Understanding Affordable Housing Financing:
Bridging the Gap with Creativity and Strategy
Understanding Affordable Housing Financing: Bridging the Gap with Creativity and Strategy
Imagine two neighboring apartment buildings, each boasting 100 units with similar designs, amenities, and construction costs. The first is a market-rate property, where rents are set based on what the market will bear. The second is an affordable housing development, where rents are restricted by regulations to ensure they remain accessible to low-income families. While both buildings might cost $50 million to develop, their financial realities could not be more different.
As you explore this article, you’ll uncover the intricate balancing act developers perform to bridge these gaps, from leveraging tax credits to piecing together complex capital stacks. This journey not only sheds light on the economic ingenuity required but also reveals the profound societal impact these projects deliver.
The Impact of Restricted Rents on NOI and Borrowing Power
Restricted rents constrain a property’s revenue. Constraining this revenue reduces the property's Net Operating Income (NOI). This reduced NOI decreases the value of the property and constrains borrowing capacity based on two major lending metrics: Debt Service Coverage Ratio (DSCR) and Loan-to-Value (LTV) (To learn more about these concepts see my previous article).
For example, a market-rate property may have 100 units at a rental rate of: $5k per unit per month. With Operating Expenses of $12.5k per unit per year. This property produces an NOI of: $4,750,000. The value of this property at a 5.0 Cap is: $95,000,000.
This same property with an affordable restriction may restrict rents to $2k per unit per month. With Operating Expenses of $12.5k per unit per year. This property produces an NOI of: $1,150,000. The value of this property at a 5.0 Cap is: $23,000,000.
Assuming the 5.0 Cap Rate values for both properties above the difference in value is: $72,000,000 If a lender will loan 80% of the Value of the property it means affordable will need to additional sources to fill the gap.
This creates a significant funding gap between the property’s value and the total development cost. Once we understand the Gap created by debt, developers turn to innovative financing tools. The primary tool for affordable housing development, the Low-Income Housing Tax Credit (LIHTC) program helps to bring in critical low-cost equity for affordable housing developments.
Estimating Tax Credit Potential: Understanding LIHTC Basis
The LIHTC program provides a vital source of equity for affordable housing projects. Tax credits are allocated to each state by the federal government based on population. Each state then distributes its allocated credits according to priorities outlined in its Qualified Allocation Plan (QAP), which reflects state-specific housing needs and goals.
The Low-Income Housing Tax Credit (LIHTC) program offers two types of credits: 4% and 9%, each serving distinct purposes and operating under different competitive frameworks.
4% LIHTC credits are considered non-competitive and must be paired with tax-exempt bonds. They are often used for rehabilitation projects or developments with lower financing gaps. These credits generate less equity compared to 9% credits, covering around 30% of development costs. Since they are non-competitive, projects must meet specific threshold criteria but do not compete against one another for allocation, making them more widely accessible.
9% LIHTC credits, on the other hand, are highly competitive and are usually allocated through a scoring system established by state housing finance agencies. These credits are predominantly used for new construction projects or substantial rehabilitations and offer a significantly higher equity contribution, often covering about 70% of the development costs. Due to their competitive nature, securing 9% credits is difficult and uncertain, as developers must craft proposals that align with state priorities and score well in the allocation process.
Both credit types play vital roles in affordable housing development, but their application depends on the specific financial needs and project characteristics. Understanding their differences is crucial for effectively leveraging these resources to fill funding gaps.
The amount of credits available for a project is determined by the qualified basis, which includes eligible development costs associated with affordable units. These credits are often sold to investors, typically banks or syndicators, to raise equity for the project. Developers estimate the amount of credits a project will generate based on its qualified basis and calculate the equity raised by considering the market rate at which investors are purchasing these credits. This process helps determine the remaining funding gap, which must be filled by subordinate sources such as state or local programs, grants, or philanthropic contributions.
Bridging the Funding Gap
Once developers calculate the gap between total development costs and funds available from debt and LIHTC equity, they must identify additional funding sources to complete the project. This is where developers invest significant time and effort, navigating a complex landscape of funding opportunities. The process involves aligning various sources, each with unique regulations and requirements, to fill the financing gap.
Affordable housing developments often rely on 5 to 15 or more sources of capital, each contributing in different ways. These sources come with distinct closing orders and financing documents, all of which must be carefully negotiated and coordinated to ensure successful execution. This intricate layering process underscores the effort required to blend funding streams, meet regulatory demands, and achieve feasibility. The resulting capital stack reflects the developers' ability to manage these complexities effectively, allowing projects to move from concept to completion.
These often include:
Subordinate Loans: Provided by housing finance agencies or local governments, these loans are designed to fill funding shortfalls.
State and Local Funding: Many jurisdictions offer grants, tax-increment financing, Housing Trust Funds, or bonds to support affordable housing.
Federal Programs: Resources such as HOME funds, Community Development Block Grants (CDBG), or other funding that can provide crucial support.
Philanthropic Contributions: Foundations and nonprofits may offer grants or low-interest loans to advance affordable housing goals.
Why State and Local Governments Invest in Affordable Housing
State and local governments make subordinate financing available for affordable housing developments because these projects generate significant social and economic benefits. Affordable contributes to economically diverse communities, fostering environments where individuals from various income levels can live, thrive, and serve in the workforce for all levels of an economy.
Stable housing also supports family stability, improving outcomes in education and employment. Furthermore, studies have shown that access to affordable housing can reduce crime and public health costs by providing safe, stable living environments that allow people to recover post medical interventions, mitigate stress and improve overall well-being.
These benefits justify the investment in subordinate funding, as they reduce public costs in other areas, contribute to broader societal goals, and long-term community development.
Typical Financing Stack for a Development
For affordable housing developments, the financing stack varies depending on whether the project uses 4% or 9% Low-Income Housing Tax Credits (LIHTCs):
4% Development Financing Stack:
40% - 50% Debt: Senior loans supported by the project’s NOI.
30% LIHTC Equity: Generated through the sale of 4% tax credits to investors.
20% - 30% Subordinate Funds: Often from state or local government programs, grants, or philanthropic contributions.
9% Development Financing Stack:
10% - 20% Debt: Minimal senior loans due to limited NOI.
70% LIHTC Equity: Generated through the sale of highly competitive 9% tax credits, which cover a larger portion of the development costs.
10% - 20% Subordinate Financing: Supplemental funding sources like soft loans, grants, or other public and private contributions.
This typical capital stack reflects the critical role of LIHTC equity in bridging the significant funding gap created by restricted rents and limited borrowing capacity.
A Delicate Balance
The process of financing affordable housing requires a careful blend of strategy, creativity, and persistence. Developers must navigate restricted revenue streams, complex funding mechanisms, and strict compliance requirements. Yet, through careful planning and the strategic use of tools like LIHTC and layered funding, they can create housing that meets the needs of communities while overcoming significant financial hurdles.
Affordable housing is more than just a financial challenge; it is a commitment to building equitable communities. By understanding the intricacies of its financing, we take a critical step toward addressing the housing crisis and ensuring homes for those who need them most.
About the Author
Charles Sims is an affordable housing developer with 17 years of experience creating communities. He’s led projects nationwide, turning complex financing challenges into opportunities for impact. Charles is passionate about navigating the nuances of affordable housing, sharing insights, and pushing for equity-driven solutions that build stronger communities.