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State housing agencies and local governments are seeking to address the widening affordability gap through new public-private partnerships to build essential housing, according to Fitch Ratings in a new report.

Amid the broader affordability crisis lies a more distressing problem for middle-income earners, such as teachers, police officers, and health care workers, looking for a place to live.

“Despite earning between 80% and 120% of the area median income (AMI), these essential workers often find it challenging to afford housing near their places of employment due to high costs and a shortage of affordable options,” says senior director Karen Fitzgerald.

The public-private partnerships have been able to take advantage of low interest loans, tax incentives, subsidies, and land grants to make projects financially viable, according to Fitch Ratings.

As an example, the report cites the issuance of approximately $10 billion in tax-exempt bonds since 2019 to finance the development of around 45 workforce housing projects throughout California. The bonds have been primarily issued by joint power authorities on behalf of local governments, such as cities, counties, or special districts, to finance the acquisition and conversion of market-rate apartments to income- and rent-restricted units for moderate- or middle-income households.

In addition, state housing finance agencies have also become increasingly involved in providing financing for the creation of essential housing by issuing tax-exempt bonds, offering low-interest loans and/or providing tax credits.

For example, California Housing Finance Agency offers below-market interest rate loans to encourage the development of affordable housing options targeting moderate-income Californians. MassHousing’s Workforce Housing Fund provides financing to developers to create workforce housing units, and the New York State Homes and Community Renewal Agency’s Middle Income Housing Program aims to develop and preserve housing for middle-income households.

“More recently, the passage of the Infrastructure Investment and Jobs Act (IIJA) in 2021 has provided substantial additional funding for infrastructure projects across the U.S.,” says the report. “As a result, the Transportation Infrastructure Finance and Innovation Act and Railroad Rehabilitation and Improvement Financing programs, both administered by the Build America Bureau of the U.S. Department of Transportation, have significantly expanded their lending capacity by making over $100 billion in low interest rate loans available to finance transportation infrastructure projects, including those related to transit-oriented development.”

Fitch Ratings notes that there are several key nuances to essential housing deals that it considers in the evaluation of demand and pricing flexibility.

“For transactions where rents are determined based on a percentage of units set aside for households at lower, median, and moderate AMI levels, there is an ongoing risk that a higher percentage of units will be occupied by lower AMI tenants than originally projected,” the report explains. “For these types of projects, Fitch will look to the market study to determine potential demand at each AMI level and to assess the likelihood that units will be filled accordingly. To the extent there is historical performance and financial data available for a particular essential housing project, Fitch may also consider what the actual breakdown of units by AMI level has been over the property’s history.”

There is also the potential for future cash flow volatility if renters at 120% of the AMI represent a significant portion of gross rental revenue. Under this scenario, increasing income levels among these renters could eventually exceed the project’s income limits, forcing them either to move out or to continue living in units otherwise intended for lower-income tenants. Ongoing reliance on demand from this segment will be considered in the analysis and could result in additional revenue stresses, according to Fitch.

In addition, essential housing projects may be subject to local rent control ordinances that limit the amount by which rent can be increased annually. Fitch says it also considers whether rents overall may be pressured by the local housing market by looking at the percentage differential between the project’s rent levels and local market rents. If the project’s rental rates are higher than or already in line with those of the local market, this could potentially limit future rent growth at the project, particularly for units targeting tenants at higher AMI levels.