How LIHTC Funds Can Help Banks Invest in Affordable Housing

By James L. Logue III, Chief Operating Officer, Great Lakes Capital Fund

More than 150,000 low-cost apartments leave the affordable housing inventory every year because of deterioration, rent increases, or abandonment. This loss of affordable housing takes a toll on low- and moderate-income families, challenges employers, and contributes to the destabilization of entire neighborhoods.

Fortunately, certain tools are available to banks and others that can help to stem this loss. Chief among these, low-income housing tax credits (LIHTCs) provide a significant means of financing the creation of new affordable apartments while simultaneously helping to stabilize neighborhoods by improving quality and supply. LIHTCs were responsible for about $7.5 billion of private investment in 2005, that will produce approximately 140,000 units with rents that stay within the reach of low- and moderate-income households for at least 30 years.

For bank investors, these credits offer a true "double bottom line" opportunity. In addition to the economic returns available to banks in the form of a credit that reduces their federal and state taxes, LIHTCs allow banks to earn positive consideration toward their regulatory ratings under the Community Reinvestment Act (CRA).

There are multiple ways in which banks can take advantage of these credits. Some banks invest directly in LIHTC developments (see the article in this edition of Investments by Michael J. Novogradac). Many other institutions participate in pooled investment funds, sponsored by state and local equity funds such as Great Lakes Capital Fund in Lansing, Michigan. State and local syndicators began to form equity funds during the 1990s to pool investment capital and match it with LIHTC projects in their service areas.

In the earlier years of the LIHTC program, syndicators offered annualized yields in the high teens. But as the investment community became more comfortable with the tax credit program and competition grew, yields have declined, but remained stable. Over the last few years, funds have been returning annualized yields of between 5 percent and 7 percent to investors. In addition, loans to housing tax credit properties operate with an average foreclosure rate of 0.02 percent on the underlying mortgages (see the sidebar on LIHTC Investment Performance).

These funds help spread the risk among many different investors and place the primary responsibility for monitoring the portfolio with the syndicator. For banks that are contemplating their first LIHTC investment, this may be the best approach to consider.

Across the United States, some 30 state or local funds provide investment capital to low-income housing developments. The National Association of State and Local Equity Funds ( NASLEF ), a professional nonprofit group formed in 1994 to promote greater understanding of affordable housing tax credits, has 22 members that have raised $4.2 billion in equity capital and created or rehabilitated more than 73,000 affordable housing units.

Great Lakes Capital Fund (Great Lakes) is one such NASLEF member. Since the fund's founding in 1993, Great Lakes has raised more than $850 million in investment capital and used this capital to create 12,000 affordable units in Michigan and Indiana. Building on its initial support from the Enterprise Foundation and the Enterprise Social Investment Corporation, the fund has developed a wide array of technical and financial services, including community and project planning, predevelopment financing, construction and permanent loans, and equity investments.

State and local equity funds, like Great Lakes, can play an important role in a bank's CRA compliance strategy. LIHTCs, as a component in a bank's compliance effort, enable the financial institution to spread its CRA investments efficiently across a large part of its service area. Investing in affordable housing through a fund also provides less experienced institutions with an important window into the real estate development process should they decide to make investments directly into tax credit projects. By their very nature, funds allow for financial institutions to funnel their investment dollars into the communities they serve.

A bank might also invest in LIHTCs through a fund with a "side-by-side" investment. If the bank is already an investor in a fund, this side-by-side would come in the form of an additional equity investment directly into a project, parallel to its investment through the fund. A bank could increase its investment in a specific project located in its assessment area in which it has a particular interest by providing a side-by-side investment of up to 49 percent with an equity fund (see the sidebar on Typical Side-by-Side Investment). As a current participant in a fund, this may allow a bank to achieve increased visibility and even greater CRA credit, while still relying upon the equity fund for underwriting and closing the investment and performing the long-term asset management function, including monitoring the project for compliance. Alternatively, a bank that has never participated in a fund may want to be a side-by-side investor in a local project included in a fund as a means to see how the fund is managed and to obtain CRA credit.

In one typical example of a side-by-side transaction, Great Lakes recently committed an equity investment of almost $3.29 million to a 45-unit senior apartment complex in Grand Rapids, Michigan. Forty percent of that equity came from the community development corporation of a large commercial bank - which also provided a $1.08 million first mortgage on the project. The side-by-side structure has worked well for Great Lakes' investors. To date eight banks have participated in 32 such transactions, representing nearly 15 percent of all the fund's transactions.

Side-by-side investments such as these provide a bank with additional flexibility in the distribution of its investments. For example, a bank might identify a need for a higher level of investment in a given CRA assessment area than could be realized with the financial institutions' pro-rata share of the fund investment. It can make an additional side-by-side investment in a specific project in that CRA assessment area to meet its need, while still having the underwriting and asset management resources of the fund behind the project. By working with a fund, banks can proactively seek out investment opportunities with the support of the fund's network of developers.