Developers discuss deal killers, other big challenges

Land for new affordable housing development is tough to find. Interest rates are on the move, and the cost of development is soaring.

How are affordable housing developers coping with these challenges and what do they see coming down the road?

Developers from across the nation told us. They took part in an exclusive AFFORDABLE HOUSING FINANCE magazine survey.

Conducted in May, the survey drew responses from 120 urban and rural, big and small, new and experienced developers.

Nearly 71 percent of the participants were for-profit developers, 25 percent were nonprofit organizations, and 4 percent were affiliated with government agencies. Participants ranged from start-ups putting together their first deals to an owner with more than 50,000 units.

Together, they paint a fresh and vivid portrait of today’s development market.

Today’s toughest challenge

When it comes to deal feasibility, one issue rose to the top. No less than half of the respondents cited rising development costs as the No. 1 issue affecting their deals. The scarcity of subsidies was a distant second, followed by rising operating costs.

In a ranking of developers’ biggest challenges, coping with rising development costs again rose to the top, with a third of the respondents selecting it as their biggest problem. Twenty-nine percent said finding land was their biggest challenge, and 18 percent cited being allocated low-income housing tax credits as their biggest hurdle.

Interestingly, these challenges rated higher than overcoming anti-development sentiments and receiving financing, which ranked near the bottom of a set of issues.

“We are competing with market-rate developers in a booming residential market with a high demand for condos, so multifamily property is selling far beyond prices our financial arrangements can afford,” said a developer.

Although he had not found a solution, the developer reported being able to leverage the little excess property that he owns in different ways, including trades with non-housing nonprofits.

“Construction cost increases on on-going projects was the single-most challenging issue,” said another developer. “We got around the issue by going to other soft-loan sources to fund additional money to offset the increase.”

One developer said he is responding to rising construction and development costs by shifting to a higher percentage of recycled and donated materials.

Another firm reported that it changed its method of construction on a project to lower the costs and enable the project to be built faster, thus lowering the interest costs it had to pay.

For one developer, the biggest challenge has been securing approval for zoning changes that would allow his projects to have the necessary densities to make them feasible.

A California developer cited a similar problem, saying the biggest challenge is locating reasonably priced and properly zoned sites suitable for multifamily housing and close enough to services to be competitive to win low-income housing tax credits (LIHTCs).

The tough development environment has pushed others to change their focus. “The cost of land and construction have forced us into new and different markets,” said one survey participant. “We have retained an affordable component; however, it is no longer the core business.”

Another said he is looking for other sources of income, including building for-sale units.

Despite these challenges, many developers are pressing on. Several said they would not be starting any new units this year, but one had plans to start 4,500 units of new rental housing or substantial rehabilitation, both affordable and market-rate. On average, developers with building plans this year expect to start about 439 new construction or substantial rehabilitation units in 2006.

Rising costs

Developers said the cost per square foot of their most recent multifamily developments ranged from $35 to $350. The average of the responses was $128, and the median amount was $115.

Most developers, 40.3 percent, have seen costs jump between 10 percent and 19 percent from a year ago. Another 26 percent reported that costs rose between 20 percent and 29 percent.

Looking ahead at the next 12 months, developers aren’t anticipating any relief. A good majority of developers, 52.3 percent, predicted cost increases of between 10 percent to 19 percent during the next 12 months.

Developers are also coping with rising interest rates on permanent loans. Nearly 42 percent reported that these rates have gone up between 51 and 100 basis points in the last 12 months. Another 33 percent have experienced rate increases between zero and 50 basis points.

For several in the industry, these rate increases have meant shopping more for loans. “It’s forced us to require banks to be more competitive and increased reliance on local subsidies since less permanent debt can be supported,” said one respondent.

Another said it’s made it much more difficult to do acquisition/rehab deals. “We’ve seen a 70 percent drop in our volume in that area over the last two years,” said the developer. “[We’re] using private placement and forward-rate locks on almost everything now.”

Several others, however, reported that rising interest rates had yet to become a major problem. “We’ve moved from conventional sources of financing to state agency financing and have been able to control financing costs to a certain extent,” said one developer.

Some expect interest rates to be a greater factor next year. “We are reaching the tipping point on interest-rate impacts,” reported a respondent.

Housing tax credits

Developers also reported a wide range in how much they spend on applying for housing tax credits. “Too much,” was the reply of one haggard tax credit developer. The lowest average amount per application that was reported was $250 and the highest, $300,000.

The average of the survey responses was $41,544 per application, with the median at $25,000.

Although 2006 tax credit awards are pending in many states, 13 out of 43 developers reported that 100 percent of their applications were successful this year while 19 developers reported having none of their applications approved.

In 2005, the number of developers who said they had 100 percent of their applications win credits was roughly the same as those who reported not having won any credits.

“The competition is greater [now],” said a developer about the tax credit program. “[It’s] forced us to make the target population lower income than we would have wanted to. Also, rather than enter into options to purchase, we purchased property before knowing of the success or failure of an application.”

The LIHTC program is the nation’s most important tool in producing affordable housing. In 2006, each state is receiving $1.90 per capita in credits to allocate. Small states receive a minimum of $2.19 million.

Each allocating agency adopts a qualified allocation plan (QAP) or other regulations that determine which development proposals receive tax credits. In most states, demand exceeds available credits by 2-to-1 or 3-to-1.

Successful developers then raise equity for their projects by selling the tax credits to banks and other corporate investors.

Developers had plenty of ideas for improving both the overall LIHTC program and the allocation of tax credits. First, several called for the tax credit percentages to be fixed.

Under the LIHTC program, the maximum amount of credits that may be taken for a project equals the applicable percentage multiplied by the qualified basis of each low-income building. States may also impose their own maximum awards.

The applicable percentage is a percentage that will yield, over a 10-year credit period, a credit with a present value equal to:

• 30 percent of the qualified basis of a building. This calculation applies to acquisitions of existing buildings and new construction or rehabilitation projects that utilize federally subsidized financing, such as tax-exempt bonds or certain other federal assistance. This is the equivalent of an approximately 4 percent annual credit over 10 years; or
• 70 percent of the qualified basis of a building. This applies to new construction and rehabilitation projects that do not use certain forms of federal aid. This is the equivalent of an approximately 9 percent annual credit taken over 10 years.

The credits are popularly known as the 4 percent and 9 percent credits, but the actual percentages are not firm. Several developers called for the percentages to be not only fixed, but increased. “The 9 percent credit was good back in the late 1980s and ’90s, [but now] it should be more like a 12 percent credit,” said one participant. “We need increased sources in order to combat rising land, development, and operating costs.”

Another developer suggested making mixed-income communities the goal. “It’s not the QAP or the allocation that is the issue,” the developer said. “It’s the shrinking number of credits available. The market dictates pricing of credits, and the investors are constantly adjusting to different ways to accomplish the goals of credits. We simply must figure out a way to stretch those credits so that more projects can be built that are stable in the later years of the development.”

Some respondents emphasized that the allocation process should not be political. “Make it a market study and a land-use issue, not a political process,” said a developer.

Another said, “Increase the financial feasibility requirements and understand that you can’t be all things to all people.”

Many respondents reported that their tax credit businesses are focused in only one state, so they were unable to identify the states with the best and worst selection criteria.

Developers, however, reported that they want an allocation process that is predictable.

Local policies that make a difference

The survey also asked developers to describe regional policies that have had the most positive impact on affordable housing production. Inclusionary housing programs, which generally require market-rate developers to include some affordable housing units in their projects, were the most frequently cited.

Two California developers also cited redevelopment and tax-increment financing from redevelopment agencies that are helping leverage tax credits.

Developers also said greater education about affordable housing, the alignment of local subsidy sources in selecting projects, surtax contributions as a local subsidy for projects, and a regional approach to the homeless problem as policies that have had a good impact.

Developers also shared their views about the latest innovations in public policy and private financing that they think hold promise for producing more affordable housing. Not everyone, however, had an example to offer. “Still waiting for one,” said one developer.

The use of manufactured housing, affordable housing trust funds, and a new willingness by local jurisdictions to work with developers were among the top developments cited.

“Addressing exit taxes for sellers of existing affordable housing sold for preservation would do a lot to stem the number of conversions to market-rate,” said a developer. “Acquisition and rehab is always much cheaper and produces more units as compared to new construction. I’ve encountered many owners who simply cannot sell because of the tax implications. Similarly, if there was an incentive for them to sell to a developer who redevelops the property and extends affordability, more of these deals would get done.”

Others stressed preservation as well.

“State and local governments must recognize that preserving affordable housing is as important as developing,” said a developer. “Many states have set-asides of 9 percent [tax credit] allocations for preservation deals. This is key.”