Investors’ reasons for investing in affordable housing are as varied as the opportunities available. But, broadly, it comes down to two factors: The returns are good, and it’s the right thing to do.

It has become a truism to say housing affordability is in a crisis, but it has been building slowly, drip-drip-drip style. The problem, growing over decades, has accelerated since the global financial crisis. In coastal markets, in particular, an acute lack of housing has exacerbated the issue of affordability. And efforts to increase supply are just a drop in the bucket.

Homeownership rates are lower now than they were a decade ago, the lingering legacy of the housing collapse and the Great Recession. That means more renters. And rising mortgage interest rates are not helping people transition from renting to home buying.

That larger pool of renters, especially in coastal markets, spends a large share of income on housing because wages have not kept pace with rent growth and housing supply has not kept pace with demand. Nearly half of renters are cost-burdened (defined as paying more than 30 percent of gross income for housing) and one-quarter are severely cost-burdened (spending more than 50 percent of income on rent), according to the Joint Center for Housing Studies of Harvard University’s The State of the Nation’s Housing 2018 report. The report found 47.5 percent of renters were cost-burdened in 2016, and young people, also bearing the weight of higher student-loan debt than previous generations, face the most severe cost burdens.

So while these figures are grim, they also highlight the huge market opportunity for investors willing to enter the affordable segment. Demand is nearly limitless. Occupancy rates are high. Turnover is low. Waiting lists are long. And the barriers to supply are high.

“Right now, we have a shortage of 3.7 million homes in America, both apartments and single-family homes,” says Clay Grubb, CEO of Grubb Properties. “And we continue to form households faster than we create new products, and what new products we are creating tend to focus on meeting the very high end of the market. And so being a landlord of multifamily housing — whether it’s older workforce housing or brand new housing that is affordable and leased — this just feels like probably one of the best investment theses we’ve seen in our lifetime.”

“You’re servicing the biggest bulk of renters in the United States. But the supply is limited. So you’re always going to be in demand if you buy correctly,” says John Williams, president and CIO of Avanath Capital Management. “You’re in a business that has unlimited demand and limited supply, and it’s not going to change in the near future. The high-end jobs aren’t really getting created at a faster pace.”

Construction of luxury

The vast majority of new apartment construction in the United States has focused on the top end of the market.

“What’s happening in the new construction market is that costs are so high for land, materials and labor that the vast majority of new construction really has to target the high end of the rental market in order to make their project pencil out,” says Rusty Ginise, portfolio manager for the workforce strategy at Hunt Investment Management.

But while luxury apartment buildings are rising across the country, affordable projects are few and far between. High-end fixtures are a small proportion of construction costs but allow developers to charge much higher rents. It’s no wonder developers have concentrated their activity in the luxury sector.

“You really can’t build affordable housing unless you have some kind of subsidies,” explains Williams. “Land costs the same. Concrete costs the same. Rooftops cost the same. Bricks cost the same. Elevators cost the same.”

“When you look at the demand side of multifamily and the supply side of multifamily, there’s virtually no new class B multifamily being built in the U.S. and certainly not in coastal markets, larger markets,” says Jay Eisner, co-founder and partner of LEM Capital. “The way construction costs have run up, it’s really hard for a developer to make a project work at class B rents,” adds Eisner.

Specific terminology

Within the industry, “affordable” has a clear meaning: It’s housing for people making less than 60 percent of area median income, or AMI, and is generally regulated and subsidized, so renters in affordable housing projects might pay 30 percent of their income for such units. By contrast, “workforce” is an unregulated term, but it generally applies to properties aimed at people earning between 60 percent and 120 percent of AMI.

“Workforce housing offers a solution to families who earn too much to qualify for affordable units, but fall well below the income requirements needed to live in luxury class A rental housing or purchase a home,” explains Elie Rieder, CEO of Castle Lanterra Properties.

The two main government programs to provide affordable housing are Low-Income Housing Tax Credits — LIHTC — and vouchers provided by the Department of Housing and Urban Development. LIHTC funds new affordable multifamily development as well as rehabilitation of existing assets, and some 2.5 million units were available for occupancy under the LIHTC program in 2017, according to The State of the Nation’s Housing 2018.

“Virtually all the LIHTC — low-income housing tax credit — deals are driven by tax investors,” says Peter Vilim, vice chairman and co-founder of Waterton and a board member of Housing Partners Equity Trust, which forms partnerships with nonprofit organizations to provide low-income housing and has attracted investment from institutions such as the Ford Foundation and the MacArthur Foundation.

In March, new legislation introduced income averaging for LIHTC properties. This means an LIHTC property can include a wider mix of tenant incomes, as long as the overall average of incomes stays within the affordable band.

The National Low Income Housing Coalition explains: “Income averaging allows LIHTC developers to choose to serve households with incomes up to 80 percent of the area median income, as long as at least 40 percent of the units are both rent-restricted and occupied by households with incomes that do not exceed the ‘designated income limits,’ which may range from 20 percent of AMI in 10 percent increments up to 80 percent AMI.”

“It’s a relatively uncaptured tenant base within the affordable housing spectrum,” says Timothy Bracken, co-head of the affordable housing investment sales team at Berkadia, a Berkshire Hathaway and Jefferies Financial Group company. “And income averaging is going to allow owners to extend beyond the 60 percent threshold to capture those folks.”

Another way properties offer a mix of units is through inclusionary zoning — local ordinances that mandate (on a voluntary or required basis) a percentage of new market-rate developments be set aside for low-income tenants. Some investors feel such mixed-income projects can have positive social impacts.

“We know that in the United States your zip code dramatically impacts your life outcomes — how healthy you are, how long you live, your education, good jobs, your economic mobility over a lifetime,” says Lisa Davis, portfolio manager, impact investments, at PGIM Real Estate. “From a social-policy perspective, I think inclusionary housing is one of the most important and impactful investments that we can make,” adds Davis.

“Mixed income is actually a really healthy kind of typology,” agrees Nathan Taft, managing director of acquisitions at Jonathan Rose Cos. He notes mixed-income properties and mixed-income neighborhoods prevent concentrations of poverty. “When you have mixed-income buildings, they tend to be sort of healthier buildings overall, more dynamic,” says Taft.

Building a portfolio

Some LIHTC developers are focused on new development, but others will acquire and rehabilitate older apartment projects. “There are developers out there who will bring product into the LIHTC program via the acq-rehab model,” says Bracken. “They’ll take a market-rate property and convert it to affordable, so that’s a nice way to increase the affordable housing stock while avoiding the expensive costs of new construction.”

For investors, the appeal of affordable housing properties is yield stability. Turnover in affordable properties is low, and occupancy rates are high. According to Reis, the affordable housing segment had a vacancy rate of 2 percent in second quarter 2018.

Typically, such properties are required to maintain their low-income tenant mandate for a decade or more after the tax credits expire (depending on state and local laws). Investors in rent-regulated properties focus on yield, not appreciation, when making investment decisions.

“People buy it on cash flow,” says Williams. “Those rent regulations usually run 25 up to 50 years, depending on where it is, so whoever owns it has to abide by the rent regulatory agreement.”

Other investors look for properties without mandates but that are still affordable to low- and middle-income tenants.

“Unlike rent-stabilization and other measures to maintain affordable housing, which has ceilings on maximum allowable rents, we prefer to operate in the ‘free-market’ space, which gives us maximum flexibility on pricing and enables us to be more aggressive when the market is receptive, or scale back when the market tightens,” says Rieder.

When a regional economy is growing, with increasing jobs and rising wages, it attracts more people and increases demand for housing of all types, from workforce to luxury. But, in a weakening economy, some renters will have to scale back their housing costs, which also increases demand for workforce housing.

As with any investment, partner skill is a make-or-break quality.

“This is a space that lends itself to firms that understand the market, that understand the value proposition in affordable housing, that can bring various skill sets to the table, in terms of sourcing and assessing assets, and managing them, improving them,” says Tom Duda, president of Hunt Investment Management.

“Workforce housing communities are typically older in vintage, and require substantial physical and operational enhancements,” notes Rieder. “As such, if the sponsor is unable to successfully carry out the business plan, the level of risk magnifies.”

After tax reform

Since the passage of the Tax Cuts and Jobs Act of 2017, LIHTC investment has become less attractive. The top corporate income-tax rate was reduced from 35 percent to 21 percent and, with lower tax rates overall, the need for tax credits has diminished.

“It’s an unintended consequence, but the demand for the tax credit was reduced when the tax rate was reduced,” says Bracken.

Reis, in its second-quarter 2018 Affordable Housing Quarterly View, forecasts new construction of affordable properties to decline by 40 percent from 2019 to 2022 because of changes to the tax code.

But if the tax reform legislation has weakened demand for the LIHTC market, it also introduced preferential tax treatment within opportunity zones (see news story on page 17).

“One policy objective that we see readily is opportunity zones, which are trying to address the imbalance of development capital for more affordable housing, both equitably in urban as well as in more rural areas,” says Ginise.

Because opportunity zones are designed to encourage investment in economically struggling areas, there is a natural fit for affordable housing development as a type of investment in such zones. Grubb Properties, for example, plans to launch an Opportunity Zone Fund in 2019 aimed at investments in opportunity-zone communities across the South, and focused on workplace and housing affordability.

“One of the very positive things I see about opportunity zones for impact strategies is that it increases liquidity in areas that haven’t had a lot of investment. And that is great,” says Davis.

She cautions, however, that opportunity-zone legislation is focused on tax strategy and not on making positive social impact. “We need to be clear that, as the opportunity-zone regulation is currently written, there’s no requirement of impact. It’s a tax-efficient strategy that may or may not have a positive impact,” says Davis.

Investors looking for impact

Affordable housing investment, however, has attracted investors interested in making positive social impacts. Impact investing has been particularly attractive to some foundations and family offices, as well as European investors, but it also can be attractive to other institutional investors.

Vilim says institutions want to invest in affordable housing, but “they need to keep their eye on the liability side of their business, and they can’t give up significant yield. We have to prove to them that affordable housing actually is as good, if not better, than a comparable conventional deal,” says Vilim.

“We’re seeing more and more investors who also want impact because they have a variety of choices they make with their capital,” says Taft. “They see the opportunity to have impact.”

European investors, in particular, are comfortable with the regulated aspects of affordable housing, as regulated residential rents are common in Europe. In addition, projects that combine environmental sustainability with social impact receive a lot of interest from European investors.

Some investors find it a compelling investment thesis that investors in affordable and workforce housing are strengthening communities, helping people to live closer to employment and education, and supporting economic mobility. They want an opportunity to make a social impact, and provide homes that are safe and secure for working people and families.

But the asset class also has attracted investors focused on the bottom line and steady returns.

“There are certainly more institutional investors now who are expressing an interest” in affordable and workforce housing, says Duda. “And I think that’s just reflective of the fact that there is just enormous demand for the product,” he adds, “and, as we said, a significant amount of shortage of product in the pipeline.”

“I don’t see a situation where investors’ demand is going to precipitously fall off in the affordable housing industry. It’s a very steady and stable product type, and even with volatility tax-credit equity pricing or interest rates, I think that tenet remains true for affordable housing from the investor standpoint,” says Bracken.

Making every drop count

The supply-demand imbalance for low-income housing has created the opportunity for many interventions, from tax incentives to zoning changes, and encouraged investment from across the spectrum, from nonprofit organizations to for-profit development.

“The people making 60 percent to 100 percent of AMI shouldn’t live in substandard housing. They should live just like everyone else lives — same buildings, same units, just cheaper,” says Vilim. “And, again, it is better for society, certainly, but it’s got to be economically good for everyone as well.”