Trouble in Paradise

March 16, 2008

Government housing programs have a long history of flaming out shortly after being launched.  Rising costs, corruption, scandals, mismanagement and popular opposition have all contributed to an average housing assistance program life span of only about 7 years, according to Charles L. Edson, one of the deans of Washington's assisted housing bar.

So when the Low Income Housing Tax Credit (LIHTC) was adopted in 1986, there was no reason to think it would fare any better. 

But the program has not only outlived the average, it has thrived for more than 20 years.  It was and remains the only significant federal construction and rehabilitation tool in the federal kit.  In return for putting up equity to help build or renovate the affordable rental housing projects, investors get 10 years' worth of tax credits to lower their tax bills.  The program is estimated to support as many as 100,000 units per year.

Now, however, it is beset by problems on both the investor and sponsor side. Fannie Mae and Freddie Mac have long been the largest users of the tax credits, accounting for between 30 and 40 percent of demand.  Other corporations make up the balance.  With real losses from bad loans and investment debts wiping out profits, Fannie, Freddie and others now find themselves with billions in tax credits they cannot use.  They are out of the market for the foreseeable future. 

On the operations side, rents in tax credit properties are fixed as a percentage of the area's median income.  After years of rising every year, these are now falling in many areas.  At the same time, energy and other management costs are rising, threatening a widening gap between rental income and expenses. 

These two new developments are squeezing the tax credit program from both ends.  Whether the program and the existing properties can survive these two challenges may be the most important affordable rental housing question confronting the next Congress and Administration.

Supply and demand drive down yields

The sudden and unprecedented shortage of investors has driven down the price that remaining investors will pay for the credits.  Last year, with credits in high demand, some investors were even paying more than a dollar in equity for a dollar in tax credit value.  Since inflation makes the future dollar of savings worth less than the present value of the purchase, these prices weren't sustainable.  Today, with demand slackening, tax credit prices have fallen to the mid-80 cent range, more in line with historical trends.  While this is good news for investors in the credits, it means that the actual capital available for development expenses in the properties has been cut by as much as 20 percent.  Development costs have not gone down.  So projects are harder to finance when the credits yield less cash.  The rents that owners can charge are capped to insure they are affordable to lower income tenants.  The difference has to be made up by other assistance, or through developers deferring or surrendering altogether the fees they would normally charge for carrying out the work.

Rents vs Costs

One of my first assignments as a reporter in 1973 was to cover a meeting of sponsors of recently built or rehabilitated apartment projects that had benefited from a 1968 housing program called Section 236.  This wildly successful program provided interest rate subsidies to developers in return for restricting rents in the properties.  Tens of thousands of apartments were built under the program. But by 1973, oil prices and inflation had decimated the project sponsors.  The meeting I attended was in a church.  The audience was mostly African-American ministers whose churches were sponsors of Section 236 properties that were going broke because operations expenses were outstripping what they could collect in rents.  You could smell the fear in the room; the mood was one step short of full scale panic.

Thirty five years later this scene could be replayed as tax credit projects face a similar crunch.  The properties developed in the last 20 years have benefited from steadily, if modestly, rising median incomes and low inflation in energy and other key items.  But median income figures compiled by HUD for program sponsors have declined in many markets this year.  At the same time, $110 per barrel oil prices are flowing through the projects' income statements.  Property owners are potentially facing stagnant or even declining rents at the same time their operating expenses are likely to balloon.

In 1973, the threat of thousands of failing apartments led to project-based Section 8 contracts to subsidize rents, and other adjustments and subsidies to re-balance income and expenses at the property level.  The interest rate subsidies could not be increased, and that monthly expense was a fixed cost anyway.  It was the volatility of the variable expenses that did in the Section 236 projects. 

Tax credit properties could be in for the same experience.  The choices facing project sponsors are not easy.  There are only a limited number of potential solutions if the trends continue into the future.  Rents could be increased.  But this would undermine the original purpose of the program, to provide affordable rents to low and very low income tenants.  Subsidies could be provided from other sources, like Section 8 or state housing funds.  But the credit was negotiated in 1986 to restrict the use of such other subsidies, and these restrictions would have to be lifted.  Since housing subsidies are pretty much a zero sum game, this means that other worthy projects would be competing with tax credit properties for scarce funds. 

When the tax credits were first created in 1986, advocates and supporters understood its limitations.  I was one of the principal advocates and architects of the program, and never thought it was more than an incomplete, and relatively inefficient, solution to the problem of subsidizing supply.  But at the time, in the middle of the Reagan Administration's assault on housing subsidies, it was the best we could do.  And it significantly improved on existing tax subsidies that were far less effective at targeting benefits to low income renters.  The peculiar economic climate of the last 25 years has enabled the program to thrive and to put off the difficult choices now beginning to confront owners and advocates.

It looks as if that long honeymoon may finally be over.