This article originally appeared on Affordable Housing Finance.
Increased construction costs and rising interest rates are among the sleep-stealing concerns going into the second half of the year for low-income housing tax credit (LIHTC) syndicators.
An escalation on either front could widen budget gaps and threaten to make already tight LIHTC deals even more difficult to pencil out.
These issues have been building over time, with no relief in sight. More specifically, construction costs increased for the 21st straight month in July, according to IHS Markit (Nasdaq: INFO) and the Procurement Executives Group, which note that steel prices in the U.S. are at or near peak levels, and labor costs continue to increase in all regions of the country.
The increased cost of construction and financing is one way that 2018 deals differ from those in 2017, says Mike Jacobs, senior vice president of originations at National Equity Fund (NEF).
To help, some states have issued state housing tax credits or other gap financing programs, report syndicators. “We’re also seeing a rise in the number of hybrid 4% and 9% credit combination deals in ones that are underallocated,” Jacobs says. “This creativity is good, but the added complexity makes deals much tougher to close.”
Rising interest rates and construction costs are creating problems for both newly allocated deals and deals that have closed on their financing but haven’t completed construction or met rental achievement, says Stacie Nekus, senior vice president, investor relations, at Alliant Capital.
One trend with properties in construction or about to enter construction is increased costs due to material price increases—some from trade-tariff market jitters—and labor shortages. This may lead to problems related to construction contingencies, placed-in-service deadlines, and the need to restructure financing, she says.
The good news is that there’s been an uptick in the Department of Housing and Urban Development’s area median incomes in certain markets, which may help offset the issues, according to Nekus.
“A significant rise in interest rates has been a topic of discussion since the 2016 election, and while there has been an increase in rates, most debt products have maintained historically low interest rates,” adds Robin Delmer, co-CEO and managing director of acquisitions at Monarch Private Capital. “If economic forces start to drive rates higher at a more rapid pace, then that could have a significant impact on 4% projects nationwide.”
Developments financed with 4% credits and tax-exempt bonds would be among the deals hardest hit by interest-rate hikes because they carry more debt than projects financed with 9% LIHTCs.
Other syndicators are also closely watching what happens with interest rates this year.
“The ongoing concern is the threat of interest-rate hikes in the coming months, which could lead to investor yield requirements being heightened,” says Anil Advani, executive vice president of originations and finance at WNC. “This would lead to a reduction in the pricing of deals.”
In the months ahead, developers should stay focused on closing deals by working closely with syndicators and investors. “Delays will be costly with increased interest expense and construction costs,” says Gayle Manganello, senior vice president at PNC Real Estate.
Life after tax reform
In addition to insomnia, many may also also suffer from a nervous stomach in the months ahead. Adding to the cost dilemma is lower housing credit prices this year, which make it harder for developers to cover rising development costs.
The average price per dollar of credit was about 92.5 cents in the second quarter of 2018, according to an affordable housing finance survey of syndicators. Yields to investors averaged about 4.7%.
In comparison, a year ago prices averaged about 95 cents and yields to investors about 5.4%.
A majority of syndicators (61.9%) expect LIHTC pricing to developers to hold steady in the second half of the year, while 28.6% expect to see a decrease. Just 9.5% say prices will inch up.
“Prices have been steady as investors are demanding minimum yields on their investments,” says Jeffrey Goldstein, COO at Boston Capital. “Margins have been reduced for all, given the increase in building costs. More credits being released in the second half of the year should help keep prices steady.”
Steve Kropf, president and CEO of Raymond James Tax Credit Funds, also expects prices to hold in the next several months. “The rising cost of capital for investors seems to have put a bottom in the market, but extreme competition for deals should keep pricing from declining over the near term,” he says.
However, if economic investors demand higher yields, that would require prices to drop. An increase in the interest rate would also contribute to lower prices, according to other syndicators.
Today’s deals are being done in a challenging post–tax reform environment. A year ago, many LIHTC deals were using a 25% tax-rate assumption. Now, they’re being underwritten at a 21% tax rate following the passage of the Tax Cuts and Jobs Act in December.
The tax legislation brought welcome clarity to the market this year. The bad news is that 2018 projects have become more complicated.
“Deals are taking a longer time to structure and close as the availability of project financing has deteriorated,” says Tony Bertoldi, executive vice president, syndication and investor relations, at CREA. “The additional stress of lower equity pricing and higher interest rates in conjunction with higher construction costs has forced developers to identify alternative financing sources, which extends the closing time lines. Additionally, many of these deals applied for credits under the assumption of a 25% tax rate, and the impact of transacting at an actual 21% tax rate is taking some time to work its way through the market.”
Despite some hefty concerns, the LIHTC market was still pretty active in the first half of the year after a rocky 2017.
“After the holding pattern that the industry was in as tax reform unfolded at year-end, investors quickly moved to action, and activity was fairly robust,” says Todd Jones, senior vice president, equity production, at Boston Financial Investment Management. “While uncertainty remained around certain aspects of tax reform and pricing had to adjust, it didn’t take long for investors to dial in and start executing on deals.”
The recent omnibus bill opened the door to a new income-averaging option, which allows LIHTC properties to include apartments serving households earning up to 80% of the area median income (AMI) as long as the average income/rent limit in the property is 60% or less of the AMI. Syndicators say the first deals are in the works but that more clarification is needed.
“While we like the concepts of flexibility and economic integration, the details will be challenging,” says Mark McDaniel, president and CEO of Cinnaire. “It will be extremely difficult for property management companies to monitor things and remain in compliance.”
It will be especially challenging for projects that have multiple buildings or are complex mixed-income projects with market-rate units, McDaniel says.
Enterprise Community Investment will evaluate and underwrite units using the income-averaging option like it does others, including looking at the demand for higher AMI units and comparing proposed rents to market rents, according to Scott Hoekman, senior vice president at Enterprise.
Syndicators cite other concerns as well, including the anticipated release of a Government Accountability Office report on project costs and possible changes to the Community Reinvestment Act (CRA).
“The potential reform of CRA is a hot-button issue for the LIHTC industry that took a back seat to tax reform this time last year but now should be top of mind,” says Jason Gershwin, senior vice president at R4 Capital. “Our industry has always functioned most efficiently with a balance of CRA-motivated bank investors and economically motivated corporate investors. If changes to CRA significantly reduce banks’ need for LIHTCs, it would have a major impact on our market.”
2018 MIDYEAR TAX CREDIT ACTIVITY
|Company||$ Closed in First Half (in millions)||LIHTC Projects Acquired in First Half|
|Boston Financial Investment Management||268.8||21|
|Community Affordable Housing Equity Corp.||53||18|
|Enterprise Community Investment||207.9||18|
|Massachusetts Housing Investment Corp.||57||6|
|Monarch Private Capital||27.5*||10|
|National Affordable Housing Trust||49||4|
|National Equity Fund||333||47|
|Ohio Capital Corporation for Housing||83||13|
|PNC Real Estate||212||26|
|Raymond James Tax Credit Funds||466||44|
|RBC Capital Markets||400||29|
|Red Stone Equity Partners||131||15|
|Regions Affordable Housing||90||12|
|The Richman Group Affordable Housing Corp.||210||16|