What About Private Equity?

7 min read

New Money to Preserve Affordable Housing

New money from pension funds, life insurance companies and commercial banks is flowing into apartments with affordable rents. These private equity investments in affordable housing are just a trickle so far – but they may soon become a flood.

“Today, I think it’s a $200 million space, if that… This should be a billion-dollar space, or a couple billion dollar space,” says Tim Rafalovich, senior vice president for Wells Fargo and a panelist at “Preserving Affordable Housing with Private Equity,” a session at the recent National Housing & Rehabilitation Association Developers Forum, held May 18 in Los Angeles.

Private equity real estate investors spend billions of dollars a year buying and selling conventional multifamily properties. A new set of firms are now using private equity investments to recapitalize aging apartment properties and preserve affordable housing– including older properties originally built with federal low-income housing tax credits (LIHTCs). These funds can bring new resources to properties where affordable rents are not being supported by new affordable housing subsidies.

A new kind of private equity
Some of these private equity firms have familiar names. In 2014, Enterprise Community Investment, Inc., used its new private equity fund to buy seven properties totaling 1,300 apartments across the country in a partnership of affordable housing developers. A newer firm launched in 2008, Avanath Capital Management, has bought about 32 affordable housing properties over the last five years, valued at more than $800 million.

Like other private equity firms, Enterprise and Avanath depend on capital from institutional investors. That includes commercial banks, which have a long history of investing in affordable housing to help them meet the requirements of the Community Reinvestment Act. It also includes newer investors. Avanath’s include four pension funds and three life insurance companies, in addition to three commercial banks, including Wells Fargo.

“We are educating people who have not been in the space,” says Daryl Carter, founder and CEO for Avanath Capital Management. Avanath regularly takes potential new investors to visit affordable housing properties in its portfolio, to show investors what safe, well-managed affordable housing looks like.

Enterprise is also raising capital from investors beyond the familiar circle of banks that already invest in affordable housing – with some success. “Our fund is 50 percent banks,” says Chris Herrmann, vice president at Enterprise Community Investment, Inc. “That has been a very tough nut to crack.”

Types of deals
Companies like Enterprise and Avanath invest private equity in a wide range of affordable housing properties. “The first product that comes to mind is the expiring LIHTC project,” says David Cohen, partner with the law firm of Katten Muchin Rosenman and session moderator. “But that is just one component of preservation.”

Private equity investors also buy apartment properties built under other affordable housing programs, like the federal project-based Sec. 8 program, in addition to properties where the rents are low because of other deed restrictions or extended use agreements. These private equity buyers even invest in properties that are simply affordable because of their location or condition, and have no formal restrictions at all on how high their rents can rise.

“We’ve been buying class-C apartments and making them class-Bs,” says Avanath’s Carter.

Preservation private equity can help owners who would like to sell part or all of their interest in a property that has affordable rents but is not yet ready or able to access new subsidies from an affordable housing program.

Companies like Enterprise and Avanath can bring private equity capital to these types of properties without using new government subsidies – like tax subsidies — as bait for investors. That’s because Enterprise and Avanath say that they can provide a competitive return to their investors based simply on rental income from affordable rents and price appreciation at their properties. Avanath provides its investors an internal rate of return of 11 to 15 percent over the seven to ten years that they hold their properties, according to Carter. That’s slightly higher than the roughly 10 percent return typically provided by a value-added investment in a conventional apartment property. Debt financing, with loans that cover up to two-thirds of the value of the properties, can help the partnerships achieve these yields.

Affordable housing properties can appreciate in value without becoming unaffordable, according to Carter. Avanath reduces expenses so that the property produces more new operating income. That is likely to produce a higher sale price when Avanath eventually sells the property, even if the rents remain about the same.

“We extract better operating efficiencies,” says Carter. “Pennies turn into nickels turn into dollars.” Energy and utility cost savings make a big difference, as can a good recycling program. “Reducing the number of dumpsters from ten to five is a significant savings,” he says. “We really look at every aspect of the operating side.”

Avanath buys these properties outright and sets itself up a new general partner, or sponsor. Avanath manages the property and does any renovation or redevelopment as needed. Avanath’s private equity investors act as limited partners. The structure is similar to the structure of the limited partnerships that own most LIHTC properties. However, in those LIHTC partnerships, the general partner usually owns a 0.1 percent ownership stake in the property, while the tax credit investors own 99.9 percent.

In private equity partnerships, general partners typically hold onto a significant ownership stake in the properties. “We put meaningful equity in alongside our investors,” says Carter.

Sponsors, or general partners, also contribute significant capital to the private equity limited partnerships structured by Enterprise. These sponsors are non-profit or for-profit affordable housing firms that manage the properties. Enterprise joint ventures with these sponsors, acting as a limited partner and contributing capital raised from private equity investors. It’s similar to the role Enterprise plays as a syndicator in LIHTC transactions.

Sponsors in private equity deals don’t earn the large developer fee earned by sponsors in LIHTC deals, though they don’t typically have to provide guarantees that their properties will perform well.

Income from rents is an important motivator in preservation private equity deals. Sponsors and limited partners split the operating income from affordable housing properties using the complicated “waterfall” calculations employed in the rest of the real estate private equity world. Limited partners take their guaranteed return from the income. Once the income tops certain levels, or hurdles, the share of the income, called the “promote,” increases that flows back to the sponsor, rewarding the sponsor for improvements in the operation of the property.

Private equity preserves LIHTC properties
Preservation private equity often targets aging apartment communities that received LIHTCs 11, 12 or 13 years before. After more than a decade in operation, many could benefit from fresh investment. Their tax credit investors no longer receive tax benefits, and may be willing to sell.

Until a LIHTC property completes its 15th year, it is too soon to bring in new LIHTCs. So for a few years, preservation private equity has an opportunity to invest in these properties without having to compete with a developer who plans to recapitalize the property with another round of LIHTCs and tax-exempt bond financing.

“Post year 15, very often we will lose deals to a developer who will do another tax credit re-syndication,” says Carter.

After owning the property for seven to ten years, the private equity partnership breaks up, because of the time-line of the private equity investors who commit their money to the fund for a set period. When that happens, the sponsor will have the opportunity to buy out the limited partner at fair market value. The property could also sell to a new LIHTC partnership or a new partnership of private equity investors.

To make these deals work, the preservation private equity investors need to convince all of the stakeholders that the new equity buyers will meet the affordability requirements at the property, starting with the old tax credit investor. Many of these older affordable housing properties still have extended use agreements with multiple government agencies, which need to approve any sale.

“We’ve done deals that require nine regulatory approvals,” says Carter.