Two big issues loom over the affordable housing industry as it heads into the new year—tax reform and construction costs. Both could have a major impact on new deals in 2018.
The good news is that the low-income housing tax credit (LIHTC) is one of only two credits, along with the research and development credit, to be explicitly retained in a tax reform outline prepared by the Republican leadership.
“Unified Framework For Fixing Our Broken Tax Code” envisions repealing other business credits, including New Markets, historic, and renewable energy tax credits.
“To see the housing tax credit in the framework is an acknowledgment that it is good tax and economic policy, as well as an affirmation of all the work the industry has done in advocating for this program,” says David Gasson, executive director of the Housing Advisory Group and vice president of Boston Capital. “It really has to do with congressional members seeing properties and becoming believers in the program. The fact that we’re one of two tax provisions that were denoted in the framework as valuable to the American economy is quite significant.”
The brief, nine-page document is only a starting point, with much heavy lifting still to be done if Congress wants to overhaul the tax code.
“Do not overreact to this framework,” Gasson says. “This is not gospel. It’s going to change. In the end, more than likely, what Congress will do will look very different than what was released in the framework. That includes the corporate rate.”
The Republican framework proposes to cut the corporate tax rate from 35% to 20%, which could significantly devalue LIHTCs for investors. President Donald Trump has called for a 15% rate. The industry was jolted by the prospect of tax reform at the beginning of the year when wary investors pulled back while weighing their risks and figuring out how to proceed. The market has since settled down, with many deals assuming a 25% corporate tax rate.
Much still needs to be figured out by the tax writing committees of the House and Senate. The early proposal is estimated to cost a staggering $1.5 trillion, according to some reports.
For the housing industry, the next steps are to thank legislators for preserving the housing credit and then work with them on implementing the details, including changes proposed in the LIHTC bill (S. 548) by Sens. Maria Cantwell (D-Wash.) and Orrin Hatch (R-Utah), Gasson says.
The bill, which seeks to increase annual LIHTC allocation authority by 50% as well as make other changes, has amassed strong bipartisan support, and officials are looking for an opportunity to include it in a tax package.
Despite a pretty rosy outlook for the LIHTC program, uncertainty remains until tax reform is resolved. Investors and lenders will be sensitive to any proposals that could affect the market.
“It was clear the market in general reached consensus around pricing at an assumed 25% corporate tax-rate level this year,” says Adam Oates, president of SunTrust Community Capital. “I think we’re into a little more variation in the market. We’ve seen some deals getting priced closer to a 28% or 30% assumed tax rate. On the other side, you still have noise being made around 15% or 20%. We expect to see some investors tick a little bit up or a little bit down depending on their outlooks. There may be a little more pricing variability than we had in the spring this year.”
Higher costs expected
After tax reform, the big issue looks to be rising construction costs, which was already a major concern but will be an even bigger challenge in the wake of this year’s devastating hurricanes.
“In Florida and Texas, the counties that were affected by the hurricanes [Harvey and Irma] represent about 14% of the national single-family housing production,” says Robert Dietz, chief economist and senior vice president for economics and housing policy at the National Association of Home Builders. “That gives you a sense of the size of those markets. The repair work that will be required for 100,000 or more housing units, particularly on materials like drywall, will push up prices locally.”
The extensive rebuilding efforts also will exhaust the local labor force and pull from neighboring markets like Dallas, says Dietz, estimating that Houston will require an additional 10,000 to 20,000 construction workers.
The need for additional workers comes at a time when the building industry is already struggling with a labor shortage. Seventy percent of construction firms report having a hard time filling hourly craft positions that represent the bulk of the construction workforce, according to industrywide survey results released by Autodesk and the Associated General Contractors of America at the end of August.
“The industry is going to have to recruit the next generation of construction workers,” Dietz says.
Affordable housing developers, who must balance expenses with the low rents produced at their properties, will feel the impact in the months ahead.
“With pricing going up, we expect to see the state housing finance agencies pushing hard to stretch credits across more units, to try to maintain or at least minimize drops in production levels,” Oates says. “We’re already seeing an acknowledgement from multiple state agencies that deals are likely to see gaps based on rising construction costs, and they’re informing developers about how to come back and request more credits. We think we’re going to see more focus by the agencies on that kind of use of credits per unit as a result.”
In a climate of rising costs, there’s going to be a premium on rate locks and increased importance on soft debt, according to Oates, who stresses that SunTrust commitment to affordable housing will remain unchanged.
“The conventional debt markets are in a fairly tight box,” he says. “There’s only so much they can do. The soft-second sources are going to [make] a difference in some deals that are financial feasible and others that don’t make it past the pro forma.”
The challenges come at a time when the overall multifamily industry is seeing a decline in unit starts, from 395,000 in 2015 to 393,000 in 2016. For 2017, production is expected to fall even farther, to about 362,000 units.
“We forecast declines continuing into 2018 and 2019 [in] a leveling-off process as total unit production declines over the next few years to roughly about 330,000 units a year,” Dietz says. “We think that’s the market equilibrium.”