Love Won’t Pay the Rent: Structuring Long-Term Affordable Housing

The current crisis regarding "expiring use" or "prepayment" HUD buildings is an historic example of myopic housing policies coming home to roost. More than 20 years ago, the U.S. Department of Housing and Urban Development (HUD) subsidized private owners who agreed to provide affordable housing for low-income tenants. However, a glaring loophole allowed these owners to prepay their HUD mortgages, escaping further rental restrictions. This option has created a crisis of Northridge proportions for those tenants who experienced significant rent increases once the prepayment occurred. The federal government responded with a new HUD program to buy the units back from owners in order to maintain their affordability. In other words, additional government subsidy was necessary to preserve affordable housing which was built only 20 years ago. 

The lesson of this program is that to avert future crises of affordability, housing programs need to consider the long-term needs of both projects and community-based development entities. This has already happened to the extent that most government agencies require 50 year regulatory agreements in order to access their funds. However, these regulations notwithstanding, many of these projects are incapable of maintaining long-term fiscal health. 

To date, projects and programs continue to be financed despite the fact they have long-term structural problems and could well create their own historic crises in the next century. For example, many projects are underwritten with subsidized interest "write downs" which expire in 10 years. These write downs allow non­profit developers to pay below market interest rates as low as 5%. Yet after 10 years, an interest rate of 5% will not only lose its subsidy but it will be adjusted for changes to the borrowing index. These projects could see interest rates increase to their cap rates of 10-12% in year 11 with very little amortization having occurred in the first 10 years. If a project could only afford a 5% rate in year 1, can it afford a 12% rate with almost the same principal balance? Such a project may need to be bailed out in the eleventh year to avoid foreclosure.

Furthermore, many cash flow assumptions include optimistic income increases of 3-4% per year. This is a critical assumption because rental income needs to increase proportional to higher operating expenses, taxes, insurance and utility payments in order to maintain the long-term health of the project. For instance, a one-bedroom apartment charging a monthly rent of $400 today will need $487 in 5 years assuming a 4% increase. If the unit is required to be rented to a tenant in a specific median income group (such as households at 60% of median income), such a household may not be able to afford the higher rent in 5 years. In fact, many of the programs intended for "very, very low-income" households are rented to tenants on government assistance who have seen their incomes decrease each year. And it does not appear these incomes will increase in the foreseeable future. 

STRUCTURING LONG TERM AFFORDABILITY 

This potential overestimation of income means that in future years, expenses could exceed income in the cash flow curve. For the many projects with barely any cash flow today, it will be a long 50 years. 

Another problem could exist when non-profit developers want to purchase their properties at the end of the 15 year tax credit cycle. For example, syndicated tax credit projects are owned by limited partnerships with the non-profit groups as general partners with a 1 % ownership interest. Many deals are structured so that the non-profit has the first option to purchase the building from the limited partnership in year 15 at the completion of the tax credit compliance period. However, when the non-profit purchases the property from the limited partnership, the sales price is calculated at the existing debt. If the debt on the project increases due to deferred interest payments (which is typical with many public lenders), and the tax basis decreases through depreciation, there could be a substantial capital gains tax as a result of the sale. No one is sure what will happen in the likely event that neither the non-profit nor the project's reserves have sufficient funds to pay the tax liability. But numerous projects will face a tax problem when attempts are made to transfer properties from limited partnerships back to the non-profit developer.

Finally, in the case of many non­profit developers, the management of low-income apartments does not pay for itself. After the management company has been paid, as well as debt service, operating expenses, and reserve deposits, there is insufficient income remaining to pay for the developer's own overhead including an asset manager, in-house bookkeeper, 

or case manager who provide required reporting or services for the limited partnerships.

LONG TERM MANAGEMENT 

Developers do receive fees at the completion of construction for successfully developing projects within budget, provided the projects received tax credits. However, the unhealthy ratcheting process which evolves is that non-profit developers who cannot afford to manage their projects will develop more units to subsidize their management personnel. But each development only creates more units to manage, which in turn creates more desperate needs for developer fees. (This situation is not helped by the L.A. Housing Department's recent funding guidelines which have reduced developer fee payments as a cost control strategy). 

This would not be a crisis in and of itself if there were unlimited sources of financing for affordable housing. But with the recent decreases in available State and Redevelopment Agency funds, fewer projects are being built. In other words, non-profit organizations with increasing appetites will be competing for a shrinking pie. 

If many of these organizations can no longer afford their own overhead while they are managing affordable housing, the tax credit investors may substitute new general partners to oversee the real estate. Such an eventuality would not be horrible (provided the entity maintained decent, safe and sanitary housing with low rents), but it would be a far cry from the community-based management currently envisioned.

AFFORDABLE SOLUTIONS 

However, there are numerous underwriting modifications which public agencies and limited partners investing in tax credits could undertake to make these projects look more like assets, and less like liabilities. For instance: 

1. A long term approach to the health of an affordable housing project should require conservative assumptions for rental income, reserve deposits and private financing. Maximizing private debt and underestimating operating expenses in the underwriting phase will only leave these projects without any healthy cushion in the future. But agencies will continue operating this way to reduce the subsidies disbursed. 

2. Payments to the property owners for management oversight should not be the last priority after debt service and interest payments to public lenders are disbursed. In fact, in the recent guidelines developed by the Los Angeles Housing Department for the latest round of funding, no line items are built into the operating budget to help subsidize the non-profit's ownership costs. Underwriting methods need to change so that ownership fees to non-profits are considered prior to calculating the amount of private debt a project can afford. Of course, this is not done because it would result in less private financing and more gap financing by public agencies.

3. All agencies require annual audits for each project regardless of whether they contain 10 units or 200 units. These audits significantly increase operating expenses and should only be required as the exception, not the rule. There are also less expensive audits which could be required such as a third party review.

4. Enormous time and energy is spent submitting reports and budgets to different government agencies and limited partners, and of course, they are all different. These agencies need to standardize one set of forms among themselves to maintain some semblance of sanity in reporting.

5. Required annual recertification of existing tenant's income is also expensive and burdensome. Perhaps it could be required ever 3-4 years with the possibility of annual recertifications if problems arise. 

It should also be understood that these long-term problems arc project-based and could not fare any better in the hands of for-profits developers. The same issues of income, expenses and cash flow would apply. 

Unfortunately, there is no adequate historical comparison to be made with affordable housing projects built more than 10 years ago. Most of those publicly financed projects developed used Section 8 certificates which guaranteed low tenants rents and high income streams. Most projects built today do not have Section 8 certificates at their disposal (and those that do are not guaranteed beyond 5-10 years). Several non-profit organizations which have been developing non­Section 8 for more than a decade, such as Community Corporations of Santa Monica and the SRO Housing Corporation, depend upon significant organizational operating subsidies to fund their overhead and property management. 

So while non-profit developers are committed to neighborhood based development with strong tenant participation and supportive services, they know their love can't pay the rent, as Sonny and Cher once sang. The rules of the game need to change before it's too late.