Affordable Housing Institute : US

“Toby, we’ll find that missing money somewhere!”

 

“Holmes,” began Watson, pushing away the mouse and rubbing the glowing pixels out of his eyes, “you have previously categorized the four kinds of capital financing — hard debt, soft debt, hard equity, and soft equity — but you have yet to articulate how they are combined into a financing plan.

 

 

 “Brewing up something potent here.”

 

Holmes turned down the gas below the bubbling beaker where he was brewing secondary markets, and asked over the dying blue flame, “In an arch, which stone is the most important stone?”

 

Watson started to reply, then checked himself.   “They all are.  Each depends on the other.”

 

Holmes arched an eyebrow.  “In a Sources Of Funds, which source of capital is most important, the first dollar or the last?”  Seeing Watson’s look of incomprehension he asked, “Which coin is most important in a stack of coins?”

 

Which of these is most important?

 

They all matter equally, said Holmes, wishing to hurry the process.  A financial detective’s continuing goal is to assemble all of the money: 100% of the total development cost (TDC) or, in an existing property, total acquisition cost (TAC).

 

Each source of capital relies on the others.

 

“Paraphrasing Abraham Lincoln,” Holmes concluded, “one needs all of the money, not just some of the money.”

 

 

“All of me, you need all of me.”

 

“How then do financiers choose?” Watson asked.  “Which money then comes first?”

 

Decoding the mysteries of capital

 

That depends on the property’s goal, Holmes explained.  There are two other principles of assembly:

 

1. Debt is senior to equity, so equity arrives later and commands a higher yield.


2. Soft capital is more complex than hard capital, so it too arrives later and buys affordability.

 

Consider the simplest concoction: the classic single-family home.  A classic market home buyer uses only two sources: hard debt, and hard equity. 

 

• Hard debt is the bank’s loan, normally constrained by a loan-to-value, LTV ceiling.


• Hard equity is the owner’s down payment. 

 

When both debt and equity have costs set by the market, the result must be market-priced housing, because markets always clear, and property value is a residual. 

 

Buyers, sellers, demand, supply, it’s all a body can do to stay in balance!

 

If affordability is the goal, one must lower the cost of capital.  Government frequently stimulates first-time homeownership by using favorable hard debt (high leverage, cheap interest rates) and friendly hard equity (down payment assistance).  But these tools go only so far. 

 

We can only ride this horse so far.

 

In the United States, for instance, they probably add 2-4% to the homeownership rate — several million households, to be sure, but leaving the 30% of households who rent high and dry.

 

“How then is affordability added?  By soft debt and soft equity?”

 

“Precisely so,” Holmes said approvingly.  “Soft debt is sandwiched in between hard debt and hard equity.  That is, soft debt is typically paid after the hard debt and before the hard equity — that is, the owner’s appreciation.”  Because sustainable affordable housing costs money, there follows its corollary:

 

More affordability requires more soft capital

 

But soft debt, though better than hard debt (because it has more flexible payment terms and a lower Weighted Average Cost of Capital), will also only take affordability so far.  For the deepest affordability — that is, affordability to those of lowest income — we need soft equity as well.

 

We can thus illustrate the evolution of the capital stock with the following diagram:

 

 

The left-hand column shows classical debt-equity financing.  This produces market affordability. 

 

Soft debt enters in the sandwich position (middle column) and delivers some meaningful affordability. 

 

For very deep affordability, however, hard debt and hard equity must both be reduced even further, and more often than not, this is accomplished by adding soft equity on top of soft debt.

 

In terms of the housing financial ecosystem, therefore, we see governments introducing affordability resources in a very predictable order:

 

1. Hard equity (grants and down payment assistance).


2. Hard debt on favorable terms.  In the US, for instance, §221d3 arrived in 1961.  Farmers’ Home loan programs go back even further.


3. Soft debt.  UDAG, the prototypical such program, arrived in 1977.


4. Soft equity.  The Low Income Housing Tax Credit was enacted in 1986.

 

“Is that sequencing universal?” asked Watson.  “Are there no counterexamples?”

 

In vain Watson searched the financial news for counterexamples.

 

“Occasionally one sees hard debt assistance offered before hard equity, but very rarely.  And soft capital always comes after the hard options have been exhausted.  That, in turn, leads to the next principle: affordability implies financial complexity.  But,” he added with a twinkle in his eye, “that’s a word count sufficient for one blog post.”

 

 

[To be continued, boys and girls, in tomorrow's thrilling post!]

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