SPECIAL FOCUS >> CAPITAL MARKETS OUTLOOK 2008

Entering Uncharted Waters

BY ANDRE SHASHATY

AFFORDABLE HOUSING FINANCE • NOVEMBER 2007

The outlook for affordable housing in the coming year is probably better than it was a year ago, but only slightly. In a phrase, one might say the heat is off. In an election year, with the Federal Reserve Board more concerned about recession than inflation, and with home building likely to keep slowing, the overheated real estate market is experiencing a welcome cooling trend, or as some call it, a return to sanity.

Making the numbers work for your deals won’t necessarily get easier, but you will get relief from constantly rising land and building prices and construction costs, and the threat of interest rate hikes.

Of course, the outlook varies greatly by region. In hot markets, a cooling down will reduce cost pressures. In weak markets, like the upper Midwest, those benefits will not be as great, and may not outweigh the problems resulting from economic weakness. But even in those areas, there’s some good news: The weak U.S. dollar bodes well for manufacturing regions where exports are a key economic engine.

The economic slowdown points to limited growth in incomes and rents, even as expenses keep rising. It could also reduce the ability of some investors to buy low-income housing tax credit (LIHTC) partnerships.

The biggest threat comes in the market for equity investment for tax credits. Several very large investors are said to be cutting back on their activity, and syndicators are beginning to suggest the supply of credits will exceed demand in 2008.

The year ahead will bring pressure from investors to increase yields for their LIHTC projects, said Shawn Horwitz, president of Alliant Capital. “Until the yields increase significantly, there may be fewer investors in the marketplace,” he said. We expect the investment community to have a smaller appetite for development and they will be much more selective of the syndicators and deals they pursue.”

On the debt side, the outlook was generally positive. At press time, many experts believed the effects of the “credit crunch” that resulted from troubled subprime home loans would be short-lived. Several developers and analysts told AFFORDABLE HOUSING FINANCE they thought most of the impact had played out by mid-October, and that the tightness in capital markets would have little long-term impact on commercial real estate finance.

But even if there’s smooth sailing in debt financing in 2008, storm clouds lie ahead in 2009 and later years. The worry among some observers is that rates will rise substantially.

It’s possible “the Fed will become too politicized in an election year, take their eye off the ball of inflation-fighting too long, and we end up needing a period of sustained high short-term rates to get things back under control,” said Todd Sears, vice president of finance at Herman & Kittle Properties, Inc.

Another real estate expert said interest rates could start moving back up in 2009, especially if a Democrat wins the White House and raises taxes, and if foreign investors cut back their holdings of U.S. Treasury bonds.

The best opportunity for 2008 might be to find a bargain on an acquisition. The short-term debt and easy credit terms that fueled higher and higher prices for marketrate apartments are gone, reducing a major driver of the high values investors have seen over the last few years. This likely will lead to some softening on prices, especially in markets with high job losses, as well as those with large inventories of unsold condos, such as South Florida.

Market-rate apartment developers said land is being repriced, dropping by as much as 10 percent to 20 percent from its recent highs in many areas as home builders stop buying development sites.

Cap rates, which measure the income from apartments as a percentage of the purchase price, are already increasing in many areas, reflecting a decline in prices for apartment properties.

How can you act on this trend? By looking for B- and C-class properties in secondary and tertiary markets, and by having financing lined up so you can act quickly.

Permanent mortgage financing forhousing tax credit deals may be slightly more expensive in 2008 and underwriting might be a little more stringent. But the impact of this year’s credit market woes may be short-lived, as the benchmark yield on the 10-year U.S. Treasury is expected to stay flat or drop.

There’s a good chance debt financing might become available at even lower rates and easier terms than it is today, as lenders continue to favor the affordable business and the economy weakens.

At press time, the commercial mortgage- backed securities (CMBS) business had rebounded from the upheaval prompted by a surge of defaults on subprime and adjustable rate home mortgages. In a flight to quality, investors demanded higher yields on mortgage-backed securities as measured by the spread over U.S. Treasury bills.

While affordable housing projects rarely use financing originated from CMBS, the problems there affected all kinds of debt financing pricing and terms.

“The collapse in the CMBS market caused spreads to increase and underwriting to tighten. The spreads narrowed some since the initial increase and seem to be stabilized,” said Hank Williams, head of Federal Housing Administration (FHA) production at Wells Fargo Multifamily Capital.

The uptick in rates, along with changes in underwriting, had reduced typical permanent loan proceeds by as much as 10 percent, said Williams.

At press time, spreads over Treasuries had returned to very close to where they were before the subprime loan problems roiled the CMBS market, said Keeley Kirkendall, executive vice president of ARCS Commercial Mortgage, which agreed to be purchased by PNC Financial Services Group, Inc., in July. Freddie Mac was quoting pricing of 140 basis points to 155 basis points over the 10-year Treasury for a forward commitment for a 9 percent tax credit deal. A lender’s servicing and guarantee fee would add 30 basis points to 40 basis points to that.

For 2008, Kirkendall predicted the yield curve would steepen, meaning that short-term rates would creep down a bit and long-term rates would move up, but by no more than 25 basis points.

Several lenders said the increase in spreads from agency deals has been partially offset by a decrease in the 10-year Treasury yield from above 5.2 percent in June to around 4.6 percent in September. With that key benchmark expected to remain flat or decline in 2008, the outlook for rates is generally favorable.

Deals insured by the FHA and securitized through Ginnie Mae were more stable, with spreads over Treasuries widening by only five to 10 basis points as of mid-October, one lender said. “The interest in FHA programs is amazing,” the lender added.

There was also renewed interest in taxexempt bonds at press time. “Investor interest in acquiring non-credit enhanced taxexempt bonds has exploded,” said Williams. “These bonds carry many of the same credit terms as the traditional affordable housing programs—rates will be aggressive.”

While Fannie Mae and Freddie Mac have increased spreads and tightened underwriting, they may reverse course in 2008 and work to attract more affordable housing business, one developer said.

Fannie Mae recently introduced a structured swap program for DUS lenders, Williams said. (For a more detailed report on the bond financing forecast for 2008, see Tax-Exempt Bond Financing Weathers the Storm.)

The problems in the CMBS market drove many market-rate borrowers to Fannie and Freddie, vastly increasing their pipeline of market-rate multifamily deals. Under federal law, both agencies must devote a certain percentage of their output to affordable housing, so increases on the market-rate side should bring increases on the affordable side.

The other area of new potential is FHA mortgage insurance programs, which offer good terms and are less susceptible to fluctuations in capital markets. Many borrowers would love to use the programs but find the process of applying for the federal insurance too time-consuming and onerous. That explains why FHA volume was down in fiscal 2007, which ended Sept. 30.

The agency insured 805 loans for $3.821 billion in fiscal 2007, down from 931 loans for $4.701 billion in fiscal 2006. This includes rental housing and nursing homes. Of the 805 loans closed, 68 were LIHTC deals. There were an additional 49 LIHTC loans made using U.S. Department of Housing and Urban Development (HUD) risk-sharing through housing finance agencies.

The Mortgage Bankers Association is hopeful that HUD can speed up insurance application processing and tweak some of its requirements and procedures, said Andrea (Dee) McClure, senior vice president of CWCapital and chair of the Mortgage Bankers Association’s Steering Committee and its Insured Projects Subcommittee.

“The association’s Multifamily Accelerated Processing (MAP) Lenders Roundtable met with HUD officials in October and learned that draft notices relating to revisions to expedite the subsidy layering process and streamline the MAP application review process for LIHTC transactions are well underway,” McClure said.

“The progression of these two important initiatives clearly signals HUD’s interest in increased production of affordable housing utilizing the HUD financing programs,” she added.

For construction financing, spreads have widened, and lenders are requiring much more cash. At press time, a developer could get loans for 75 percent of cost, down from 85 percent to 90 percent of cost. Spreads widened by 25 basis points over the London Interbank Offered Rate. (For a more detailed report on the construction financing forecast for 2008, see Construction Financing Unscathed by Credit Crunch.)

All in all, permanent mortgage rates and terms were not expected to have deteriorated enough to torpedo deals in 2008.

“We try to avoid planning around interest rates as much as possible and instead focus on deal feasibility—we anticipate that lots of things change in a deal over the course of a year (costs, utilities, revenues, interest rates, etc.) and if the deal falls apart due to changes in a single issue like the 10- year rate, then it was a questionable deal to begin with,” said Sears.

Ten-Year Treasury Bill Looking Good

The best news of late 2007 was that declining Treasury yields were helping to offset the widening in spreads used to set rates on permanent apartment loans.

“That trend should continue into 2008 within a 25-basis-point range of current rates,” said Hank Williams, head of Federal Housing Administration production at Wells Fargo Multifamily Capital.

Developers and lenders surveyed by AFFORDABLE HOUSING FINANCE predicted the 10- year Treasury next year would remain below 5.25 percent, and might even dip as low as 4.5 percent.

At press time, the 10-year Treasury bill yield was 4.65 percent.

Equity Pricing May Slip in 2008

For tax credit developers looking to raise equity in 2008, good relationships with capital sources could be critical, and weak deals may still go begging.

“2008 appears to be a ‘Magellan’ year—circumnavigation of unknown waters,” said Bob Moss, senior vice president at Boston Capital Corp.

“Regardless of which investors are still buying and at what amounts in 2008, it would appear that the mix of buyers is going to change and we may be entering into an overall equity deficit. In that environment, we would expect that yields will rise and prices will fall,” said Paul Cummings, senior vice president of syndication at Enterprise Community Investment, Inc.

“2008 is going to be a search for equilibrium in the market—right now there are more transactions in the market than capital and, for the good of this industry, we have to find equilibrium quickly,” said Greg Judge, director of acquisitions at MMA Financial. “There is a lot of uncertainty right now, and developers need to do more due diligence on the offers they are receiving to make sure they are executable.”

Several syndicators expressed concern that Fannie Mae has announced that it is subject to the alternative minimum tax, which makes it less able to benefit from the tax break offered by the low-income housing tax credit (LIHTC). Consequently, the agency’s investment in tax credit equity will be significantly reduced. Freddie Mac has similarly reduced its investing over the last year and is rumored to be at AMT also.

The two firms represented more than $4 billion of tax credit capital in 2005, but will probably invest a much smaller amount in 2008.

In addition, Fannie Mae sold approximately $1 billion of its portfolio into the market in 2007, further straining the supply/demand balance.

“We are very concerned about just how much the pricing may drop by mid-year,” said Cummings. Downward pressure on prices is likely to come from investors cutting back or leaving the market, uncertainty in yields over the next six to 12 months, and large amounts of highpriced but still unplaced investments on closed deals or committed deals.

“Indications from some investors at this point suggest that existing or new investors filling out the market will probably do so at a higher yield than is currently being accepted,” said Cummings. He predicted that actual yields to investors could rise by 50 to 75 basis points by mid-year, adding that such an increase in yields could easily translate into a reduction of 5 to 8 cents on a typical equity payout.

Fannie Mae would not comment on its plans, saying only this: “Fannie Mae looks forward to continued participation in this important affordable housing market in the future. As with other investors in this market, we periodically adjust our levels of new investments and our levels of sales of LIHTC assets to correspond to our current corporate tax liability.” The demand for tax credits varies greatly by region and by deal size and type, said Moss.

One developer AFFORDABLE HOUSING FINANCE spoke to has a more positive view. Herman & Kittle Properties, Inc., is expecting project buyers to be a bit more aggressive on pricing in 2008. By mid-year 2008, the firm expects to land equity per dollar of tax credit in the mid- to high-90s, as opposed to the mid-90s in 2006, said Todd Sears, vice president of finance for the Indianapolis-based affordable housing developer.

The price per dollar of tax credit averaged about 94 cents in the second quarter of 2007, compared to 97 cents at the end of last year, according to leading national syndicators surveyed by AFFORDABLE HOUSING FINANCE in July.

Of course, equity pricing will still be healthy for the strongest deals in the best market areas, particularly those where a number of banks are looking to satisfy their Community Reinvestment Act obligations with tax credit investments.