It’s not easy to spot new affordable housing. From the outside, the communities often look like market-rate developments or are even the best property on the block.
On the inside, however, there’s a lot going on. Some developments have expanded to become mixed-income communities, housing both low-income and market-rate residents. Many properties also work to blend different populations, setting aside units for formerly homeless or special-needs individuals along with those for families and seniors.
We invited several experts in development, finance, and policy to dig into the benefits and challenges of mixed-income and mixed-tenant communities to give AHF readers their perspectives and insight.
Taking part in the discussion are Laura Bailey, senior vice president of community finance at Capital One; Beverly Bates, senior vice president of development at The Community Builders; Gregg Gerken, head of commercial real estate at TD Bank; Diana McIver, president and owner of DMA Cos.; and Mark Shelburne, senior manager at Novogradac & Co.
What are the benefits of having different incomes or different residents in the same developments?
McIver: I believe that a mixed-income community is a healthy community. I grew up in a small, rural town where people with a wide diversity of incomes lived side by side, working and playing in the same community. Friendships were based on values and interests, not on wealth or lack thereof. We do a disservice when we segregate people of lower economic means. In a mixed-income community, children and adults alike from lower-income families are exposed to role models whom they might not otherwise encounter and values that might not have been part of their upbringing. With our senior communities, residents tend to face a myriad of problems such as the loss of a spouse, declining health, and loneliness, and they create common bonds around these, regardless of income.
Bates: Overall, I don't think that putting people in any kind of segregated housing situation is good for either the families involved or the larger neighborhood. Segregating low-income people whether in big public housing communities or all Sec. 8 developments doesn’t tend to create healthy, safe places over time the way that economically integrated communities do, particularly those with the kind of resources (transit, services, schools) that higher-income neighborhoods tend to have.
There’s an important discussion going on in the industry about creating affordable housing in "high-opportunity" areas versus investing in lower-income neighborhoods. Our thinking at TCB is that you don't have to choose. We certainly have and continue to seek opportunities to create affordable housing in higher-income communities. But for us, it’s also important to work in transitional neighborhoods and try to make them high-opportunity areas by virtue of the transformative development that we are doing and the key to that strategy is, in part, to build mixed-income housing.
Is there a “secret sauce” to having a successful development that mixes incomes and residents?
Bates: I think that once you have a thoughtful design and rent structure that reflects the mixed-income nature of the development, property management becomes the secret sauce. It’s a tricky job to manage a community that has a wide diversity of households in terms of their income, family composition, and life experiences.
McIver: If there is a “secret sauce,” it is to NOT make people aware that there is rental diversity. No one wants to sit on an airplane when you’ve paid $600 for your ticket, only to discover that your seatmate paid $149!
How is financing and underwriting these developments different than a straight low-income housing tax credit (LIHTC) project?
Bates: There’s the world of institutions that subsidize, finance, and buy equity in affordable developments, and there’s the world of organizations that finance and buy equity in market-rate housing. The two do not integrate very neatly. They have different risk tolerances and return expectations. We often separate the legal ownership and financial risk associated with the affordable and the market-rate units by creating a condominium/master-lease structure. You wouldn’t know that is the structure if you lived there, but it allows for a differential allocation of risk and reward to the two types of financial participants. For example, the LIHTC units might be master-leased to a limited partnership through which the LIHTC equity and certain government subsidies flow resulting in a degree of protection from market risk for the investors in those units. Similarly, private equity can be raised to finance the market-rate units without the limitations and regulation associated with a LIHTC structure. The development operates like one development but with two differently structured subparts.
McIver: You do not receive tax credits on the market-rate units, and yet investors/lenders factor the rents into the financial feasibility. Generally, investors and lenders are very conservative on how they treat market rents as part of their feasibility. It is common for them to “pro forma” them at 60% rents—or allow a modest 10% advantage to 60% rents—when you may actually have a 30% rental advantage. We generally start our “market-rate” units at rents equivalent to an 80% area median income (AMI). Sometimes developers make the mistake of thinking they can get the same market rents as a 100% market-rate development down the street. They can’t.
Shelburne: The main differences occur when housing persons with disabilities and unrestricted units. With the former, the challenge is affordability. Households limited to Supplemental Security Income do not earn enough to afford even 30% AMI rents. Therefore, some form of assistance is necessary.
There are several issues when mixed-income takes the form of including “market-rate” units, one of the most important being whether the rent differential is enough to cover the additional debt service. Generally speaking, an applicable fraction below 100% means less equity and more debt. In many, if not most markets, owners are not able to charge a great deal more for the unrestricted units. As a result, the greater amount of debt service means low-income tenants have to pay more in rent.
Gerken: There are many of the same elements we find in a regular LIHTC deal, but you'll need to spend more time working through the elements of the capital stack in your underwriting process. For example, since a number of the units are affordable, they will draw less rent, but the expenses don’t change. In addition, there are underwriting challenges in making sure the project works and there’s enough debt coverage available. There is also typically a unique way the capital is structured in how the property receives subsidies. For example, in New York, there’s the 421-a (tax exemption), and in other cities it may be a form of a PILOT (payment in lieu of taxes).
As a lender or investor, what are the challenges of underwriting mixed-income or mixed-tenant developments?
Bailey: Challenges for mixed-income developments are all related to balance. The market-rate rents must be set at just the right level—in a band where they are seen as a good value proposition. Otherwise, the overall success of the property is jeopardized. Balance is also important in the quality of finishes and amenities that both market-rate and affordable tenants receive. Those tenants in the lower end of the income spectrum want to be given the same high quality that is offered in every other unit in the building. It’s all about balance and making sure that the development functions as a whole community.
What do you look for in these developments?
Bailey: Because these developments must attract both market-rate and affordable market residents, we look for a design and location that will appeal to each of these demographics.
What are the red flags for investors when evaluating mixed-income or mixed-tenant developments?
Bailey: One red flag would be too high a proportion of very low-income units compared with market-rate units. Achieving balance in the overall demographic is a real art. Another red flag would involve offering lower-quality amenities or finishes to the tenants in affordable units. They must have the same high-end appliances and access to communal amenities like a gym and a community room that the market-rate tenants have. And overall, these types of amenities are crucial for drawing the market-rate tenants to a development.
Gerken: The timing of the capital coming in is very, very critical. In some cases, especially when you look at subsidies, grants coming from community groups or from the agencies, the capital is back-end loaded. And, there’s the viability of the project itself in case there’s any political or funding risk in any of those sources.
Are more housing finance agencies encouraging mixed-income or mixed-tenant developments? Why or why not?
Shelburne: There has been an increase in deeper targeting, which is a form of mixed-income. The reasons vary, including promoting integrated permanent supportive housing and more recently to utilize the National Housing Trust Fund.
The documented and widely observed shift toward building in opportunity areas also creates more mixed-income when that phrase is defined at the neighborhood level. Thinking beyond the property itself makes sense: People do not spend all day at home. Rather we interact with others at church, parks, school, stores, and work.
The trends for unrestricted, “market-rate” units are less clear. Most agencies do not have a policy but rather let developers decide what to submit. A few qualified allocation plans either provide incentives or discourage the practice.
Please share two or three best practices for developing mixed-income or mixed-tenant developments.
Bates: First of all, we think it is important to avoid "the barbell effect” when structuring your income tiers. In other words, create a gradual increase in the income groups being served from very low to pure market, rather than just the two extremes. This can be challenging as that middle or "workforce" tier can be the hardest to finance since public resources don't easily support those units, and yet the rents don't pay the full cost of building or operating them. But having a strong moderate tier softens the disparity between low- and high-income households and allows lower-income people to remain in the community as their incomes rise. Second, it’s important to offer services to all residents who need them, particularly if you are offering housing to folks with special needs or who just need support in order to be successful tenants and otherwise take advantage of the great housing to strengthen other parts of their life.
What trends do you see emerging for mixed-income or mixed-tenant developments?
Shelburne: From a long-term perspective, the LIHTC program will be an important part of responding to the needs of extremely low-income households, particularly persons with disabilities. Those who say doing so was not the original intent have a point, although Sec. 42 makes clear serving the lowest incomes is a high priority. Regardless, the nations’ affordability crisis is most severe for those who have the least.
Another trend will start after enactment of the Affordable Housing Credit Improvement Act: income averaging. Since the legislation makes its use optional, there’s no way to know the extent to which owners will take advantage of the opportunity. Odds are very few allocating agencies will award points, at least at first.
Bates: The way pure market-rate housing most often gets developed is through a combination of debt and private equity invested by the developer or an equity partner in return for cash flow and other economic benefits of the transaction. In the LIHTC world, we get our equity through the sale of housing tax credits, and the cash flow may be fairly modest as the rents are restricted. But, in a mixed-income community you may have significantly more cash flow due to the market units, and it may be important to leverage that cash flow in order to make your numbers work.
For pure market-rate developments the cost of private equity capital can be quite high. Many in the industry are now looking for ways to raise private equity from sources who are willing to accept a lower return because they value the social impact of the investment. Those players tend to be Community Development Financial Institutions, foundations, or other socially motivated investors. We are also having conversations with a handful of LIHTC investors who may be willing to also invest in the private equity/cash flow side of the deal. This approach has some real advantages in terms of aligning the returns and timeframe expectations of the LIHTC and market-rate sides of the transaction. To me, this is an important area for innovation over the next few years among those who support the mixed-income approach.
