All eyes will be on interest rates as the calendar turns to 2019.
The Federal Reserve raised its benchmark interest rate a quarter point, to a range of 2% to 2.25% near the end of September, the third hike this year. Additional increases are also expected in the months ahead.
“Interest rates have continued to increase, and the yield curve has flattened,” says Richard Gerwitz, co-head of Citi Community Capital. “Those are the two outstanding changes in the capital markets this year. While we’re still in a relative low point if you look over the last 30 years or more, rates have climbed and there’s certainly concern that the trend will continue.”
He points out that the 10-year Treasury is cracking 3%, compared with about 2.3% a year ago, a 70–basis point increase.
“That type of increase results in a meaningful decrease in debt proceeds,” Gerwitz says. “With all the stresses and strains in the affordable housing market, every dollar is important.”
Ten-year Treasury rates are projected to increase to 3.3% in 2019 and 3.5% in 2020, according to a recent Urban Land Institute (ULI) Real Estate Economic Forecast. However, these rates remain below the 20-year average of 3.6%.
Borrowers are looking closely at interest rates and how they impact their deals, agrees Jeff Englund, senior managing director of the multifamily affordable housing finance platform at Greystone, noting that Fannie Mae and Freddie Mac have rolled out early rate-lock products, which are gaining attention in today’s environment.
The high cost of construction
In addition to rising interest rates, developers will likely face higher development costs as the prices of materials and labor continue to increase.
“There’s huge activity in the market-rate group,” says Noel Khalil, chairman and CEO of Columbia Residential. “For us affordable housing specialists, we’re feeling tremendous price pressure on construction costs.”
On the labor front, there’s more demand for qualified workers, which is driving up the price, says Khalil, attributing this trend to more construction jobs as well as immigration policies that have resulted in some workers leaving the country.
“Our single biggest concern is the cost of construction and the impact that’s having on the ability of affordable housing developers to structure viable projects,” Gerwitz says. “Certainly, we’ve seen that basic materials used for the construction of housing have increased—lumber, steel, concrete—but labor markets have also become increasingly tight. We have situations in some parts of the country where contractors are in danger of losing their labor force if there’s an interruption in the progress of a job, because they’ll move to another project.”
At Columbia Residential, officials have studied their database of recent construction projects and factored in cost increases to try to come up with a good estimate for their latest deals. Even with this conservative approach, they’ve been surprised by recent costs and have had to defer some developer fees, according to Khalil, whose 27-year-old Atlanta-based firm owns about 8,000 housing units.
Heading into 2019, the veteran developer says he’ll work to identify additional subsidy sources and explore new programs, including the income-averaging option for low-income housing tax credit (LIHTC) developments.
In another move, the firm may also look at scaling down the size of its developments. “I’m an old-school developer, and I often believe in building a lot of square footage,” Khalil says. “[But] we may have to get a little tighter, a little more of a European square-footage orientation than traditional American.”
Same demand, new products
What won’t change is the need for affordable housing. Despite the recent challenges, several finance executives report that their 2018 activities are outpacing their 2017 volumes.
“The demand is out there,” says Englund. “We don’t see that changing going into 2019.”
The industry has also been able to adapt to changes brought on by recent tax reform legislation, and financial players have returned to “competitive approaches to financing affordable housing,” adds Alice Carr, head of community development banking at Chase.
“It’s a testament to the stability and quality of the affordable housing asset class and the commitment of the financial services industry to community engagement and the Community Reinvestment Act,” she says. “Banks continue to recognize that there’s a lot of opportunity to invest in local communities and see steady returns.”
Others also expect affordable housing activity to remain strong in 2019 despite the expectation of higher costs.
“We don’t see any significant market reduction in terms of what’s going to be coming to market in the affordable space,” says Bob Simpson, vice president of affordable and green financing at Fannie Mae. “Over the next couple of years, you’re going to see some leveling off of Year 15 tax credit deals simply because you’re starting to see the cohort of tax credit transactions that closed in 2008 and 2009 start to come into their Year 11 and Year 12 periods. There were fewer units that were put on line during the recession, so you’ll see some gradual plateau of tax credit preservation deals.”
On the other hand, he expects to see more “Year 30” tax credit deals that are reaching the end of their original LURA (land-use restriction agreement) periods.
“We expect to see a significant pickup, like we did this year, on the bond side, and we’re expecting to see significant continued growth in our bond business,” adds Simpson. “We also had a good year with our revamped tax credit forward-commitment product this year. We anticipate continued strong steady growth with our ability to provide forward commitments on new construction and deep rehab, as well.”
Both Fannie Mae and Freddie Mac returned to the LIHTC market this year after not investing in housing credits for nearly a decade.
“We’re excited about the number of deals we’ve done recently in underserved rural markets,” Simpson says. “I’m especially excited about some of the deals we’ve closed recently on Native American reservations. It’s gratifying to be back in that market.”
The value of the housing credit took a hit during the time leading up to and after the passage of tax reform legislation. “I think the market has adjusted to that, but it means there’s less subsidy,” Simpson says. “So, being able to partner with state and local governments is important. We’re finding there are over 800 different state and local inclusionary housing programs across the country. Being able to utilize those programs often provides borrowers with property tax abatements, opportunities to access state and local tax credits or state or local housing trust funds. I think that’s a trend that’s only going to continue. We’ll continue to look for ways in which we can partner with those state and local inclusionary housing programs to make deals more feasible for borrowers.”
The industry will also continue to hear more about the connection between health and housing. “When you create healthier living environments in affordable housing, you not only improve the well-being of the renters, you also increase the length of stay and reduce turnover in the building,” Simpson says.
In 2019, Fannie expects to be active with public housing authorities and developers on Sec. 8 Rental Assistance Demonstration conversion deals. “We think that’s a good part of the market,” Simpson says. “We’re going to continue to be competitive for tax credit preservation deals. That’s a significant part of our business, and I don’t want to minimize the importance of that. We’re also going to continue to push the MTEB [mortgage-backed security as tax-exempt bond collateral] product, especially in a rising-rate environment.”
Freddie Mac is also planning for another busy year. In addition to returning as a LIHTC investor, the company recently rolled out its Non-LIHTC Forwards product, which consists of unfunded forward commitments for affordable housing developed by nonprofits and subsidized, rent-restricted affordable housing developed by for-profit developers for new multifamily construction or substantial rehabilitation, says David Leopold, vice president of targeted affordable sales and investments at Freddie Mac Multifamily.
“By making a forward commitment, this financing is designed to help eliminate interest-rate risk and create and preserve affordable housing stock by offering flexibility and certainty of execution at lower costs for borrowers,” he says. “We also just announced our Targeted Affordable Mezzanine product for refinancing or acquiring Sec. 8 properties and Year 11 or later LIHTC properties, or repositioning any affordable property for resyndication with a new allocation of LIHTCs.”