Financing Affordable Housing

LIHTCs and Tax-Exempt Bonds Offer Options for Investors and Brokers.

When considering ways to use vacant land and existing buildings, commercial real estate investors and brokers often overlook a viable alternative — government-sponsored affordable housing.

Real estate investors should be aware of the myriad opportunities to purchase underdeveloped land or debilitated buildings by tapping into affordable-housing financing. Working within the often-complex affordable-housing rules and regulations, for-profit investors and developers can create subsidized multifamily housing that meets both a critical community need and earns profits for its investors.

Under specific conditions, real estate professionals and investors can use two financing tools administered by the Internal Revenue Service to develop new apartments or rehabilitate existing housing stock: low-income housing tax credits and tax-exempt private-activity bonds.

The LIHTC program provides roughly $3 billion annually nationwide, which, in turn, can leverage a vast amount of capital resources to meet affordable-housing needs. So far, the tax credit effort has leveraged more than $1.2 billion in private investment, generating 60,000 new jobs, $1.8 billion in wages, and $650 million in federal taxes annually.

Of the nation’s $15 billion private-activity bond cap, more than $3.7 billion was targeted for affordable multifamily housing in 1998, according to the Novogradac & Co. 1998 State Bond and LIHTC Survey of certified public accountants.

Low-Income Housing Tax Credits
Created in 1986 and made permanent in 1993, the LIHTC is an indirect federal subsidy used to finance the construction and rehabilitation of low-income housing. Without tax credits, policymakers believed private developers and investors would not provide enough low-income housing because these projects usually do not generate enough profit to warrant the investment.

LIHTCs give investors a dollar-for-dollar reduction in their federal tax liability in exchange for providing funds to develop affordable rental housing. Investors’ equity contribution subsidizes low-income housing development, allowing some units to rent at below-market rates. In return, investors receive tax credits paid in annual allotments generally over 10 years. LIHTC-financed projects must meet eligibility requirements for at least 30 years after project completion, meaning that owners must keep the units rent restricted and available to low-income tenants. At the end of this period, the properties remain under the control of the owner.

The credit, which is claimed pro rata over 10 years, can be used in connection with both newly constructed and renovated rental buildings. The LIHTC is designed to subsidize either 30 percent or 70 percent of the low-income unit costs in a project. The 30 percent subsidy (known as the automatic 4 percent LIHTC that is often combined with tax-exempt bonds) covers new construction that taps additional subsidies or the acquisition cost of existing buildings. The 70 percent subsidy (or 9 percent LIHTC) supports new construction without any additional federal subsidies. New construction includes the cost of rehabilitating an existing building if a minimum per-unit expenditure threshold is satisfied. The minimum threshold amount varies by state.

Tax-Exempt Bonds
The Internal Revenue Code of 1986 restated that interest income on any state or local bond is excluded from federal income tax. State and local governments sell tax-exempt housing bonds and pass on the interest savings for the construction of low-income apartments. Each state’s annual supply of housing bonds is included in an annual limit for a whole laundry list of projects including industrial development, public-private partnerships for municipal services, redeveloped or blighted areas, and student loans.

Tax exemption allows bondholders to retain more of their investment income. The higher the marginal tax rates that an individual or entity experiences, the greater the economic benefits of municipal bond ownership. As a result, tax-exempt bonds are issued at below-market interest rates and are less expensive for bond issuers.

To reap the economic benefits of tax-exempt bond financing, developers must adhere to technical requirements. For example, developers must use at least 95 percent of bond proceeds toward land and construction costs. In addition, under the IRC, bond-financed apartment owners must earmark either 40 percent of the units for residents earning 60 percent or less of the area’s median income or 20 percent of the units for residents earning 50 percent or less. Bond-financed apartments must maintain these rent restrictions for at least 15 years.

Bond transactions are not cheap. Taking into account legal and professional fees, affordable housing developers typically pay 5 percent to 6 percent of project costs toward professional services such as underwriting and legal fees. Due to the high cost of bond issuance, projects with less than $5 million in tax-exempt bonds generally do not make sense economically.

Combining LIHTCs and Bonds
In 1998, LIHTC demand outweighed supply by an average margin of 3-to-1, according to the Novogradac survey. In large states such as California and Texas, demand exceeded supply by about 5-to-1. Competition for the 9 percent LIHTC has spurred developers to consider financing their projects with tax-exempt bonds and the automatic 4 percent LIHTC.

Whenever tax-exempt housing bonds are used to finance a multifamily project, the owner automatically qualifies for a 4 percent LIHTC allocation as long as the investor follows certain state requirements. The combination of tax-exempt bonds and tax credits can be used to fund both new construction and the acquisition and rehabilitation of existing stock.

A key benefit to combining tax-exempt bonds and LIHTCs is the exemption from the volume cap limitation, which is the total LIHTC allocation each state receives each year based on its population. Only 9 percent LIHTC allocations are deducted from a state’s volume cap, not the automatic 4 percent LIHTC allocations. If 50 percent or more of the aggregate basis in land and building is financed with tax-exempt bonds, then the entire project is eligible for credits without reducing the state’s LIHTC volume cap.

Developers use tax-exempt bonds to provide both a lower interest rate on permanent financing and a source of substantial equity capital. If a developer chooses to couple the bonds with 4 percent LIHTCs, the owner may have to earmark additional units to low-income use and/or lower the rents of the existing low-income units. If an investor is considering purchasing an existing building using the LIHTC and bond program, the previous owner generally must have held the property for a minimum of 10 years in order for the purchaser to claim credits on the acquisition costs.

Program Administration
Since the LIHTC program’s inception, states have received $1.25 per resident each year from the federal government. For example, if Wyoming has 481,000 residents, it will receive a $601,250 LIHTC volume cap ($1.25 x 481,000). The U.S. Census Bureau determines each state’s population at the beginning of a calendar year.

Within the general guidelines set by the IRS, states administer the LIHTC program, setting their own allocation criteria. State agencies review applications submitted by developers and allocate the tax credits. State allocation plans must prioritize projects that serve the lowest-income tenants and ensure affordability for the longest period. State agencies also must consider the reasonableness of development costs and provide the minimum amount of tax credits per project that would allow the project to be built.

Once the developer wins a tax credit allocation, the developer leverages the financial resources for the development. A typical project receives a conventional loan from a private lender or public agency, gap financing from a public or private source, and equity from the developer or a private investor in exchange for the flow of tax credits.

After the project is completed, states must ensure that it meets the LIHTC eligibility requirements. The property must comply throughout the 15-year period or expose the investors to risk of recapture of some of the tax credits. State tax-credit allocating agencies monitor LIHTC property owners by requiring them to certify on an annual basis that they are renting units to qualified low-income tenants. If they are found not to be following the IRS rules, they can lose their tax credits.

Although developers can claim LIHTCs, they usually sell them to investors for upfront cash that is funneled into the development. The developer sells the LIHTCs either directly to an investor or to a syndicator who acts as a broker between the developer and investor. To take advantage of economies of scale, syndicators pool several projects into one tax-credit equity fund. Syndicators market the tax credits to investors who essentially buy a piece of the syndicator’s fund. This spreads the risk across the fund’s various projects.

Procuring Subsidies
To increase the likelihood of an LIHTC allocation, savvy developers should apply as early in the year as possible. If the annual state credit allocation is completely tapped in a given year, some states will give the remaining applications priority over other projects the following year. States often favor specific project types serving certain populations, such as large families — typically those with four or more members — or seniors. Developers then can submit an application that reflects a state’s policy and priorities.

For private-activity bond allocation, each state differs in its procedures and priorities. Issuing agencies often mirror tax-credit threshold standards because the two programs frequently are used together. Some states maintain a competitive process, similar to the LIHTC application process, while others employ a first-come, first-serve strategy or a lottery system. The tax-exempt bond volume cap is $50 per resident per state, with a $150 million minimum per state.

Although competition for bonds isn’t nearly as fierce as for LIHTCs, tax-exempt bond financing requests increased 32 percent between 1995 and 1996, according to the National Association of Home Builders. Again, the earlier the application is received, the better.

Something to keep in mind: Some states — especially those with few urban areas — allocate no multifamily bonds, while populous states such as California prioritize multifamily projects. States also increasingly combine multifamily housing bonds with LIHTCs; Home funds, offered by Housing and Urban Development’s Home Investment Partnership Program; community development block grants; and other federal subsidies to serve even lower-income residents for longer periods. Contact a state’s bond-allocating agency to determine if it maintains a multifamily set aside.

Understand the Programs
There are some drawbacks to investing in government-sponsored affordable housing. Like all real estate investments, LIHTCs and tax-exempt bonds carry a certain risk to investors. When deciding whether or not to apply for an LIHTC or a bond allocation, investors should consider several issues:

  • Can the project’s rental income plus subsidies support its total development costs?
  • Does the project have additional government subsidies? (States often want to serve the lowest-income residents. This goal can decrease the economic viability of projects, making investments in affordable housing less attractive unless additional subsidies are available.)
  • Are the project’s design and location strong enough to attract high occupancy over the life of the project?
  • Is the administrative burden of complying with the tax credit program bearable, such as maintaining the required number of income-eligible tenants and ensuring that the appropriate documents are filed and maintained? Bear in mind that the paperwork associated with LIHTC allocations is extensive. Developers/owners must contend first with the application, the carryover allocation, and cost certifications and then must submit myriad compliance information on an annual basis.

Despite these questions, a major reason that commercial real estate brokers and investors should consider bond and/or LIHTC financing is because of the large amount of money at stake.

What’s Next?
Future prospects for both affordable-housing programs are bright. Lawmakers from both sides of the aisle, as well as the Clinton administration, voiced support for expanding the LIHTC and bond programs last year.

President Clinton signed a 1999 spending bill that includes an incremental increase in the private-activity bond cap. The new law will raise the current $50 per capita bond cap by $5 a year for five years beginning in 2003, reaching $75 per capita or $225 per state. Affordable-housing advocates consider this a major victory but hope to accelerate the increase in 1999.

Meanwhile, House and Senate lawmakers plan to introduce legislation to increase the LIHTC volume cap from its current $1.25 to $1.75 per capita. Affordable-housing advocates argue that the tax credit’s purchasing power has failed to keep pace with inflation. Since Congress established the $1.25 per resident cap in 1986, inflation has eroded the tax credit’s purchasing power by nearly 46 percent. Bipartisan bills to increase the LIHTC cap failed, in part, because Congress failed to enact comprehensive tax legislation, the necessary vehicle to alter current tax law. But affordable-housing practitioners remain optimistic that the tax credit cap can be enacted in 1999. Lawmakers planned to reintroduce new LIHTC cap legislation early this year. Republican leadership has promised to introduce a broader tax bill in 1999.

Examine the Opportunities
Both the LIHTC and tax-exempt bond programs offer great opportunities for commercial real estate professionals and investors. Both programs take advantage of market efficiencies while offering local policy flexibility. However, due to the programs’ complexity, it is essential for developers and investors to make a serious investment in learning how the programs work.

Michael J. Novogradac, CPA

Michael J. Novogradac, CPA, is the managing partner of the San Francisco-based certified public accounting firm Novogradac & Co. The company specializes in affordable-housing issues nationwide. Contact him at (415) 356-8000 or Affordable Housing AttractionThe Encinas Group is a for-profit developer that has successfully used both tax-exempt bonds and low-income housing tax credits to build new affordable multifamily housing throughout California and the Southwest.The San Diego-based developer plans to break ground in April on the 176-unit Creek Side Village Seniors Apartments housing community in Austin, Texas. All units, which will be reserved for seniors aged 62 and over, will rent to tenants earning between 50 percent and 60 percent of the area’s median income.Project financing came from a mixture of sources. The price tag for the land and construction is about $12 million. After failing to win an initial 9 percent LIHTC allocation from the Texas Department of Housing and Community Affairs last year, the Encinas Group reapplied for and received a $6.3 million tax-exempt housing bond fixed at a below-market interest rate of about 4.37 percent and $4.3 million in tax credit equity (4 percent LIHTC allocation). Once it received the bond/tax credit reservation, the developer received a 12-month construction loan from Wells Fargo Bank and a permanent loan from a national mortgage real estate investment trust. The developer purchased the 10-acre site with cash.The Encinas Group conducted a market survey, which showed a need for both affordable multifamily and seniors housing in the area. As a result, the company decided to divide the land into two phases — one for the now-completed 104-unit multifamily complex, the Timbers, (financed with 9 percent LIHTCs) and the 176-unit to-be-built seniors development. The Encinas Group used the equity in the land to enhance its partnership with SunAmerica Affordable Housing. SunAmerica, the project’s general equity partner, will syndicate the 4 percent tax credits, while the Encinas Group will act as the managing general partner in the transaction. The tax credit equity will be used to pay down the permanent mortgage. Mirroring the typical profit margins of fair-market multifamily development, the Encinas Group expects to earn a fee of around 15 percent of the construction cost, some of which may be deferred.The developer believes that placing the four-story, garden-style independent living seniors project next to a multifamily complex will help leverage multiple social services for both complexes, from the police department to health and welfare services. In fact, the Encinas Group plans to establish an Adopt-a-Grandparent program, which will foster intergenerational relations between the two apartment communities.Despite the complexity and administrative burden involved with tapping government programs, the Encinas Group has found them to be well worth it. The 4 percent tax credits allowed the developer pay down the mortgage, while the bonds allowed it to receive below-market financing. And the Encinas Group is not worried about leasing up the seniors project once construction is complete due to the high demand for quality, affordable housing in the Austin area.


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