18 MONTHS OF WAITING, Patrick McNerney was no closer to getting his construction loan.

In early 2009, the developer submitted an application to the Federal Housing Administration (FHA) for a $50 million loan to build Portrero Launch, a 196-unit development in downtown San Francisco. But a year and a half later, the FHA suddenly stopped processing the application.

McNerney's firm, Martin Building Group, was building another project with FHA funds—a loan that took 20 months to close—and the agency wanted to see how that project performed before approving another deal with him.

Frustrated, and unable to find conventional bank debt, the developer went back to the drawing board. Though the plan all along was to build a luxury Class A deal, McNerney instead applied for tax-exempt bond financing—which came with low-income housing tax credits (LIHTCs)—and easily won an allocation.

“Within 60 days, I had a loan approval from Citibank, which felt miraculous,” McNerney says. “And the reason they moved so swiftly was because it was now a tax-credit project, and the bank wanted Community Reinvestment Act [CRA] credits.”

The use of tax-exempt bonds requires the developer to set aside 20 percent of the units for those earning up to 50 percent of the area median income (AMI), while the other 80 percent remain market rate (aka, an “80/20” deal). And while McNerney believes in the social value of mixing incomes, it wasn't as though he was on a social mission.

“I'd love to say it was altruism,” he says, “but I was really just struggling to attract financing.”

Meanwhile, down in Southern California, that same struggle inspired market-rate developer Bill McGregor to pursue a similar strategy on his own long-delayed project.

In January, the McGregor Cos. broke ground on the $160 million One Santa Fe, a 438-unit mixed-use development in the arts district of downtown Los Angeles. The project was conceived seven years ago, but the recession derailed that vision and prodded the developer to use taxexempt bonds for the first time in his company's 25-year history.

“Securing a construction loan was proving to be somewhere between extremely difficult and impossible,” says McGregor. “As we got further downstream, it became clear that the best financing package we could put together would have affordability inherent in it.”

The developer received funds through the New Issue Bond Program, and the bonds were credit-enhanced through an $86.2 million FHA-backed loan. McGregor also received LIHTCs, which provided roughly $8 million in equity when they were purchased by Goldman Sachs Urban Investment Group.

“It's more complicated than the average deal by far,” says McGregor. “But this project would not be where it is today were it not for the opportunity to put together an 80/20 deal.”

McNerney's and McGregor's mixed-income approaches offer a possible solution for all of the market-rate developers out there struggling to attract construction capital. While borrower scrutiny is at an all-time high, sometimes serving a public purpose—even in just 20 percent of your building—is as important to a financier as dissecting every last line item on your bank statement and real estate–owned (REO) schedule.


The construction financing market has come a long way since the depths of the Great Recession, but not far enough for market-rate developers like McNerney and McGregor. Lenders continue to target only the surest bets—backing only the most well-heeled developers— and balk at almost everything else, still shell-shocked from a downturn that ravaged their balance sheets.

“It's a tale of two markets; everyone is taking a very conservative approach,” says Charles Halladay, a director in the Irvine, Calif., office of brokerage firm HFF. “If you're the right kind of borrower, you're going to get five lenders bidding on the deal, and if you're outside the strike zone, you're going to see a lot less interest.”

When banks and life insurance companies dropped out of the market during the recession, the FHA found itself the most popular game in town, which overwhelmed the former “lender of last resort.” The agency has always taken its time, and its molasses-slow pace was one of the most glaring examples of how differently it functioned from the private sector. Yet, even the FHA, whose programs stayed the same for decades, made some changes during the downturn to the way it assesses a borrower.

“HUD became much more prescriptive as to who the principals were that they want to look at and the information they want you to collect,” says Ed Tellings, FHA chief underwriter for Columbus, Ohio–based Red Mortgage Capital. “In the old days, you wouldn't be collecting REO schedules, but you are today. And HUD also established some new liquidity requirements of those principals.”

So, scrutiny is at an all-time high. But here's the thing: Banks are under regulatory pressure to lend on affordable housing deals and will often fight for the few tax-credit deals in their market to fulfill CRA requirements. Meanwhile, the FHA has refocused on serving the LIHTC market much more than it has in the past—in March, it opened a new program meant to streamline the processing of tax-credit deals. So, why not play to that desire?

“A mixed-income deal offers a better story,” says McNerney. “HUD loves it, and banks love it too.”

That's not to say that tax-exempt bond financing is a panacea—there's no such thing as a free lunch. Developers must consider several factors before taking the 80/20 plunge.

Federal laws governing the use of tax-exempt bonds require all the units, not just the affordable ones, to remain rentals for at least 15 years. Some states impose a longer time frame, such as California, where the affordable units must stay affordable for 55 years. And many local bond issuers have their own requirements governing the location and size of the affordable units.

But if the choice is between dealing with those requirements and not being able to attract financing, the decision is a no-brainer.


Sometimes, it's only a stone's throw to get to that 20 percent affordable set-aside. Many municipalities already have inclusionary zoning laws, which mandate that a percentage of all apartment buildings be set aside for affordable housing. In San Francisco, that requirement is already 15 percent, which developers can satisfy either within the building itself or off site in a separate structure.

“There are additional incentives to doing it on site, the biggest one being the LIHTC,” says McNerney.

While arranging a capital stack that includes LIHTCs and tax-exempt bond credit enhancements adds complexity—and time—to the process, other factors can expedite things. Municipalities are often more inclined to give the green light—and offer additional incentives—to a deal that serves a public purpose.

“If the public policy is pushing you in that direction in any event, you're going to have to deal with it one way or another,” says Bill Witte, president of Irvine, Calif.–based developer Related California. “Manhattan, for instance, gives a 10-year property-tax exemption if 20 percent of the units are affordable. So oftentimes, communities will provide incentives, and developers will then look to the bond program.”

The Related Cos. has developed nearly two dozen 80/20 deals and worked with many municipalities in its 40- year history. But sometimes even the full cooperation of a city can't trump trends in the capital markets.

Related broke ground in February on the $350 million Village at Santa Monica, a 318-unit mixed-income development that utilizes 4 percent LIHTCs and tax-exempt bonds. When the developer won the request for proposal in 2006, it was given affordability parameters by the city: Roughly half of the 318 units had to be affordable. To make the deal work, the company decided to develop the other half as highend condominiums.

“At the time, for-sale housing was literally riding into the boom, so the residual land value for condominiums was much greater than for apartments,” says Witte. “The way to make this project work financially was to pay the city for the land in a sufficiently large number such that they could take the proceeds to subsidize the affordable units.”

But that decision set them back. Scoring the tax-exempt bonds was the easy part; finding construction debt for a condo project remains a wild goose chase. As recently as last October, Witte was still having a hard time finding a condo lender. But the company finally found a 65 percent leverage loan from Wells Fargo and HSBC, with 35 percent equity coming from the development team—a capital stack that was impossible two years ago, when the company was raring to break ground.

“The recession probably cost us a couple of years,” says Witte. “But that's a very good deal in today's world for condominiums, if you can fi- nance them at all.”

Related hopes to sell the condos for upward of $800,000 when they come on line in 2014 and is confident that such a price can be achieved in a high-cost seaside area like Santa Monica.

“From a financing point of view, mixedincome works best in very strong markets—the higher the rent, the easier it is to work financially,” says Witte. “By contrast, a working-class neighborhood—where the tax-credit rent and market rent are relatively close—doesn't work very well.”


Affordability not only attracts construction capital and municipal support, it's also useful in finding gap financing.

McNerney's $80.4 million Portrero Launch is set to open in September—but when it does, the affordable units will serve even lower-income tenants than the 80/20 program requires. The developer applied for a $7.4 million Infill Infrastructure Grant through California's Proposition 1C program, and that money only goes to affordable housing deals—the more deeply affordable, the more likely to win a grant.

“I volunteered to set units at 30 percent AMI so that there was a higher likelihood of getting the award,” says McNerney. “I pieced together every source possible that I could in order to make this project move forward.”

McGregor's One Santa Fe also found some gap financing by virtue of its affordability. The developer scored a $4 million loan from the Los Angeles Housing Department, though the financing was conditional. The loan required two-thirds of the affordable units to be targeted at those earning up to 40 percent AMI.

“That $4 million was one more piece of a complex puzzle, and the fact is, each one of those pieces in the capital stack was critical,” says McGregor. “If you pulled any of the pieces out, then the whole thing doesn't work.”