Affordable Housing Institute : US

[Continued from yesterday's Part 2 and the preceding Part 1.]

So far, in the two posts expanding upon my analytical essay Rethinking and Reengineering the LIHTC Value Chain [.pdf, and worth downloading in full – Ed.], originally published on my for-profit company’s Web site and its email distribution list, we saw that (Part 1) the US’s multifamily rental affordable housing finance ecosystem got disrupted by the capital markets, and that (Part 2) Congress’s solution – a combination of ‘buying back’ previously issued but unsold LIHTC and delivering gap financing for the lost value – will probably help the current pipeline but undermines the value chain’s ability to self-repair.

That’s not going to fix itself, is it?

[Editor's note: for a step-by-step primer on the mechanics of LIHTC allocation, click here.]

Why won’t the system repair itself?

The last six months’ market (in)activity, culminating in the exchange proposal, have conclusively demonstrated that the current LIHTC value chain – the 18-24 month sequence that begins with allocation request and ends only at financial closing – is over-engineered based on the now-false presumption of low-volatility and only rising prices.

Did you really need all those features?

All is not lost, however.

It is fixable, and it needs to be fixed – now.

Now, for our prescription, which is in three parts:

Better get your House in order

1. The goal of value-chain re-engineering

2. What allocators can do

3. What investors can do

It should be no surprise by now that a coevolved system can only return to equilibrium by complementary actions from each of its symbiotic actors, the allocators (those who give out LIHTC awards) and the investors (those who buy the LIHTC futures).

1. The goal: allocation quote matches market price

Let’s start with context, and what we’re after.

The LIHTC system worked perfectly well in 2001 with 77¢ credits. It worked well in 1996 with 65¢ credits. It even worked well in 1989 with 45¢ credits. The market will function, and function efficiently, if we back ourselves out of the over-engineered cul-de-sac that a decade’s benign financial environment led us to create.

Our goal is a value chain in which the allocation quote matches the market price. The ‘allocation quote’ is the net equity price per dollar of credit that is incorporated in the sponsor’s LIHTC application. The market price, of course, is what the awarded LIHTC fetches in the market.

In auction parlance, we want to recreate a world of reliable forward commitments.

Need to know you’ll be there when the time comes

So long as prices are volatile, with quality differentiated pricing still shaking out, the key to minimize the quote-price gap is to shorten cycle time between LIHTC award and LIHTC equity placement.

Shortening allocation-to-close cycle times is a variant of speeding up the marketplace’s OODA loop, or compressing the volatility of a normal yield curve.

To make the vehicle more nimble, get rid of extraneous deadweight:

Keep it nimble, and win!

That in turn requires both allocators and investors to recognize that precision-oriented procedures and requirements they adopted in earlier times now are entanglements that slow them down from the critical goal – matching the allocation quote to the market price.

Today’s 24-month risk cycle from LIHTC application to equity placement is unsustainable. We have to get to a cycle where the time delay from award to closing is no more than six months, and the shorter it is, the better. This includes both trimming procedural requirements and building in shock absorbers, particularly on equity pricing, that allow deals to close at the then-market.

Looks costly, but prevents crackups

2. What allocators can do: improve underwriting viability

Allocators can shorten cycle time by improving underwriting viability and building in adjustable uses of funds that can flex up and down as sources of funds change.

1. Increase the cash development fee.

As I’ve said before, profit is the price you pay for competence. Over the last decade, the LIHTC industry largely forgot this.

Competence, baby!

Allocating agencies have moved from capping permissible total development fee (TDF) to squeezing on the cash portion of development fee, with the balance as DDF. While that’s sensible in a rising-price environment, in a falling-price scenario Cash DF is the shock absorber. States could establish minimum expected Cash DF’s and size these as a percentage of the projected equity raise. That way they could be sure the property could close even in the face of a declining LIHTC price of stated amount.

2. Eliminate ‘minimum bid’ requirements.

LIHTC prices are an auction marketplace of a perishable commodity. It makes no sense to establish a high ‘reserve price’ when you’ll throw out the goods later if nobody meets the minimum.

Some things we just have to sell

Minimum-bid prices are unenforceable and unreliable. They also can act as a barrier to the creation of new demand, risk having some properties fetch no bid at all, and hence can work actually to drive capital away from low-demand states.

When in doubt, simplify. Clear away the clutter.

3. Reduce administrative-minimum requirements; use points. Generally speaking, QAPs are scored on points; highest wins. Some requirements are mandatory, however; they must be fulfilled or the application is disallowed regardless of its other strengths. Over the last half-decade, there has been a trend to more requirements, particularly in areas that do not help the underwriting. Point systems should begin to show wider range of differentiation across applications, in contrast to the “every winning deal scores 100% of available points” that has evolved in some states.

That’s the thinking we like!

4. Create a flexible-source pool of cash.

Generals heading into battle maintain a reserve force, to be committed where circumstances require.

Going where the need is

In financing, bullets are bucks; keep some handy to plug gaps.

Some Exchange funds should be held back as flex cash, in the range of 2-4% of total development cost, to be provided as additional soft debt tied specifically to changes in demonstrable underwriting parameters.

5. Give priority to properties with firm equity commitments.

Which line do you want to be in?

Anyone who’s ever run up to an airline boarding gate knows the key question, and the right answer:

Key question: “Have you checked any luggage?”

Right answer: “No!”

The luggage question is essentially a readiness inquiry; are you ready to go? In stimulus-legislation parlance, it’s ’shovel-ready,’ and in financing parlance, it’s ‘firm quote.’ If you have one, you should move to the priority boarding line.

3. What investors can do: develop more flexible, faster-responding acquisition vehicles

The allocators’ changes above will be sensible on their own; they will work much better, and have much more rapid takeup around the country, if the remaining LIHTC investors who are continuing to buy – and they represent perhaps half of the projected 2009 demand, meaning more are required – re-engineer their acquisition and closing procedures so they can take off faster:

The faster we lift, the better

Investors that want to stay in the business – that want the business to be a business – need to take the lead in innovating capital forms, in directions that were already emerging in 2007 and whose emergence will be accelerated by the demise of antiquated and uncompetitive capital-raising vehicles. They all involve having a faster response to properties offered.

Again the principle, shorten the OODA loop.

1. Develop fast-closing flexible acquisition entities.

In a fluctuating-price market, an investor with an ongoing tax capacity will be interested in dollar-cost-averaging – being able to close properties one by one, as they become available, at customized market prices. Doing so requires an ability to close quickly, so that proposals are not routinely overtaken by market fluctuations.

2. Make investor requirements clear and transparent to sponsors.

That’s clear enough

You don’t always get what you ask for, but if you don’t ask for it, you’ll never get it by making sponsors guess.

As the investor pool has shrunk and sponsors with overhanging-pipeline properties have become ever more desperate for equity, the fewer remaining investors face an even larger pile of proposals to evaluate, straining their capacity and thinning their margins.

Investors need to develop new mechanisms to inform sponsors of what deal features are attractive and unattractive based on tax capacity, yield requirements, CRA interest, underwriting criteria, and investment parameters. This could happen through guidance from individual investors, industry-wide or investor coalition white papers, dissemination of detailed data on closed deals, or use of syndicators as custom-tailoring intermediaries, where particular syndicators are private-label acquirers on behalf of particular investors on particular property tranches.

3. Anticipate the reinvention of CRA. The Community Reinvestment Act, now a venerable thirty years old, is due for an upgrade.

Time to install …

Count me among those who think that the CRA, as it now stands, is smart legislation and effective public-policy. But like anything else that’s gone thirty years without a tuneup, it needs a substantial modernization.

Pretty cool for 1977, eh?

When that happens, LIHTC housing is almost certain to be a preferred and incentivized investment.

CRA’s mania for micro-geographies is a byproduct of its origins in the late 1970’s, when redlining was the geographic proxy for income discrimination. In a world of electronic banking, the geographic fixation is anachronistic. A reinvented CRA will change investors’ spending patterns, and their investment vehicles should be designed with the flexibility to adapt.

Conclusion. Around my neighborhood, it was common in 2008 to see bumper stickers chastising, If you’re not outraged, you’re not paying attention. In 2009’s equity marketplace, the paraphrase should be, If you’re not terrified, you’re not paying attention.

Being terrified is so boring, you know?

Necessity is the mother of invention; fear can concentrate the mind wonderfully. Even with its flaws, the LIHTC value chain is a great invention, one that its stakeholders need to nurture and protect by re-engineering and improving it.

If we start now …

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