidies attached to projects owned by for-profit and nonprofit sponsors, who must rent units to eligible households. Other federal programs produce affordable housing, but households pay the established rent rather than a percentage of their income. So without an additional subsidy, the poorest households often cannot afford this housing. The primary programs are: Equity Capture: the Low-Income Housing Tax Credit. Subsidizes the capital costs of units with rents affordable to household with incomes at or below 60 percent of area median income. This program has produced more than 400,000 units since its enactment in Block Grants: the HOME Investment Partnership (HOME) Program and the Community Development Block Grant (CDBG) Program. HOME is a formula grant to states and local governments that can be used to assist existing homeowners, first-time homebuyers, or renters. Between 1990 and 1995, HOME produced 63,000 affordable rental units. Qualifying rents must be affordable to households with incomes at or below 65 percent of area median income, or below local fair market rents. Interest Subsidies: tax-exempt bond financing and the Affordable Housing Program (AHP) of the Federal Home Loan Bank (FHLB). Federal tax law makes provision for states to issue tax-exempt bonds for financing home purchase and multifamily development. The AHP of the FHLB system provides low-cost on-lending to member banks, which are required to provide a certain number of these loans. C Insurance and Guarantees: FHA and Veterans Administration (VA). The FHA (HUD) provides full insurance for single-family and multifamily loans (within limits on loan size and

13 12 Michael J. Lea and James E. Wallace loan-to-value ratio) and the VA guarantees up to 100 percent of the share of homes purchase by veterans. C Regulatory Influences on Supply of Mortgage Funds: housing goals for the secondary mortgage market and the Community Reinvestment Act. Each of these is discussed before turning to a brief discussion of state housing trust funds. Equity Capture: The Low-Income Housing Tax Credit Description. The notable current federal affordable housing production program, the LIHTC, is designed to capture equity for affordable housing. As the earlier project example illustrated, substantial equity and funding sources other than amortized loans are necessary to create affordable rental conditions in multifamily housing. The LIHTC provides a stream of ten years of tax credits available to investor/owners. To obtain a claim to the value of these credits, which reduce the investors federal income tax liability, the investors provide up-front cash payments to the sponsor/developer of a qualifying project. To qualify, a project must have at least 40 percent of the units occupied by households with incomes at or below 60 percent of median area income (adjusted for family size) or, alternatively have at least 20 percent of the units occupied by households with incomes at or below 50 percent of median area income. Rents must not exceed 30 percent of the applicable income limit. In practice, most projects have nearly 100 percent of occupants with incomes at or below 60 percent of median. Projects receive the annual tax credit over the ten-year period only if occupancy is maintained. Owners must make a commitment to rent the agreed number of units to households under the income limit for a period of 30 years. 10 If the owners fail to maintain the qualifying status of the project, the tax credits are reduced accordingly, and if the project fails to maintain its qualifying status in the extended commitment period beyond the ten-year credit period, the owners are required to make a pro-rata payment to the Internal Revenue Service. This obviously provides a financial incentive for the owners to keep the property in compliance during the commitment period. The annual allocation of tax credits is $1.25 per capita. Projects financed by tax-exempt bonds are not subject to the per capita limit on tax credits. The credits are allocated to eligible projects by housing agencies of the states and territories, plus city agencies in New York and Chicago. Credits not used by a state become available for reallocation to other states. The annual amount of the tax credit is a percentage of the qualifying basis (essentially total project costs if all the 10 In the original 1986 legislation the commitment period was 15 years. The Omnibus Reconciliation Act of 1989 extended the commitment period to 30 years. The project owners are allowed to sell or convert the project to conventional market housing, however, if they so apply to the state credit allocation agency and the agency is unable to find a buyer (presumably a nonprofit organization) willing to maintain the project under its low-income restrictions for the balance of the 30 years. If such a buyer cannot be found, the tenants are protected with assistance only for up to three years or when they move out.

14 Current Practices for Financing Affordable Housing in the United States 13 project units are qualifying). Two percentage levels are used, depending on the type of project. For new construction projects not federally-assisted (meaning having a reduced-interest mortgage or financed with tax-exempt bonds) the nominal percentage is 9 percent. For acquired property or federally-assisted projects the nominal percentage is 4 percent. These nominal percentages are adjusted monthly to maintain a discounted present value of 70 percent of the project basis for the 9 percent projects and 30 percent of the project basis for the 4 percent projects, discounted at an applicable federal rate related to Treasury borrowing rates. Recent percentages for the annual amount of tax credit were 8.65 and 3.71 percent (Warren, Gorham & Lamont 1997, 813). Because the tax credit is available over the ten-year allocation period and not as an up-front lump sum, and because of the legal and accounting services that must be used to syndicate the tax credits to interested buyer/partners, it has been noted above that the actual amount of money delivered to a typical project for direct project costs is about half of the value of the credits discounted to the present at the federal discount rate (roughly 50 cents on the present value of federal costs). This happens because the investors exposed to the risk of recapture of the tax credits require a much higher effective rate of return than the federal discount rate, and because the syndication and transaction costs can amount to roughly one-fourth of the amount raised up front from the investor/owners. A survey conducted by the National Council of State Housing Agencies (NCSHA) (1995) of its membership indicates 1994 allocations of tax credits sufficient to generate 2,136 projects with 117,099 tax credit-qualifying units. Seventy percent of the allocations were for new construction units, with the remainder divided roughly equally equally between substantial rehabilitation and acquisition and more modest rehabilitation. These planned numbers were increased by the projects with tax-exempt bond financing, which must fit under some overall limits on tax-exempt financing but are not specifically limited by the per capita allocation of tax credits. Bond-financed projects planned in 1994 were 37, representing 4,565 tax-credit qualified units (NCSHA 1995, 48). A separate survey conducted for HUD indicates that the total number of projects placed in service in 1994 was 1,291 with 57,625 units 11 (Abt Associates Inc. 1996). The tax credit statute provides for a 15 percent set-aside for nonprofit sponsors, unless not claimed by nonprofit applicants. Based on the NCSHA survey, nonprofit organizations were allocated 27.3 percent of the tax credit units in 1994 (NCSHA 1995, 53), and the Abt Associates survey indicates 26.5 percent of the units placed in service in 1994 were by nonprofit entities (Abt Associates Inc. 1996, 4-11). The Abt Associates survey also obtained location data for as many projects as possible. Based on the projects that could be geocoded (representing 55 percent of the units), it appears that the projects sponsored by nonprofits were more likely than for-profit projects to be in neighborhoods with a high incidence of poverty households, to have substantial minority concentrations, and to be located in central cities (Abt Associates Inc. 1996), as shown 11 These totals cover all tax credit allocating agencies except the City of Chicago and exclude 20 properties on which no information was available on the number of units.

15 14 Michael J. Lea and James E. Wallace in table 5. Most of the tax-credit projects are targeted to the narrow range of households with incomes in the range of 50 to 60 percent of area median income (NCSHA 1995), as indicated in table 6. Those projects intended to reach to the lower end of the income distribution are likely to be those making use of several forms of assistance, both to reduce capital and carrying costs of development, as well as rental subsidy (such as project-based Section 8 rental assistance). Table 5. Neighborhood Characteristics by Nonprofit vs. For-Profit Sponsor Neighborhood Characteristic Nonprofit-Sponsored Projects (Percent) (n = 23,774) For-Profit-Sponsored Projects (Percent) (n = 68,682) Census Tracts with Over 50 Percent Low- Income Households (below 80% median) Census Tracts with Over 50 Percent Poor Households (below the poverty line) Census Tracts Where Percent Minority Exceeds MSA or County Percentage Census Tracts with Median Contract Rent at or Below the MSA or County Median 70.2% 61.9% 22.1% 8.6% 68.3% 54.3% 72.2% 55.4% Central City (n = 123,495) 64.5% 48.0% Source: Abt Associates Inc. 1996, Exhibit 4 5, p. 4 8 for Central City percentages and special calculations added to Exhibit 4 11, p for tract characteristics. Table 6. Distribution of Credit Units by Household Income Categories Income Category (as percent of adjusted median) Percentage of Units Below 30% 1.0% 30 to 50% 18.7% 51 to 60% 79.9% Source: NCSHA 1995, Table 7, p. 51, state percentages weighted by state number of 1994 tax credit qualified units allocated, excluding Georgia (not reporting).

16 Current Practices for Financing Affordable Housing in the United States 15 Example. For a typical 9 percent project, the LIHTC captures an effective equity contribution to the project of about one-third 30 percent of total costs. The remainder of the costs are financed in a wide variety of ways, including grants and subordinate loans in addition to the first mortgage loan. A simplified example may show why the tax credit is not enough to provide the financing required for affordability. In this example shown in table 7, we return to the typical multifamily project introduced earlier and assume now that 100 percent of the project is rented to tenants with income equal to 60 percent of median, and that, because of the subsidized nature of the project, vacancies will only be 3 percent. The maximum market rate loan the project will support is approximately $1.76 million, or 20.1 percent of the total development cost. Thus, the developer must raise additional funds for 80 percent of project costs from equity contributions and gap financing. First, look at the approximate size of the equity raised from the tax credit. The tax credit is based on total development cost excluding land. 12 If we assume that the $8.5 million in total development costs comprise $1.3 million of land costs and $7.2 million in construction costs, and that the proportion of units occupied by low- and very low income tenants is 100 percent, the undiscounted sum of tax credits available would be $6,480,000 ($7.2 million years). Table 7. Example of Financing a LIHTC Project Assumptions Inputs Loan Term 240 months Loan Rate 8.00% annual Total Units 100 Project Development Cost $8,500,000 Total Vacancy % 3.00% Per Unit Annual Op Exp ($2,600) per unit Median Income $39,600 % of Total Units (Input) 0% 0% 0% 100% 0% Number of Units % of Median Income (Input) 120% 100% 80% 60% 25% Monthly Income $3,960 $3,300 $2,640 $1,980 $825 25% of Monthly $990 $825 $660 $495 $206 Utility Allowance $120 $120 $120 $120 $ The tax credit basis is quite a bit more complicated. The owners are allowed to consider deferred developer s fees and other elements, making the basis effectively larger than simply the construction costs.

17 16 Michael J. Lea and James E. Wallace Rent Income Available $870 $705 $540 $375 $86 Total Monthly Rent $0 $0 $0 $37,500 $0 Total Annual Rent $0 $0 $0 $450,000 $0 Gross Annual Rent $450,000 Vacancy ($13,500) Total Annual Operating Exp ($260,000) Net Annual Rent Available $176,500 Max Loan Given Net Rent $1,758,444 Mortgage Payment ($176,500) Loan as % of Development Cost 20.69% Financing Gap $6,741,556 Net Tax Credit Equity $3,500, % of development cost Remaining Financing Gap $3,241, % of development cost In order to raise cash for the development, the developer must syndicate or sell the tax credit. Because the 1986 tax act restricts the ability of individuals to use tax losses (passive loss restrictions), the primary market for the credits is large tax-paying corporations. Tax credit investors typically do not purchase the credits for their full face value, because they are future payments, and there are also substantial transaction costs in marketing and selling the credits (Stegman 1991). The demand for tax credits has been rising recently, in part due to the fact that the program was made permanent. Thus, developers are realizing a larger proportion of the credit in cash today than in earlier years of the program. A GAO study found that average prices have increased to over $0.60 per ten years worth of tax credits (GAO 1997, 90). If we assume a sale at $0.55 per dollar (net of transactions costs), the developer will realize approximately $3.5 million, leaving a gap of $3.3 million. This simple example has omitted a number of devices by which the amount of equity raised is increased, such as spreading out the required investor payments over a period of years or taking advantage of the depreciation allowances usable by a corporate investor. The basic fact is illustrated, however. A substantial portion of tax credit project development costs must be paid out of gap financing of some kind. Concessionary Financing. A 1997 GAO study provided data from a national probability sample 423 tax credit developments from which owner responses were received on 380 projects on the costs of tax credit projects and the role of tax credits in financing these low-income housing developments. On the basis of the sample, the GAO estimated that tax credit projects placed in service in the period 1992 through 1994 cost a total of about $10.7 billion to develop: about $5.8 billion in construction expenses; about $2.7 billion in construction-related fees, such as those paid

18 Current Practices for Financing Affordable Housing in the United States 17 to developers and builders; and about $2.2 billion in other costs, including the costs of acquiring the property (GAO, 1997, 75). The equity investment raised through the award of tax credits ($3.1 billion) amounts to about one-third of the total development costs of the projects sampled, commercial mortgage loans about one-third, and concessionary financing in some form about another third (GAO, 1997, 76). Concessionary financing is necessary because, in a typical project, the restricted rents generate only enough revenue over and above operating expenses to pay for the debt service on about onethird of the costs of the project. It helps that the tax credit equity covers another third of project costs, but that still leaves a large gap. The upshot is that developers must seek grants, donated land or services, or loans at concessionary terms (low interest rates or deferred repayment) in order to complete the financing of the project. The GAO estimated that 69 percent of the tax credit projects placed in service between 1992 and 1994 required subsidies in addition to tax credits, amounting to about $3 billion in concessionary loans or grants. These concessionary loans or grants provided 37 percent of the financing for these projects. Much of the concessionary financing (loans or grants) noted in the GAO study comes from locally-administered federal block grant programs (Community Development Block Grant or the HOME Investment Partnership Program) or from the interest-subsidized financing of the Section 515 program administered by the Rural Housing Service. Besides concessionary loans and grants, tax credit projects may receive rental subsidies for the operating side that effectively lower the capital financing required for the projects to meet the rental restrictions for low-income tenants. The GAO estimated from their sample that tax projects placed in service between 1992 and 1994 received about $229 million an year in combined project-based and tenant-based rental assistance payments. With this type of assistance considered, the percentage of tax credit projects in the GAO study with assistance beyond tax credits increases to 86 percent (GAO, 1997, 87). Limitations of the Low-Income Housing Tax Credit. 13 As noted in the tax credit example, a basic inefficiency lies at the heart of the tax credit. The present value to the government of the revenues lost to the tax credits are only partially delivered to a project as funds to cover project costs. This is partially because the investors discount the value of the tax credits at a higher rate than the government because of the risk of the projects and the need for a competitive return on investment. Another component of loss is that the mechanism itself requires accountants, lawyers, and partnership marketing experts to link the potential investors and a particular project, the so-called syndication costs. The U.S. Congress has required state agencies that allocate the tax credits to give priority to projects that use the highest percentage of housing credit dollars for project costs other than the cost of intermediaries For a broader discussion of issues on the LIHTC, see Wallace 1998 (forthcoming). 14 Revenue Reconciliation Act of 1989.

19 18 Michael J. Lea and James E. Wallace To increase the efficiency of capture of capital by the LIHTC, that is to reduce the syndication and transaction costs involved in collecting and disbursing the tax credit project investments, a number of nonprofit tax credit equity funds have been created. These include the National Equity Fund and other activities in support of nonprofit developers provided by the Local Initiatives Support Corporation (LISC) and the equity fund of the Enterprise Foundation, the Enterprise Social Investment Corporation. These equity funds undertake management of the syndication process and provision of bridge loans to advance funds in anticipation of a series of spread-out investor payments. These bridge loans serve to increase the amount of money actually delivered to the project because the bridge loan interest rates are much lower than the effective rate of return demanded by the investors, so that financing a spread-out series of payments increases the total amount of money an investor is willing to put into a project. In addition, a number of equity funds have been set up at the state level by state housing finance agencies or other nonprofit state organizations (such as the Massachusetts Housing Investment Corporation), as well as several city funds (such as the Chicago Equity Fund). The Equity Program of the Massachusetts Housing Investment Corporation (1996) now reports that it is able to deliver 69 cents of equity funds to project costs, net of fees and syndication costs, for every dollar of total tax-credit amount (tenyear sum). Another question about supply-side subsidies for direct production of affordable housing is whether the housing units produced constitute a net addition to the stock. A study in progress at the University of Wisconsin on LIHTC production suggests that over the period 1987 through 1994 tax credit units were substituting one-for-one for unsubsidized multifamily construction, based on an econometric model of factors affecting housing supply at the state level (Malpezzi and Vandell 1996). It can be argued, however, that these units would not have been supplied to tenants in the target income range and that, unlike conventional development, these projects may be located where they can contribute to neighborhood stability. Housing Block Grants Federal block grant programs (the HOME Investment Partnership program and the Community Development Block Grant) provide funds that can be used for affordable housing. The HOME Investment Partnership program was created in 1990 as part of the National Affordable Housing Act. It provides federal housing block grants to participating jurisdictions, primarily states and local governments, to undertake a wide range of housing activities, from construction and rehabilitation of multifamily and single-family housing (including housing for special needs populations) to use of the funds for tenant-based housing assistance. Federal funds must be matched by state/local funds at one dollar of matching funds for four dollars of federal funds. Activities are targeted to those with incomes below 80 percent of area median income. Most states use the HOME funds in conjunction with the LIHTC program, and many use HOME funds in conjunction with homeless programs (under the McKinney Act) and the state s tax-

20 Current Practices for Financing Affordable Housing in the United States 19 exempt bond financing of single-family and multifamily building. In fiscal year 1994, $350 million in HOME funds were distributed (NCSHA 1995, 86-89). Tax-Exempt Bond Financing The main interest rate subsidy program for both owner-occupied and rental housing is the use of tax-exempt debt. State agencies are allowed to issue bonds for a variety of purposes on which the interest is exempt from federal income taxes. These are tax-exempt issues sold to investors by housing finance agencies, which then use the proceeds to fund below-market mortgages for firsttime home buyers or multifamily rental housing. The Mortgage Subsidy Bond Tax Act of 1980 (the Ullman Act) set annual caps on total bond volume for each state, imposed income targeting requirements on the beneficiaries, and restricted single-family tax-exempt financing to assist firsttime home buyers. Of particular interest with regard to affordable housing are tax-exempt bonds used to support home purchase and development of multifamily properties. For multifamily housing, state housing finance agencies issue both taxable and tax-exempt bonds. Only the taxexempt bonds are subject to the annual state cap on tax-exempt issues. New Money issues finance new programs or production, and therefore serve to increase the available housing stock. Refunding issues are used to pay off and replace older issues at better interest rates (or under more favorable terms) or are issued prior to the older bonds call date, with proceeds reinvested until needed, but do not increase the housing stock. Tax-Exempt Financing of Single-Family Housing. The primary source of funding for state housing finance agency homeownership programs is the tax-exempt bonds for single-family finance termed mortgage revenue bonds (MRBs). Housing finance agencies can also convert MRB authority into mortgage credit certificates (MCCs) that, in lieu of tax-exempt financing, provide first-time home buyers with a nonrefundable federal income tax credit for a specified percentage of the annual interest paid on the conventional (not tax-exempt) mortgage of a principal residence. Table 8 summarizes the 1994 activity for MRBs and MCCs. Mortgage revenue bonds and mortgage credit certificates are required to be directed to first-time home purchasers with incomes under 115 percent of area median income. Some state housing finance agencies are able to direct these loans (credits) to lower income households. In 1994 the national average of MRBs directed to households with incomes under 50 percent of area median was 14 percent. For MCCs the percentage to households under 50 percent of median income was 7 percent. The distributions are shown in table 9. Note that interest rate subsidies are a costly way to support affordable housing as they last for the entire life of the loan, and thus do not take into account the potential increase in purchasing power of the household.

21 20 Michael J. Lea and James E. Wallace Table 8. Mortgage Revenue Bond (Tax-Exempt Single-Family) and Mortgage Credit Certificate Activity 1994 MRB Issuance New Money Issues Refunding Issues Home Loans Financed with MRB Issues Purchase, New Purchase, Existing Home Improvement $3.587 billion 581 billion $9.169 billion 15,251 loans 74,037 loans 3,404 loans 1994 MCC Authority Used $0.615 billion MCCs for New Construction Purchase MCCs for Existing Home Purchase 1,987 9,333 Source: NCSHA 1995, 26, 29, 34. Table 9. Mortgage Revenue Bond and Mortgage Credit Certificate Distribution by Income Category Mortgage Revenue Bonds Percentage of Applicable Median Income Under 50% 50+ to 60 % 60+ to 80 % 80+ to 100% Mortgage Credit Certificates Percentage of Median Income Under 50% 50+ to 60 % 60+ to 80% 80+ to 100% Percentage Distribution Percentage Distribution Source: NCSHA 1995, 29,36 Notes: Averages are computed for reporting states. Of 52 states and territories, five did not report income distribution data for MRBs. Of 17 states reporting use of MCCs, two did not report income distributions. Among the remaining 15, five reported income distributions that sum to less than 100 percent below median income. This can easily occur because the income limit for MRBs is 115 percent of median income. The applicable median income was defined as the greater of the statewide or area median income.