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Since 1986, a majority of affordable rental housing projects have been financed using the low income housing tax credit (LIHTC), which provides either a 9 percent or 4 percent credit against federal income tax liability. The proceeds from the sale of the tax credits to investors provide equity for the project. The 9 percent credit is viewed as more desirable because of its higher value, but there is intense competition to obtain the credit. The 4 percent credit produces less equity but is available without the need to compete for it if the project uses tax-exempt multifamily bonds.
For most projects, the combination of bank financing and tax credits still results in a budget gap. Historically, two federal sources — the Community Development Block Grant (CDBG) Program and the HOME Investment Partnerships (HOME) Program — have been widely used to try to close this gap. Both of these programs are administered by the United States Department of Housing and Urban Development (HUD).
Closing the funding gap has become more difficult in recent years. As more funding is being sought, two problems have arisen simultaneously. First, in many states the competition for the 9 percent tax credits now far outstrips the allocation of credits available. Therefore, many worthy projects are delayed for years and often fail to obtain credits. Second, HUD budget cutbacks have reduced the funds available to fill in the gaps.
Over the past eight years, most HUD entitlement jurisdictions have experienced reductions in their CDBG and HOME allocations. This is true in Lancaster County, Pennsylvania, as well as in other counties across the country. In 2004, Lancaster County received $4,057,000 in CDBG funds and $1,507,922 in HOME funds (see Figure 1). In 2012, Lancaster County received $2,508,661 in CDBG funds, a 38.2 percent reduction from 2004, and $834,992 in HOME funds, a 44.6 percent reduction from 2004 (see Figure 2).
In the past, the state of Pennsylvania was also an important source of gap funding. However, because of program restructuring and budget cuts, many of the state’s programs have been consolidated or eliminated, severely limiting funds available for affordable housing projects.
In response to the reductions in gap funding, Lancaster County is exploring the use of tax-exempt multifamily bonds with the 4 percent LIHTCs. The 4 percent credits are part of a current preservation project in which 376 affordable rental housing units in central Pennsylvania are being renovated as part of a $26 million bond transaction.1 The units are being renovated at an average total construction cost of $22,202 per unit. In this model, the higher number of units generated enough revenue to cover the debt service. However, for new construction, which has a much higher cost per unit, revenues are often not high enough to cover the debt service. Furthermore, the high issuance costs and other technical restrictions associated with the tax-exempt multifamily bonds make them difficult to use. In more expensive markets, developing mixed-income projects can solve the problem when revenues from the market rate units subsidize the lower rents of the affordable units. In Lancaster County, the difference between market and affordable rents is not big enough to fill the funding gap.
Lancaster County is exploring a strategy to finance as much of the project’s cost as possible, using tax-exempt bonds and 4 percent tax credits and then filling the remaining gap using a double bottom-line fund. A double bottom-line fund is a fund that provides some financial return and has a positive social, environmental, and/or economic impact on the local community. It is a vehicle for socially engaged investors to help the community while still receiving a return on their investment, albeit at reduced rates. The model has been used with varying degrees of success in several major markets nationally.2 Lancaster County is seeking to use the model as a vehicle to attract local institutional funds in a subordinate position in affordable rental housing developments. These funds will replace HUD funds that were lost to budget cuts.
The first step in this strategy is to achieve the lowest possible interest rate for the tax-exempt bond, enabling a larger bond to be issued based on projected operating revenues. In initial discussions, bankers have suggested that a lower rate could be offered if the bank could also buy the tax credits, thus blending its return on the debt and equity portions of the deal. However, purchasing the bond and tax credits within the same project compromises the tax-exempt status of the bond interest.
This problem may be solved if two projects were undertaken in tandem by two banks. Each bank would buy the bond for one project and the tax credits for the other, thus achieving the desired blended rate of return. If this succeeds, the final piece of the puzzle would be financing the final 20 percent of the project that exceeds the bank’s loan-to-value requirement. In the past, this was generally done using government funds. In this new model, the interest rate used for the bonds purchased by the bank would be low enough not only to accommodate the primary debt but also to support a small rate of return on a subordinate note to provide the gap funding. The result is a two-tiered debt structure, whereby formerly there would have been a single primary debt instrument supported by a subsidy in the form of grants or other soft funding.
Reductions in the traditional sources of gap funding for affordable rental housing projects lead to increased competition for the limited gap funding available. As a result of the increased competition, fewer affordable housing units are built and rehabilitated each year. Any long-term solution would most probably use local institutional capital as a source of funds. The challenge is to create a financing model that attracts local institutions to invest in affordable local housing projects using a double bottom-line investing model.