Volatility returned late last year and may persist for the foreseeable future. A well-diversified portfolio will help to manage such market ups and downs, and an allocation to fixed income can provide a reliable stream of income during periods of market uncertainty.
With such strategies in mind, we believe there is an underexposed part of the market that may be attractive for institutional investors: impact investing focused specifically on affordable housing mortgages. While many investors use impact strategies to fulfill a desire to promote social good, we believe that affordable housing has built-in characteristics (along with the low correlation we’ve discussed in previous posts) that make affordable housing debt a source for stable, attractive, long-duration investment.
When we refer to “affordable housing” we are referring to affordable, multifamily rental housing financed in connection with the federal Low Income Housing Tax Credit (LIHTC) program. While LIHTC financed units are a subsection of the wider affordable housing space, the program is the largest single source of subsidized units nationwide.1 To date, IMPACT has originated over $1B of these mortgages since 2000.
In our experience, affordable housing has shown itself to perform well throughout market cycles. Whether we are in an up or down market, the need for affordable housing persists. In peaks, the cost of housing rises, increasing demand for affordable housing. In troughs, job or income loss exacerbates the need for access to affordable housing. As we discuss below, this continuous demand as well as other factors unique to affordable housing have historically led to low volatility and predictable income.
Supply and Demand: Given the relatively high-level of real estate appreciation in recent years, there’s a correspondingly high demand for affordable housing but supply remains tight. As of 2016, there were 17.8M renters who made less than 50% of area median income (AMI)2, but only 2.5 million LIHTC units available3.
The vast majority of renters earning less than 50% AMI are cost burdened, meaning they spend more than 30% of their income on rental payments.4 LIHTC housing can alleviate this cost burden for the most vulnerable families. Take a metropolitan area like Miami, for example. As of year-end 2018, market rent for a three-bedroom apartment (which according to HUD metrics can house a family of four) was $1,796/mo5. A LIHTC-eligible development can rent a three-bedroom apartment to a family of four earning 30% of AMI for $613/mo6. The difference in lease payments represents a 66% monthly saving in housing costs. Savings than can be spent on education or childcare, which helps to explain the high demand for these units.
From an investor’s point of view, the dislocation between demand and supply results in occupancy levels that historically have remained high and stable. According to REIS, as of Q3 2018, the market rate multifamily vacancy rate remained low at 4.8%, but the vacancy rate for affordable multifamily was significantly lower at 2.2%7. High occupancy rates are a key driver of stable, long-term income.
LIHTC Safeguards: The LIHTC program provides federal tax credits in order to subsidize the cost of building affordable housing. In return, long term use restrictions are often placed on the underlying properties to restrict these units to families/individuals making no more than 60% of AMI. These rental restrictions combined with strong demand for affordable housing serve to keep vacancy rates low. Furthermore, developers may face tax credit forfeiture or recapture if they fail to adhere to the rental restrictions and other compliance rules, providing a strong incentive to keep developments operating well and out of default. These powerful incentives and the long term program horizon of affordable housing developments create strong alignment of interests between the development owners and mortgage holders.
(More information on the LIHTC program can be found at: https://www.novoco.com/resource-centers/affordable-housing-tax-credits/lihtc-basics/about-lihtc)
Stable, Growing Cash Flows: Another key attribute found in fixed income investments that help reduce volatility is stable underlying cash flows. LIHTC properties are currently generating higher net cash flows per unit than in any period during the program’s history.8
We compared affordable housing loans in IMPACT’s investment platform to corporate earnings in the S&P 500 Index to determine the volatility of cash flows that would potentially pass through to the investor in an investment. Net operating income (NOI) in a real estate investment measures whether a property can produce a profitable income stream from operations, excluding financing or tax costs.
Comparing the NOI of affordable housing loans underlying IMPACT’s affordable housing loans with earnings reported for corporate issuers of S&P 500 companies, the cash flows for such affordable housing loans have been more stable. Since 2011, the trailing 12-month NOI of IMPACT’s affordable housing loans relative to the market value of the outstanding portfolio balance had a standard deviation of 0.75%, whereas the earnings yield, or trailing 12-month earnings per share divided by the market price of the index over the same period had a standard deviation of 0.97%9.
In addition, over the same time period, the growth of S&P 500 companies trailing 12-month earnings yield declined an average of -8.2% while the trailing 12-month NOI of IMPACT’s affordable housing loans relative to market value grew at an average of 0.56%10.
Improving Debt Coverage Ratio: Another key cash flow metric is debt coverage ratio (DCR), or the net operating income of a property, excluding replacement reserve deposits, divided by payments for debt service. Properties with a DCR of <1.00 are considered underperforming. Across the spectrum of property types, DCR of LIHTC properties has steadily improved over the past decade, reaching a national median of 1.40, after hovering around 1.15 during most of the decade prior to 2008.11 IMPACT’s LIHTC loans had a weighted average DCR of 1.86 as of the end of 2018.
These key metrics demonstrate the potential for stability and long-term consistency of cash flow that investments in affordable multifamily housing mortgages can contribute to a well diversified portfolio for institutional investors particularly in times of market volatility. Furthermore, investments in affordable multifamily housing make a significant positive impact on families by lowering their cost of housing when compared to rents for the market rate alternatives. Our 20 years at the forefront of managing purpose-driven investments, leads us to believe that these investments offer a stable, predictable source of long term income and come at a time when consumers are increasingly conscious of how the companies that they do business with, undertake efforts to promote positive social outcomes. Let us know if you’d like to learn more about IMPACT and its investments at firstname.lastname@example.org.