Perfect Storm

Affordable housing investors and developers should expect something of the proverbial “perfect storm” borrowing environment for the balance of 2015. In the positive sense, that is.

Not only did the new year usher in a mortgage-interest benchmark back below 2%, but, as well, the matured affordable housing sector continues to attract more and more lenders looking to meet its burgeoning 2015 borrowing needs with all manner of debt products. “There’s a lot of capital chasing deals,” observes Phil Melton, senior managing director with Hunt Mortgage Group. “And that means lots of options for ­borrowers.”

It makes for a competitive lending environment benefitting a lengthening list of interested borrowers. For instance, heavy battles over large transactions in high-cost top-tier metros are prompting some of the biggest lenders to expand their geographic reach into newly targeted secondary markets.

And the already crowded competition for affordable lending opportunities across the board might become all the more cutthroat if Wall Street conduit lenders jump on the affordable housing bandwagon in the coming months, as Melton and other pros fear.

“It’s not like we’re seeing anyone exit this business,” says Richard Gerwitz, co-head of the sector’s highest-volume lender, Citi Community Capital, which leads affordable housing finance’s 2014 Top 25 Lenders list, with $3.2 billion in loans.

Notwithstanding booming borrower demand for a wide variety of affordable lending products, fierce competition appears destined to further tighten already eroded interest-rate spreads, Gerwitz and other insiders lament. Amid all-too-fresh memories of a recession that devastated the housing market, lenders, for the most part, remain distinctly disinclined to win deals by loosening loan terms.

Hence the most viable deal-winning strategy: more-aggressive pricing quotes. “Spreads have narrowed,” Gerwitz acknowledges, “and it seems pretty clear they will become even tighter.”

All the better for so many would-be borrowers around the country pursuing a broadened and deepened roster of affordable housing production and preservation opportunities—even as continued tight multifamily markets push rents further upward.

The pipeline of planned affordable housing construction projects requiring debt financing in the coming months continues to look robust. And lending facilitating preservation activities appears to be brisk as well.

Considerable looming expirations of Sec. 8 contracts and low-income housing tax credit (LIHTC) compliance periods will keep lenders busy with complex capital restructurings. Meanwhile, more public housing projects are likewise slated for recapitalization into ventures entailing private-sector participation.

With interest rates so low—and with the general consensus expecting relative permanent-loan rate stability throughout the year—some pros even anticipate burgeoning interest in refinancings long before existing mortgages mature.

“You’re wondering how much lower rates could possibly go—and then they’re suddenly down another 25 basis points,” relates John Epstein, executive vice president overseeing debt originations with Wells Fargo Community Lending & Investment.

Add it all up, and loan origination specialists at affordable housing finance shops around the country appear positioned for another exhausting year.

“All the lending cylinders are hammering away,” from construction-loan facilities to the longest-term permanent solutions, Epstein adds.

If there’s any debt-related hitch in the affordable sector’s giddyap, it relates to ever-higher development costs (land, labor, and materials) in the bigger markets, generally. That can make construction projects challenging to pencil out, now that key federal and state gap financing programs aren’t as generous as they had been.

Diversified offerings

Beyond quoting ever-tighter spreads, lenders are logically looking to compete in this environment by bundling optimal rosters of affordable housing finance products and services. Even as they continue originating loans under Fannie Mae’s and Freddie Mac’s innovative affordable programs, many of them are deliberately diversifying their offerings—often with private-label products.

Those with considerable balance sheets, in particular, are touting shorter-term bridge-type lending programs. These products are providing clients with flexible and customized means of financing acq–rehabs of properties headed for comprehensive recapitalizations that preserve their affordability. And it doesn’t hurt if they can package debt tranches with equity infusions (tax credit, preferred, joint venture, and so on) and quasi-equity slices such as mezz capital.

For instance, specialty finance firm Lancaster Pollard recently launched and staffed up its Lancaster Pollard Finance Co. unit in an effort to “broaden our balance-sheet funding products to include construction and term financing, bridge lending, mezzanine, and preferred equity products,” managing director David Lacki explains.

Pillar Finance, too, is in the process of expanding its offerings to include conventional equity and mezzanine lending aimed at owners of tax credit properties facing compliance-period expirations.

Indeed, lenders—such as Bank of America Merrill Lynch’s Community Development Banking (CDB) group—that can fund construction facilities, infuse tax credit equity, and hold tax-exempt bonds on their portfolios when advantageous can help developers save meaningful fee expenditures and time commitments, stresses Maria Barry, who runs the BofA Merrill Lynch CDB group.

“It helps to have a lot of tools in your toolbox,” she says.

Meanwhile, as Barry and others also note, the increasing popularity of some of the Federal Housing Administration’s (FHA’s) affordable multifamily mortgage insurance programs is prompting lenders to boost their participation. BofA Merrill Lynch is expanding its FHA activities, and Citi is in the process of launching its FHA lending platform.

FHA programs offer the “attractively priced” long-term, fully amortizing structures a lot of developers prefer, says Tracy Peters, senior managing director overseeing affordable housing originations at Red Capital Group. “And with their consolidation of offices and streamlined underwriting, transaction execution will become more timely in 2015.”

Preservation nation

Preservation appears to be the most popular topic among lenders, given all the expiration-related refi needs at LIHTC and Sec. 8 properties. Early waves from a tsunami of upcoming Year 15 recap requirements are bound to command a substantial share of this year’s affordable debt–placement activities, says Mark Dean, Citi Community’s head of production.

As is the case with Sec. 8 contract expirations, the marketplace will need debt for simple refinances of some properties, more comprehensive recapitalization of others, and acquisition financing for the many such communities likely to change hands with the compliance and contract expirations, Dean elaborates.

Like others, he notes that many large lenders are devising proprietary programs for such situations, while the government-sponsored enterprises (GSEs) have also continued to fine-tune their popular targeted debt products.

Amid rising construction costs in major markets, “we are tending to see less emphasis on new construction and more on acquisitions and rehabs,” adds Citi’s Gerwitz.

Through BofA Merrill Lynch’s participation in the FHA’s LIHTC Pilot Program, the lender’s affordable team continues to see considerable interest in recapitalizations (including tax credit ­resyndications) allowing for mod–rehabs along with new permanent financing, adds Barry. She says the firm’s ground-up development finance pipeline for 2015 is running quite deep as well.

A good amount of the preservation-minded ventures will find bridge-lending programs appropriate for rehab needs—with some decision makers likely opting to lock in fixed debt for two or three years at today’s low rates rather than the more typical variable structure of shorter-term credits. But Hunt’s Melton also notes that as many tax credit developments are still in pretty decent shape physically, some rejiggered ownerships will opt for intermediate-term debt to take them past their 20-year useful lives—and then seek new financing for substantial rehabs.

Finance pros, likewise, foresee continued solid activity ahead of recapitalizing at-risk public housing projects through mechanisms such as the Department of Housing and Urban Development’s Rental Assistance Demonstration program.

“There are lots of immediate opportunities there” to substantially improve many of these underperforming communities’ operations under the more “market-driven” business models emerging with recapitalizations into new partnership structures, Melton relates. Today’s ultra-low interest rates even seem destined to generate some straight debt refinancing transactions long before housing credit periods or Sec. 8 contracts expire—particularly with large communities carrying sufficiently heavy debt balances to justify the related costs and efforts.

“If interest rates stay at the historically low levels we’re seeing at the start of the year,” says Red Capital’s Peters, “I think you will see deals that are a year or two from the end of their 15-year tax credit compliance period get permanently refinanced.”

However, some pros caution that affordable program structures tend to limit such activities. For instance, lockout periods and yield-maintenance requirements may be impediments at some properties where refinancings otherwise would be no-brainers given the substantial differentials between existing coupons and prevailing rates, Melton notes.

Production function

Even as rising land and construction costs and declining gap financing programs are making affordable ground-up construction projects more difficult to pencil out in high-priced urban districts, strengthening demand for 4% LIHTCs that come with tax-exempt bond-financed projects should keep the construction/substantial-rehab pipeline relatively lively this year, experts generally agree.

And because taxable conventional mortgage rates available through FHA and GSE programs are expected to remain lower than for permanent loans funded through such tax-exempt bond issues, the so-called “cash-collateralized” structure should remain the construction/perm model of choice over the traditional credit-enhanced tax-exempt alternative, at least through the first half of the year, the consensus also holds. The 3% to 3.5% rates available through the former model are simply too compelling to ignore compared with the 4-plus seen with the traditional tax-exempt structure, Melton stresses. “So we’d need to see a big increase in the taxable bond rate to make the economics shift in favor of ­tax-exempt,” he says.

But some experts think there’s a ­decent chance that may just happen as the year progresses. “A year ago, the cost differential between a traditional bond deal and a short-term, cash-backed bond deal was 125 basis points,” Lancaster Pollard’s Lacki points out. “But, now, we’re closer to 50 basis points.”

Wells Fargo’s Epstein concurs. While cash-collateral structures still pencil out relatively favorably as 2015 gets under way, conditions could just as easily shift back toward the traditional tax-exempt model within a matter of months, under certain scenarios.

“Just like we saw with oil prices over the last few months, you just can’t predict with certainty where rates on various products will be 12 months ahead,” Epstein elaborates. “That’s why it’s important to give borrowers plenty of options to choose from depending on what happens in the marketplace.”

Despite the often-prohibitive costs of development in near-in districts of major cities, Melton anticipates a decent amount of activity arranging financing for urban mixed-income projects, for three reasons: Some cities intent on discouraging suburban sprawl are willing to subsidize such development; Community Reinvestment Act (CRA)–motivated banks are looking to help finance these projects; and chances are LIHTC investors are willing to pay aggressive prices to participate as well.

And those high costs are one reason would-be borrowers in secondary markets should expect enhanced attention from major lenders going forward. As Melton explains, some lenders that aren’t thrilled about the narrow spreads they need to quote to compete with CRA-driven banks in major markets see better risk-adjusted dealmaking opportunities in second-tier cities.

Citi, for one, has been expanding its geographic reach, boosting its active markets from about 15 to more than 25 just over the past year or so. “Borrowers in many secondary markets now have access to certain executions they couldn’t get previously,” Dean reports.

Meanwhile, amid diminished allocations to federal gap-filling programs such as HOME and Community Development Block Grants, as well as to various state programs, the affordable housing finance community continues its quest for additional soft-money alternatives to fill out capital stacks.

“Any further decreases in gap financing would have a significant impact on the overall affordable housing business,” Barry Concludes.