REGIONAL REPORT

MIDWEST

Low-Cost Housing a Challenge for Midwest Developers

BY JERRY ASCIERTO

AFFORDABLE HOUSING FINANCE • OCTOBER 2007

Familiar local issues combined with recent changes to federal programs are making the Midwest affordable housing markets more challenging for area developers.

Modest population and job growth are par for the course, and the Midwest is home to the nation’s most affordable housing markets—regions of Indiana, Michigan, Ohio, and Iowa offer a median home price under $100,000.

While the local markets are rarely as dynamic as those on the coasts, other challenges loom. Changes in the way the area median income (AMI) is calculated, as well as funding cuts to the Community Development Block Grant (CDBG) program and the U.S. Department of Agriculture’s (USDA’s) Rural Development assistance programs, combine with high construction and utility costs to slow the pace of development here.

But acquisition rehabilitation opportunities as well as a hot seniors housing market are offsetting limited demand for new construction in the area.

Tilting the unit mix

Developer Herman & Kittle Properties, Inc., recently broke ground on Canterbury House, a 230-unit development in Southgate, Ky., a five-minute drive from downtown Cincinnati. About 70 percent of the units will be affordable to those earning up to 60 percent of the AMI, and the rest will be market rate.

That unit mix would have tilted more toward affordable in the past. “We favor a little bit heavier market component than we would have traditionally,” said Todd Sears, vice president of finance at the Indianapolis-based developer. “That gives you an indication of just how tough the tax credit side has become. Where in the past, a deal would’ve been 80/20 [affordable/market rate], suddenly you start saying, ‘Let’s make that 70/30.’”

Several factors are tipping the scales toward market-rate. A rash of singlefamily foreclosures due to the collapsing subprime loan market has driven up occupancies in the Midwest, making market-rate units more feasible. Plus, developing affordable housing has become more challenging due to the way that the AMI is calculated under the Department of Housing and Urban Development’s (HUD’s) new methodology.

HUD now uses American Community Survey data, instead of its traditional extrapolation of census figures, to set AMIs, which drops the estimates in many communities. This reduces rents and wreaks havoc on the ability to underwrite both existing and new affordable housing deals, since underwriting presumes annual rent increases.

“It’s a driving issue for our older projects that have declining rents and therefore declining net operating income,” said Jeffrey Kittle, executive vice president of Herman & Kittle. “And with higher construction costs and operating expenses, and rents lower than they were three or four years ago, the ability to underwrite new projects is strained.”

Another challenge facing developers is the way that utility allowances are calculated. Internal Revenue Service rules require tax credit rents to include a “utility allowance” for utilities paid by the tenant. But the method used to compute the allowance is based on an older, less energy-efficient housing stock, which often overestimates the cost. This causes owners headaches since the overestimated utility allowance is subtracted from the rent they receive.

Higher costs, fewer resources

Upfront costs like construction materials (especially copper), energy, and insurance continue to rise, making new construction opportunities more difficult to pencil out. But the funding to offset such costs is becoming more difficult to find.

“Properties cost more to build and operate, and at the same time there’s less federal subsidy available,” said Matt Meier, a project manager for affordable housing developer The Alexander Co., based in Madison, Wis. “The CDBG program has been slashed recently, and it’s harder to make deals pencil out.”

Funding for the CDBG program reached $5.05 billion in 2001, but that figure slipped 25 percent to $3.77 million last year, and further cuts have been proposed in the 2008 budget. And many key USDA Rural Development programs, such as the Sec. 515 rural rental housing program, have been severely reduced over the last decade—in 1994, the program funded 11,542 rental units, but that figure dropped to 486 by 2006. The Bush administration has proposed eliminating the program next year, a possibility that gives developers pause when considering future deals in rural areas.

With limited new construction activities, many developers like The Alexander Co. are focusing on acquisition rehabilitation. The company recently received the go-ahead from the General Services Administration (the branch of federal government that deals with federally owned real estate) to convert an abandoned Depressionera federal courthouse in downtown Kansas City, Mo., into 176 one- and two-bedroom units affordable to those earning up to 60 percent of the AMI.

Earlier this year, the company opened the doors on the 4th Street Lofts in downtown Davenport, Iowa. Of the 126 units, 40 percent are slated for those earning up to 60 percent of the AMI, and the other 60 percent are for those earning up to 80 percent of the AMI.

Ohio QAP changes

The Ohio Housing Finance Agency (OHFA) just completed its 2007 tax credit allocation round, reserving more than $18.75 million to 34 developments. Half of the awarded developments were for seniors housing, a figure that has steadily risen in recent years. “The future market looks to be strong for seniors housing,” said Kevin Clark, OHFA’s housing credit allocation manager.

OHFA made some significant changes to its qualified allocation plan (QAP) process in 2007. The agency began conducting site and market evaluations as a preliminary vetting process. OHFA staff would visit each applicant’s site and judge it on such subjective factors as the strength of the local market, the quality of the site, and the design of the property, as a way of zeroing in on the strongest projects.

The new system adds points to the previous system’s objective process, which scored applications based on criteria like affordability of rents, support from local elected officials, and serving special-needs populations. The old system “sometimes resulted in well-designed developments on the most desirable sites being unsuccessful in the competition,” said Clark.

OHFA whittled 160 pre-applications down to 90 this year, and those 90 were then invited to submit full applications for review. The new system reduced the amount of paperwork developers initially had to put together. “Developers seemed to pay more attention to the quality of the sites that they were turning in,” Clark said. “We’re not taking in as much paperwork, and also we’re not asking the developers to give us a huge binder of information.”

Also new this year is a second round of financing, which OHFA calls its “maximizing outcomes” pool of funds. The pool is a sort of post-mortem, awarded in mid-September or a month after the initial allocations, to meet any distribution goals not met in the first round. This second round totals $3.9 million in tax credits, and any development turned down in the first round is eligible. OHFA plans to make this second round a mainstay of its allocation process.

Clark notes that the vacancy rate across OHFA’s portfolio has fallen in the last year, from around 9 percent to 7.8 percent, and hopes that the new QAP process will help lower it further. “We try to favor those areas that have the stronger markets, and hopefully that contributes to lower vacancies in the future,” he said.

Illinois QAP changes

The Illinois Housing Development Authority (IHDA) has also proposed some changes to its 2008-2009 QAP based on trends observed in the last few years. More affordable housing developers are including energy-efficient features such as double-glazed windows and increased insulation in their developments, the agency said. But last year’s QAP awarded just one point if green materials and energyefficient techniques were used.

For the 2008-2009 QAP, IHDA is proposing to award up to three points for green initiatives, and expand eligibility to include geothermal heating, the use of recycled construction materials, bamboo flooring, and even bike stand installation. The state agency based the proposed changes on a similar change in the city of Chicago’s 2007 QAP plan.

IHDA is also proposing to give more resources to supportive housing for the homeless and disabled, by making “supportive housing satisfied” its own category in the 2008- 2009 QAP. In the past, supportive housing was included in the “special needs satisfied” category, and supportive-housing developments had to compete with supportive-living facilities for the elderly. But the proposed 2008-2009 QAP includes $2 million for supportive housing, defined as developments where at least 50 percent of the units are affordable to and occupied by supportive-housing populations, and where at least one service provider is specified.