The affordable housing market could become too expensive for REITs and REOCs

Home Properties' St. Bernard's Park interior. [Click for larger image]

Gates Mill Villa formerly in Mayfield Heights, OH, is a popular senior citizens complex. Built in 1972, the 191-unit, eight-story high-rise offers a library lounge, picnic areas, a community room and a full schedule of social programs. Situated near a main thoroughfare in this middle-class, Cleveland suburb, the property is convenient to shopping, places of worship and bus routes.

Evergreen Hills in Macedon, NY, offers families garden-style living in a peaceful, natural setting. Family-friendly one- and two-bedroom units feature private entrances and patios and balconies with French doors. Located in a quiet suburb, Evergreen Hills is close to schools, daycare and a golf course.

These pleasant, well-maintained properties owned by Associated Estates Realty Corp., Mayfield Heights, OH, and Conifer Realty, the affordable housing division of Home Properties, a New York-based multifamily REIT, are targeted to seniors and young families. They are the new face of affordable housing today.

However, many real estate companies are beginning to look away from this growing market, because, they say, the profitability of affordable housing is eroding due to changes in the financial climate and a lack of government support.

A Widening Gap

According to a recent report from the Department of Housing and Urban Development (HUD), the gap between the supply of affordable units and the demand is steadily widening. The 1999 HUD report called the situation a "crisis in affordable housing." Even a cursory look at supply and demand data reveals that the crisis has been developing over several years.

The number of affordable multifamily units has been in decline for at least 10 years, due to a combination of demolition and the conversion of many Section 8 properties to market rate under the federal Mark-to-Market program. Meanwhile, rent increases are outpacing inflation, and the number of low-income households is growing. Seniors and single-parent families are two of the fastest growing subgroups, but low-income households also include many disabled individuals and families with low skill level wage earners.

New construction has not offset the changes. In fact, between 1999 and the end of 2000, rising interest rates will effectively prevent some 1,500 new affordable multifamily housing starts, a recent Wall Street Journal article reported.

Tax Credits Purchases

Many REITs have been in affordable housing since the 1960s when Section 8 began. However, since 1986, the introduction of the Low Income Housing Tax Credit gave REITs and other affordable housing owners an even more attractive program by creating a partnership between public and private financing. The tax credits have been a useful tool for helping to create profitability in the affordable housing market.

Fannie Mae, Washington, D.C., the largest private sector provider of multifamily financing, is an active player in tax credit purchases. The company buys tax credits at a discount through investor funds such as the Enterprise Fund and the Richmond Group that hold or sell them.

Fannie Mae's main product for REITs is a credit facility that can be structured with a fixed or variable rate to meet the REIT's needs. With this product, Fannie Mae has assisted 18 of the top 20 multifamily REITs with rehabilitation, new construction and refinancing, says Carolyn Elakely, who heads Fannie Mae's structured transaction group.

"We are interested primarily in loans of $50 million or greater, which is typical for REITs," says Elakely. "We essentially create one loan with multiple collateral that can change over time. We try to work with the business strategy the REIT has set for the next five to 10 years."

In 1994 Fannie Mae pledged to invest $1 trillion in affordable housing by the end of 2000. The company met that commitment April 30, eight months early. For 2000 Fannie Mae plans to invest $15 billion, 95 percent of which will be for affordable housing, with about $4 billion of that total targeted to REITs.

Freddie Mac, Tyson's Corner, VA, newer and smaller than Fannie Mae, has a $17 billion multifamily portfolio that is 90 percent affordable housing. Through its 27 ProgramPlus lenders, Freddie Mac offers a half dozen products for REITs.

Like Fannie Mae, Freddie Mac supports affordable housing with a tax credit purchase program, negotiated transactions for creation of a credit facility and a conventional mortgage purchase program. The company also offers bond credit enhancement, rate-reset mortgages, second mortgages and participates in government-sponsored senior and assisted living projects.

Fannie Mae and Freddie Mac are doing all they can to enhance the financing for affordable housing through their secondary market activities. But the primary lending situation remains a substantial problem.

There is no doubt that REITs are feeling the crunch of higher interest rates. "It hurts," says Richard Crossed, president of Home Properties' affordable division. "There isn't enough money for subsidies, and the federal government is decreasing the amount of money available, so it's hard enough to create and maintain affordable housing, even without rising interest rates."

Tax credits are not indexed to inflation, so they have not changed since the program was started. As interest rates climb, tax credits are less appealing to investors, which makes them less saleable.

Affordable housing developers cannot pass higher borrowing costs on to tenants because tax credit eligibility requirements dictate rent levels. As a result, affordable housing developers are often stymied in their search for affordable capital for new projects that can maintain their tax credit eligibility.

Still Affordable for Owners?

The changing financial and economic conditions are causing many REITs to rethink their affordable housing position, says JoAnn Hirsh, vice president of operations for Associated Estates, a multifamily development and management REIT. The REIT has a long history of involvement in affordable housing. The real estate investment and management company of the same name that preceded the public REIT started developing affordable housing projects more than 35 years ago, at the start of the Section 8 program.

"At the time affordable housing seemed to be an opportunity for the company to grow," explains Hirsh. When the company became a public REIT in 1993, management decided to hold onto some of the properties, aging though they were.

Associated Estates currently owns 15 affordable properties and manages another 17, making up less than eight percent of Associated Estates' portfolio and contributing about eight percent of Funds From Operation (FFO). All of Associated Estate's affordable units are senior apartments and are located in the metropolitan Cleveland and Akron areas.

When Associated Estates got into affordable housing, "It was a good deal, especially during times of recession," says Hirsh. "Not only were you keeping your employees working, it was helping the community."

Times have changed, she says. "Affordable housing development used to be a lucrative business, but it no longer is."

The last time that Associated Estates developed an affordable project was in 1981. The last time the REIT acquired and rehabilitated a property as affordable housing was 1987.

Hirsh describes Associated Estates affordable portfolio as "low risk, with a stable, steady stream of income," but no growth.

That is not in keeping with Associated Estates' current business strategy. "Our president says we either grow a business sector or get out of it," she says. "That applies to affordable housing—if we can't grow it, we'll exit."

Considering the age of the REIT's affordable portfolio and changing market conditions, there can be only one logical approach for Associated Estates to increase revenue from affordable housing. Hirsh, who openly states that Associated Estates is not interested in new development or ownership, is shifting the focus to expanding its fee management business.

Company president Louis Vogt has charged Hirsh with growing the affordable business, and she is actively seeking properties in need of a solid management team. The ideal candidate would be a property that is basically sound but experiencing management problems and low FFO.

Associated Estates has considerable experience in successful property management and is known throughout the industry for low turnover and low vacancy rates. As it does with its present affordable management portfolio, the REIT will hold any additions to the same strict standards it applies to market rate properties, says Hirsh.

In contrast to Associated Estates fee management growth strategy, Home Properties, a multifamily REIT, has been involved in a proactive affordable housing development strategy since 1995.

Home Properties' St. Bernard's Park front entrance. [Click for larger image]

Home Properties was created in 1995 by the merger of Home Leasing and Conifer Development, a private affordable housing developer. Through the Conifer division, five percent of Home Properties' portfolio of 45,000 units is affordable housing. Between 1995 and 1998, Home Properties development fee revenues grew by 52 percent and management fees by nearly 400 percent. Much of that spectacular success was due to development acquisition and rehabilitation using tax credits.

Creating and managing that level of growth has not been easy. "Making affordable housing development profitable has been a challenge," says Richard Crossed, president of the Conifer division. "There really is no advantage to being a REIT in affordable housing."

To make the affordable housing equation work, Home Properties participates as a general partner in projects with Conifer and makes loans as needed to close the gap in financing between tax credits and the actual cost. Conifer, which is not a REIT, can participate in the tax credits. Meanwhile, Home Properties earns a percentage of the development fee for writing the loan to Conifer.

The second part of Home Properties' affordable housing success formula is the configuration of the properties themselves. "What makes it viable for us to do affordable housing at all is that our developments are a mix of affordable and market rate housing," explains Carrie Senefelder, with Home Properties investor relations group. "As long as we meet the standards for the tax credit program as far as percentage of residents who must be at or below 30 percent of median income, the other units in a development can be market rate."

The mixed development concept has worked well for Home Properties, fueling a nearly 50 percent increase in stock price between 1992 and the present. And the company's thoughtful approach to the affordable market has earned the REIT several prestigious awards from the affordable housing industry.

Even so, Home Properties has had to overcome significant barriers to developing affordable housing. "It's the 'not in my backyard syndrome,'" says Senefelder. "Everybody thinks affordable housing is great, as long as it isn't near them. There are still a lot of stereotypes about affordable housing to overcome."

St. Bernard's Park in Rochester, N.Y., a newly constructed senior housing project built with tax credits, exemplifies how skillfully Home Properties negates community concerns about the density and aesthetics of affordable housing. Built on the grounds of a former seminary, St. Bruno's preserves a park-like setting and does not intrude on the community's existing landscape.

"We often end up using old private schools or old seminaries for redevelopment," says Senefelder. "These types of properties overcome the stereotypes and prejudices many communities have about affordable housing and satisfy the community's desire to maintain green space." Occupancy rates at Home Properties' affordable properties range from 93 percent upward.

Although the affordable group has served Home Properties well, its useful days may be numbered. Like Associated Estates, Home Properties is re-evaluating its position in the market.

One consideration is the changes in SEC requirements for management fee reporting. Another is the imbalance between the size of the affordable portfolio and its performance in terms of Home's FFO.

Home has poured substantial management time and expertise into the properties in the Conifer division and has been rewarded by the affordable group's phenomenal growth. The down side of that commitment, however, is that affordable housing now makes up five percent of Home Properties' portfolio, but it generates just two percent in FFO. All things considered, "this is the right time to sell," said Senefelder. "The sale of Conifer will give both the REIT and Conifer better opportunities to access capital and reach their full growth potential."

Gates Mills Villa.

Conifer's profitability is "excellent," said Senefelder. External conditions such as HUD's plans to stimulate affordable housing growth also favor the Conifer sale at this time, she added.

Another REIT involved in the affordable housing market, Denver, CO-based Apartment Investment and Management Co., (AIMCO) was preparing to drop its Foxchase of Alexandria apartment complex from HUD's Section 8 affordable housing program, until the agency offered to raise its subsidy through the Mark-up to Market program. This 5-year program was instituted last year as a way to encourage owners to stay in the Section 8 program after the Mark-to-Market program failed to keep up with conventional market rents. This program starts at market rents that are raised annually based on HUDs Operation Cost Adjustment Factor. However, those increases, based on HUDs method, have stayed between two or three percent annually, which owners say will not keep up with the market.

"One of our issues with the program is that in a one year period, rents will fall behind," said Bruce Terwilliger, senior vice president, AIMCO. "HUD has to be more realistic with rent adjustments."

He also noted that HUD should offer owners alternatives in the term of the program. "If they shorten that five-year period we would have more flexibility," he said. When originally purchased 20 years ago, the 2,113-apartment complex, with 423 affordable units, was renovated with a $76 million loan from the Virginia Housing Development Authority that obligated the landlord to provide Section 8 housing until November 2000. Financing such as this and mortgage finance through HUD limits cash distributions to owners and forces them to put most of the money back into the property.

"That's why owners say it doesn't make sense to own one of these properties, unless you're a non-profit," said Terwilliger.

A Specialty REIT Finds Opportunities

If owners decide to sell, the Community Development Trust, New York, NY, may want to buy. CDT, the only private REIT devoted exclusively to affordable housing, started last summer with $29 million in capitalization. Its purpose is to help create a larger capital base to enhance borrowing for affordable development. (See Real Estate Portfolio, "Win-Win", July/August 1999) CDT plans to purchase mortgages on community development projects, including multifamily affordable housing. By targeting loans that are under $3 million or larger loans that do not meet Fannie Mae or Freddie Mac requirements, CDT hopes to carve its own niche in the secondary market.

CDT made its first mortgage purchases in fourth quarter 1999, slightly behind projections, says John Divers, chief financial officer. "Rising interest rates last year slowed down our progress somewhat in the mortgage purchase area, but we have made several small purchases," he says.

He adds that CDT has access to sources of capital, such as state housing agencies, that are not available to public REITs. In addition, CDT is supported by banks and insurance companies that are required to make Community Reinvestment Act investments. As a result, says Divers, "Rising interest rates have not completely shut us out of the market."

On the equity side, the REIT offers an exit strategy for Section 8 owners with expiring contracts or other owners wishing to sell their subsidized affordable properties. CDT is structured as an UPREIT so it can offer property owners a tax-deferred solution and preserve affordable housing by exchanging operating partnership units in the REIT for property.

CDT does not subscribe to the belief that affordable housing and profitability are incompatible. "We continue to see opportunities in this marketplace if you have patient capital," says president and chief executive officer Judd Levy. "Community Development Trust is committed to preservation of affordable housing. Our investor base is interested in the long-term performance of their investment, and we are not subject to the same pressures that a public REIT may face."

Federal Legislation

Levy does not deny the need for an expanded federal program to assist affordable housing. "The crisis in affordable housing is that Congress has not developed a new program in years, and the number of low income people is not decreasing," he says. Last year, legislation to increase the per capita on the tax credit from $1.25 to $1.75 passed Congress but was vetoed by President Clinton as part of a larger tax bill. If passed, it would have allowed states to finance about 25,000 to 30,000 more units each year. It also indexed the tax credit to inflation by a nickel, an important precaution against rising interest rates.

The tax credit increase is now included in a House minimum wage-tax package that is awaiting House and Senate conferencing. The proposed increase is gaining broad-based support, although it is not included in the current Senate version of the package. Supporters are hopeful that the tax credit increase will be included in the final version when it is returned to Congress for approval before being sent to the President.

Without this type of legislation many of the companies that are currently in the affordable housing market may be forced to abandon it as unprofitable. That would not be good for those in need of housing and could end up costing taxpayers more in the long run, if direct government run housing becomes the only alternative.