Many of the issues that have been vexing affordable housing developers will remain into early 2023, with hopes that financial conditions will gradually improve as the year goes on. Rising interest rates, escalating construction costs, and a slowing economy continue to be the key concerns as a tumultuous 2022 turns into a new year.
“There’s uncertainty in the market, and it will likely carry on into the first two quarters of this year,” says Pamela West, senior portfolio manager, impact investing, at Nuveen Real Estate. “I think everybody is sitting on pins and needles waiting for the next recession. We’ve seen rent inflation double in the last year. In New York, the average rent was recently quoted as $5,000 per unit per month. Because of that rent inflation, people have been pushed into the rent-burdened and severely rent-burdened categories. It’s created a need for more affordable housing. This uncertainty going into 2023 is difficult. We need more capital to come into the market to preserve the housing we have and create new housing. It’s going to be difficult in 2023 given the interest rate environment.”
Federal Reserve officials have indicated that they will raise interest rates further, but possibly at a slower rate, to combat inflation in 2023.
The Fed’s key benchmark borrowing rate is projected to increase to about 5% to 5.25% this year, up from about 4.25% to 4.5% in December.
“This along with the increased cost of capital may continue to cause funding gaps in some deals,” says Maria Barry, national executive, community development banking, at Bank of America. “There may be a need for more subsidy funding to help deals close due to everything being more expensive.”
Others will also be closely monitoring the steps taken by the central bank in the months ahead.
“Inflation and the Fed’s response to it will be our No. 1 concern in 2023,” says Al Beaumariage, senior vice president and affordable housing program manager at KeyBank Real Estate Capital. “We will be watching the relationship between long- and short-term interest rates and the FOMC’s [Federal Open Market Committee’s] decision path to adjust short-term rates in order to regulate inflation and mitigate further recessionary impacts.”
Looking at the capital markets in 2023, Beaumariage says he expects “an elevated interest in shorter-term debt with flexible prepay options” in the company’s preservation business.
In addition, he anticipates there will be an “abundance of interest in early-rate-lock products, hedges, and other derivatives that can soften interest rate risk.”
For developers, a key question is what will they see from their financial partners in the new year.
“Volatility in construction pricing, supply-related delays, and higher interest rates engender increased capital provider focus on strong project level capitalization, developer expertise, and wherewithal,” says James Spound, president of R4 Capital Funding. “Investors and lenders are looking for transactions that incorporate increased levels of public capital support. The overall 2023 environment will favor seasoned development firms that have the skills to attain public support and weather challenging construction markets.”
Others note that credit standards will tighten if the economic environment worsens. While leading banks remain committed to financing affordable housing, they will likely be looking more closely at a sponsor’s financial stability when it comes to reserves and cost contingencies.
Total commercial and multifamily mortgage borrowing and lending is expected to fall to $700 billion this year, a 5% decline from an expected 2022 total of $740 billion, according to an updated baseline forecast from the Mortgage Bankers Association (MBA). Multifamily lending is forecast to fall to $393 billion this year, an 11% drop from 2022’s expected total of $439 billion. MBA anticipates that borrowing and lending will rebound in 2024.
Construction Costs
As interest rates climbed and made borrowing more expensive in the past year, affordable housing deals were also hit with soaring construction costs. The National Council of State Housing Agencies found that affordable housing developments recently experienced cost increases averaging 30% and in some cases even greater amounts. Nearly all deals that were awarded low-income housing tax credits (LIHTCs) from 2019 to the present have faced significant, unexpected cost hikes after being awarded credits, according to a study by the organization.
Construction cost increases, delays caused by supply chain disruptions, and rising interest rates that created a need for larger interest reserves were issues for many 2022 projects, agrees Barry, who cites strong collaboration among developers, housing agencies, municipalities, and financing partners for getting deals over the finish line.
“We are optimistic that construction costs will begin to moderate,” she says. “We’re seeing labor tightness start to ease in some markets as higher rates have slowed the pace of new construction. We’ll continue to watch interest rates, which the Fed signaled are expected to continue to rise through midyear. In some cases, new deals are being underwritten more conservatively as developers, agencies, and financial partners recognize the impact of rising interest rates.”
There are other signs that conditions are slowly getting better. In December, the National Multifamily Housing Council (NMHC) saw small improvements in the share of survey respondents experiencing construction delays and deals being repriced up. Additionally, lumber prices, on average, dipped for the third straight quarter, dropping 5% over the last three months. However, costs for many other materials, including electrical components and exterior finishes and roofing, continued to rise, according to the NMHC.
In its 2023 real estate market outlook, CBRE also said it expects “total construction cost escalation in 2023 to be slightly higher than the historic norm but well below that of 2022.”
Community Development and Social Lending Outlook
Developers aren’t the only ones who still face tough sledding. Community development and social lending (CDSL) “faces numerous headwinds heading into 2023,” according to Fitch Ratings, which views the outlook for the sector as neutral.
“Given Fitch’s macroeconomic forecast for 2023, demand for the essential services provided by CDSL issuers will inevitably rise. At the same time, falling home prices and rising unemployment could potentially lead to higher delinquency and default rates,” said the firm in December. “In Fitch’s view, CDSL issuers are well-positioned to face these challenges, given their solid financial profiles, their effective oversight of loan portfolios, and the strong federal government support they typically receive, in the form of loan guarantees, mortgage insurance, housing subsidies, tax exemptions, and other forms of assistance.”
The firm noted that in 2022 the sector experienced a decline in bond issuance for affordable housing lending, from $40 billion in 2021 to $25 billion as of October 2022, largely driven by the market turbulence during the year.
In its report, Fitch cited several issues to watch, including a mild recession turning into a longer one. While a housing market crash like the one during the Great Recession is highly unlikely, a slow recovery similar to that of the Great Recession may mean more job losses and declining income, further fueling the demand for affordable housing. However, persistent volatility in the capital markets may keep investors nervous and issuers wary.
New Finance Models
Over the years, LIHTC developers and policymakers have been able to create new finance structures to help produce affordable housing, including the
average-income option, which allows some units at a housing credit property to serve residents earning up to 80% of the area median income (AMI). In October, the Internal Revenue Service prepared new regulations to utilize this option.
The new rules eliminate the “cliff effect,” in which a small number of units out of compliance can threaten recapture of the tax credits for not meeting the minimum set-aside. Now, the revised rules limit the impact of one unit’s noncompliance on the ability of a project to satisfy the average-income test. The final regulations also allow for the average-income test to be satisfied if at least 40% of a building’s units collectively average 60% or less of the area median gross income; it is no longer necessary to consider all low-income units in a residential rental property when determining whether the average-income test is met.
The changes are expected to help a number of deals move forward after being stalled while waiting for clarification on the option.
There’s also been a recent influx of governmental money that emerged during the COVID-19 pandemic, including the American Rescue Plan Act (ARPA), which could help finance some affordable housing deals, according to Joel Henney, vice president of finance at TWG, a major affordable housing developer headquartered in Indianapolis.
“We’re also seeing more and more states looking at and passing legislation for state housing credits,” he says. “Georgia has been a leader in state credits for years, but it seems like every year there are three or four more states with programs. The state credits can help make up for the gap created by an increase in interest rates and costs.”
What to Watch
Affordable housing industry leaders have a long list of trends that they will be watching in the new year.
“The 10-year Treasury is important. It drives the permanent financing. Also, as rents go, the AMIs go,” says Henney. “We’ve had interest rates go up, and we’ve had costs go up. In a world where rents have gone up across the country, that can usually help offset the costs, but in affordable housing those rents are capped. A trend to watch will be the AMIs that are released each year by the Department of Housing and Urban Development. An increase in AMI may help offset those other increases.”
Most cities and municipalities understand the need for affordable housing, and they understand that rising construction and interest rates are making it harder to develop, adds Henney.
“We’ve been focusing on talking to the agencies, cities, and states to see what kind of incentives they have,” he says. “If there’s some kind of tax abatement, TIF [tax increment financing], ARPA funds, or other extra funding that can help affordable housing developments. We’re trying to find other sources on a deal that can help bridge that gap that’s been created by increased costs in recent years.”
Looking ahead, KeyBank’s Community Development Lending and Investment platform will maintain its aggressive position to increase the affordable housing inventory, according to Beaumariage. The team plans to expand its private-placement bond program and its equity initiative this year.
Others stress the importance of holding on to the current pool of affordable housing.
“We have to preserve the housing that exists today,” says Nuveen’s West. “That should be our No. 1 focus as affordable housing investors, not allowing regulatory agreements to expire. We have to be defensive in that way to make sure residents are not being displaced.”
In the year ahead, Nuveen will double down on preservation, according to West.
“One million units are expiring over the next decade so the work we are doing on the preservation side is important,” she says. “We are working with municipalities to create public-private partnerships to get to those communities that need our capital. Our capital is mission-focused, and we have a fiduciary responsibility to provide a return—it’s intentional and responsible.”
The company has mainly been doing this work on behalf of parent TIAA but is expanding. “Now, we will offer this strategy to investors, and they’re asking for it,” West says.
Barry also names preservation as a major area for the industry. “As the need for housing continues to outweigh supply, we anticipate a focus on preservation to stretch available subsidies,” she says. “More projects will leverage other sources, such as historic tax credits, state tax credits, or other subsidies, to close the financing gap. And we expect to see projects continue to use income-averaging and twinning. We also anticipate seeing more mixed-income housing with LIHTC for the below 80% units. We also expect many projects to incorporate green features as we all continue to work toward getting greenhouse gas emissions to zero by 2050.”
