The four kinds of money
“Four kinds of money, Holmes? Four?”
Is this napkin large enough for four kinds of money?
In affordable housing, every financial transaction involves a capital producer (who gives money) to a capital consumer (who needs money). In investment terms, money may be either debt or equity:
- Debt: money rented for a time interval on specified terms: interest rate, term for repayment, regular repayments, priority of repayment, security.
- Equity: money that buys ownership: it is a permanent trade where the equity investor acquires a share in the venture, whose value depends on future events.
In practice, the boundary between debt and equity can be blurry, with intermediate hybrid products such as mezzanine debt, subordinated debentures, and preferred equity. Investment bankers not only stitch together the financing quilt, they often conjure up new customized capital forms for special circumstances.
Every transaction requires both debt and equity. By definition, not all debt can be secure; there is always some risk of loss, and that risk is borne by equity. A lender who levers (gears) above a safe level has unknowingly made a combined debt-equity investment with the worst of both worlds: equity risk at the top end but no equity upside. Indeed, the history of affordable housing is strewn with the corpses of failed properties that over-levered.
In the short run, debt is more costly, because its debt service payments are level, whereas equity holders will accept lower initial cash flow because they anticipate appreciation … but in the long run, equity costs more (commands a higher return) because it has taken higher risk. Debt is also generally easier to find; equity is scarcer and more demanding (intrusive, collateralized).
All other things being equal, therefore, capital consumers want the most debt they can get — and lenders will provide it if and only if there is adequate equity behind them. But this leads to a further affordability paradox: whichever form of money we take compromises deep affordability:
- More debt means more debt service, which means higher rents up front.
- More equity means investors who expects cash flow, which means rent increases over time.
Government initially tries to create affordability by offering cheaper debt with higher gearing, either through direct loans or credit enhancement in current and past programs such as:
- Section 202: direct government loans
- Section 221(d)(3): forty-year loans, 90% leverage, 3% interest rate.
- Section 236: forty-year loans, 90% leverage, interest subsidy to create an effective 1% rate.
- Section 515: fifty-year loans, 90% leverage, 1% rate, rural properties only.
- Tax-exempt bonds under volume cap or Section 501(c)(3).
Even with interest slimmed down almost to zero and repayment terms pushed past a property’s useful life, hard debt can only be so cheap, and therefore affordability can be only so deep. To achieve deep affordability, we have to get out of the hard-capital straitjacket into the roomier confines of soft capital.
- Hard capital: money whose return is purely economic: cash flow, refinancing takeout, or appreciation and equity buildup via sale proceeds.
- Soft capital: money that expects return other than economic, which comes in two principal forms: (1) social impact (beneficial change), and (2) tax impact (tax savings, derived from specific government-endorsed tax incentives).
This leads us to the consultant’s classic 2×2 grid — in this case, defining the four kinds of money:
“Surely this is fascinating,” Watson interposed,
The great detective noted the impatient body language
“but why the lengthy disquisition, Holmes”?
Watson wondered, Were these new men soft capital sources?
For a simple two-part reason:
1. Deep affordability requires soft capital.
2. At scale, soft capital requires government.
And this, you see, is the absolutely fundamental truth: if you want quality affordable housing at scale (at small scales, foundations play a key role), government must facilitate soft capital.
In the
- Soft debt: HOME, CDBG, mark-to-market soft second loans, Flexible Subsidy, accruing purchase money financing.
- Soft equity: Low Income Housing Tax Credits (LIHTCs), historic tax credits, New Markets Tax Credits, state tax credits, accelerated depreciation.
“But how do developers use them in their nefarious plans?”
“That, Watson, is quite a three-pipe problem ….”
