Borrower's Market

To hear many industry observers tell it, the strong demand for and performance of affordable housing this year should only continue in 2017. Indeed, the consensus among the lenders, investors, bankers, and other experts we spoke with for this story is that the broad array of financing options available to developers will grow, as will flexibility in how to use them.

Bond activity on the upswing

A little more than $6.6 billion in multifamily housing bonds was issued in 2015, an increase of $130.3 million, or 2%, from the year before, according to a recent analysis by the Council of Development Finance Agencies.

So far, it looks like this year is even busier, according to bond finance expert Wade Norris, a partner at the Eichner Norris & Neumann law firm in Washington, D.C.

“In 2016, for the first time, we’ve had seven or eight states that have run out of private-activity bond volume for multifamily housing bonds,” he says. “Those states include Massachusetts, Minnesota, New Jersey, New York, Utah, and Washington. All of those states have had more demand for multifamily housing bond volume in 2016 than they’ve had volume to give out.”

It will become a bigger issue if the current pace of demand continues in 2017, and grow to be an even bigger issue in 2018, says Norris.

States can use their private-activity bonds for a variety of purposes, but a good case can be made that they should maximize their bond volume for multifamily housing.

“Not only is there a critical need for affordable rental housing in almost every state, but it’s the only use of private-activity bond volume that triggers another major federal subsidy,” Norris says, explaining that the bonds make housing developments eligible for 4% low-income housing tax credits (LIHTCs).

On a 100% affordable housing development, equity from the 4% LIHTCs usually covers about 25% to 35% of the project costs, estimates Norris. It can be even greater if the project is in a “difficult to develop” area or a qualified census tract.

To be eligible for 4% LIHTCs, developments must meet the “50% Rule,” which requires that at least 50% of the eligible basis in the buildings plus land be financed with volume-limited tax-exempt private-activity bonds and that these bonds be kept outstanding until the development’s placed-in-service date.

“Projects are making sense with 4% credits where they didn’t just a few years ago,” says Richard Gerwitz, managing director and co-head of Citi Community Capital. “Perhaps nowhere is this more evident than in a state like Texas. Active before the crisis, bond issuance virtually stopped in 2008 to 2009 until about two years ago, and now, as far as we can tell, about 60 to 70 projects penciled with bonds and credits in this last cycle. We’re also seeing 4% credits used more actively­ in all of the South and Southeastern states, including Louisiana, Alabama, and Arkansas.”

As a result, it’s increasingly important for developers to be aware of the private-activity bond situation in the states.

In those states with high demand, developers should work with their tax-exempt debt partners, including bond issuers and bond volume allocators, to get an application in early while there’s still bond volume available, Norris says.

The market is seeing strong activity through both bank private-placement programs and the recent Freddie Mac tax-exempt loan (TEL) structure.

“The permanent-loan rates that we’re seeing quoted are even lower than in 2015,” Norris says. “In early 2015, we began to see permanent-rate quotes that were in the 4% range or lower. Now, especially in the more high-demand markets like California, New York, and Chicago, we’re regularly seeing permanent-rate quotes in the high 3s, sometimes even in the mid-3s.”

The same low permanent rates can be achieved by combining Federal Housing Administration (FHA) insurance or U.S. Department of Agriculture Rural Development loans with short-term cash-backed bonds and through Fannie Mae’s new tax-exempt monthly mortgage-backed securities pass-through structure, according to Norris.

All of these executions often have 35-year to 40-year amortization, a 1.15x debt-service coverage ratio (DSCR), and an 85% to 90% loan-to-value ratio, he says.

Bond deals still often require soft funds to make deals work, but they’ve been benefitting from today’s strong tax credit pricing and market conditions.

“People are getting favorable rates, so we’re seeing deals move that may have been sidelined for a while,” adds Alysse Hollis, an attorney at Jones Walker.

Hollis recently co-authored the Beginner’s Guide to Tax-Exempt Bonds for Affordable Housing for the American Bar Association.

Bond deals still mostly involve rehabilitation projects, but ­Hollis is starting to see more new-construction projects in the mix.

LIHTC market expectations

At the same time the bond market is picking up its pace, the LIHTC market continues to roll and is expected to remain very strong in 2017.

“There’s a limited supply of tax credits,” says Vihar Sheth, senior vice president at U.S. Bancorp Community Development Corp. (USBCDC), a major LIHTC investor. “I think everybody who is in the market will be returning to the market, especially on the bank and insurance-company side.”

Prices may tick up slightly in early 2017 after a calm period when investors are setting their goals for the new year, according to Sheth. However, he and others expect the LIHTC market to look much like it has this year as long as key factors stay the same.

Sheth puts rising interest rates in the “minor category,” but they still bear watching. The industry also has the unknown of an upcoming Government Accountability Office report that will look at LIHTC development costs and how the industry will respond to that review, he says.

“If developers are planning projects now, they need to be wary about a changing-rate scenario,” Sheth says. “If they’re going into an application process, they won’t be closing their deals until six or nine months from now, and then they’ll have an 18- to 24-month construction period. I think we need to be more conservative and more proactive in making sure we have the proper balanced budget.”

Competition for debt

The number of projects looking for capital, and Citi’s activity level, has increased each year since the financial crisis, according to Gerwitz.

The demand for affordable housing is great, but it’s low interest rates and strong LIHTC pricing that have been driving the market, making more projects feasible, he says. “Market-rate rent inflation has also outpaced wage growth throughout the country, increasing market-rate/­affordable rent differentials,” he says. “This has attracted more capital to areas that have previously lagged in affordable housing production, and spread the benefit of lower interest rates and higher tax credit pricing to a broader area.”

Interest-rate watch

So, what could throw a monkey wrench into the market?

“In my mind, increased interest rates have the greatest potential for slowing the pace of activity in the affordable housing market, but we’ve been singing that song for a few years now,” Gerwitz says. “Eventually they will rise, but I would expect that would impact a few marginal projects and, unless it was a severe spike, not have the broad impact one might think.”

There’s also increasing concern that the market has peaked in terms of market-rate rents and low cap rates. “Those concerns do have an impact on the willingness of banks to extend credit, and those concerns can certainly cross over to the affordable side,” explains Gerwitz.

“Again, however, I think that impact will be marginal barring a major credit crisis, and any change will, at least initially, have the greatest impact on mixed-income projects with significant market-rate components and certain urban areas where there is fear of a bubble in employment and real estate,” he adds.

Officials at Bank of America Merrill Lynch also will be ­closely watching interest rates next year. “If rates go up, that would increase the overall cost of a project, and that will require looking at the overall financing structure of deals,” says Maria Barry, community development banking national executive at Bank of America. “It could require looking at a different kind of solution or possibly more subsidy.”

The 2016 election results, also, could trigger some ­changes that would affect the affordable housing industry. “Will it bring any new programs, other changes?” Barry says. “If there are changes to housing programs, we feel we are in position to very quickly get up to speed. We’ve been able to do that for other changes, to get out there, understand the program, and deliver quickly.”

One area the bank is focusing on is further integrating its ­equity and debt platforms. It recently rolled the underwriting of debt and equity together onto the same team to provide more streamlined services­ for clients.

Bank of America also starts a new Community Reinvestment Act (CRA) cycle next year, which will open up all of the bank’s CRA areas for potential investments and activities, says Barry.

The supply and condition of affordable housing is a main concern, says Rob Likes, national manager, KeyBank Community Development Lending and Investing team.

“Every year, affordable housing stock in the United States gets older and less inhabitable,” he says. “We must commit to the rehabilitation of housing that is nearly three decades old and the creation of new housing options.”

Another major concern is rising development costs, which can make affordable housing projects less feasible. “It is imperative our industry finds a way to control costs and manage this issue,” Likes says, noting that public–private partnerships are required to address housing needs.

He points out that the FHA recently motivated private ­sources of capital to invest in affordable housing by cutting ­insurance rates for multifamily mortgages.

One change in 2017 may be the entry of more market-rate players in the development of affordable housing as a result of incentives enacted by agencies like the FHA, according to Likes.

In 2017, KeyBank’s team will launch an $8.8 billion, five-year commitment to community development lending and investment as part of a plan the bank developed upon its acquisition of First Niagara Financial Group. The effort will build on KeyBank’s investment and loan portfolio, worth more than $2 billion.

“There’s a lot of demand for affordable housing debt,” says Dan Smith, senior vice president at USBCDC. “There’s a lot of competition, with a lot of players lending money, particularly on 4% bond deals. The agencies, particularly Freddie Mac, have been very active.”

When it comes to underwriting and deal structuring, the norm in most markets is a 1.15x DSCR and 35-year amortization, but lenders are starting to go to 40-year amortization in order to win deals that are attractive to them, Smith says.

He expects to see more 40-year amortization deals in the top markets next year.

Smith thinks the industry has bottomed out on underwriting assumptions, however. The 1.15x DSCR has become pretty much a rule for most deals. People are also starting to see 5% vacancy assumptions on deals in strong markets, a drop from 7%.

“I don’t see underwriting going any lower,” Smith says. “I probably see the more-optimistic underwriting just being applied more broadly in the market.”