A Different World: An America without the Low-Income Housing Tax Credit

By David A. Smith
June 4, 2013 22 min read

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Each man’s life touches so many other lives. When he isn’t around he leaves an awful hole, doesn’t he?

– It’s a Wonderful Life

George Bailey, Secretary of the U.S. Department of Housing and Urban Development, surveyed his agency’s FY 2013 portfolio-level report. Across the board, results were dismal. With HUD alone bearing the burden of financing the development, renovation, and preservation of the nation’s entire supply of affordable housing, costs were rising; scandals abounded; and banks, investors, and states were unwilling to help. Now, in a time of sequestration, with further budget cuts coming, the Secretary had to choose which of his already-underfunded housing programs would be cut…and therefore which portfolios would fail. He did not relish the prospect.

Born a little over a quarter-century ago within the 1986 Tax Reform Act, the federal Low-Income Housing Tax Credit (LIHTC) has become the tent pole around which the nation’s entire affordable rental housing delivery system has been restructured – a system vastly different from and better than the HUD-centric model which dominated before. More than circumstance, this is due to core features that make LIHTC, for public-policy and practical reasons, a much better funding source for the development and preservation of affordable apartments for families and seniors than direct federal appropriations. The LIHTC program has benefits (risk transfer, collectible recapture, and outcome-based regulation) that appropriated programs cannot duplicate.

LIHTC’s benefits are multi-dimensional – to financing and delivery, renters and markets, cities, and housing policy.

Based on my 37 years in the affordable housing business, including involvement with virtually every federal housing program to come along, it is clear to me that if the LIHTC program had never existed, the nation would be much worse off across four principal dimensions of societal and economic health. These include:

 

• Financing and delivery. Had there been no LIHTC, neither banks nor state housing finance agencies would have had the motivation or mechanism to play the critical roles they play today in delivering affordable housing finance that addresses housing needs and is soundly underwritten for long-term successful performance.
• Renters and markets. Had there been no LIHTC, America’s affordable renters would be consigned to a narrow set of housing choices without mobility and without market-quality or market principles that motivate virtuous-circle innovation.
• Urban affordable housing and America’s cities. Had there been no LIHTC, rehabilitated historic buildings would not be anchoring downtown revivals; workforce housing and transit-oriented development would be rare; and homelessness would be higher.
• The nation as a whole. Had there been no LIHTC, permanent supportive housing would never have emerged as an alternative tenure model; inclusionary zoning would have been stillborn; affordable housing would have been a partisan issue; and the nation would face even larger budget deficits.

 

To appreciate just how critical LIHTC has been and still is, consider the following snapshot of how affordable housing in the U.S. would look if Congress had left Section 42 out of the 1986 Tax Reform Act.

 

Financing and delivery

Before LIHTC, equity investment in affordable housing was provided exclusively by high-income individuals, most of whom neither knew much about affordable housing nor cared about poor people and urban upgrading. In addition, debt financing for multifamily rental developments was almost exclusively from the federal government (via FHA or the Farmers’ Home Administration).

LIHTC’s entry into the ecosystem was the galvanizing event that pioneered corporate social responsibility (CSR) by giving CSR a viable business case. LIHTC spawned new agencies and new corporate business models that are well distributed today throughout the country. These units are:

 

• Multi-activity state housing finance agencies, whose LIHTC-fueled growth has led them to supplant HUD as the principal locus of policy innovation and resource delivery for affordable housing, resulting in much greater diversity of housing strategies without sacrificing the capital-markets efficiency fostered by scale and standardization.
• Community Reinvestment Act (CRA)-motivated financial institutions, which established community development departments and community development banks. This created a capital pipeline from Wall Street to Main Street, and a knowledge network infusing economic principles in affordable housing developers, owners, and managers as well as acceptance by banks of social-responsibility principles.

 

Had there been no LIHTC, housing delivery and housing finance would be impeded because of:

 

• No profit-motivated investors in affordable housing. By its nature, affordable housing delivers a below-market economic return. Prior to LIHTC (1968-1985), private entities invested in affordable housing almost solely for tax deductions. (Before 1968, private investors were not involved; affordable housing development was almost entirely by public housing authorities and a tiny handful of merchant builders – general contractors making money just on the construction.)No knowledge-transfer of market-based management principles into affordable housing. Before LIHTC, there was management of conventional apartment properties and management of affordable rental properties – and never the twain met. Because non-LIHTC affordable properties were driven by HUD subsidies and HUD regulations, many managers of these properties never developed a customer-centric focus. Rather, they oriented toward HUD as their sole customer, not the residents.
• No equity syndication, ergo no outsourcing of risk. Within two to three years of passage of the 1986 Tax Reform Act, all forms of real estate equity syndication but one became extinct. Only in affordable housing were some syndicators able to migrate from their previous model into persuading corporations to invest – and in the process educating companies and preparing what would become the CRA-motivated investment market.
• All housing funded by direct federal appropriations, with frequent, expensive, disruptions in production pipelines. Unlike all appropriated programs, which require annual funding from Congress to continue, the LIHTC program is permanent in the tax code, and thus not subject to the increasingly difficult and bitter appropriations battles in Congress, which have led to the sequestration – across-the-board federal spending cuts – that no one wanted but yet came to pass. Sequestration means HUD Section 8 rent subsidies are being funded at only 94.1% of need; public housing operating subsidy/ modernization funds at 83% of need. Families, properties, and communities are going to suffer as a result.Over the previous decade, every appropriated federal housing program has had its funding cut, zeroed out, or disrupted. The HOPE VI public housing revitalization program is a shell of its former self, while the Section 202 program, which once produced affordable apartments for seniors, has been zero-funded. The drop-off in production and capacity of appropriated federal housing programs has rendered them largely irrelevant to state and local housing strategies, and contributed to the United States building far too little affordable housing to keep up with demand. Meanwhile, LIHTC continues unaffected, with state allocating agencies annually making tax credit awards for new housing projects, unbothered by the weekly machinations and tribulations in Washington.
• No community development banking. The late 1980s saw the collapse and dissolution of many savings and loans institutions, wiping out the principal source of community-development lending. Into this void stepped regional and national financial institutions, expanded as the result of the repeal of the Glass-Steagall Act and the emergence of true interstate banking. Spurred in part by these banks’ CRA motivations (see next point), LIHTC’s rise motivated financial institutions to establish community development banks which engaged in community development lending and investment. Before LIHTC, these entities were backwaters within banks not viewed as profit centers or innovation laboratories. LIHTC changed all this, making community development banks an integral and rewarding arm for their parent institution – for financial, CRA, and public-relations reasons.
• CRA infeasible or modified. Although enacted in 1977, the Community Reinvestment Act during its first decade operated more like an encouragement or aspiration to commercial banks for community development lending, rather than a core banking imperative. That changed a decade later as:

(a)    Banks’ CRA ratings became the basis for decisions by federal banking regulators about whether to approve or deny applications for bank mergers and acquisitions. Earning an Outstanding CRA rating became a major competitive advantage to acquisition-minded banks, such as North Carolina National Bank (ultimately emerging as Bank of America after two decades of CRA-enabled acquisitions).

(b)   LIHTC’s rise as an investment vehicle, enabling banks to achieve an Outstanding CRA rating by making equity investments in tax credit properties located within their CRA assessment areas, where it qualifies under CRA’s investment test.

 

These two forces elevated affordable housing and community development from an afterthought in the banking universe to pride of place among the objectives of the bank’s CFO – and hence, those of the CEO. This spurred a vastly expanded commitment to community banking.

 

• No conventional-market interest in affordable housing development or property management. In the time before LIHTC, residential rental property existed in three parallel non-contiguous universes: public housing, affordable housing, and conventional housing. Each had its own: laws of energy (money) and gravity (regulation); imperatives; distinctive areas of expertise and primacy; vocabulary; and practitioners. No one – neither properties nor people nor capital – ever crossed from one universe to the other; each of the three regarded the other two with ignorance, suspicion, and disdain. With LIHTC that changed. By structuring affordability without an inherent commitment to property-based rental assistance, LIHTC moved affordable housing developers and managers into market-equivalent business spaces. By drawing in large financial institutions as investors and lenders, LIHTC moved conventional real estate thinking into the challenges of affordability. With the marriage of HOPE VI to LIHTC, public housing joined the conversation. The resulting admixture cross-fertilized ideas, improved business practices, and encouraged entrepreneurial and socially minded people to migrate across universes. All three have since become more professional, and the result is better housing across all income levels and ownership forms. None of this would have happened without LIHTC’s unique features: the absence of subsidy or regulatory boundaries between affordable and market-rate housing, and the arranged marriage of banks with community development corporations.

 

• Financially weak, cautious state housing finance agencies largely un-innovative in affordable housing. Before LIHTC, many state housing finance agencies did little more than finance single-family mortgages, or the occasional new construction seniors rental project assisted by property-based Section 8 subsidies for the life of the mortgage (an arrangement that largely eliminated real estate operating risk but obligated the federal government to commit up to forty years’ worth of appropriations). Fewer than ten HFAs financed rental housing developments for families and only a handful issued tax-exempt bonds without using FHA mortgage insurance. Most HFAs regarded affordable rental housing as largely HUD’s problem.The enactment of LIHTC, vesting responsibility for the allocation of housing credits in the state HFAs, triggered a massive learning curve for these agencies. It also positioned them to expand dramatically their tax-exempt lending. By allocating housing credits and issuing tax-exempt bonds, HFAs earned fees, built up their net worth, and rapidly gained knowledge and skills in affordable rental housing underwriting and asset management. And, in the process of crafting their annual Qualified Allocation Plan (QAP), state HFAs moved to front and center on issues of affordable housing and urban development policy, gaining substantially in their understanding and political engagement in urbanization issues. The agencies became the forum for debates about transit-oriented development, green improvements, special needs housing, and other initiatives.

 

Renters and markets

Before LIHTC, each rental housing universe focused inwardly, rather than being connected to the wider world of rental markets, capital markets, and property innovations. LIHTC’s rise led to extremely rapid innovation and cross-pollination of ideas, such that today affordable housing is seen as a continuum – of rent levels, income levels, and tenure options – giving households many more choices and more mobility, and leading to a virtuous circle of knowledge exchange and experimentation, innovation, and replication of successful ideas.

Had there been no LIHTC, America’s renters would confront the following substantial challenges of:

 

• Affordable housing rents bearing no relation to market. Prior to LIHTC, there was almost no connection in federal housing programs between how rents were set and market norms.Some programs established an initial rent and then applied automatic percentage increases – these projects were supported almost entirely by long-term property-based Section 8 contracts. Once these contracts disappeared in 1996, no one in the marketplace would underwrite rents at above-market levels, necessitating the Mark-to-Market (M2M) program with its multi-billion-dollar FHA insurance payments.

  Other programs (public housing, Section 202, Section 515, Section 221d3/236) used a cost-based approach. Every year the owner submitted a budget of costs, which HUD reviewed (and usually cut back). As each year brought a fresh round of requests-and-reviews, an elaborate game developed between owners and regulators, and the HUD handbook swelled and swelled in size.

 

Had there been no LIHTC, rents in any given affordable property could be above-market or below-market, more or less at random, and without anyone knowing where the market rents were. As a result, residents effectively would be trapped in their apartments by the development’s property-based rent subsidy contract or regulatory agreement. Without a market check, owners and managers would devote all their energies to tangling with and placating regulators, not improving the housing. This pattern has occurred in pre-M2M HUD properties, in military housing (under the §801 program), and even today in many legacy public housing properties.

 

Significant gaps in affordability options. Before 1986, renters’ housing options were limited to four distinctive types each separated by wide moats of affordability and regulation:

 

• Public housing, called the housing of last resort by some, serving extremely low-income households (30% or less of area median income, or AMI);
• HUD Section 8 affordable housing, serving residents with incomes as high as 50% of AMI;
• Budget-based HUD properties without HUD subsidy, targeting households at 60% to 80% of AMI; and,
• Market housing, with rents affordable (depending on the particular state and city) to residents between 60% and 115% of AMI.

 

Because these housing types each had a distinctive and isolated regulatory and funding structure, they became constrained channels: neither residents nor executives moved from one category to another. On the street, each category of housing was recognizable at a glance. Moreover, many local markets had significant gaps of affordability, configuration, or management practices – four portfolios co-existing in space but never interacting at all. With LIHTC’s entry into the financing scheme, residential models blended; ideas cross-pollinated. Connection to the market became not an idle concept but an essentiality. Older public housing properties were reborn under HOPE VI (see next point). Legacy HUD properties gained new life and new income banding through acquisition-rehab transactions. Executives and trade associations that once barely knew of each others’ existence now regularly exchange ideas and collaborate in idea-sparking ways.

 

No public housing revitalization via HOPE VI. Though originally intended to be a one-source revitalization solution, the HOPE VI program’s maximum per-apartment funding amounts are far short of what is needed to revitalize or rebuild distressed public housing properties. Thus, virtually every HOPE VI development in the last decade has tapped LIHTC as a critical source of “rent-free” equity contributions. Had there been no LIHTC, HOPE VI would have been stillborn.

 

Urban affordable housing and America’s cities

The last quarter-century has been a period of increasing urbanization in the United States. Americans and immigrants to the U.S. move warm, wet, and west. The result has been an increased concentration of population, job growth, and opportunity in the nation’s cities. As America urbanizes along the coasts, the role of affordable housing has evolved from something done as social welfare or social justice, into an inherent driver of urban efficiency and hence of

national economic competitiveness and growth.

Unless cities build affordable housing into their urban fabric, cities fail – people who fill the lower-wage jobs which make the city work cannot afford to live in the city in which they serve. Affordable housing is recognized as an essential element of urban infrastructure, every bit as necessary as public transit or broadband. In contrast with public housing or Section 8 housing, which have both been stigmatized as warehouses for the poor, LIHTC housing is viewed as integrated into communities. Without LIHTC our nation would have much less affordable housing embedded into those cities where the jobs are being grown.

Had there been no LIHTC, America’s cities would confront the challenges of:

 

• Continuing scandals in unspent or unaccounted-for appropriated funding. For the federal government, LIHTC is a different and better kind of money – the government pays after performance, not before. By contrast, other urban revitalization programs like CDBG and HOME award the cash up front, before the work is done. Some dollars can remain unspent; some are consumed in pre-development administrative or overhead costs; some sink into properties that are later suspended or abandoned; and some can go missing. In May 2011, The Washington Post ran a blistering series of articles documenting numerous spending snafus in the HOME program.
• No historic rehabs into elderly housing. Before LIHTC, few historic buildings were converted into apartments using the federal historic rehabilitation tax credit – higher-value uses were preferred. Since the arrival of LIHTC, conversion of (say) old hotels into elderly apartments has become a fixture of downtowns in old secondary cities, as developers utilize both housing and historic tax credits to finance these projects.
• No New Markets Tax Credit. Had there been no LIHTC, federal New Markets Tax Credits would never have been conceived; NMTCs were designed using the lessons from LIHTC experience; their structuring and investment models have built upon the infrastructure of LIHTC equity syndicators and corporate CRA-motivated institutions that gained their knowledge through years of committed investment in LIHTC properties.
• Homelessness out of control with minimal service-enriched rental. Even with the support infrastructure now in place, homelessness is on the rise in America. Some is due to the rural-to-urban migration within America, and some to individuals whose lives are disrupted and fall into a self-perpetuating cycle of depression, substance abuse, unemployment, and homelessness. Permanent supportive housing is one of the few interventions with a proven successful record of helping these individuals regain their economic and personal footing. Had there been no LIHTC, production of permanent supportive housing would be microscopic, and homelessness would be much higher than it is today – with extremely large societal costs as a result.
• A national crisis in affordable rental housing. For more than twenty years, over 90% of the new affordable housing produced in America has used LIHTC as an essential funding resource. Likewise, probably more than 50% of all housing preservation projects utilize LIHTC. Since 1986, Congress has not authorized any new appropriated affordable housing production program, and funding has been cut significantly for many long-time existing programs. Over this same period, LIHTC has been integral to the production or preservation of more than 2.5 million apartments nationwide. Had there been no LIHTC, the underwriting would not pencil, and new production of affordable housing would have collapsed.
• Lack of effective disaster-rebuilding rapid response. Because LIHTC created an entire ecosystem of adaptable delivery (allocator, developer, builder, lender, investor, asset manager), it has been an effective way to target federal relief or rebuilding efforts to areas hit by natural disasters, such as the GO Zone in the South and the Midwest flood zones. In both these cases, LIHTC became the stimulus of choice for targeting private-sector rebuilding or redevelopment activity in disaster areas. Congress could target and time-limit the assistance and be confident that the delivery mechanisms were in place to produce quality housing with proper accountability thereafter. By contrast, appropriated programs face all of the delivery and market-adaptation challenges that made the phrase “FEMA trailer” a byword for government that doesn’t work.

 

The nation as a whole

The nation does not exist that has no poor people in it; nor can a society succeed unless it offers those poor a path to self-sufficiency and personal success. Housing is at the crossroads of all anti-poverty strategies, whether for the homeless, elderly, jobless, or underemployed. LIHTC has been and remains integral to the delivery of any form of affordable rental. Its removal would leave a gaping void in housing preservation and production, in the efficiency and vitality of cities, and hence in the nation’s economic health and social well-being.

Had there been no LIHTC, America’s economy and society would grapple with the problems of:

 

• Minimal innovation in configurations or service models. Any appropriated program can do only what Congress permits – the specifics laid out in the authorizing legislation. For LIHTC, by contrast, the statute specifies only a minimal number of outcomes – tenant income caps, rent ceilings, and the annual amount of tax credits that can be allocated in each state. Within this broader envelope, any innovation can be encouraged by the state agency as part of the design of its annual QAP or in its annual award cycle. As a result, the LIHTC program has spawned multiple innovations in housing target population, apartment configuration, resident service package, and even in service delivery models. The best demonstration of this element of LIHTC flexibility is permanent supportive housing, which is not only authorized under the tax credit program but is encouraged or has a set-aside in many state QAPs. Very little of this flexibility has been possible in HUD housing funded by appropriations; it is precluded by overly prescribed regulations (including difficulty in using property funds to pay for services) and the absence of resources to retrofit apartments.
• The 1987 affordable housing prepayment moratorium extended, made permanent, and the subject of massive continuing litigation. In 1987, Congress, concerned about the loss of existing older assisted affordable apartment properties (HUD Section 221d3 and 236) because of the ability of owners to prepay their mortgages, enacted legislation to curb prepayments. First was the Emergency Low Income Housing Preservation Act (ELIHPA), followed in 1990 by the Low Income Housing Preservation and Resident Homeownership Act (LIHPRHA). Under these laws, owners’ contractual rights were breached and HUD was authorized to offer a menu of incentives – chiefly larger property-based Section 8 rent subsidies to cushion the rise in rents to market levels or above – as a means of approaching “just compensation” as required by the Takings Clause of the Fifth Amendment to the Constitution. ELIHPA and LIHPRHA spawned many preservation transactions, causing a massive expansion of HUD’s workload and a protracted approval process (averaging 20 months) which was often contentious and involving dueling appraisers, appraisal reconciliation, and enervating disputes about the scope of rehab work. In 1996, Congress finally suspended all LIHPRHA funding and restored the right of owners to prepay, in large part because “renewed affordability” and LIHTC-financed transactions by then had demonstrated that life after prepayment could result in extended affordability if the property was sold to a nonprofit or other LIHTC-motivated buyer. Had there been no LIHTC as a funding resource, these properties would have languished in limbo.
• No inclusionary zoning. Inclusionary zoning laws require a minimum percentage of newly constructed units in a municipality be affordable to low- to moderate-income households. Over the last three decades, inclusionary zoning has taken hold in America’s large metropolitan centers. Whether adopted by statute (as in Massachusetts’s Chapter 40B, in 1974) or by judicial decision (New Jersey’s Mount Laurel, in 1975), states and towns now confront the reality that if they fail to deliver their “fair share” of affordable housing, outside forces can override local, exclusionary, zoning. In all of these inclusionary zoning environments, LIHTC properties are a principal way of satisfying the affordability requirements. Other forms of affordable housing – public housing, mobile home parks – are much more fiercely resisted and thus have seldom been used. Further, LIHTC’s delivery of incremental resources makes it possible to build affordable apartments in high-cost communities.
• Affordable housing as a partisan issue. Among LIHTC’s distinguishing features has been its extraordinarily broad, bipartisan political support – in Congress and at the state and local government levels. No other federal affordable housing program has had the enduring, broad-based, bipartisan support enjoyed by the Low-Income Housing Tax Credit. This is not luck: it is due to the program’s track record of operational success; adaptability in individual state circumstances; and blend of fiscal-conservative principles (risk transfer, public-private partnership, private accountability and collectability) and social-liberal aspirations (reaching extremely low income households, supportive housing, permanent affordability). Without these features, LIHTC would never have survived: sooner or later, virtually every other federal housing program has been captured as a principally partisan issue, where no program can endure, for eventually the other party will gain control and kill it out of vengeance or ignorance. All large-scale HUD production programs eventually ended in scandal headlines, Congressional hearings, Inspector General reports, and legislative demise.
• Larger budget deficits. Housing is an essential need. It captures a core American value, one which has been an explicit national goal ever since President Truman’s 1949 National Housing Act of 1949 pledged “decent, safe, sanitary, and affordable living environments for all Americans.” That commitment finds its expression across many national programs – everything from Medicaid to Housing Choice Vouchers to the home mortgage interest deduction. Moreover, because housing is a necessity – everyone needs a safe place to sleep – failure to deliver quality housing means immediate hardship. As taxpayers, we pay the cost of that hardship. Not only do these people suffer personally, but society as a whole suffers, and society pays – in disease, crime, incarceration, and health-care costs – all of which cost our government money to remediate while doing little to fix their root causes. Thus, if the federal affordable housing budget is cut, the federal financial ecosystem pays in higher costs elsewhere. Other budget line items, especially health care, rise even faster, because cleaning up the consequences of failing people and households is more costly than investing in their success.Had there been no LIHTC, budget deficits would be higher.

 

Secretary Bailey surveyed the challenges in front of him. Despite HUD’s failing inventory, the states were not interested in helping, the owners were demotivated, and the property managers were starved for resources.

Failure loomed imminently.

What on earth could possibly be done?

Someone knocked softly at his open office door. “Sir,” said Special Assistant Clarence Odbody diffidently, “let me show you the concept paper for a program called the Low-Income Housing Tax Credit.”