Hedging the unhedgeable?

May 13, 2011 | Capital, Hard debt, Innovations, LIHTC, MacArthur Foundation, Rental, Soft equity, Theory

Doing business with the government comes with the territory in affordable housing – because it always costs money to fill the cost-value gap, and government is the ultimate source of evergreen, scalable subsidy resources – which raises an eternal question: how do you hedge government-performance risk?   


Theoretically, one can sue the government, and I have, but that’s little consolation if, while you’re pursuing your litigation, your property has been foreclosed through disruption of subsidy flows.  So what’s to do?  Ideally you find someone willing to put her head into the sandwich position in between the property’s operations and the government’s funding obligation – and for that, you need someone brave and selfless:


Nothing to worry about, son


That’s where my friend Debra Schwarz of the MacArthur Foundation comes in, with a terrific innovation: a philanthropic guarantee of HUD’s renewal of expiring Section 8 subsidy contracts.  As profiled in the February, 2011 issue of Tax Credit Advisor:


Risk-taking Schwartz


MacArthur Supports New Enhanced LIHTC Preservation Fund


The John D. and Catherine T. MacArthur Foundation has seeded a new “enhanced” low-income housing tax credit (LIHTC) fund providing added protection to investors against any cut-off of HUD Section 8 rent subsidies to financed projects.


Because the sovereign can be bound only to the extent it is willing to bind itself, there is no foolproof hedge, so the hedge has to be provided by someone else willing to stand in for the government as a collectible source of cash equal to the expected losses.


In preservation deals, one concern of many investors is Section 8 risk – the possibility, however, remote –


‘Remote’ is in the eye of the beholder. 


Never saw that coming!


When the government is involved, the probability of breach is either zero or one: zero until it breaches, one when it does. 


– that project-based Section 8 rent subsidies now flowing to properties might end, such as if HUD fails to renew the contract.


Indeed, the government has from time to time breached contractual obligations, and paid the price.  Here, if the resident income subsidy is canceled, then the residents will be unable to afford their apartments’ rent, and either they will be evicted or the property will immediately default … or possibly both.  While such a default would be politically damaging, and quite possibly expensive to the government as well through its insurance of the underlying mortgage, it is the prerogative of those who print the money to decide they will spend some of it changing course.



How hard is it to print some more?


Even more risky than a breach of government contract is the possibility of a contract not being renewed. 


Appropriations risk.  One subset is appropriations risk – the possibility that Congress one year fails to appropriate annual funding for current Section 8 contracts.


Remember, a program can be de-funded not solely because Congress has decided it doesn’t like a program – Congress and the President can get into a standoff and fail to enact the appropriations legislation and shut down parts of the government.


We were all younger then, before the budget impasse


Then too, the government could decide to offer a new contract, but at lower rents, and that is the real risk here. 


Overhang risk.  Investors worry about Section 8 ‘overhang’ – projects with Section 8 contract rents significantly higher than maximum tax credit rents.


What, me worry?


Under the tax credit program, rents are capped no higher than 30% of 60% of area median income (they could be lower if the owner offered lower restrictions in its application, in an attempt to win scoring points).  The LIHTC credit-cap rents could be higher than the local rents that Section 8 contracts will generally pay, or (typically in blue cities) they could be lower.  If so, then adding Section 8 to a LIHTC property gives the owner a rent boost, and that can make the difference between a property that doesn’t pencil out versus one that does.


The fear is that if a Section 8 property ever had to adjust to charging the lower housing credit rents, rental income would tumble and the property would no longer be self-sustaining.


There goes our income stream!


Now, there is a legitimate policy question – should Section 8 rents on a LIHTC property be allowed to be higher than LIHTC rents?  Isn’t that double-dipping?


We’re against that, aren’t we?


The case can be argued either way … but fortunately, it’s been settled favorably for developers.  As a regulatory matter, one can have the higher rents – until Congress changes the Section 8 rules, which it can do at any time.


Enter MacArthur to the rescue:


We’re on our way


“Our nation’s need for affordable rental housing has never been greater and continues to grow,” said Debra Schwartz, MacArthur’s Director of Program-Related Investments.  “This innovative approach, which brings together major financial institutions, philanthropy, and the federal government, shows that we can mobilize the capital needed to save thousands of at-risk affordable rental homes, even in difficult economic times. Much more needs to be done but this model offers one creative way forward.”


The MacArthur Foundation’s guarantee provides extra protection to investors in three areas.


Of these three, only one deals with Section 8 risk:


[1] The guarantee may be drawn upon to cover rental income shortfalls [a] if Congress doesn’t appropriate funds for the contract, or [b] if a project’s Section 8 contract isn’t renewed by HUD in substantially the same form.


Thus both contract non-renewal and contract downward adjustment are covered by the guarantee, which eliminates Section 8 risk entirely (assuming MacArthur’s commitment to be creditworthy, which it has to be or there would be no point in the structure). 


The other two guarantee elements are broader:


Two more guarantees from Super MacArthurio?


[2] It provides added assurance of the completion of construction of projects. If problems arise in a property and the surety bond and sponsor guarantee are inadequate to fund completion, the guarantee may be tapped for this purpose.


[3] The guarantee provides an additional backstop for investors in the case of recapture of housing credits.


Neither of these two guarantees has anything to do with Section 8 per se, so I deduce that they were added to make the guaranteed ‘creditworthy’ under EITF 94-1, making the fund ‘guaranteed’ for FASB accounting requirements, allowing the investors to use the effective yield method of accounting.  That presumption is buttressed by the guarantee’s length:


Holding up that investor yield


The guarantee’s protections are all for 15 years.


In addition to its benefit in LIHTC pricing, the guarantee has an immediate value to developers:


Schwartz noted that MacArthur’s guarantee eliminates the need for property sponsors to capitalize a large cash reserve to protect investors for Section 8 risk – a common requirement of many syndicators and investors.


Exactly – the equity syndication marketplace has concluded that investors should not take the Section 8 overhang risk, so unless someone else will, the equity investors insist on the developer putting up cash equal to some fraction of the potential annual revenue loss.


Patrick Sheridan of Volunteers of America (VOA), a national nonprofit developer of LIHTC projects, praised the enhanced fund and said that because of it his organization won’t have to take money from each project’s funding sources to capitalize a transition reserve as is often required by equity sources due to the Section 8 risk and overhang concern. “That cash reserve would deplete some of the funds that we would have had available for either paying for more renovation work, or paying developer fees, or things like that,” he said. “So the fact that we don’t have to post a cash reserve of Section 8 transition really makes the deals work much better.”



The notional guarantee amount is substantial, one-fifth of the fund’s total raise:


The Foundation is providing a $20 million guarantee in connection with the fund, which aims to provide $100 million to nonprofit developers to help finance the preservation and renovation of approximately 20 project-based Section 8 LIHTC properties nationwide serving more than 2,000 low-income residents.


Evidently it’s a solid foundation


Aside from eliminating the need for a Section 8 overhang cash escrow, a feature of immense benefit to the developers, it also supports the property’s hard debt, and may well have led to better financing terms.  Given MacArthur’s orientation toward Mission Entrepreneurial Entities as owners, it’s not surprising that the fund emphasizes non-profits.


Deb Schwartz at AHI’s World Habitat Day event in Washington DC


The tax credits are being syndicated and the fund co-managed by the National Affordable Housing Trust, a nonprofit syndicator based in Columbus, Ohio, and Cornerstone Real Estate Advisors, LLC, a unit of Massachusetts Mutual Life Insurance Company (Mass Mutual).


An initial fund of $50 million recently closed and has been committed to finance eight preservation projects in Massachusetts, Minnesota, Nebraska, Ohio, and Oklahoma. Investors in the fund include JPMorgan Chase, Mass Mutual, MetLife, and United Bank. A second fund of $50 million is expected to close later this year.


Naturally the guarantor wants to know that its sponsors are both mission-worthy and credit-worthy:


That fund will finance additional LIHTC Section 8 projects developed by sponsors approved by the Foundation.


What’s in it for MacArthur?  Impact:


Making a difference on earth


In an interview, Schwartz said that while the LIHTC equity market has recovered significantly, there continue to be certain geographic areas and types of projects – among them preservation deals – that still have a tough time attracting equity. “Right now preservation doesn’t have a fair shot in the capital markets, in our view. We want to show that there is this challenge, but there are solutions, too.”


Compared with new construction, affordable housing preservation is often more cost-effective and politically acceptable, due to the production paradox.


The initial fund will also help finance Renaissance Senior Apartments, a 100-year-old property in Toledo, Ohio being renovated by National Church Residences.



Taking the guarantee risk is a brave and appropriate thing to do


All in a day’s work, Commissioner