Real Estate Research provides analysis of topical research and current issues in the fields of housing and real estate economics. Authors for the blog include the Atlanta Fed's Jessica Dill, Kristopher Gerardi, Carl Hudson, and analysts, as well as the Boston Fed's Christopher Foote and Paul Willen.
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March 2, 2018
Tax Reform's Effect on Low-Income Housing
The recently enacted Tax Cuts and Jobs Act of 2017 substantially reduced corporate taxes, from 35 percent to 21 percent. Some commentators and practitioners have voiced concerns about how the new tax law will affect demand for Low Income Housing Tax Credits (LIHTC), America's primary mechanism for producing new or refurbished affordable housing units. According to Dawn Luke, chief operating officer with Invest Atlanta, the lowering of the corporate tax rate continues to present challenges to the market in terms of LIHTC pricing, with credit prices being lowered by as much as 16 cents on the dollar for projects in the near-term pipeline. Luke says this means that several affordable housing projects could become bottlenecked as developers scramble to find subsidy to fill this gap. In addition, this firm expects that declining demand for LIHTCs will generate 20,000 fewer low-income housing units a year, a roughly 15 percent decline.
It's worth taking a few moments to review how the LIHTC actually works. The LIHTC program, created as part of the Tax Reform Act of 1986, allows developers to receive tax credits in exchange for committing to rent their units for 30 years to households earning less than 50 to 60 percent of the area's median income. Private developers apply to receive an LIHTC subsidy through their state housing authorities, and are allocated a subsidy equal to a percentage of construction and eligible soft costs. Developers awarded an allocation receive a 10-year annuity of nonrefundable tax credits that they can use to offset positive future federal income tax liability. For example, through the program, the developer of a $10 million apartment building could receive up to $1.17 million a year for 10 years. (This assumes that, to receive a basis boost, the developer would receive a 9 percent allocation and the project would be located in either a sufficiently low-income neighborhood or a high-rent metro area.)
Due to the rental restrictions, it is virtually impossible for LIHTC properties themselves to generate enough tax liability to claim the full value of allocated tax credits, so developers need to have either sufficient other federal income tax to offset or the income tax of a limited partner. These outside investors, usually organized through a partnership called syndication, would contribute a fixed dollar amount to the developer upon completion of the subsidized property in exchange for 99.9 percent of the equity, including allocated tax credits, of the project.
The allocated tax credits themselves offer a dollar-for-dollar reduction in future tax liability, so changing the corporate tax rate does not directly reduce their statutory value. So why might the after-market value of the credits fall with the new tax law?
First, the recent tax cuts reduce the pool of firms with sufficient tax liability. If a business has less tax liability than it has tax credits, that business would effectively leave money on the table. The business would have to at least wait until it had enough tax liability to claim the subsidy. Several past investors in LIHTC properties, including Fannie Mae, learned firsthand how illiquid their LIHTC investment actually was after the 2008 financial crisis. With the lower corporate rate and other favorable provisions that are coming out of the new tax law, some firms that previously may have found the investment profitable may well reconsider.
Even firms that expect to have large profits may now have greater uncertainty about their future taxes as they work through the 1,100-page bill. The increased risk could cause firms to value less any future reductions in their tax liability.
The owner of an LIHTC project, like owners of all residential buildings, gets to deduct the building’s depreciation over a 27.5-year schedule. These depreciation allowances, coupled with LIHTC rental restrictions and relatively high operation costs due to compliance with those restrictions, often result in large expected tax losses that go beyond the allocated tax credits. For example, the $10 million apartment building mentioned above would be expected to generate more than $290,000 in depreciation allowances a year that outside investors not limited by passive-loss restrictions (such as C corporations) could use to offset other taxable income. The reduction in the corporate rate from 35 percent to 21 percent would lead to about a $626,000 decrease in outside investors’ willingness to pay developers for those deductions under reasonable assumptions. (A potential headache is that depreciaton allowances are subject to recapture if the project is eventually sold for more than tax basis. This provision rarely needs to be enforced.) This represents a 5.9 percent reduction in the overall valuation of the investment, which could require additional debt on the property and perhaps make some projects no longer feasible.
At the same time, lower taxes should expand the supply of market-rate housing. Only a small fraction of low-income households occupies newly built, rent-capped homes produced under the LIHTC. Most of these households use their own earnings or HUD vouchers to pay the market rents for older, existing apartments. A recent study by Stuart Rosenthal in the American Economic Review showed that while newly constructed units are often unaffordable for most households, they eventually supply the majority of future low-income affordable housing. This "filtering down" occurs as a result of physical depreciation or shifts in style or location preferences. If lower taxes generate new market-rate construction—and thus increase the aggregate supply of housing—these lower taxes should lower rents throughout the market or increase landlord participation in HUD voucher programs.
Eriksen and Lang suggest two changes to the LIHTC program that would increase the supply of affordable housing produced under the program without increasing tax expenditures. The first, and most immediate, would be simply to make the allocated tax credits through the LIHTC program refundable, because uncertainty about future tax liabilities reduces both the pool of otherwise eligible investors and the market value of allocated tax credits. Making this change would also give some developers at least the option of claiming the credit themselves rather being forced to partner with outside investors. The second change would allow developers to claim an actuarially equivalent subsidy over a shorter time period than the currently required 10 years. Developers and LIHTC investors are thought to have a much higher cost of capital than the federal government. In the extreme, allowing developers to claim the full value of refundable tax credits when projects are completed would give them the greatest flexibility in financing their projects.
Increasing the supply of housing affordable to low-income families could be achieved using other policies that focus on reducing other barriers to increasing housing production, like state and local zoning laws that limit the location and density of multifamily housing. A bill working its way through the California legislature would appear to be in this spirit.
Chris Cunningham is a research economist and associate policy adviser at the Federal Reserve Bank of Atlanta; Mike Eriksen is associate professor of real estate in the Linder College of Business at the University of Cincinnati.
The views expressed here represent those of the authors and not the Federal Reserve Bank of Atlanta or the Federal Reserve System.
November 3, 2015
Keeping an Eye on the Housing Market
In a recent speech, Federal Reserve Bank of San Francisco President John Williams suggested that signs of imbalances were starting to emerge in the form of high asset prices, particularly in real estate. He pointed out that the house price-to-rent ratio had returned to its 2003 level and that, while it may not be at a tipping point yet, it would be important to keep an eye on the situation and act before the imbalance grows too large. President Williams is not the only one monitoring this situation. Many across the industry are keeping a watchful eye on the rapid price appreciation (see here, here, and here), including my colleagues and me at the Atlanta Fed.
While it is too soon to definitively know if a bubble is forming, the house price-to-rent ratio seems like a relevant measure to track. Why? Basically, because households have the option to rent or own their home, equilibrium in the housing market is characterized by a strong link between prices and rents. When prices deviate substantially from rents (or vice versa), the cost-benefit calculus in the rent-versus-own equation changes, inducing some households to make a transition. In effect, these transitions stabilize the ratio.
In an effort to better understand house price trends, we chart the house price-to-rent ratio at an annual frequency on top of a stacked bar chart depicting year-over-year house price growth (see chart below). Each stacked bar reflects the share of ZIP codes in each range of house price change. Shades of green indicate house price appreciation from the year-earlier level, and shades of red indicate house price decline. The benefit of considering house price trends through the lens of this stacked bar chart is, of course, that it provides a better sense for the distribution of house price change that is often masked by the headline statistic.
Looking at these two measures in concert paints an interesting picture, one that doesn't appear to be a repeat of the early 2000s. While the house price-to-rent ratio indicates that house prices on a national basis have been increasing relative to rents, the distribution of house price change looks a bit different. In 2003, roughly 20 percent of ZIP codes across the nation were experiencing house price appreciation of 15 percent or more on a year-over-year basis. In 2014 and 2015, less than 5 percent of ZIP codes experienced this degree of appreciation.
To better understand the regional variation, we repeated this exercise at a metro level using the Case-Shiller 20 MSAs (see charts below). (House price-to-rent ratios for Las Vegas and Charlotte were not calculated because the Bureau of Labor Statistics does not provide an owners' equivalent rent for primary residence series for these markets.) This more detailed approach reveals that elevated price-rent ratio readings were only present in a few, perhaps supply-constrained, metropolitan areas (see top right corner of each chart for the Saiz supply elasticity measure). Moreover, current home price appreciation across ZIP codes does not have the breadth that was present during the early 2000s.
Notes: (1) All price-to-rent ratios are indexed to 1998, except Dallas and Phoenix, which are indexed to 2002. (2) SE = Saiz's Supply Elasticities. Pertains to city boundaries, not metropolitan areas. For more information, see Albert Saiz, "The Geographic Determinants of Housing Supply," The Quarterly Journal of Economics (August 2010) 125
As John Krainer, an economist at the San Francisco Fed, pointed out in a 2004 Economic Letter, "it is tempting to identify a bubble as a long-lasting deviation in the price-rent ratio from its average value. But knowing how large and long-lasting a deviation must be to resemble a bubble is not obvious." We will continue digging and report back when we think we know something more.
Jessica Dill, economic policy analysis specialist in the Atlanta Fed's research department
May 16, 2014
Are Single-Family Rental Securitizations Here to Stay?
In the fall of 2013, private equity firm Blackstone LP issued the first single-family rental (SFR) securitization: Invitation Homes 2013-SFR 1. In March, Colony Capital released another SFR securitization. The Invitation Homes 2013-SFR 1 was backed by 3,207 single-family rental homes concentrated in Arizona, California, Florida, Georgia, and Illinois. Deutsche Bank arranged the deal. There are a variety of estimates of the size of institutional investors’ activity in the SFR market, but with numbers like 90,000 to 150,000 homes and 15 to 20 billion dollars invested, most agree that we can expect more securitizations like these in the future. So what exactly is this new asset class, and how did it obtain its strong credit rating?
In this post, we look at how the structure of the Invitation Homes SFR emerged and compare it to more familiar commercial mortgage-backed security (CMBS) and residential mortgage-backed security (RMBS) classes to better understand the triple-A rating. We also consider some factors that could determine whether the SFR security class will stick around.
(For a nice discussion about the entry of institution investors into the rental market, read this second-quarter 2013 EconSouth article.)
Please note that much of the information that follows is based on reports from the rating agencies:
- Kroll Bond Rating Agency. "Kroll Bond Rating Agency Assigns Final Ratings to Invitation Homes 2013-SFR1". (November 11, 2013.)
- Kroll Bond Rating Agency. 17g-7 Disclosure (Invitation Homes 2013 SFR1).
- Moody’s Investor Services. “Moody's sees growth for single family rental securitizations; outlines rating approach.” (March 6, 2014.)
- Moody's Investor Services: “Moody's identifies key risk factors in securitizations of single-family rental properties.” (August 23, 2012.)
Commercial or residential—or both?
This product took a long time to come to market. For nearly two years, the industry discussed how to structure this new security class. Discussions in 2012 and 2013 about the rating and pricing of an SFR security focused on three gray areas. The first was housing market risk. Would housing markets, and the underlying value of investor-owned homes, appreciate on a market-wide basis?
The second was property management risk. Could scattered-site, single-family homes be managed cost-effectively? And with a lack of historical data for scattered-site, single-family rentals, how could credit rating agencies predict vacancy rates, maintenance costs, and income streams with any precision?
Finally, there was confusion about how to structure an SFR securitization and what tensions and risks would exist in that structure. There was also some uncertainty about whether an SFR securitization would be more like CMBS or RMBS. Like RMBSs, the underlying assets of SFRs are single-family homes. And many risks—for example, home price depreciation and household income—are the same as in the homeownership market (Joseph Hu 2011). But like CMBSs, the borrower is a corporation, not a homeowner, and the cash flow comes from rental, not mortgage, payments. That means the payments come from highly variable net operating income, which is sensitive to vacancy rates, market rents, and maintenance costs unlike the fixed-income streams of mortgages, which are sensitive to repayment and default risk but otherwise fairly predictable. Also like CMBSs, the sponsor of the SFR deal would be responsible for maintenance, meaning they might have to keep some cash on hand.
Equity pledges or first-priority mortgages?
These issues influenced the structure of the security. High maintenance costs associated with the rental properties created a nontrivial conflict. Ideally, in a security, assets are owned by a tax-neutral, special-purpose vehicle (SPV), with assets and liabilities perfectly matched. However, retaining cash flows for maintenance jeopardizes that tax-neutral status. Early discussions favored a structure in which the borrower, not the SPV, would retain ownership of the properties and instead of mortgages, equity pledges would collateralize the securitization. While these equity pledges might be preferable for maintaining properties and would be less transaction-intensive than issuing individual mortgages, equity pledges would create a weaker claim than first-priority mortgages for investors in the event of default. Further, equity pledges were not deemed to be as bankruptcy-remote as mortgages. All this meant equity pledges could be vulnerable to material consolidation in the event the sponsor were to become bankrupt or if the sponsor were to mismanage the properties, either selling them or borrowing further and creating competing liens on the properties (Matthew Clark 2013). For this reason, Moody’s and Kroll stated that they would cap securitizations using equity pledges at Baa or A.
Ultimately, the Invitation Homes/Blackstone SFR security used first-priority mortgages, not equity pledges, and secured a triple-A rating. In structure, the security is probably more like CMBS than RMBS. Deutsche Bank compared the instrument to CMBS, and the ratings agencies also leaned this way—Kroll and Moody’s compared the security to CMBS on the forms where they express their expectations for representations and warranties. Aspects of the transaction itself suggest that it is more like a CMBS deal than an RMBS one. For instance, the special servicer, Situs Holdings LLC, specializes in CMBS (not RMBS) workouts. Still, the security remains a hybrid. Kroll used a CMBS model to determine the probability of default and an RMBS model to determine severity, working on the assumption that the income-based approach typically used in valuating CMBSs would not be appropriate for pricing the sales of single-family homes in a distressed housing market. Similarly, Morningstar used both Cap Ex and HPI stress tests to generate ratings of the various tranches, feeling that both an income/expense approach and a sales approach to valuation were appropriate.
The structure of the securitization reflects a priority for enhancing an investor’s ability to take ownership and sell the homes in the event of a default, rather than other structures which might have prioritized management of homes to enhance rental income. Moody’s did not base its rating on an evaluation of the income streams from the properties, because the agency did not feel it had the ability to evaluate with certainty vacancy rates, maintenance costs, and other key factors. Instead, it based its rating on the strength of investor claims on the homes in the event of default, and estimated sales prices of the underlying properties assuming a distressed housing market. Another factor in the triple-A credit rating is that the security is overcollateralized. That is, the value of the collateral ($638M) is well above the value of the loans ($479M)—Invitation Homes took a 25 percent advance rate on these homes.
Will they last?
Some negative commentary has surfaced in the five months since the Invitation Homes offering. And S&P has come out strongly against the triple-A rating, arguing that without historical performance data there is too much uncertainty about income streams. Recent appraisals noted that several tranches were trading below par, and that rents had declined 7.6 percent due to increasing vacancy rates. Firms that had hoped to make margin by “pushing rent” or increasing rents every year are now talking about keeping rents stable in order to minimize turnover and the associated vacancy rates. So with all of these issues, how much staying power does the SFR securitization structure really have? To the extent that these transactions are driven primarily by the value of the underlying collateral and not by rental income, they begin to resemble trades that will decline as home prices approach normal levels. Indeed, many SFR investors and managers say they ultimately intend to sell single-family rentals back into the owner-occupied market either 1) when maintenance costs begin to outweigh the potential of the asset’s income stream or 2) it appears that, in the medium term, home prices and mortgage markets have recovered—and thus the opportunity for this market to exist disappears.
Other commentators suggests otherwise: this asset class will grow, possibly driven by fundamental demographic shifts such as increasing labor mobility and shifting preferences for rentals. These attributes, combined with stagnant wages and tight mortgage markets, suggest increased demand for single-family rentals. They may also suggest that SFR securitization represents a new normal.
By Elora Raymond, graduate research assistant, Center for Real Estate Analytics in the Atlanta Fed's research department, and doctoral student, School of City and Regional Planning at Georgia Institute of Technology
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