The low-income housing tax credit (LIHTC) market just isn’t behaving the way it’s supposed to these days.
Housing tax credit prices and yields move in an inverse relationship with one another. If housing credit prices rise, investor yields must come down and vice versa. This was illustrated in dramatic fashion when the LIHTC equity market fell apart in 2008 and 2009. When demand for housing credits fell sharply, housing credit pricing fell to as low as $0.60 per dollar of tax credit in some markets and yields skyrocketed to double-digit numbers.
Over the past three years, investor demand has sharply rebounded. With demand now at historically high levels, average tax credit pricing routinely exceeds $0.90 per dollar of credit, with housing credits trading well in excess of $1 per dollar of credit for projects located in hot Community Reinvestment Act (CRA) markets, says Fred Copeman, principal and leader of CohnReznick’s Tax Credit Investment Services Group.
The firm recently analyzed the tax credit pricing in more than 600 lower-tier property investments syndicated over the past 12 months with the yields offered in the 60 multi-investor funds that acquired those investments. According to Copeman, the average tax credit price rose from $0.87 to $0.91 per dollar of credit during that period, but the average multi-investor fund yield only dropped by 10 basis points from an average yield of 7.2 percent to an average of 7.1 percent. As a mathematical matter, yields should have fallen below 7 percent, but syndicators have been working hard to keep that from happening.
There are several reasons this has happened. The first, but most painful, strategy is to lower their fees. Cutting the fees that syndicators charge and/or deferring receipt of the payment of their fees help to offset the negative impact of higher credit prices on yields, Copeman says.
A second strategy is to find properties in markets with limited CRA value. Housing credit projects developed outside the CRA assessment areas of the Top 25 banks typically command lower credit prices. A third strategy is to use their own working capital to tie up lower-tier property investments and bring them into their funds at a date when the properties are closer to going into service than might normally be the case. There are other available strategies, but they have a common denominator—lower profit margins for fund sponsors, according to Copeman.
“The market has a certain emperor-has-no-clothes quality to it,” he says. “This can’t go on forever. Assuming that tax credit prices don’t come down, and I don’t see any reason why they should, something has to give.” That may mean that yields in multi-investor funds will drop below 7 percent before the end of 2014, but Copeman says that is a tough prediction to make. After all, the market has been on the same course for a little while now, with little movement on yields.
The risks and rewards of rising prices
It’s clear the market has returned to 2006 levels, with aggressive bidding in many markets. The question now becomes how long can these levels be maintained. How likely is it that prices will suddenly drop?
“The unknown is how far prices increase before you lose current investors or lose the interest of potential new investors, particularly economic investors,” says Beth Stohr, director of new production, affordable housing tax credit investments, at U.S. Bancorp Community Development Corp. “This will be tested over the next six months as more states allocate credits and funds roll out with newly allocated projects at the higher current market pricing. Markets that have traditionally generated the most interest industrywide from a CRA perspective have been very competitive this year. Those who are not competing in CRA high-demand markets, like downtown San Francisco for example, are moving their investment dollars to other markets in hopes of better economics. But, with a limited supply of LIHTC allocation and growth in demand by investors, the non-CRA markets have strong competition as well.”
The LIHTC market is back to pre-recession levels, particularly on a relative basis given how low interest rates have remained, says David Leopold, senior vice president and tax credit equity executive at Bank of America Merrill Lynch, one of the nation’s largest LIHTC investors.
“I don’t see a lot of risk out there,” he says. “That’s not to say there isn’t any. It is real estate. It can be impacted by external factors, including interest rates. If interest rates rise very quickly, you would see prices drop. There’s potential for some external factors to destabilize the market, but I don’t think any of them are very likely in the short to moderate term.”
Stohr points out the price increases couldn’t have come at a better time for developers.
“At the end of the day, it’s all about building housing that will strengthen our communities and help people at the lower-income spectrum,” she says.
With the 9 percent rate floating now, interest rates going up over the past 12 months, and with the loss or reduction of subsidy sources, developers are needing the higher pricing to get housing done.
“It’s a perfect match in terms of timing,” Stohr says. “The question is whether current economics are sustainable for a broad base of investors.”
Growth of direct investing
The LIHTC market has been seeing substantial growth in the direct-investing segment of the market, primarily because several of the bigger banks have moved to make it a major part of their platform.
CohnReznick estimates that the total equity volume in the LIHTC market reached approximately $11.5 billion last year. However, firm executives note that the amount of capital flowing through direct investments is much harder to nail down than the volume of equity raised through syndicated funds.
“I think the trend toward direct investing has grown in large part as a result of pricing becoming more competitive,” Leopold says. About 70 percent of Bank of America Merrill Lynch’s volume is direct investment, and 30 percent is through syndicated funds on a proprietary basis.
If the competition is investing directly, it’s hard to compete through a syndicator because there are additional fees, he says.
Still, many investors continue to work with syndicators.
“The growth of direct investing has increased price-based competition for clients, but it’s a real opportunity for those investors who can differentiate themselves beyond pricing,” says Laura Bailey, managing vice president, community development finance, at Capital One. “We use a proprietary and multi-fund based approach—our partners are syndicators that have, in many cases, maintained client relationships for a very long time. That triggers an opportunity to compete based on value: service, relationships, and pricing.”
Investors are eagerly watching to see if recent accounting changes blessed by the Financial Accounting Standards Board will have an impact on the market. The hope is that the changes will make the accounting of LIHTC investments clearer and therefore entice new companies into the LIHTC market, deepening the investor pool.
“I think the view on that is that it’s a 2015 impact to be measured,” says Stohr.
Leopold agrees that it’s still too soon to see any effects. However, he points out that if and when new investors arrive, they will likely invest through syndicators. “As a result, the proportion of investing that is done directly may not grow because there could be growth on the fund side,” he says.
The expectation of many is that the changes will be a “net” positive for the industry, adds Terce Sandifer, senior vice president and director of originations at Union Bank Community Development Finance. “I imagine there are still many investors (direct and fund) determining exactly what impact the changes will have on their books.”
Looking ahead, investors anticipate the market will hold steady for the near future.
“Absent some external event, I think the market is going to look similar to today,” Sandifer says. “In the coastal markets, the theme of a lot of capital chasing a handful of deals is likely to continue.”
Others also feel that the market is where it will be for the rest of the year.
“Forecast for the next six to 12 months is sunny, with a chance of further price increases this year,” Bailey says.
Connect with Donna Kimura, deputy editor of Affordable Housing Finance, on Twitter @DKimura_AHF.