Located in San Luis Obispo, one of the least affordable markets in California, the Madonna Road Apartments was originally developed by the Carpenters Union in 1971 to provide housing for its workforce. But by 2012, the 120-unit development, with rents as much as 40 percent below market, was at high risk of market conversion.

Over the years it had operated under Sec. 236 of the National Housing Act in combination with a Rent Supplement Contract, both of which were regulated by the Department of Housing and Urban Development (HUD). In August 2011 the Rent Supplement Contract expired, and in March 2012 the HUD Sec. 236 use agreement expired.

Calculated risk

The Madonna Road Apartments is well located on an approximately 8-acre site in the high-cost area of San Luis Obispo, where there is great demand for housing. Recognizing the disparity between incomes and the cost of housing, we seized an opportunity to preserve the much needed affordable housing and entered into a contract with the Carpenters Union to purchase the property.

Together with Nixon Peabody and the Housing Authority of San Luis Obispo (HASLO), we aggressively pursued options for subsidy before and during a limited due diligence period. While both project-based and tenant-based housing choice vouchers were discussed with HASLO in an effort to protect those residents who had lived at the property for many years, no commitments were guaranteed.

Time was of the essence to perform on the purchase contract. In late spring 2012, HUD introduced the Rental Assistance Demonstration (RAD) pilot program. RAD was one of several new programs designed to preserve the long-term affordability for affordable housing properties at risk of market conversion, and the Madonna Road Apartments seemed the perfect candidate. With guidance from Nixon Peabody and support from HASLO, we approached HUD with an application to participate in the RAD program in early summer 2012.

Financial partners

Structured as a combination of pri­vate-activity bonds allocated by the California Debt Limited Allocation Committee and issued by the California Municipal Finance Authority, and 4 percent low-income housing tax credits, we brought in Citibank for debt and City Real Estate Advisors (CREA) for equity. We have a successful history of transaction activity with both of these financial partners.

Despite not having approvals in hand from HUD or firm commitments from HASLO, let alone any word on RAD, we needed our financial partners to begin their underwriting relying on our operating assumptions related to RAD or we would not be able to close the transaction pursuant to our obligations under the purchase and sale agreement. Throughout the summer we continued to press forward with plans to renovate the property tempered by stress-testing of assumptions and financial models.

High anxiety

Anxious to realize pro-forma assumptions, tensions ran high as we approached the Sept. 28 closing date. Then in late August, with less than a month to closing, HUD announced the RAD award for Madonna Road Apartments consisting of 23 project-based vouchers. In conjunction with continued support and additional vouchers from HASLO, operating assumptions materialized, and the Madonna Road transaction was closed as scheduled.

The renovation

The Madonna Road renovation focused on the building envelope, energy-efficient upgrades, durable materials, and drought-tolerant landscape—all of which translate into reduced operating costs over the life of the property. The rehab was handled as an in-place rehab, so residents were not displaced during the renovation. While tensions again ran high as construction neared completion, there was an overwhelming sense of accomplishment and reward shared by the development team, our financial partners, and residents as the modernization of a dated property was brought to fruition.

Lessons learned

Madonna Road represents a strategic acquisition for Vitus. It has all the hallmarks of a great asset—it is well located, it runs at full occupancy, and thanks to HUD and HASLO, it is appropriately subsidized enabling the property to receive a $5 million renovation while preserving affordability for 120 families and individuals. However, if we had sized up the property on its face value a year ago with expiring restrictions and no alternative subsidy, it is an opportunity we may have regrettably chosen not to pursue. We learned several things through the acquisition that we intend to carry forward in our pursuit of other properties.

1. Be committed: We remained confident that we would find a way to preserve affordability for the Madonna Road Apartments. This unrelenting optimism translated into everything we did, every conversation we had, and every message we communicated. The intensity of our commitment was contagious, and before long every member of our team believed in the mission.

2. Seek guidance from the experts and the policymakers: We recognized early on we needed a strong leader to partner with us in our dialogue with HUD and brought in Nixon Peabody to champion the effort. Further, we needed the support of the local housing authority to become an advocate for our mission, or we would have been going nowhere fast. We began working closely with HASLO, and it was instrumental in the success story for Madonna Road.

3. Be open to new opportunities and jump when they are announced: We are exceedingly comfortable with traditional financing methods for affordable housing projects, but acquisitions are becoming more complicated, subsidies are in short supply, and the demand for limited resources is greater than ever. While we consider ourselves risk adverse, we recognize the need to be creative and explore new opportunities in today’s economic climate. We quickly step up to participate whenever we learn of a pilot program. We closed eight transactions in 2009 using various tax credit exchange and assistance program resources introduced under the American Recovery and Reinvestment Act. Do not be so risk adverse that you limit your opportunity to succeed.

4. Stay informed: Resources are in short supply, and the demand for affordable housing is strong and growing stronger. Federal, state, and local governments continue to work aggressively to introduce new programs. However, most new programs have a narrowly defined window of opportunity, and by the time they are formally announced they have been in development for many months. Securing even a chance at the opportunity can be a challenge.

5. Work with financial partners who know you: All transactions have their share of challenges, and if you can simplify only one aspect it can make all the difference. This was very important for the Madonna Road transaction because we needed Citibank and CREA to trust our assumptions and pursue their underwriting in earnest to meet closing obligations with the seller. We could not have expected a lender or investor who had never underwritten us to have performed under such conditions.

6. Know what you want: While this may seem obvious, even we catch ourselves abandoning our original objective before embarking on the pursuit. Model the objective so that it is clearly defined and exhaust every avenue at every level before abandoning altogether. Having a fallback strategy is important, but don’t let it become the mission without first pursuing the primary objective.

Stephen Whyte is founder and managing director of Vitus Group, and Rebecca Ralston is a senior development manager with Vitus. The Seattle-based developer specializes in the acquisition and preservation of affordable housing at risk of market conversion. With offices in California, Hawaii, and New York, Vitus has developed projects in 14 states representing more than 7,000 residential units. For more information, visit www.vitusgroup.com.