Spiking interest rates can impact low-income housing tax credit deals in a number of different ways.
Most notably, higher rates can make borrowing debt more expensive and reduce loan proceeds, putting increasing stress on development budgets.
“First, with short-term rates anticipated to rise further, and with construction financing typically taking the form of floating-rate debt, both we and construction lenders are requiring higher underwritten construction period interest to be carried in development budgets,” says Stephanie Kinsman , managing director, investor relations, at Red Stone Equity Partners. “Second, with the cost of long-term debt also on the rise, projects are able to leverage fewer permanent hard debt proceeds. To help limit interest rate exposure, we are encouraging our developer partners to purchase a cap or fixed interest rate on variable-rate construction debt where it makes sense and to also pro forma the deal with a cushion in the permanent interest rate until closer to closing when it can be locked.”
The rates, which are expected to rise even further this year, can have other effects on housing credit transactions.
“As investors start to recalibrate IRR (internal rate of return) hurdles, we anticipate a sustained higher rate environment may begin to create a drag on equity pricing thus resulting in more strain on development budgets,” says Todd Jones, head of production at Boston Financial. “The availability of state, local, and other financing sources to fill the development gaps will be increasingly more important.”
Others also cite the potential for equity pricing to be affected.
“In addition to the stresses on development budgets at the property level, syndicators that utilize bridge credit facilities in their multi-investor funds will bear increased costs, and it will be more expensive to deliver higher yields to investors,” says Tony Bertoldi, co – president of CREA. “If both yield expectations and the cost to deliver yield to the investors both continue to increase, there will be more downward pressure on pricing to developers.”
The Federal Reserve raised its key interest rate by 0.75% in September in an effort to curb inflation. It was the fifth hike of the year, and the third consecutive three-quarter point increase. That means the Fed’s benchmark interest rate is around 3% to 3.25%, with expectations that it will exceed 4% by the end of the year.
Syndicators and lenders have been “building in lots of cushion to try and account for the rising rates,” says Amy Dickerson, managing director, investor relations, at Hunt Capital Partners. “The two have not been historically tied, and we don’t think they will be during this time. If we all want to continue to have projects coming on line to meet the community needs, equity pricing will need to play its part along with additional credits and soft loans.”
The effects of inflation are seen in the LIHTC industry mainly in higher construction and operating costs at developments.
“Regarding construction costs, we are optimistic that the worst is now behind us and that prices on construction-related materials will begin to stabilize over the next several months,” Bertoldi says. “Investors are prioritizing having fully bid-out construction contracts as close to closing as possible to minimize this pricing risk and are placing more emphasis on the bonding requirements of general contractors or major subs to ensure the builders have financial wherewithal to deal with cost fluctuations or overruns.”
Operating expenses are also being reviewed. “We are looking closely, as part of our deal review, at the property management fees but also the utility costs, real estate taxes, and other management-related costs that all seem to be creeping upward,” says Christina Tracy, director of investors relations at the National Affordable Housing Trust.
Developers should be prepared for investors to do enhanced stress testing for construction cost overruns and delays and for operating expense escalation, according to Elizabeth Hibbard, director of capital development at the Massachusetts Housing Investment Corp.
Equity Pricing and Market Concerns
The average price paid per dollar of credit averaged 88.9 cents in the recent second quarter, according to an Affordable Housing Finance survey of syndicators. That’s up from the 85 cents average seen in the fourth quarter of 2021.
Yields to investors averaged 5.11% in the second quarter, close to the 5.17% average at the end of last year. A good majority, 71%, of the 21 LIHTC syndicators surveyed in August expect credit pricing to developers to hold firm, while 29% expect prices to hold or dip in the second half of this year. No syndicator predicted an increase.
“Overall, we expect LIHTC pricing to remain relatively stable during the second half of 2022,” says Jason Gershwin, executive vice president at R4 Capital. “Although developers on certain projects are seeking higher credit prices to help offset increased costs, and we have seen highly competitive bidding in certain markets causing pricing on those properties to increase over levels we saw in 2021, we nevertheless expect LIHTC investors to demand investment returns that are similar to those delivered over the past 12 to 18 months, which should hold pricing steady.”
Budget gaps will continue to be an issue as deals push to get to the closing table before the year’s end.
“We are concerned about the number of properties that will be financially viable in the absence of state, local, or other subsidies,” says Boston Financial’s Jones. Many transactions are submitted for application based on then-current market assumptions, and many of those assumptions may be materially different by the time such properties are awarded LIHTCs. That’s why it will be crucial for developers to work with experienced development and financing teams who will collaborate to identify solutions in those situations.”
The worry is getting deals that work for all parties to the closing table and the impact this may have on total affordable housing production, adds CREA’s Bertoldi.
“We are also concerned that pools of available relief funds at both the state and federal level may be depleted and that if costs and interest rates continue to rise, there may not be sufficient sources for deals to pencil,” he says. David Leopold, senior vice president and head of Berkadia Affordable Housing also cites budget gaps as an issue, with some deals potentially getting pushed into next year.
“Additional delays in 2022 transactions will carry forward to 2023, impeding investors’ ability to sign up new deals until they clear existing pipelines,” he says.
Several LIHTC syndicators are also worried Community Reinvestment Act (CRA) reform could have a negative impact on the market.
“As a nonprofit syndicator who works exclusively with CRA-motivated investors, CRA reform is at the top of Merritt’s watch list,” says Ari Beliak, president and CEO of Merritt Community Capital Corp. “If adopted as proposed, the loss of a separate investment test is expected to dramatically reshape the LIHTC landscape. When we turn the LIHTC market from CRA-driven to a profit-driven, we may deal a debilitating blow to great organizations doing much more than providing an economic return. Specifically, nonprofit syndicators, like Merritt, that dedicate substantial resources to supporting the broader needs of low-income communities and the affordable housing industry may be hurt.”
Although final changes have yet to be determined, others also cited concerns that CRA reform could potentially reduce investor appetite.
“Banks make up about 75% of the tax credit equity market, and if we reduce the incentive for banks to participate, we’ll undoubtedly see less private investment in affordable housing,” says Julie Sharp, executive vice president at Merchants Capital.
In addition to being asked about their concerns, syndicators were asked to share what they are optimistic about in the months ahead.
A few LIHTC leaders, including Sharp, are hopeful that the Internal Revenue Service will provide revised guidance that will allow more deals to use the “average income” set-aside.
“I am also optimistic about an infusion of State and Local Fiscal Recovery Funds permitted under the American Rescue Plan Act (ARPA),” Sharp says. “The recent Treasury guidance with respect to using long-term loans as a mechanism to deploy ARPA funds to support LIHTC transactions has been a game-changer that will get many projects off the sidelines and back into closing.”
|Company||$ Closed in First Half of 2022 (in Millions)||Projects Acquired in First Half of 2022|
|Aegon Asset Management||200||9|
|Berkadia Affordable Housing||15.5||1|
|Enterprise Housing Credit Investments||457||29|
|Hunt Capital Partners||71||12|
|Massachusetts Housing Investment Corp.||46||7|
|Merritt Community Capital Corp.||161.3||8|
|National Affordable Housing Trust||66.8||5|
|Ohio Capital Corporation for Housing||27.7||14|
|PNC Real Estate||483.2||39|
|Raymond James Affordable Housing Investments||618||45|
|RBC Community Investments||452||26|
|Red Stone Equity Partners||643.9||44|
|Regions Affordable Housing||269||20|
|The Richman Group Affordable Housing Corp.||310||21|
|Source: AHF Survey, August 2022|