You've heard of affordable housing development, but you're not sure if it's for you.
As you continue in your development career, you will inevitably come across affordable housing as a specialty and have some degree of interest.
How does affordable housing work, given that the projects seem to lose money on paper?
The obvious answer here is the role of subsidy and grants from government or other funding sources.
DON'T BE Intimidated!
We know the labyrinth of affordable housing funding can be intimidating and confusing to those who have no experience.
We were interested in developing affordable housing for several years… before we actually began doing so.
It took a lot of research and networking with the right team of professionals who already have the experience to guide us to the point that it was even possible.
My aim in this article is to make that learning curve a little bit less daunting and set out a brief explanation of how to get into affordable housing.
The biggest pieces you need to assemble to get into affordable housing development are selection by government agencies and obtaining the necessary funding to make your project viable.
OK, you want to get into affordable housing. What do you need to know?
Before we get into the details, the first step in understanding affordable housing development involves the role of subsidy and how you as a developer make your money from this form of development.
The goal of an affordable housing development is to roughly break even every month, with the developer receiving compensation by the way of a developer fee, which is a percentage of the total project costs for the development.
2. Developer Fee:
The exact percentage developer fee can vary from place to place.
In certain situations where developers need to compete to be awarded the right to develop an affordable housing proposal (explained further later in this article), you may also be motivated to lower your fee in order to be awarded a potential project with several others also vying to develop it.
While grants and similar subsidies are an important component of affordable housing, there will still be a large debt component with standard monthly payments.
Whatever the amount is that you and your investors and investors contribute, along with the combined amount of grants and long term no interest loans amounts to, you will still have to contend with these carrying costs.
Lending institutions have certain restrictions that they must follow when dealing with affordable housing that can give you longer loan terms (40 years or more in extreme cases) with lower interest rates, and state housing agencies can also lend for these purposes.
In spite of all this, with affordable housing restrictions in place, your monthly rental income from a new construction development will usually not be able to cover your monthly debt service, after subtracting operating expenses.
How Much Subsidy Will My Project Need and Where Do We Get It?
1. Area Median Income:
The first thing you will want to do to understand the level of subsidy required is to get familiar with the income limits and associated rental rates for the community you are building in.
In the 3 Effective High Level Development Strategies article we previously published, I discussed the nature of LIHTC subsidies from the federal government.
Their rules stipulate certain guidelines that govern which projects qualify for their subsidy.
The main way that prospective tenants or buyers are categorized under the affordable housing system is their income in relation to the average median income for their area, or AMI.
The name itself may be self-explanatory, but it is important to keep in mind that the “area” may be highly local and refer to specific neighborhoods within the city you are developing in.
For the federally-awarded low income housing tax credit (LIHTC) program, you are allowed to include some market rate units, so long as 40% of the units are rented to tenants with incomes that are 60% or below the median for the area.
That said, given the competitiveness of the program, I usually see buildings that are made up of 100% affordable units nowadays.
2. Cost of Acquisition:
Your local municipality will also, in all likelihood, have affordable housing programs set in place that are avenues for development.
It is typical that the parcel you develop must be acquired at an extremely low cost to make the project feasible.
While a benevolent property owner or family that has owned a parcel for generations have certainly been involved in affordable housing, the common route is the local government awarding land they possessed through foreclosure, or had all along for whatever reason, to qualified developers that submit affordable housing proposals.
3. Subsidy from Multiple Sources:
For larger development, you will need to stack multiple layers of subsidy, including federal low income housing tax credits as well as state/local grants or low/no interest loans.
Most of these more local level agencies that work with affordable housing will also adhere to the AMI system.
Many of our developments are in Boston, Massachusetts and its surrounding cities as it is a high growth area with strong economic drivers and a robust life sciences sector.
We will roughly use Boston’s AMI figures for the following example:
- You are building a 30 unit new construction affordable housing building.
- Your construction costs are $215 per gross square foot and
Your soft costs (interest, legal, architectural, engineering, closing costs, etc.) are $20 per square foot.
- To make things simple for this example, let’s say that every apartment is a 2 bedroom, 850 square foot unit.
- Each unit is designated to be occupied, upon completion, by a family at 50% of the neighborhood’s median income.
- If your building has a 77% efficiency ratio, which basically means that only 23% of the overall building space is dedicated to common area and the rest is all livable building area dedicated to each unit, then the gross square footage of your building should be 31,365 square feet.
- With our combined costs of $235 per square foot and an acquisition price of $100 (purchased from you’re a property your city repossessed via foreclosure), your total project costs for this project would be $7,370,875.
NOTE: For this example, to keep things simpler, we assumed that the parking was in the exterior grounds of the building.
Were you to include garage parking, please make sure to include the garage parking as a separate cost calculation.
If your 30 unit building had a 77% efficiency ratio and included 3 stories of living space, BUT also included a first floor of garage parking, that building would obviously be more expensive than a standard asphalt parking lot surrounding or abutting the building.
A rule of thumb is to discount the square footage used for normal building area by anywhere from 40-60% for garage or basement spaces.
What about grants and other investors?
While you will likely have grants and other investors involved in your capital stack for larger deals, let’s assume just for the sake of this example that 80% ($5,896,700) of the costs are financed by a 40 year, 2.5% loan, leveraging better terms due to it being an affordable housing development.
Affordable housing loans are serviced with a significantly lower minimum debt service coverage ratio (DSCR) in order to make the numbers work.
The amount can vary depending on the deal and the lending institution. Let’s also say that the 20% in equity is covered fully by grants from local agencies involved in affordable housing funding.
Note that 20% of your development costs being fully covered by grants is extremely rare, but it makes it easier to understand this example.
Your monthly debt service will thus be $19,446.
Say you are building in one of Boston’s major neighborhoods, where the maximum allowable rental rate for a 2 bedroom, 50% AMI unit is $1039. (These rates can be found by researching the AMI sales and rental rate limits for your area.)
With a monthly rental income of $31,170, and an expense ratio of 35%, this building would have a net operating income of $20,260.5.
This building will, then, roughly break even and should be a competitive bid for an affordable housing proposal. In order to make these numbers work, you need to subsidize a large percentage of project costs.
Different Kinds of Affordable Housing
Affordable housing can come in a variety of different forms.
You could own land already and decide to erect affordable housing on the lot, but this is an exceedingly rare scenario.
More often than not, you will need to acquire the land from another party to begin the process. The problem with that is, the acquisition costs in many areas are prohibitively expensive, making the required subsidy to construct your project larger than they would need to be just from your construction budget.
Your network is your net worth
This is why funding is the name of the game in the affordable housing world.
The developer with the right relationships to subsidizing agencies will be more nimble and confident they can pull together the money needed to make things happen.
One tool to keep in mind is to look for your city’s requests for affordable housing proposals.
As mentioned above, the municipality will re-possess land via foreclosure or own land for whatever reason that they will sell for next to nothing. This will take some pressure off of you as the amount of subsidy needed will be less.
Often called RFPs, or request for proposals, the government will provide guidelines for what type of affordable project they envision and you and your team create a proposal matching that vision.
The team that ticks the most boxes for the government (ability to execute, cost of construction, and inclusionary/local hiring practices being some).