The Federal Reserve voted to raise short-term interest rates at the end of 2015, and there’s strong opinion that rates could inch up several more times this year.
That could be a problem for a number of low-income housing tax credit (LIHTC) deals. Higher interest rates can create funding gaps and other challenges, so syndicators are keeping a close eye on what happens.
“On the developer side, higher interest rates coupled with a lack of state and local funding sources and increased construction and land costs could make deals more difficult to pencil out,” says Todd Jones, senior vice president at Boston Financial Investment Management. “On the investor side, it could translate into higher costs of capital and make alternative investments more attractive relative to the LIHTC.”
In LIHTC deals, housing credits provide developers with critical equity to build or rehabilitate their developments. However, most projects still require a level of debt. Rising interest rates could make it more difficult, not to mention more expensive, for developers to borrow what they need. In particular, bond deals could be impacted because they often carry more debt than 9% LIHTC projects.
“At the lower tier, there has been a push to increase leverage with the reduction in soft funds,” says Hal Keller, president of Ohio Capital Corporation for Housing. “With an increase in interest rates, it may mean project-level gaps if projects cannot support the same amount of debt as they did in the lower interest rate environment.”
Marginal deals won’t make sense, according to Steve Kropf, president and CEO of Raymond James Tax Credit Funds, explaining that higher rates will impact deal structures and make deals tighter.
Fortunately, several syndicators believe any rate increases will be modest this year, and, so far, long-term rates have not increased. They also point out that rates have been so low in recent years that an increase of 25 to 50 basis points shouldn’t have a major effect.
Rates and LIHTC demand
Even so, interest rates remain one of the key trends to watch and not just on the debt side. They could also create wrinkles in a deal’s equity and what LIHTC investors do, according to an Affordable Housing Finance survey of syndicators.
“For the last few years, interest rates have been abnormally low,” explains Christine Cormier, senior vice president at WNC. “Interest rate increases will have an impact at both the deal level as well as the potential to dampen investor appetite. At the deal level, there will be deals that pencil well now but will potentially be underwater with higher interest rates. At the investor level, yield requirements could well be impacted to the extent that there are material increases in interest rates in the coming year.
Rising rates will be the first real test to the limits of the influence of Community Reinvestment Act (CRA) on LIHTC investment decisions, according to Joseph Jones, director of equity funds for the Virginia Community Development Corp.
“This is the first time in the post-Fannie/Freddie era that we’ve been in a rising rate environment,” he says. “Economics would seem to dictate that pricing must level off and eventually start to pull back as interest rates creep up. However, the demand for CRA has managed to defy the gravity of all other market forces tugging down at pricing to this point.”
Bond deals will likely impacted, but it’s less of a concern than the general economic outlook and the fact there is already an expectation of higher rates, says Joseph Macari, managing member, Hudson Housing Capital
“It is of a concern as it relates to equity investor expectation of returns,” he says. “Syndicators warehousing product without equity commitments are subject to being squeezed if investment yields rise during warehouse periods.”
Ryan Sfreddo, managing director at Red Stone Equity Partners, provides more context between higher rates and housing credit prices. “While I ultimately think that higher interest rates will lead to lower LIHTC pricing in order to generate higher LIHTC yields, the two are certainly not perfectly correlated given the distorting effect of CRA and investor demand for LIHTCs in a market with a relatively fixed supply of them,” he says.
Mark McDaniel, president and CEO of Cinnaire, adds that higher rates could mean investors will look at alternative investments or loan opportunities to meet their CRA needs.
He adds that modest rate increases will likely be positive for banking profitability, and that could lead to more demand for LIHTC investment.
If long-term interest rates do increase this year, that could trigger several changes, according to John Wiechmann, CEO of the Midwest Housing Equity Group.
“Economic investors will require higher yields—the investment will need to remain attractive when compared to the 10-year Treasury bills and other tax-advantaged investments with similar risk profiles,” he says. “This will mean lower pricing for developers. On the property side, higher rates translate to increased debt-service payments. This will put a strain on free cash flow, increasing foreclosure risk. Fewer deals will pencil out. States that require deep income targeting may find it necessary to adjust their target rents in order to make deals financeable."