For many in the affordable housing industry, 2009 was the worst year they had ever seen. The low-income housing tax credit (LIHTC) equity market's continued decline, higher prices on debt financing, and the disappearance of many gap financing sources meant that very few new deals penciled out. And all indications are that 2010 will bring more of the same: Developers will, once again, have to be extremely creative to summon a feasible capital stack.

Interest rates are expected to rise, construction financing will prove elusive, and nobody is predicting a swift rebound in tax credit equity prices next year. What's more, many subsidies, such as housing trust funds and Federal Home Loan Bank funds, will likely continue to dwindle.

“It's a new paradigm in terms of how you put your affordable housing deal together,” says Phil Melton, a senior vice president who leads the affordable housing debt shop at Charlotte, N.C.-based Grandbridge Real Estate Capital.

But as the economy struggles out of recession, there are also reasons for hope. The higher yields on LIHTCs may lure some nontraditional or dormant investors back into the market. And the Tax Credit Assistance Program (TCAP) and tax credit exchange program (TCEP) introduced through the American Recovery and Reinvestment Act, may help to jump-start the dormant pipeline of tax credit development.

“2010 will still be an extremely challenging environment,” says C. Lamar Seats, a senior vice president who leads the debt platform at Columbia, Md.-based Enterprise Community Investment, Inc. “But with the TCAP and the exchange program, and alternate investors coming back to the equity market, it should be a better year.” But “better” is a relative term, and an easily attainable goal when you're starting from the bottom.

Stimulus efforts

Many industry players are pinning their hopes on TCAP and TCEP as a short-term path out of the current malaise. TCAP provides much-needed gap financing for tax credit developments allocated from 2007 to 2009, and TCEP allows developers to exchange their unsold credits for $0.85 per tax credit dollar.

While TCAP and TCEP are long on promise, they have been short on efficiency. The programs also have a limited life. Meanwhile, the Treasury Department, the Department of Housing and Urban Development (HUD), and state housing finance agencies (HFAs) have been slow to issue guidance and plans on how to disperse the funds.

“The TCAP and exchange funds aren't going to jump-start anything, they're woefully bureaucratic,” says Steven Fayne, a managing director at Citi Community Capital, the community development arm of the New York-based bank. “There's a lot of uncertainty on some of the rules administered by the federal government and the states, and that hasn't gotten resolved.”

Many in the industry believe that the volume of deals saved through the programs are just a drop in the bucket, and that an extension of the programs is desperately needed.

And ironically, in some cases, the programs have had a converse effect: Developers are further stalling projects, holding out to see what they can get from TCAP and TCEP.

“The legislation has delayed production of new affordable developments or has put a lot of things on hold,” says Tim Leonhard, who heads up the affordable housing debt platform for St. Paul, Minn.-based Oak Grove Capital. “Why would a developer sign up a deal with a syndicator at $0.70 when he has the ability to potentially go back to the state and get $0.85?”

Some long-stalled projects, bolstered by TCAP and TCEP funds, did begin to break ground in the third and fourth quarters. But it's a modest pace of activity. The dizzying heights that the affordable housing industry reached in 2005 or 2006 seem like decades ago, as the industry nurses its wounds and goes back to the drawing board.

A sea change

Affordable housing deals have long enjoyed more favorable underwriting than their market-rate brethren. The large amount of equity in 9 percent tax credit deals, and the presence of deep-pocketed investors and syndicators, gave lenders a certain peace of mind, leading to high loan-to-value (LTV) ratios and low debtservice coverage ratios (DSCRs).

Those days may be coming to an end as lenders experience a crisis of confidence. For the first time in recent memory, syndicators struggled with their own finances, and equity investors began to turn their backs and walk away from troubled projects in 2009.

The underwriting on affordable deals is beginning to look a lot like conventional market-rate underwriting, as lenders cast a jaundiced eye on the equity side.

“It may be a sea change. What's happening is a reconsideration of what the proper underwriting criteria should be,” says Hal Kuykendall, a managing director at Citi Community Capital. “It's not going to return to that kind of aggressive underwriting unless people believe that LIHTC investors and syndicators will be there to support deals that get in trouble.”

Most lenders are underwriting tax credit deals to a 1.20x DSCR and 80 percent LTV, as opposed to the 1.15x DSCR and 90 percent LTV that had been the standard. This is especially true for deals that use TCEP funds: Since the funds come directly from the HFA, there's no syndicator in the deal. That absence has led to requests from lenders for higher reserves as a safeguard against potential shortfalls.

“The lessons of this year will cause underwriting standards to continue to tighten in the foreseeable future,” says Fayne.

Breaking ground

Construction capital remains elusive, and it won't get much better in 2010.

The strongest borrowers in major markets can still access construction funds based on long-standing relationships and the Community Reinvestment Act (CRA) needs of banks. But the majority of borrowers will have a tougher time in 2010.

The spreads on construction loans from banks have doubled over the last 18 months to as much as 500 basis points (bps) over the benchmark LIBOR rate. And since most banks have very little appetite for new balance-sheet executions, that trend isn't expected to reverse.

Though the government-sponsored enterprises (GSEs) have been a muchneeded source of liquidity, not all executions are created equally. Rates on forward commitments from the GSEs rose steadily this year, and unfunded forward commitments were pricing between 8.5 percent and 9.5 percent as of late October.

“Forward pricing is now so steep that invariably your LTVs are pretty low,” says Melton. “If you're rate-locking at 9.5 percent, chances are your LTV is about 70 percent.”

Fannie and Freddie were stepping up their efforts to manage those rates, according to several agency lenders, though no relief had emerged by late October. Since the GSEs are under a congressional mandate to shrink balance sheets, both were working on ways to sell forward commitments into the investment market. But the market for that paper is very limited, so a significant premium has emerged.

“There are so many options for investors out there, and the last thing a third-party investor wants is to enter into a 36-month forward commitment on a 15- or 18-year term, with inflation looming,” says Leonhard. “So, in order to induce them, you're going to have to pay up, and that's why you've seen such a widening in the spreads.”

Mini-perm loans from banks offer more favorable rates than GSE forward commitments, by as much as 150 bps. But the fact that mini-perms don't cover the entire compliance period can give a syndicator pause.

The best bet for construction financing continues to be the Federal Housing Administration (FHA). Its Sec. 221(d)(4) program, a blended construction/perm loan, was offering rates in the high-6 percent range in late October. Plus, you don't need a bank credit facility on an FHA deal, as you would need on a GSE forward.

But the program's unbeatable terms—it's nonrecourse, and includes 40-year amortizations, 90 percent loan to cost, and 1.11x DSCR—are tempered by the time-consuming process of dealing with the agency. And as the FHA gets inundated with more loan requests, questions remain about how much capacity the agency will be able to take on next year.

Bond deals in the shadow

Four percent LIHTC deals are headed for another tough year in 2010. Investors heavily favored 9 percent deals in 2009, and there's no indication that next year will be any different. Outside of large coastal metro areas, where CRA needs are highest, tax-exempt bond deals will have a hard time in 2010, many predict.

Investors are less attracted to 4 percent deals since they require much more debt financing and are therefore more risky. And TCEP and TCAP might not be much of a help. While the programs can technically be used for tax-exempt bond deals, many states have prioritized 9 percent deals over 4 percent deals in their allocations, sending tax-exempt bonds to the back of the line.

With the private placement market frozen, the best execution for a bond credit enhancement in 2009 was Freddie Mac's variable-rate execution with a swap. Fannie Mae exited the variable-rate bond credit enhancement market in late 2008, and there's little hope of a return.

While Freddie Mac is expected to remain in the variable-rate market next year, the company adopted stricter underwriting standards and much higher liquidity and guarantee fees as 2009 wore on.

As a result, fixed-rate bond credit enhancements from the GSEs became more competitive in the fourth quarter of 2009, and the all-in rates on both executions were nearly running neck and neck in late October.

“The other thing we've seen on the bond debt side is an absolute rebirth of FHA financing,” says Wade Norris, a partner at Eichner & Norris, a Washington, D.C.-based law firm specializing in tax-exempt bond finance. “Fannie and Freddie liquidity charges have gone to the moon, and they've tightened their underwriting standards. But HUD has not changed a thing.”

The fee stack on an FHA deal is about 70 bps, compared to more than 200 bps for the GSEs. “And you don't have any reunderwriting on your loan after you finish construction,” says Norris.

Immediate funding rates

In contrast to new construction financing, rates on immediate fundings were stable throughout 2009 and are expected to remain that way through next year. The GSEs were offering rates close to 6 percent, while the FHA's Sec. 223(f) program was coming in closer to 5.75 percent.

The FHA also offers longer amortizations and higher LTV ratios than the GSEs. This is especially true in pre-review markets, such as Florida, where the GSEs are much more selective. In hard-hit markets, immediate fundings from the GSEs could offer just 65 percent LTV, maxing out at 75 percent, while the FHA will go up to 85 percent LTV as long as you're not taking cash out.

Cautious optimism

Several critical issues loom large over the affordable housing industry.

The yield on the benchmark Treasury note is expected to rise next year. The future of Fannie Mae and Freddie Mac will be taken up by Congress in 2010, and many industry players are anxious to see how the GSEs will move forward. And a swift return of substantial job growth is not in the cards for 2010.

“We're about a third of the way through this commercial real estate downturn, in my opinion,” says Norris. “Everyone is cautiously optimistic that 2010 will be a transitional year, a rebuilding year.”

But there are several reasons to keep hope alive. The continued presence of Fannie Mae, Freddie Mac, and FHA is giving developers access to very well priced debt. The new team at HUD is staffed with many experienced affordable housing players who are familiar with the nuances of the industry.

While crystal ball predictions are always difficult, many feel that at the least, the worst is behind us. “One thing I do know,” says Kuykendall, “is that we're closer to the recovery than we were a year ago.”