Why affordable housing can’t pay for itself

This is the first in a series of posts about how affordable housing works, by an affordable housing developer. This post walks through the math behind developing a three-bedroom unit for a family making 50% of the area median income. Read the rest of the series here.

If you’ve spent any time following a discussion about a new development project in your neighborhood or a proposed change to housing policy in your local jurisdiction, you know how frequently “affordable housing” comes up. With the DC region in a long-term crisis of steadily rising home prices and rents, the question of how to build and preserve housing for low- and moderate-income households is top of mind for many local residents. However, debates about affordable housing are often heavy on rhetoric and light on specific details. While many may support building affordable housing conceptually, it can be very difficult to understand the financing tools, design considerations, and operational requirements that are needed to actually build affordable housing in practice.

This article will be the first of a series of posts intended to demystify how the development of affordable housing works. I’ll explain the practical considerations that affordable housing developers, like myself, grapple with on a daily basis, with emphasis on financing and the economics of housing markets. The series will highlight both the opportunities and the limitations of affordable housing development as a means of solving the region’s housing crisis.

First, an important definition: what is affordable housing, exactly? In the United States, the Department of Housing and Urban Development (HUD) defines affordable housing as ”housing on which the occupant is paying no more than 30 percent of gross income for housing costs, including utilities.” The term is often used as a shorthand for income-restricted affordable housing for low- and moderate-income households. Low- and moderate-income households are defined based on how their income compares to the area median income (AMI) of the specific metropolitan region where they live. While precise thresholds can vary by program, I will use the HUD “Community Development Block Grant” program definition, which specifically defines low-income households as those earning 0-50% AMI and moderate-income households as those earning 50-80% AMI.

For this series, I will use the term “affordable housing” to refer specifically to income-restricted housing for low- and moderate-income households, with a particular emphasis on 50% AMI and below (i.e. low-income housing). Note that HUD updates and publishes AMI estimates each year for each metropolitan region using household income data, so precise income limits and rent levels change annually.

In this post, I’ll explain some of the basic concepts in affordable housing finance by exploring a common question: “What would it take to build more family-sized affordable housing in DC?” In particular, I’ll look at the math behind building a three-bedroom unit affordable to a family of four earning up to $76,050 annually, equivalent to 50% of DC AMI as of 2023. While families are, of course, not the only demographic in need of affordable housing, this example can serve as a useful starting point for understanding the general math behind any given development project.

The development budget: Project “uses”

The first step to explore this question is to understand the cost of building a three-bedroom apartment. For any given unit, the “total development costs” (or “TDC” in developer-speak) can generally be broken down into the following categories:

• Acquisition costs: Cost to purchase the property, whether that property is vacant land or an existing building

• Construction costs (“hard costs”): Cost of actual construction, including materials, labor, and the general contractor’s administrative costs

• Design, permitting, taxes, insurance, legal, and miscellaneous costs (“soft costs”): Costs paid to architects, lawyers, local government, insurance agencies, and other miscellaneous items; usually about 10% of hard costs

• Financing costs: Costs related to the funding used to pay for the project during construction, primarily debt, that includes interest on any construction loan as well as bank fees; usually 7-15% of hard costs, depending on interest rates, construction duration and financing sources

• Construction and operating reserves: Funds set aside both during the construction phase and operating phase to cover any shortfalls; construction reserves are usually 5-10% of hard costs, depending on project type, while operating reserves are usually sized to cover six months of projected operating expenses

• Developer fee: Costs paid to the developer that form the basis of the company’s revenue (similar to architects and contractors, developers usually earn revenue from the project on a fee basis to cover costs and earn income); usually 7-15% of hard costs, depending on project type

To determine what these costs look like in practice for our hypothetical three-bedroom apartment, let’s start with some basic assumptions:

Apartment size: 1,000 square feet of “net residential area,” i.e. in-unit living space. Some building space is required for hallways, mechanical equipment, and other uses. Let’s assume that the net residential area is only 85% of the total building area (this percentage is referred to as the “core factor”). This requires a “gross construction area” of 1,000 / 85% = 1,175 square feet.

Acquisition cost: While land costs vary significantly based on location and timing of the business cycle, let’s assume $100 per square foot of buildable net residential area, which is in line with historical averages in DC in recent years.

• Total: $100 per sq. ft. * 1,000 sq. ft. = $100,000

Hard costs: For building type, we’ll assume a new construction low-rise wood-frame apartment. Wood-frame apartments can go up to five stories and are generally cheaper to build per square foot than taller steel or concrete buildings. Construction costs have increased enormously over the last several years, so while a low-rise wood-frame apartment may have cost around $215 per square foot in 2019, right now, a more realistic assumption is $300 per square foot. (Steel and concrete projects, by comparison, have recently hovered around $400 per square foot, while preservation/renovation projects have tended to cost around $300-$350 per square foot.)

• Total: $300 per sq. ft. * 1,175 sq. ft. = $352,500

Soft costs: 10% of hard costs = $35,250

Financing costs: Because the financing tools of affordable housing involve higher transaction costs (more on this below), we can assume that financing costs will be on the higher end of our original 7-15% range. So, let’s use 12% of total hard costs.

• Total: 12% * $352,500 = $42,300

Construction reserve: 7% of hard costs = $24,675

Operating reserve: Assuming an operating cost per apartment of $11,000 per year (more on that below), we can size an operating reserve to cover projected expenses for six months.

• Total: $11,000 / 2 = $5,500

Developer fee: Developer fees are generally structured to be paid upfront as a construction period cost (“paid” developer fee) or paid over time from the property’s cash flow as a loan from the developer to the project (“deferred” developer fee). The standard percentage of developer fee often depends on whether the fee is paid or deferred, with 7% being typical for a paid fee and 15% typical for a deferred fee. For this example, let’s assume a fully paid 7% fee.

• 7% of Hard Costs = $24,675

Putting this all together, our “total development costs” are as follows:

Acquisition cost: $100,000
Hard costs: $352,500
Soft costs: $35,250
Financing costs: $42,300
Construction reserve (contingency): $24,675
Operating reserve: $5,500
Developer fee: $24,675

TOTAL DEVELOPMENT COSTS: $584,900

You may be thinking: “$585,000 for one three-bedroom apartment is extremely expensive!” And you would be right. Building new housing is always expensive, but the significant increase in construction costs in recent years has made it even more challenging.

In the example above, if we kept all the rule of thumb percentages the same but reduced the estimated hard costs to $215 per sq. ft. (a more standard number in 2019), then the total cost would be $449,070. Material and labor cost inflation has had an enormous impact on the entire housing market in recent years, as it has in most other sectors of the economy. For comparison, a 2023 national survey from the National Association of Home Builders found the average TDC of a single-family home was $644,750 in 2022, compared with $485,128 in 2019.

One caveat: these numbers do not suggest that apartments are roughly comparable in cost to single-family homes. The apartment example is DC-specific, while the single-family home figure is national. Development costs are significantly higher in expensive cities like DC, confirming an old rule of urban economics that “prices adjust to achieve locational equilibrium”. The cost of building a single-family home in DC is well above the national average, and single-family homes are indeed significantly more expensive to build on a per-unit basis.

While costs do tend to ebb and flow in accordance with the business cycle (and real estate is extremely cyclical), only time will tell if we are in a new normal cost environment or if we can expect some reversion to the mean in future years.

The financing tools: Project “sources”

Now that we’ve looked at the factors that go into the cost of building an apartment, let’s consider how to pay for it. One of the primary jobs of any developer is assembling the funding sources to fully cover a project’s cost, i.e. “balancing the sources and uses”.

As with any project, real estate financing sources can generally be divided into two buckets: equity and debt. If you think of a standard home purchase, equity is the amount you contribute yourself, via a down payment, while debt is the mortgage you take out from a bank or other financial institution. If you make a 10% down payment and then pay the balance of your costs with a mortgage, you are financing the transaction of your home purchase with 10% equity and 90% debt.

Debt financing

In a normal home purchase, the bank evaluates your income streams to determine what size mortgage you qualify for. Similarly, in real estate development, the bank evaluates the completed building’s estimated long-term cash flow to determine how much debt it can sustainably maintain. Banks often require a “Debt service coverage ratio” of 1.15 to 1.20, meaning that the property’s projected income stream is 1.15 to 1.2 times the regular payments due on the loan. 1.15 is considered more aggressive (because it allows for less cushion), while 1.20 is more conservative. The amount of debt available is thus limited by the project’s cash flow, which in turn depends on estimated rents and operating expenses. As with a regular home mortgage, the available loan size depends on the project’s estimated income as well as interest rates. Higher-income equals a larger loan, while higher interest rates equal a smaller loan.

In standard market-rate deals, banks also often cap their loan size based on a ratio of the Total Development Costs to reduce risk during the construction phase. This “loan to cost” (LTC) ratio is often 60-65% of a project’s total development costs, meaning that developers must contribute 30-35% in equity. In affordable housing deals, specialized loan products exist that allow projects to go well above the 60-65% LTC limit, so debt is usually sized primarily as a function of long-term projected income rather than total development costs. In the case of our three-bedroom apartment, the income will depend primarily on rent and expenses.

For our three-bedroom apartment example, we are assuming a 50% AMI unit, which means the rent level is affordable for a four-person household earning $76,050 annually (50% of the 2023 area median income in the DC metropolitan area, which is $152,100 for a family of four). The rent is then calculated, based on bedroom size and a family-size adjustment factor, at $2,090 per month.

For operating expenses, we assume a cost of $11,000 per unit annually. In a standard multifamily apartment building, major operating expenses include property management services, including management and maintenance staffing; third-party contracts, including janitorial, landscaping, and trash-pickup services; routine repair and maintenance work; property insurance; common-area utilities; marketing and leasing; and office administration. Property taxes are also a major expense item, although the District does have an existing property tax exemption program specifically for nonprofit affordable housing projects, which is essentially an operating subsidy for affordable housing. The $11,000 operating reserve figure assumes standard unit operating expenses as well as the property tax exemption.

For loan financing terms, multifamily affordable housing projects generally have mortgage rates that are 50-100 “basis points” (0.50% - 1.00%) lower than conventional 30-year mortgages. These loans also often amortize over a longer time frame—generally 35-40 years, depending on the project. For this example, let’s assume a 6.5% mortgage with a 40-year amortization period and 1.20 Debt Service Coverage.

Based on these numbers, our loan size for the three-bedroom apartment is as follows:

Annual rent: $2,090 * 12 = $25,080
Net operating income: $25,080 - $11,000 = $14,080
Maximum annual debt service: $14,080 / 1.2 = $11,733

TOTAL DEBT PROCEEDS: $167,006*

*Based on a mathematical formula for sizing amortizing debt based on rate, period, and periodic payments

As you can see, this total amount leaves us well short of the total cost of building the unit, which, again, is $585,000. While the current high-interest-rate environment certainly does not help the total loan size, even in a low-interest rate world, the debt is still not enough to fund the project. For example, a 4% mortgage rate would allow for $233,946 in debt, which is significantly higher than the amount under current rates, but still well short of total costs.

To address this shortfall, we’ll turn next to the other side of the financing equation: equity.

Equity financing

As I mentioned earlier, equity is cash put into a project either directly by the owner or by the investor. When purchasing a house, it is the down payment the buyer provides. In traditional market-rate development, very large corporate developers can occasionally fund equity from their own internal balance sheet, but this is rare. More frequently, developers will pursue external funding from institutional investors such as private equity, pension funds, and insurance companies.

The key thing to understand about equity is that it is generally much more expensive than debt; the higher cost compensates for the higher risk. Whereas debt is first in line to be repaid, equity investors are only paid back from a property’s net cash flow after mortgage payments. While there is, therefore, more upside if the property does well, there is also more risk if the cash flows do not meet projections. Furthermore, equity investors interested in owning real estate can always purchase stock of publicly-traded real estate companies (real estate investment trusts, or “REITS”) rather than invest directly into a major construction project where it is much harder to “exit” the deal.

In exchange for this higher risk, equity investors generally expect a significant premium above standard rates of return on REIT stocks. Over the last 25 years, residential REITS have earned an average return of 12.6% annually, so institutional investors in individual projects expect a return significantly above that threshold, often 16-18%. Below that projected return, institutional investors are highly unlikely to contribute equity, and the project will not have the funding to move forward.

In affordable housing projects, rents are generally too low to ever meet that equity return threshold, which means they do not represent a good investment opportunity compared to stocks. Instead of relying on third-party equity, affordable housing developers most often rely on federal funding, particularly the Low-Income Housing Tax Credit (LIHTC). Similar to the tax credits created in the Inflation Reduction Act to spur green energy projects, Low-Income Housing Tax Credits are a program in the federal tax code to spur affordable housing development. Institutional investors, most often banks, provide upfront equity investment for a project during construction in exchange for writing off the costs of the equity investment from their corporate tax liability. To learn more about the program and how these tax credits work, see this GGWash explainer.

Since the creation of these tax credits in 1986, they have financed the development of 3.55 million housing units through 2021. In the early 2000s, units built with LIHTC surpassed the total number of traditional public housing and project-based Section 8 housing units; by 2013, LIHTC units also passed Section 8 vouchers to become the primary affordable housing financing program in the United States by total unit count. Today, nearly all new affordable housing projects include LIHTC as part of their financing strategy.

The total tax credits available for any individual project are based on the project’s total eligible costs as well as the trading price of the tax credit on the market; depending on location and other factors, credits usually trade at $0.90 - $0.95 per $1 in tax reduction. There are two types of tax credits—4% and 9%—but for our three-bedroom example, we will focus exclusively on the more common 4% credit, which means annual credits received are equal to 4% of total eligible costs.

Most hard costs, soft costs, financing costs, and developer fees are eligible costs, while acquisition costs (unless renovating an existing building) and reserves are not. To calculate the exact amount of tax credits the project can receive, let’s assume that 100% of hard costs, 100% of construction contingency, 90% of soft costs, 75% of financing costs, and 100% of developer fees are eligible and that the credits trade for $0.93. The project will then receive an annual credit equal to 4% of total eligible costs for ten years, and the upfront LIHTC equity the investor provides will be the total credits received multiplied by the price per credit.

Eligible costs:

Acquisition cost: $0
Hard costs: 100% * $352,500 = $352,500
Soft costs: 90% * $35,250 = $31,725
Financing costs: 75% * $42,300 = $31,725
Construction reserve (Contingency): 100% * $24,675 = $24,675
Operating reserve: $0
Developer fee: 100% * $24,675 = $24,675

Total LIHTC-eligible costs: $465,300

Tax credits received: $465,300 * 4% * 10 years = $186,120

LIHTC equity: $0.93 * $186,120 = $170,092

TOTAL TAX CREDIT PROCEEDS: $170,092

In this example, our project will now have a LIHTC investor who provides $170,092 of funding during the construction period and becomes a co-owner of the property, while receiving a tax deduction of $18,612 (4% of eligible costs) each year for ten years after the property begins operations.

Balancing sources and uses

We now have our two project funding sources, mortgage debt and tax credit equity, accounted for. Unfortunately, even these funding sources combined are still not enough to cover our total development costs, so we have a funding shortfall:

Total development costs (“uses”): $584,900

Total debt proceeds: $167,006

Total equity proceeds: $170,092

Total funding (“sources”): $337,098

FUNDING SHORTFALL: $247,802

Understanding “the gap”

For those of you who have patiently followed along with all of these calculations, this is the key mathematical insight: affordable housing cannot pay for itself and is heavily reliant on government subsidies. This projected funding shortfall even already accounts for two government subsidies, federal tax credits, and a local property tax exemption, which illustrates just how subsidy-dependent the industry is.

Often, people like to blame “land speculation” and “developer greed” as the causes for the undersupply of affordable housing. But our three-bedroom example shows this is mathematically incorrect. If we remove all acquisition costs from the equation (i.e., assume the property has been acquired for free and all “speculation” has been removed from the equation), there is still a funding shortfall of $147,802. If we further remove all developer fees from the equation (i.e. assume all the development work has been done for free and the costs of financial guarantees and risk are not accounted for), there is still a funding shortfall of $129,307, accounting for reduced LIHTC equity as a result of lowered eligible basis.

The shortage of affordable housing is not a result of speculation or greed. It is a function of the cost of building new affordable housing. Affordable three-bedroom apartments are not getting built in the District because the cost to build them is greater than the funding sources available. While the precise funding shortfall per unit varies over time due primarily to construction costs, interest rates, and rents—which all fluctuate with macroeconomic conditions—the overall challenge remains. Affordable housing cannot pay for itself.

This funding shortfall is what affordable housing developers refer to as “the gap”. Much of the work of affordable housing development involves finding creative ways to close the gap so that a project’s sources and uses balance and the housing can be built. This often involves tapping into additional government funding programs, finding philanthropic partners, or utilizing market-rate housing to cross-subsidize affordable units.

In the District of Columbia, one powerful tool that the affordable housing development community relies on heavily is the Housing Production Trust Fund, a revolving loan fund managed by the city government that provides “gap financing” via a second mortgage to affordable housing projects on a competitive basis. In future posts, I’ll dive further into how this mechanism works and how it compares with funding approaches in other jurisdictions, as well as discussing other opportunities and challenges in the field of affordable housing development.