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Private Institutions and Affordable Housing Report-1989PRIVATE FINANCIAL INSTITUTIONS AND AFFORDABLE HOUSING IN NORTHAMPTON: AN OPPORTUNITY STUDY A REPORT BY THE TASK FORCE ON FINANCING AFFORDABLE HOUSING J l _1 I F L Li THE TASK FORCE _ ON FMNANCMNG AFFORDABLE HOUSING ED SHEA MASSACHUSETTS BANKERS ASSOCIATION WILLIAM SPRING SUZANNE OAKES FEDERAL RESERVE BANK OF BOSTON PAT LIBBY MASSACHUSETTS ASSOCIATION OF COMMUNITY DEVELOPMENT CORPORATIONS CAROL GLAZER LOCAL INITIATIVES SUPPORT CORPORATION MILTON BENJAMIN COMMUNITY DEVELOPMENT FINANCE CORPORATION DIANE GORDON NEIGHBORHOOD REINVESTMENT CORPORATION L - RON HAFER COMMUNITY DEVELOPMENT CONSULTANT CONSULTANT TO THE TASK FORCE CARRAS ASSOCIATES. JAMES CARRAS, PRESIDENT GREGORY BYRNE, PROJECT DIRECTOR MARINA SAMPANES Funding for this study was provided under a Challenge Grant from the Massachusetts Housing Partnership. r ) i During periods of the 1960s and 1970s, many urban and rural lending institutions throughout the nation refused to extend credit in certain neighborhoods regardless of the creditworthiness of the individual applicant. It was the fear of falling property values that caused lenders to deny credit to targeted neighborhoods. This was true for both home loans and multi - family loans. In today's housing market, it is no longer a matter of getting banks to overcome their perceptions of market conditions, perceptions which, if acted upon, would result in a self - fulfilling prophecy. The problem of producing affordable housing has little to do with financing. In fact, there has never been a time when there has been more capital for bankable projects. In Massachusetts, at least, the problem of producing affordable housing is primarily a subsidy and land use problem. Because -of high land prices, one simply cannot build housing for rent or for sale at prices that are affordable to low- income families and that meet community standards. In Northampton, and throughout western Massachusetts, a number of small, community -based organizations are attempting to build, rehabilitate, or preserve affordable housing. Because of huge cutbacks in federal housing subsidies, these groups face great challenges in accomplishing their objectives. Lending institutions cannot and should not subsidize these projects. But they can provide a more positive climate for those attempting to build affordable housing. One strategy is for each bank to organize itself to give affordable housing projects priority loan considerations. While often helpful, this approach is primarily reactive. For reasons to be discussed later, it is not always very efficient. A second strategy, one that would get lenders out in EXECUT1VE SLT,NINIAI The purpose of this study was to recommend ways for Northampton's private financial institutions to increase their involvement in affordable housing. A similar study was also to be undertaken for the ten communities known as the Hilltowns. Both studies were to be followed by lender forums. For all practical purposes, we have combined the studies and the accompanying forums. We have done this for two reasons. First, both communities are served by essentially the same lending institutions. Second, the problems are not so different that they require dramatically different solutions. front on the housing issue and one that we suggest lenders consider, is to create a lending consortium for affordable housing., A lending consortium would serve three major purposes. o First, lending institutions could invest in affordable housing without each bank having to develop the specialized knowledge of housing programs. o Second, affordable housing sponsors could be provided with a reliable source of capital. o Third, the consortium could work with the public and private sector to expand the financial resources available for affordable housing and to improve the skills of entities working to produce affordable housing. There are many examples nationwide where lenders have acted collaboratively to provide pools of mortgage funds and 'to centralize underwriting services in support of affordable housing initiatives. Usually, these reinvestment programs have taken • advantage of large supplies of vacant land or blighted buildings. The housing stock in the Northampton area, however, does not provide the same type of opportunity. There are few multi - family dwellings and most of them are occupied and in good condition. Therefore, the task of building affordable housing is much more formidable. A consortium cannot solve solve the problem of subsidy availability of high land prices. It can, however, be an important step forward. By providing a dependable source of financing, the consortium would stimulate demand and not merely substitute for what lenders would otherwise finance. Moreover, it would get lending institutions more ivolved in housing policy matters and in the design of new systems and programs. Absent of a consortium, it is hoped that this study will, at a minimum, increae the common understanding between lenders and affordable housing developers. TABLE OF'CONTENTS I. INTRODUCTION 1 II. AFFORDABLE HOUSING: Setting the parameters 8 III. PERSPECTIVES ON NORTHAMPTON'S HOUSING MARKET . . . 13 IV. A FRAMEWORK FOR UNDERSTANDING HOW AFFORDABLE HOUSING IS PRODUCED 21 V. BANKS AND AFFORDABLE HOUSING 33 VI. THE LOCAL HOUSING DELIVERY SYSTEM 53 VII. RECOMMENDATIONS FOR COLLABORATIVE ACTION 55 2 N'TRODUC "xi x ON Funded with a Challenge Grant from the Massachusetts Housing Partnership, the Task Force on Financing Affordable Housing, a gathering of housing and banking groups, contracted with Carras Associates to conduct studies in five Massachusetts communities of ways in which regulated private financial institutions -- commercial banks, savings banks, and savings and loan associations -- could greatly expand their involvement in affordable housing. The five communities selected for study were Lawrence, Northampton, Worcester, the ten Hilltowns of western Massachusetts, and the Mt. Bowdoin /Glenway neighborhood of Boston (Dorchester).' These communities are broadly representative of the constraints local communities face throughout the Commonwealth in producing affordable housing. They include a booming small city fighting to maintain its shrinking supply of affordable housing, two densely settled cities with old and deteriorating housing stocks, a poor rural community that has problems of infrastructure, and the neighborhood of a large city that once suffered disinvestment but now faces the threat of gentrification. STUDY COMMUNITIES o Hilltowns o Lawrence o Mt. Bowdoin o Northampton o Worcester severe It has been our longstanding premise that one of the major obstacles to greater lending institution involvement in affordable housing is getting key banking and housing groups together to agree on the problem. Rarely, however, is there a mechanism to bring this about, at least not in a manner that is conducive to mutual collaboration. The notion of the Challenge Grant, therefore, was that, after an assessment of local housing market conditions, including an analysis of affordable housing efforts, Carras Associates would organize meetings in each of the communities to review the respective findings and to explore opportunities for collaborative action. 1 rl HOUSING AFFORDABILITY IN MASSACHUSETTS The growing shortage of affordable housing in Massachusetts has become the state's most pressing domestic and economic problem. In late 1983, housing and land prices in Massachusetts began rising at unprecedented levels. HO S PdG PR I CEO Fueled by the turnaround in the economy and falling interest ' rates, the price of single- 170 ) family homes in Massachusetts more than doubled in less than 10° three years. It was the most :a r apid escalation in housing ,q° prices recorded in the post -war period, exceeding the California housing boom of the mid -to -late 1970s. By 1987, housing prices '`° in Boston were the highest in 110- the nation. While the boom has 100 finally cooled off, prices are 1 still more than twice the national average. As a consequence, low- and moderate - income households across the Commonwealth face an �-- o[, unprecedented housing crisis. 2 f 1901 Housing is the single D ,K BOW% largest item in family budgets. Hence, it exerts an enormous impact on the quality of life. As housing costs rise, and if wages do not keep pace, households must change their consumption patterns. For some, this can mean cancelling a vacation or delaying the purchase of a new car. For others it can mean doubling up with friends or relatives, going without heat inithe winter, or life on the street. Clearly, the past few years have been a boon flor homeowners. Their equity has increased geometrically, far beyond what anyone could have anticipated at the start of the decade. For renters, the past few years have been devastating. A growing number of households must pay 30, 40, or 50 percent of their income for rent. Hardest hit have been families on fixed incomes. A recent report by Michael Stone of the University of Massachusetts estimates that _J r as much as one -third of the state's population, or 700,000 households, are "shelter poor ", meaning that they are homeless, living in substandard housing, or suffering from severe health and nutrition problems left unattended in order to pay for rent. z The. acute shortage of affordable housing also threatens to undermine the state's continued economic prosperity. With LAECP FORCE GROWTH housing costs that are twice the national average, it has become 13 increasingly difficult for industry to attract and retain 1 .t 2 workers. Since 1984, the 1 Massachusetts labor force has grown at half the national average. Many employers, unable 199 to expand operations because t.9E they cannot find workers, have I had to offer huge relocation 1071 benefits to executive and ,.3E management personnel "imported" from the midwestern and southern regions of the country. At the 10 same time, many existing :0 = =� employees are forced to commute ; long distances to find an 0= • E. affordable place to live, ' "' a placing' great strain on outlying towns and clogging roadways. 1920 1961 1992 1983 1?J 198`.• A study published in the Harvard Business Review found Boston to have the nation's highest affordability index, a 7.7 to 1 ratio of home prices to annual wages (the average ratio for nation's 50 largest cities was 4.2). 3 Not surprisingly, this study located housing costs as the single greatest restraint to economic growth, resulting in higher wage demands, labor shortages (by inhibiting in- migration), and plant relocation. 3 2 0 '.6 1 1WS5 199 1907 RATIONALE FOR COLLABORATIVE INVOLVEMENT There were two primary motivations behind this study. First, for most banks, the economic health of a community directly impacts on the growth and profitability of the bank. As the economy grows, so grows the bank's deposits and its demand for loans. The high cost of housing threatens that economic health. Unlike earlier in the century, industry is no longer bound to any one state or region. With advances in technology, industry can rationalize the production process for assembly anywhere in the world. Unable to find workers, or forced to pay higher wages, many employers have moved their operations elsewhere. Moreover, it is not just our old -line manufacturing firms that are pulling up shop. The service industry is equally . sensitive to regional price variations and just as mobile. Second, with the loss of federal housing subsidies, lending institutions are under added pressure to increase their participation in community lending projects. In 1981, Congress terminated the Section FEDERAL HMS I NG SUBSIDIES 8 New Construction program and, with it, ended a fifty -year commitment to low income housing. Overall, federal, funding for housing programs has been cut by more than 70 percent in the past eight years. The 1986 Tax Act added to that problem. Under tax reform, severe restrictions were placed on the use of both tax - exempt bond financing and tax - syndication, the two major sources of debt and equity capital for low- income housing. While it is widely recognized that financial institutions have become a critical capital resource, seldom is there a constructive method for involving the banking community in affordable housing programs. One of the most 4 ts it l a ji Vii/ J 12 ,/;./ i . /../,',/, . // / (/// ) r/ /r , // .%/r • 1° ,, /;' (..///./././,,, . /// 11 r i 1 u 'i /q � /2/ l%/ �1 / /j/ I/i •/ 7/ i' 1381 1982 1983 1984 1995 =1sr.L !TAP. 1995 1997 1989 1999 common tools used to leverage bank involvement is the Community Reinvestment Act (CRA), which has seen renewed interest of late. Rarely, however, do CRA challenges lead to productive partnerships. Although some community groups have been successful in forging positive relationships with local lenders, for others the CRA process has pitted community groups and lenders as adversaries. Moreover, because CRA challenges have more force when a lending institution is in the process of 'merging or expanding, one bank typically gets singled out for protest when it might be both more productive and more equitable to involve a host of lenders in community development projects. Only infrequently is the city and the wider business community brought into the planning process. One of the principal objectives of this study is to provide a more positive tone for lending institution involvement in affordable housing. It is.to take a forward look at the role that lending institutions can play,, absent of the confrontational nature of most CRA challenges,. At the same time, it is'to recognize that lending institutions are just one sector in what remains a systemic problem, one that includes the high cost of land, restrictive zoning, regulatory controls, construction technologies, tax and fiscal. policy, and, of course, financing. Lending institutions cannot resolve all these matters. The best approach is a collaborative approach.that also includes the city, the state, and the wider business community. ORGANIZATION OF STUDY In Section II, Affordable Housing: Setting the Parameters, we attempt to define what is meant by the term "affordable housing ". In Section III, Perspectives on Northampton's Housing - Market, we examine some of the demographic and economic forces that have shaped today's housing market. Section IV, A Framework for Understanding How Affordable Housing is Produced, is intended to familiarize lending institutions with the context in which affordable housing is now financed and produced. It recognizes that, for the most part, banks are used to dealing with for - profit institutions and can be unfamiliar with the workings of non - profit housing developers, who have become one of the key participants in the new housing delivery system. This section is also intended to illustrate that the problem of affordable housing is more than just a financing problem. Section V, Banks and Affordable Housing, examines some 5 Li of the reasons why affordable housing projects have trouble receiving private financing. It also examines ways that lending . institutions have sought to expand their involvement in affordable housing programs. Section VI, The Local Housing Delivery System, describes efforts to produce affordable housing in Northampton. Finally, Section VII, Recommendations for Collaborative Action, offers strategies for expanding bank involvement in affordable housing in the Northampton area. LOCAL FORUMS The accompanying "opportunity study" is designed to provide Northampton's lending institutions with an understanding of the need for affordable housing, the impediments that affordable housing developers face, and recommendations for expanded bank involvement. In conjunction with the study, the Task Force will help convene local forums of key banking, city, and community officials for the purpose, of facilitating discussion and guiding the formation of, policy responses. We hope that this study, and the forums to accompany them, can lead to better relationships between lenders and affordable housing producers. Working together, these groups can form a powerful resource in support of housing ventures. 6 1 . The Mt. Bowdoin study is tenatively being folded into a larger study of community development lending in Boston. G. Boston Globe, December.15, 1988. NOTES 3. Dreir, Peter, Schwartz, David C., and Greiner, Ann. 1988; - "What Every Business can do About Housing ", Harvard Business Review, September /October. j Over the past 50 years, there has been a major shift in the J • focus of housing policy, from concern over the condition of the housing stock to its cost. In the 1930s, more than one -third of the nation's housing stock lacked basic plumbing, heating, and j electricity. Today, less than 5 percent of the housing stock can be considered substandard. However, while enormous strides have 71 been made to improve housing quality -- and some will argue as a Li consequence of high quality standards -- the problems of affordability have continued to mount. Moreover, with the r extraordinary run -up in property values in recent years, the excessive cost of housing now affects a much wider range of household types. L� L_ 1 AFFORDABLE HODS I NG = SETTING THE PARAMETERS Throughout much of the post -war period, a household . was considered to be paying too much for a unit of housing if the cost of shelter exceeded 25 percent of income, which was what occupants of subsidized housing were charged. Now, consistent with 1981 legislative changes affecting rents for subsidized housing, a household is considered rent - burdened if housing payments exceed 30 percent of income. Affordability studies, however, are plagued with a number of methodological problems. First, at least at the local level, there are major limitations with the data. The most reliable source of rental and home price data comes from the decennial Census, which is now nine years old. Hence, researchers are often in the position of having to estimate both costs and rent burdens. Second, most studies assume that people are paying more not out of choice, but out of duress (although, in Massachusetts, this is a fairly plausible assumption). Third, it is extremely difficult to control for changes in the quality of the housing stock, and so most studies do not. Notwithstanding these limitations, affordability is clearly more of a problem in the 1980s than it was in the 1970s. Nonetheless, while there is widespread concern to do something about the affordability problem, there is no consensus over how to respond. There are disagreements over what to build (rental vs. homeownership), where to build it, who to serve (elderly vs. 8 family; low- income vs. very -low income), and who should build it (non - profit, for - profit, or public). There are also questions (,7 about whether to build new units or preserve existing units and whether the subsidy should go to the builder /owner (supply side) or the occupant (demand side). Unfortunately, the answers to these questions are not to be found in housing affordability studies. The answers are a function of both politics and resources. In the face of both growing need and limited funds, providers of affordable housing often find themselves in the position of building whatever has the most chance of getting funding -- not necessarily where the need is the greatest, to the extent that such need could be quantified. In Northampton, a moderate income household (80 percent of the has an income of about $25,000. Using conventional underwriting standards, this household can afford about a $60,000 home or $520 in monthly rent, amounts that are substantially below the costs of producing housing.' For households at the low end of the income range, the situation is far more problematic. For example, a 2- person household on public assistance could afford no more than a $15,000 home, or around $120 in rent. Essentially, there are three methods for making housing more affordable, including reducing the cost of land, reducing the cost of building or rehabilitating housing, and reducing the cost of owning and operating housing. There are any number of ways of accomplishing these objectives, but most all of them require public subsidies of one sort or another -- typically, state or federal. The resources that local communities can devote to affordable housing are limited. They can waive certain permitting fees, they can donate excess land or buildings, and they can use their powers of zoning to permit projects to be built at greater densities (which results in lower per -unit costs). None of these actions, however, is generally enough to make housing affordable to families at the low end of the income range. Even when subsidies are sufficient to house the truly poor, there is often great opposition to getting that housing built. For most households, their home is their greatest asset. The fear of existing homeowners that affordable housing will reduce the market value of their properties is one of the greatest obstacles in getting housing built. This fear is frequently combined with the desire to exclude households of lower socio- economic status from the neighborhood, to protect open space, and to avoid traffic congestion, school overcrowding, and crime. Since affordable housing projects invariably require a change in zoning, and cannot be built "as of right ", developers must defend their projects through the public approval process. In many homeowner - dominated communities, few residents have anything to gain from permitting development to take place. The benefits accrue to the developer, if for - profit, or the potential occupants. Since the potential residents do yet live or vote within the community, they are not represented at the public hearings that may determine their fate. Proposed developments that serve families in the moderate income category, or that combine a mix of income groups, often have an easier time getting necessary public approvals than properties serving families at the lower end of the income range. For both of the above reasons -- the lack of subsidies and the politics of development -- the term affordable housing, as used in this study, refers to housing that is affordable to families in the moderate range, loosely defined. Housing for very -low income families requires more than a tinkering with credit mechanisms. It requires a major federal housing program. As for Northampton, we can also assume that we are talking mostly about new construction projects. Unlike many older urban areas, the local housing market does not have a large supply of vacant, abandoned, or substandard housing. Rather, the housing stock is well maintained and the vacancy rate is extremely tight. The choices available for expanding affordable housing opportunities are limited, more or less, to new construction activities, either rental or homeownership. If there is an obvious bias in this study, it is towards housing built by non - profit, community - based development organizations. Prior to the 1960s, it was generally assumed that the responsibility for producing low- income housing was a public responsibility, to be carried out by a public agency -- public housing authorities. For the next twenty years, great efforts were made to encourage private enterprise to build and manage low- income housing. Each successive program contained more elaborate and expensive incentives, first by offering federally- insured mortgages, next by making below- market loans, and finally by subsidizing the difference between what tenants could afford to pay and what it cost *to operate the units. In recent years, with the decline in federal housing subsidies, non - profits have taken on the tough task of packaging largely unprofitable, but viable developments. We focus on them in part because they have become the builders of last resort. We 10 also focus on them because they have the greatest difficulty in securing commitments from private lenders. Indeed, much of this study is an attempt to increase the.comfort level of banks with community -based development. 11 LJ i { I � . � NOTES 1.. Figure calculated by increasing the 1979 median household income for Northampton by the increase in household incomes for the nation as a whole: 2. Throughout this study, the amount that a household can afford for a home is based ona 10 percent down payment, 28 percent of gross income for PITI (principal, interest, taxes, and insurance), and prevaling interest rates. 12 ll PERSPECT=VES ON NORTHAMPTON ' S HOUSING MARKET Northampton, not unlike most areas in Massachusetts, has become a city of housing haves- and housing have -nots. According to the Franklin /Hampshire County Board of Realtors, the average sale price in Northampton increased from $59,903 in 1983 to $138,309 in 1988. Thus, in just five years, the typical homeowner has seen his /her equity increase by about $80,000. These households, largely middle -aged or elderly, have been able to use their newly acquired equity to trade -up to a new home, to finance home improvements, to save for their retirement, or to assist their children with their downpayments. On the other hand, renter households, which largely includes young families and minorities, have had their incomes fall in real terms. For them, homeownership is an increasingly distant and unreachable goal. AVERAGE SALE PRICE OF NORTHAMPTON HOMES 1980 $44,012 1981 $53,607 1982 $59,270 1983 $59,903 1984 $71,384 1985 $84,241 1986 $118,983 1987 $122,902 1988 $138,309 ROWS: FRAII6n/HMIPsHffi COON! BOARD OF Y®LR+D M Northampton's housing problems are not isolated. What happened in'Northampton, as what happened throughout nearly all of Massachusetts, was the workings of a speculative market that began in the eastern section of the state in late 1983 and spread west. ' As a result of these events, only a small percentage of households -- about 15 percent -- can afford to buy housing if they do not have considerable equity in a previous home. Moreover, as vacancy rates tightened, rental prices soared, drastically contracting the supply of affordable apartments. Presently, the Northampton market is operating under much more more normal conditions. Prices have slowed (but not fallen) and the number of listings have doubled. Despite this settling, both rents and home prices remain well beyond the reach of most low and moderate income families. Prices would have to fall substantially 13 1 : ( to improve affordability. Moreover, many lenders, now holding non- performing condominium loans, have tightened their underwriting standards. For groups trying to produce affordable housing, the current environment makes it particularly difficult to get private financing. THE 1970s: RESURGENCE During the 1970s, several demographic and social forces combined to diversify and dramatically increase the demand for housing throughout most of the nation. These forces included the maturing of the baby boom generation, the growth in the number of small households, and changing lifestyles (more people of all ages wanting housing, high divorce rates, and the rapid increase in two- income households). Nationwide, the number of households grew 24 percent in the 1970s. This growth fueled a strong (though cyclical) housing market. Housing starts averaged 1.8 million units a year in the 1970s, compared with 1.4 million units in the previous. decade. In Northampton, the number of households actually declined 4 percent during the 1970s. Under these conditions, . one might have expected a depressed housing market. Instead, significant upward pressure was building on Northampton's housing market. Older housing units, which had previously been allocated to low- income groups through the process of filtering, became of interest to many younger families and single - person households. As this occurred, pressure on Northampton's housing :market began to build. According to Census figures, the median value of an owner- occupied home in Northampton in 1980 was $38,200. While this amount was substantially below the median value of an owner - occupied home for the nation as a whole, $47,200, these prices compared favorably after controlling for differences in income. In Northampton, a home was valued at 2.6 times the median household income, compared with 2.7 for the nation as a whole. Apartments were slightly more expensive. In 1980, the median contract rent (excluding utilities) was $202 in Northampton, compared with $198 nationally and $197 in Massachusetts. In all, Northampton offered good quality housing at moderate prices in the late 1970s. It was becoming, however, a choice location for students and young professionals, which meant that '� pressure was building on the housing market. 14 THE MID- 1980s: DESTABILIZATION During the 1980s, but particularly in the past 5 years, the fundamentals of Northampton's housing market changed dramatically. While one could have anticipated a modest increase in prices, it was the magnitude of the increase that was surprising. When the decade began, much of Massachusetts was suffering from the impact of a major, national recession. The combination of high unemployment and high interest rates created a reservoir of pent -up demand (as a great many households put off purchasing homes). Housing sales were down sharply and few new units were being added to the housing stock. Faced with the prospects of unsold inventories, builders cut production levels. Statewide, between 1980 and 1983, housing permits were down 40 percent from 1970 levels.' Northampton simply mirrored this trend. As the economy began to recover in late 1983 and early 1984, and as interest rates fell, housing activity quickened. At first, pent -up demand was met by a tightening vacancy rate. Next, investors began rehabilitating marginal structures and reclaiming vacant units. Only later was the increase in demand met through new construction. NORTHAMPTON: HOUSING UNITS AUTHORIZED BY BUILDING PERMITS 1980 44 1981 23 1982 34 - 1983 28 1984 70 1985 260 1986. 273 1987 202 1988 136 Housing stock growth is a function of two variables: (a) the rate in which units are taken out of the housing stock (through abandonment, condemnation, demolition, or conversion to non - housing use) and (b) the rate in which units are added to the housing stock (through new construction, rehabilitation of abandoned structures, and conversion of commercial or other property to housing). In the early years of the recent housing boom, developers could not build housing fast enough to meet the surge in demand. Instead, added demand was met through greater utilization of the existing stock and a rise in prices. This rise in prices, however, had the effect 15 of creating more demand. Each price increase fed expectations of future gains and generated excess demand (particularly among homeowners and investors who feared being priced out of the market). In 1984, the average price of a single - family home in Northampton increased 19 percent. It increased another 18 percent in 1985 and 41 percent, in 1986. Unlike other commodities, the supply of housing responds slowly to changes in demand. Under the best of circumstances, it takes 15 months to produce a unit. More realistically, development is a 2 -3 year process. In Massachusetts, the normal lag in housing markets is exacerbated by regulatory controls and the scarcity of land. Massachusetts has 351 separately incorporated cities and towns, each with its own zoning requirements. Moreover, Massachusetts is the 4th most densely populated .state. The relative scarcity of open space limits development to small parcels, to land where there is ledge or other site problems, or to areas where there is strong community opposition. Therefore, even a small increase in demand, if it is unexpected, can take some time to work off. Rising home prices also had a devastating effect on the rental market, the primary source of shelter for low- income households. There is a close, but not perfect, relationship between the homeownership and rental markets. Most non - elderly households prefer to own than to rent; therefore, if rents rise to levels approximating homeownership, more households will choose to become homeowners. Conversely, when high housing costs make it difficult for households to purchase homes, and without an expansion in the rental inventory, rents will rise, which is what happened in Northampton at mid - decade. Between 1980 and 1987, rents in Northampton tripled. According to a. city survey, the average contract rent for a_2- bedroom apartment in 1988 was between $600 and $650, up substantially from the $202 contract rents in 1980. Had rents increased with inflation, a 2- bedroom apartment would rent for less than $300 today. Households who normally would have bought a home, but who had been shut out of the homebuyer market, crowded the rental market and helped bid up the price of the existing rental inventory. In 1980, roughly two out of five households could afford a home. By 1987, around one in seven households had the income to purchase the median - priced home. 16 By mid - decade, then, the following phenomena were at work in Northampton: A tightening vacancy rate. o High levels of rehabilitation expenditures. o High levels of new construction activity, concentrated in the high end of the market. o Rising housing costs locking a great many households out of the homebuyer market. o High levels of investor - purchases, particularly in the new condominium and multi - family market. o A large drop in apartment construction. An increase in the number of condominium conversions. o Increased competition for rental housing leading to rising rents and a continued tightening of the low end of the rental market. THE LATE 1980s: A POST -BOON MARKET As the economy of western Massachusetts rebounded from the recession of the early 1980s, and as interest rates fell, the demand for housing increased. This demand was met first by a tightening of the housing market and, later, by a small increase in prices. The rise in prices created more demand, as speculators entered the market. If demand had been more constant, i.e. had it not been interrupted by the recession, prices would have risen to much more reasonable levels. Instead, rising prices became a self - fulfilling prophecy. By late 1987, the housing market in the eastern area of the state, which was largely responsible for the speculative market, finally lost its steam. In western Massachusetts, the end of the boom occurred slightly later. For many, the slow -down can be attributed to three major facators -- an excess of supply over demand, particularly in the condominium market; tax reform, which reduced the incentives for investor -owned property; and the simple 17 Carl E. Case and Robert J. Shiller, in a recent article in. the "New England Economic Review ", suggest that housing markets are downwardly rigid. i.e., that home prices do not easily decline.' The reasons include (a) high transaction costs, which make it difficult for the market to clear during times of excess supply; (b) the psychological disposition,of owners to sell for less than their purchaser price (owners are more willing to rent for a loss than to sell for a loss) ; and (c) the belief of many investors that housing markets are cyclical and, therefore, that is better to hold onto an asset until it appreciates than to sell when the market is soft. These factors make housing markets different than, say, the stock market. A caveat to the above is the condominium maret, which was greatly overbuilt throughout the state. As housing prices !J escalated, developers rushed in to build market rate condominiums. Unlike single - family homes, condominiums can be built more quickly r and more intensively. Despite its softness, the condominium market is not likely to have a large crossover effect on the low end of the market. Housing markets are comprised of many submarkets, making it possible to have an oversupply of units in one market (such as condominiums) and excess demand in another (such as for " affordable" units). Prices would have to fall substantially -- and not just settle -- to affect housing affordabi.ity. fact that prices had climbed beyond the means of most households. About the only way for a family to afford a home, therefore, is to have considerable equity in a previous home. Although the housing market has entered a new period of adjustment, it is not likely that prices will fall in any dramatic way. In states such as Texas and Colorado, where a housing boom was followed by a housing bust, the collapse of the housing market was precipitated by a collapse in the economy (which, in these cases, was caused by the fall in oil prices). The Massachusetts economy enjoys a far more diversified mix of industries. In the absence of a national recession, the economic outlook for Massachusetts looks positive, although not robust. CONCLUSION Until relatively recently, the shelter needs of low and moderate income families were met principally in t,443 ways. First, as middle and upper income families traded up into more expensive housing, older units filtered down. This housing was not always of great quality, but it was generally of a reasonable price. 18 Second, low- income housing was provided directly by the federal government through a succession of housing programs, beginning with the public housing program in 1937. Nationally, about 14 percent of all renter households live in subsidized housing (28 percent of renter households with incomes at or below the poverty level). The situation in Northampton today is much the opposite. Housing units are no longer filtering down. The huge number of households who have been shut out of the homebuyer market, particularly younger families, have put tremendous pressure on the low end of the rental market. At the same time, subsidized housing has come to a near halt. As a result, the supply of moderately priced units continues to shrink, both absolutely and relatively. 19 Notes 1.. For a background discussion, see Case, Karl. E. 1986. "The Market for Single- Family Has in Boston," New England Economic Review, May /June. 2. Census figures are based on self - reported estimates of property values. Consequently, they will differ from actual sales prices. 21. Massachusetts Institute for Social and Econonic Research. 1988. "Building Permits, 1980 - 1987 ". 4. Northampton Housing Survey, May, 1988. 5. Case, Karl E. and Shiller, Robert J. 1988. "The Behavior of Home Buyers in Boom and Post Boom Markets ", New England Economic Review, November /December. 20 A FRAMEWORK FOR UNDERSTANDING HOW AFFORDABLE HOUSING XS PRODUCED When Congress terminated the Section 8 New Construction and Substantial Rehabilitation program in 1981, it did more than eliminate the major source of funding for low- income housing. It also changed the way in which affordable housing is financed and produced. An entire delivery system had developed around Section 8, one that was steady, predictable, and well- understood. In its absence, at least four major patterns have emerged. First, few projects produced today are able to reach families with very low incomes. The population served is a function of subsidy: only with "deep subsidies" can projects house very low- income families. Mostly, today's affordable housing projects serve families in the $15,000 - $25,000 income range.' Second, an increasing number of affordable housing projects are homeownership projects, as opposed to multi - family rentals. While some of this has to do with the longstanding community bias against apartment complexes, much also has to do with the difficulty of financing a rental project in the absence of federal subsidies. It is far simpler to build a project for sale than it is to build one for rent. Both the developer and the lender are "out" of the project after the units are sold. Third, the development process is no longer made easy by federal subsidy. A smooth and steady delivery system had developed under Section 8, one with easy access to investment capital. Section 8 worked because there was a lot of money in it, but also because the mechansim was simple to understand and reproduce. To build an affordable housing project today requires many different sources of subsidy and financing, often combined in extremely complex and creative ways. Finally, an overwhelming majority of projects produced today are being built by community -based development organizations (CBDOs). These groups go by different names -- Neighborhood Housing Service Agencies (NHS's), Housing Development Corporations (HDCs), Community Development Corporations (CDCs), and more. While they may differ slightly in the organization of their boards and in their sources of support, these groups all share the same basic 21 objectives of expanding housing and economic development opportunities to low- income communities and persons. Sometimes, CBDOs are the sole sponsors of affordable housing ri projects -- they option the property, arrange the financing, and supervise the construction. Other times, CBDOs enter into arrangements with for - profit developers or development consultants to piece out the work that they themselves do not have the capacity to complete. In either case, CBDOs are at the heart of affordable housing efforts here. in Massachusetts. Ten years ago, there were no more than two dozen CBDOs in Massachusetts. Now there are more than 100. It is estimated that, in the past five years, CBDOs have been involved in the production of 5,000 units of affordable housing. Il In Massachusetts, two major factors have contributed to the growth in community -based development. organizations. The first is the combination of the loss in federal housing subsidies and the rise in neighborhood self - determinism. Massachusetts has long had a history of community organizing. But as federal housing subsidies dried up, and as private housing developers turned to more profitable ventures, more and more communities decided to take on development for themselves. In fact, in many communities CBDOs are the only ones producing affordable housing. Second, Massachusetts has the nation's most extensive support system for community -based housing. This system includes the Community Development Finance Corporation (CDFC), which provides small loans and venture capital to qualified community groups; the Community Economic Development Assistance Corporation (CEDAC), which provides technical assistance and small, interest -free loans to non - profits; and the Community Enterprise Economic Development (CEED) program, which provides operating support grants to community development corporations. In addition, Massachusetts has a host of subsidy programs and development finance intermediaries, including the Massachusetts Housing Finance Agency and the Massachusetts Government Land Bank. The purpose of this section is to provide lending institutions with a conceptual understanding of the financial constraints that affordable housing developers face.. The focus is on community - based development organizations, since they are at the forefront of affordable housing efforts and since they have the greatest difficulty getting private financing. We begin this discussion with a quick review of the Section 8 program. Although a host of new subsidy tools and techniques have developed over the past eight years, none has been able to rival Section 8 either in terms of ■ L. 22 n overall funding levels or production efficiency. Moreover, one can better understand each new program by the specific gap or gaps that it attempts to fill. THE SECTION 8 HOUSING DELIVERY SYSTEM Section 8 was the outgrowth of two multifamily housing programs from the 1960s -- the Below Market Interest Rate (BMIR) program and the Section 236 program. These earlier programs were modest experiments at stimulating private investment in moderate income housing. Enacted in 1963, the BMIR program contained two basic inducements. First, it provided federal mortgage insurance up to 100 percent of replacement costs. Second, it subsidized the loan down to 3 percent (conventional financing was around 6 percent). Although 160,000 BMIR units were eventually produced, many of these properties ran into financial troubles, a combination of rising utility costs, low resident incomes, and careless management. In 1968, Congress replaced BMIR with Section 236. By offering direct federal loans at 1 percent interest, Congress hoped to avoid the fiscal problems that plagued BMIR. Within a short time, however, it was clear that this simple formula was not enough and a new production program was in the works. When Congress enacted the Section 8 program in 1974, it had to persuade private developers that (a) there was sufficient profit to be made from building and managing low- income housing and that (b) rents would be adequate to cover operating expenses over the life of the property. Section 8 was not a- financing program, as were the programs before it; rather, Section 8 was a subsidy program. It guaranteed project sponsors an income stream equal to the difference between the so- called "fair market rent ", or the going rent for newly constructed units in the area, and what tenants could afford to pay (defined as 25 percent of their income). A developer who received a commitment for, say, 100 Section 8 rental subsidies would approach a private financial institution or a state housing finance agency (HFA) for construction and permanent financing. With the commitment for subsidies in hand, obtaining financing was relatively easy. In a d;bst- containment measure, developers were required to keep construction costs within certain prototype levels. •These ceilings, however, rarely posed a problem for developers and waivers were common. 23 1 Section 8 sponsors were limited to between a 6 and 10 percent annual return on their equity. Operating income, however, was not how profits were made. The main source of revenue from these projects derived from their tax value. In a typical project, particularly those built after the 1981 Tax Act (pipeline projects), the sponsor would have been able to raise upwards of 20- 2.5 percent of the total development costs through tax syndication, a process by which investors (limited partners) paid money (equity) for the right to claim a property's generous tax losses. These "paper" losses enabled the limited - partners to shelter income earned elsewhere. Through tax syndication, sponsors were able to accomplish two things. First, they were able to raise funds well in excess of their required equity investment. The excess amount became, in effect, their fee or profit. Second, because of the way in which tax laws were structured, project sponsors were able to raise these funds, or at least a good portion of them, at the time of closing on the construction loan. Therefore, developers could get into these projects with little of their own equity. Quite substantial rewards were available for a small amount of up -front costs. The rental subsidy arrangement under Section 8 guaranteed that the units would remain affordable and that the project would remain solvent. Instead of having to petition . the federal government for rent increases, as was the practice under BMIR and 236, rents were to increase automatically each year by a built -in adjustment factor that, more -or -less, reflected local changes in the cost of operating rental property. Since tenant contributions were limited to 25 percent of income (raised to 30 percent in 1981), tenants were insulated from rent increases. Section 8 was not exclusively for private developers and a small, but significant, number of projects were built by various non - profit and community -based organizations. Non - profit sponsors were more common in Massachusetts than in most states. In the earlier years of the program, non - profit sponsors were more likely to have developed the projects by themselves and without tax - syndication. Later, as non - profits learned that syndication enabled them to raise substantial equity, often well above the amount needed to fund the project, many more non- profit sponsors entered into joint- partnerships with experienced developers and syndicated their properties. In the latter years of the program, the vast majority of Section 8 projects were being financed by state Housing Finance 24 it Agencies (HFAs). It was not that banks were unwilling. Rather, by selling tax - exempt bonds, HFAs could make loans at several points below what private lending institutions were able to offer. DEVELOPING HOUSING WITHOUT FEDERAL SUBSIDY In terms of production levels, Section 8 was undeniably the most successful housing program in history. At the height of its popularity in the late 1970s, 150,000 units of Section 8 were funded annually. Section 8 was also enormously expensive and, on that basis, Congress terminated the program in 1981. But in a break with tradition, Congress did not replace it with something. new. Once the pipeline of projects ran dry, there was no major source of federal funding for subsidized housing and the level of activity plunged. Although the Section 8 program only provided developers with a rental subsidy, the guarantee of that deep subsidy was enough to assure a smooth and steady delivery system, one with ready access to investment capital. Now, to get affordable housing produced, and without the easy availability of federal funding, CBDOs face six basic needs -- technical assistance, program funds, seed money, equity capital, subsidy, and financing. These needs are the same in whatever community one works. There is never, for example, enough seed money. The only difference is the relative availability of these resources from one community to the next. Moreover, in areas where there is an active effort to coordinate these resources, one usually finds higher levels of production activity. THE ELEMENTS OF A NEW HOUSING DELIVERY SYSTEM o Technical Assistance o Program Funds o Equity Capital o Seed Money o Financing o Subsidy Technical Assistance Most CBDOs operate on too small a basis to retain specialized development staff. Hence, all CBDOs rely on outside help to some degree to put together their development projects. Usually, the older the organization, the less outside help is needed. Probably the greatest need for technical assistance is in the field of finance -- preparing feasibility studies, raising equity capital, 25 r and securing debt financing. Program Funds In Massachusetts, there are a number of organizations that offer technical assistance to CBDOs. Generally, these services are provided on a contingency basis (contingent on the project getting funding) and the fees are reasonable. The Massachusetts Community Economic Development Assistance Corporation (CEDAC) has, for 10 years-, provided a broad range of technical assistance to non - profits at a nominal charge. Among other things, CEDAC helps . community -based developers prepare development proposals, analyze potential development sites, and estimate rehabilitation costs. Greater Boston Community Development (GBCD), a private non - profit corporation that began as a CDC in the South End neighborhood of Boston in the early 1960s, also offers pre - development, development, and property management services to non - profit developers. GBCD operates throughout the state. A similar function is performed by the Housing Allowance Project in Springfield. While there are also several national technical assistance providers, it is both more difficult and more expensive to work with a consultant who is not locally based and who is not fully knowledgeable of local circumstances. Under the Section 8 program, it was easier to obtain technical assistance and to pay for it out of the development budget. This no longer being the case, it is increasingly important for CBDOs to have on -staff development expertise. Because of the technical skills needed to put together a development project, CBDOs sometimes joint- venture their projects with private developers. Joint - venturing is a way of expanding the expertise of the development team (joint- venturing is also used in cases where the non - profit cannot raise sufficient equity on its own). Joint - venturing is only practical, however, when there is a profit to be made. For this reason, joint ventures are more common in projects involving significant government subsidies and /or in mixed - income projects, where the developer can earn a return on the market -rate units. Seldom are small projects joint- ventured. Additionally, not all CBDOs are willing to joint- venture, since it means losing an element of control. Also known as core operating support, program funds are what pay for staff, rent, office equipment, etc. Historically, CBDOs 26 generated their program funds from profits earned from development projects. With the fees earned from one project, CBDOs would begin the next project. The combination of declining federal subsidies and rising property values has not only made it harder for CBDOs to find projects to build, it has also limited their ability to generate profits. More and more, potential profits are being used to defray development costs. Thus, it is harder for CBDOs to survive as they go from one project to the next. Indeed, because CBDOs rely so much on development fees, delays from one project to the next can be life - threatening. If a CBDO does not have a new project to start work on, and if it has not already lined up its funding sources, it may not survive. It is nit unusual, in fact, for a CBDO to dissolve after just one project "or to be organized for the purpose of developing a specific project. Massachusetts is one of the few states in the nation to provide CBDOs with program funds. In 1988, the Community Economic Enterprise Development (CEED) program provided $1.35 million dollars in program funds to 34 CDCs. The grants are not large -- they average around $40,000 -- but they are leveraged to rai 'e funds from other sources. Moreover, not all CBDOs receive or ate eligible to receive CEED funds. In addition to CEED, many CBDOs receive operating grants from a variety of local, state, and national foundations. As might be expected, the competition for these funds is intense. CBDOs may also receive operating funds through the Community Development Block Grant (CDBG) program, either as an outright grant or as payment for administering one of a number of community development programs, such as fuel assistance or weatherization. Several of the older CBDOs are also the managing agents for properties that they developed under Section 8 or 236, which are used to defray operating expenses. While some have more stable funding bases, CBDOs are, for the most part, fragile organizations that live from year to year and find it extremely difficult to conduct long -range planning. Seed Money As non - profit institutions, CBDOs rarely have the resources to acquire potential development sites or to pay for various pre= development architectural and engineering work. Without these resources, many potential development opportunities get missed. 27 The lack of seed money is one of the major differences that separate non - profit from for - profit developers. In Massachusetts, seed money, or working capital, is available on a competitive basis from the Community Development Finance Corporation (CDFC).' CDFC provides three types of seed funds: technical assistance advances, site control loans, and front money loans. The loans and advances range from just a few thousand dollars to $40,000. Various philanthropic organizations also provide seed money to. non - profits. The conditions under which seed monies are awarded vary depending on the funding source. They can be in the form of outright grants, recoverable grants (to be paid back if the project is funded), or 'loans. Grants and recoverable grants are the hardest to come by. Loans are typically provided at rates several points below market and they can be structured as simple interest loans or deferred payment loans. As might be expected, competition for seed money is fierce. Moreover, with rare exceptions, the funds are only available for projects with a good chance of success and where there is already strong interest from other funding sources. In other words, the CBDO must be fairly well along in the development process. Seed money is rarely so flexible and so accessible that it could be used to purchase, say, a property that suddenly has been advertised for sale at a foreclosure auction. This inhibits community - based developers from acting quickly on development opportunities. Equity Capital The BMIR and Section 236 programs of the 1960s were designed to allow non - profit sponsors to put down only 5 percent of a project's development costs, when market -rate projects typically required equity contributions of 20 -30 percent. This was possible because the federal, government either provided direct federal loans, in the case of Section 236, or provided mortgage insurance, which reduced the risk of default. The Section 8 program, with its huge tax advantages, made it even easier for non - profit sponsors to raise equity capital -- often well in excess of a project's needs. Without Section 8, and because of recent changes in tax laws,' the market for equity capital for low- income housing has essentially dried up. To raise.equity capital, CBDOs must frequently (a) acquire the development site for substantially below its appraised value, which is often done with tax -title property, (b) secure a direct 28 grant, such as CDBG funds for site improvements, which the may agree to treat as equity, or (c) obtain funding from one of the many development finance intermediaries that have emerged in recent years. Although these organizations, including loan funds, philanthropies, and social lending units, usually accept a below - market rate of return, the access to equity capital is far more important than the rate charged. (CDFC also provides equity capital for CDCs.) Subsidy In Massachusetts, it costs about $85,000 to build a modest apartment unit, a figure that varies according to amenities, design, and location. Assuming reasonable operating costs, the required rental for this unit would be approximately $1,000 and, assuming not more than 25 percent of income for rent, would be affordable only to families with incomes in excess of $40,000. To reach families making less than this amount requires subsidy, which comes in many different varieties, both public and private. Direct public subsidies can take the form of operating support grants, rental subsidies, capital grants, and low- interest loans. Examples include the Massachusetts State Housing Assistance Program in Support of Rental Housing (SHARP), the federal Section 8 rental assistance program, the Community Development Action Grant Program (CDAG), and CDBG interest subsidies, respectively. Indirect public subsidies include tax incentives for investing in low and moderate income housing, loan guarantees, and land use powers that allow for greater densities. Market subsidies include cross- subsidization (reducing the rents or sales prices of the low- income units with the income from market -rate units), inclusionary zoning (requiring developers to set -aside a certain percentage of their units for affordable housing), linkage, and various forms of private contributions, including agreements from lenders to accept lower raks of interest and to reduce financing charges. Affordable housing projects typically must utilize several different subsidies. Even when these various sources of subsidies are combined, however, seldom are the projects t able to reach families at the low end of the income range. << Unquestionably, the SHARP and HOP programs have been responsible for the overwhelming majority of affordable housing 29 units produced in recent years in Massachusetts. SHARP has financed about 10,000 units since 1984; HOP has financed about 5,000 (these figures include projects that have been approved but not built and include market rate units). Absent of these subsidy programs, it is extremely difficult to produce affordable housing. Financing Under Section 8, Congress provided the rental subsidies, FHA guaranteed the mortgage, and state HFAs provided the debt financing. While HFA underwriting was not required, HFAs could, through their power to issue tax - exempt mortgage revenue bonds, offer financing at several points below what private depository institutions could offer. Consequently, private lending institutions were not required to play a major role in the financing of affordable housing projects. The same has been true under SHARP, since both construction and permanent financing are provided by the Massachusetts Housing Finance Agency. Because of cutbacks in federal and state housing programs, and because of volume limitations placed on tax - exempt bond financing, affordable housing producers must rely increasingly on private lenders as their primary source of debt financing. To obtain a loan, however, an affordable housing project must be able to support a market rate of interest and also meet the lender's standard of risk, liquidity, and size -- criteria that is not easy for an affordable housing project to meet, particularly for newer, smaller CBDOs. Intermediary financial institutions and technical assistance providers, such as CEDAC and CDFC, often play a critical role in securing private financing by assuming secondary debt positions, which reduces risk to the lender. At the same time, however, the need for multiple sources of financing complicates the deal and adds legal costs (which really hurts smaller projects). Banks prefer to write fairly standard mortgages. Hence, the less traditional the project, the more difficult it is to get private financing. One of the more significant developments in recent years has been the increased reliance on bridge financing (sometimes called gap financing). Bridge financing is used to cover operating deficits in the first few years of operation, often as a consequence of staged syndication payments. Under Section 8, the combination of up -front syndication payments and proceeds from the 30 1 J u permanent loan were almost always enough to meet cash needs. Now, there is often a gap in the flow of funds that must be filled with bridge financing. CONCLUSION The process of producing affordable housing has changed dramatically over the past eight years. No longer is there one source of subsidy to meet project needs. Instead, affordable housing sponsors, which increasingly include community -based organizations, must seek multiple sources of funding. As a result, it takes far more time to get a project built. It also takes more skill and sophistication, as different subsidies must be combined in intricate ways. In the next section, we will look more closely at the role of private lending institutions and how they can better involve themselves in affordable housing initiatives. 31 ■ NOTES 1. Enacted in 1974, the Section 8 program consisted of three different programs: (a) New Construction and Substantial Rehabilitation, (b) Moderate Rehabilitation, and (c) the Existing housing program (housing certificates). In 1981, Congress terminated the New Construction and Substantial Rehabilitation program. Unless otherwise specified, references to Section 8 will refer to the New Construction and Substantial Rehabilitation pry. 2. In Massachusetts, the vast majority of "affordable" housing units built in the past 5 years have been funded under either the Massachusetts State Housing Assistance to Support Rental Production (SHARP) program or the Homeownership Opportunity Program (HOP). At least 25 percent of SHARP units must rented for families of low - income. In most cases, the "low- income" units are "piggy- backed" with Section 8 or 707 rental certificates, which allows them to rent to families with very -low incomes. At least 25 percent of the units in a HOP project must also be sold at "affordable" prices, up to about $110,000. 3. Eligibility for CEED is limited to Community Development Corporations, as defined by Chapter 40 (f) of Massachusetts General Laws. In effect, CDCs must serve a defined geographic boundary and have a majority of the board elected by community residents. 4. Eligibility for CDFC assistance is also limited to CDCs. 5. Four major provisions in the Tax Act of 1986 reduced the tax incentives for investing in low income housing. They included (a) the lengthening of the depreciation schedule, (b) the lowering the tax rate (which reduced the value of tax losses), (c) restrictions on the use of passive losses to offset earned income, and (d) and limitations on the use of tax - exempt financing. While Congress did introduce new low- income tax credits, the conditions under which they must be used are so restrictive as to make the credits prohibitive. To take advantage of the credits, between forty and sixty percent of the units must rent to families with very -low incomes. The problem is that, without tenant rent subsidies, it is nearly impossible to reduce rents sufficiently. Thus, while there are investors who would want to utilize the credits, and several national organizations have formed tax - credit equity pools, only a small number of projects have been able to aggregate the necessary amounts of subsidy to make the rents affordable to very -low income families and, therefore, to qualify for the credits. In Massachusetts, this rnaans mostly SHARP projects or projects with Section 8 rental subsidies that have been assigned to the units. 32 BANKS AND AFFORDABLE HODS Z NG The purpose of this section is (a) to provide a conceptual understanding of the difficulties affordable housing sponsors often have in getting banks to finance their projects and (b) to look at how various banks have organized themselves to support housing initiatives. In particular, this section examines the criteria that banks use to underwrite development projects and suggests that the problems of financing affordable housing can be divided into three categories -- issues of substance, perception, and process. Substance issues are those that have to do with subjective matters of risk and return, including the financial feasibility of the proposed project or the capacity of the development team. Issues of perception are those that have to do with how banks sometimes view affordable housing projects, irrespective of substantive matters. Process issues are those that arise out of, or are compounded by, the way in which negotiations between borrower and lender are conducted.' This section is intended for two audiences -- banks and affordable housing sponsors. For this reason, parts of this section will be familiar for one group and instructional for the other. Before proceding, it is necessary to make a few introductory comments on the structure of the banking industry. First, *not all banks are alike. Banks differ in the products they offer, the regions they cover, and their tolerances for risk. Some banks specialize in home loans, while others specialize in commercial lending. A construction lender, therefore, is not likely to be a good source of permanent financing. Similarly, some banks are more aggressive than others in their lending practices. What one bank may view as creditworthy, another may not. These differences can greatly affect a bank's ability and willingness to participate in affordable housing programs. Second, as far as home loans are concerned, an increasing number of banks today are secondary market lenders. In 1970, 36.7 percent of all original mortgages for one- to four -unit family housing were resold in the secondary market; in 1982, that figure 33 rose to over 75 percent. The growth in the secondary market has brought with it 'a number of benefits, including an increase in the total amount of capital flowing into housing, a decrease in geographical disparities in the availability of credit, and an overall lower cost of credit to the consumer. The secondary mortgage market has also helped minimize discriminatory lending practices that were based solely on race, ethnicity, or geographical location. To obtain a loan, a homebuyer needs only to satisfy the underwriting and appraisal standards of the secondary market. Moreover, it is not even necessary for a borrower to go to a bank. Mortgage companies can originate secondary market loans as well. One of the major disadvantages of the secondary market. is that it systematically excludes large classes of borrowers, principally those with low incomes or minor credit problems. In an effort to provide investors with greater sureties, the secondary market has moved to adopt increasingly tighter underwriting criteria. A borrower who does not meet secondary market criteria, but who otherwise would be considered a good credit risk, must find a lender willing to hold loans in portfolio. Not only are portfolio lenders becoming more scarce (particularly with the growth in large banking organizations, a topic to be discussed below), but, to protect themselves from interest rate risk, portfolio lenders tend to write mostly adjustable rate mortgages. Even when a lender holds its loans, it may use the underwriting criteria of the secondary market in the event that it decides to sell its loans at some future point in time. The secondary market for mortgages on apartment buildings (5 or more units) is not nearly as large as the secondary market for residential mortgages (1 -4 family units). Consequently, the tendency towards greater uniformity and standardization in underwriting procedures is less prevalent. However, because banks hold a greater percentage of their, commercial /apartment loans in portfolio, they are disinclined to write long -term, fixed -rate mortgages, something which has long been criticalifor low- income housing. Third, the entire structure of the bankintig industry is changing rapidly. Following the collapse of the banking system during the Great Depression, strict limits were placed on the financial services that could be provided by bank, thrifts, and other financial institutions. Lines were drawn not only over the products that banks could offer, but also in the prices that they could charge and where they could operate. Throughout the 1970s, 34 technological .changes began to undermine the integrity of this system and created pressure for sweeping regulatory reforms. Most notable was the development of the money- market mutual fund. During periods of rising interest rates, depository institutions were unable to raise the rates paid on deposits to compensate for inflation. Unregulated financial institutions -- from the large brokerage houses of Merrill -Lynch to Sears Financial -- took advantage of this situation by designing market -rate savings instruments attractive to small investors. The result was financial "disintermediation" -- the flow of funds out of regulated depository institutions into non - regulated financial institutions. In 1982, to stem the withdrawal of deposits out of regulated financial institutions, Congress passed the Depository Deregulation Act. This law led to the gradual elimination of deposit rate ceilings and to the expansion of asset powers. Essentially, thrifts, which perviously could invest only in home mortgage loans, were permitted to invest in small business, consumer, and mixed - used projects. Likewise, commercial banks were permitted to invest in home loans. Then, in 1985, the Supreme Court opened the door for interstate banking by overturning the McFadded Act, which had prohibited banks from crossing state lines. Now, states can pass regional banking agreements to allow banks from within their region to open new branches or to acquire existing bank organizations. As a result of both technological and regulatory changes, the banking industry has become increasingly competitive. Previously, banking regulation had the effect of promoting the retention of local savings in local institutions. For the most part, banks were ` ' locally owned and operated. Entry barriers limited competition. In recent years, there has been an enormous growth in the size of I banking organizations as numerous small, local banks have been acquired by large, expanding banking organizations. How these changes affect the attitudes, policies, and practices of banks towards affordable housing lending is not entirely clear or obvious. i According to one school of thought, because community - controlled banks were more familiar with local needs, they were also more responsive. With the growth in large banking organizations, loan officers must now conform to fairly rigid underwriting standards and ratios established by the parent company. In particular, community- controlled banks may have been more willing to grant small and unsecured loans, whereas large banking organizations may emphasize larger loans, which are more profitable. In addition, large banking organizations are prone to close branch banks that fail to meet certain deposit threshholds ,35 or minimum levels of profitability.. Branch closings can be particularly harmful in rural areas and inner -city neighborhoods that are not served by other banks. When a bank is unfamiliar with a particular market, which can happen when it does not have a physical presence in the community, it must obtain information about that market before any loans are made. Because information is costly, it follows that fewer loans will be made, all else being equal. Others argue that the growth in large banking organizations has been beneficial for small businesses and affordable housing sponsors. Large banking organizations, for example, can participate in larger, more complicated, and riskier projects -- because they have greater technical sophistication and because they are better able to diversify their risk. Competition has also made banks more aggressive. While locally - controlled banks operated autonomously, the result was not always benign. Community banks could also be arbitrary or exclusive in their lending practices. rl, Although there is, as yet, little empirical evidence to measure the impact of the growth in large banking organizations on community credit needs, one thing is certain: affordable housing lending requires a special commitment on the part of bank management. Loans to affordable housing projects are not the type of loans that banks are used to making. Large or small, banks have . to make .extra efforts to participate in affordable housing programs. HOW BANKS UNDERWRITE DEVELOPMENT PROJECTS Banks take funds from one source (depositors) and make them available to others (borrowers). This transaction is done for a fee (interest) , the rate of which is influenced by several factors, including the cost of funds (what they must pay depositors), a reserve for loan losses, the expense of, packaging and servicing the funds, and a satisfactory return on investment. The fee charged also reflects risk. The higher the perceived risk, the higher the interest. Underwriting is the method by which banks determine whether a particular project or borrower is a good credit risk. To help make that determination, lenders are guided by five basic criteria: the credit of the borrower, the character of the borrower, the capacity of the borrower, the collateral value of the project, and the cash flow from the project. These criteria are discussed 36 below. Credit of the Borrower: The more that one borrows, the more credit one develops. Consequently, newer housing developers have the hardest time getting financing. If a borrower has little or no credit history, the lender has no experience in which to judge whether the loan will be repaid. With greater uncertainty, a lender will want either to reduce its exposure or be compensated for in the form of higher interest. Character of the Borrower: In determining a borrower's character, banks look at whether a sponsor has made met past credit obligations (which makes this criterion somewhat redundant), the financial strength of the borrower, including its net worth and liquidity, and, as a last resort, at the borrower's moral integrity and standing in the community. Capacity of the Borrower: Capacity is a measure of the likelihood that the sponsor can build and manage the project in accordance with the terms of the mortgage. First and foremost, does the sponsor have demonstrated experience in undertaking the same type of development? Were these projects built according to plans or were they plagued with delays and cost overruns? Collateral Value of the Project: As a general rule, banks do not like to lend more than 80 percent of the appraised value of . a project. This protects the bank against the loss of principal in the event of default. It also gives the sponsor a financial stake in the project. If a project is considered particularly risky or it is located in a less than desirable location, the lender may loan less than 80 percent of value. The appraised value is not the same as total development costs. At times, subsidized properties can cost more to build than what they would sell for, particularly in depressed neighborhoods. In such instances, the amount that the lender would be willing to lend may be far less than what is necessary to complete the project. Cash Flow of the Project: Because projects that are built too close to the margin can run into financial troubles, banks generally prefer that, for every dollar of loan to be repaid, the project have available about 37 Substantive Issues Taking the above criteria in combination, it is easy to see LJ why affordable housing projects, particularly those built by CBDOs, often have difficulty getting private financing. To begin with, most CBDOs have little net worth, which means that a bank must be willing to grant a loan only on the collateralized value of the project. Depending on the project's location, however, the bank r may not feel that the prorerty is adequate security for the loan. Also, depending on the organization's experience in developing housing, a bank may be concerned that the project will not get built on time or within budget. Because of the limited amount of equity that non - profits have available to put down on any project, banks may be asked to make highly leveraged loans, ones that exceed 80 percent of appraised value. Again, this is not common practice for banks, not unless the borrower is a preferred customer, has substantial outside equity and is willing to personally guarantee the loan, or the bank is taking an equity participation in the project (which, for practical reasons, rarely happens with affordable housing projects). Lending institutions may be reluctant to participate in affordable housing projects simply because these deals can be so much more complicated than commercial loans of similar size, requiring several different funding sources. Each additional source of funds necessitates added paperwork, legalwork, and staff $1.15 to $1.20 in net operating income (income after expenses). This provides lenders with a reasonable margin to cover debt payments if vacancies or expenses rise unexpectedly. In projects where the market for the units is less certain or where expenditures are more variable, banks will require higher debt - coverage ratios. Some lenders also require a certain "cash -on- cash" return -- calculated by dividing the annual cash flow by the equity investment. For example, if a project's cash flow is, say, $60,000, and the equity investment is $1,000,000, the cash -on -cash return is 6 percent. In this instance, a lender may consider this return insufficient incentive for the investor to sustain an economic interest in the project. Instead, the bank may want, say, a 15 percent return on investment. 38 training. Hence, these loans can be costlier to originate. Additionally, since each loan,is custom -made, it is impossible to standardize loan processing. Loans to affordable housing sponsors may also be more costly to service. This may be particularly true if the entity managing the property is new or inexperienced. In all, there may be quite legitimate economic reasons why affordable housing sponsors, particularly younger organizations, face a tough time getting private financing. From the bank's perspective, there can be problems both of profitability and credit quality. The loans can be more costly to originate, the assets of the entity doing development may be limited, the cash flow exaggerated, and the project highly leveraged. Perceptions Regardless of objective criteria, a number of banks are simply unwilling to finance affordable housing projects because they perceive them to be unprofitable or risky. They will do so only under extreme political pressure. A bank that does not want to finance an affordable housing project can find any number of reasons to justify its position. It can argue that the assets of the organization are indadequate, that the group has insufficient development experience, or that anticipated rents are unrealistic. Once a sponsor corrects one problem, it then learns that it must correct another. This process can go on until the sponsor finally abandons the project or seeks finacing elsewhere. Since risk is a subjective measure, and since it is human nature to trust the familiar, any project that does not closely resemble other loans in a lender's portfolio -- which is the'case for most affordable housing projects -- will almost always be considered a more risky venture. Process Issues Under better conditions, a potential borrower would approach a lender in the early stages of development to di:;cuss plans for a proposed project. The lender would review the plans and provide preliminary feedback. As the plans get more fully developed, discussions between the lender and the borrower become more formalized. After a series of negotiations -- how much the bank is willing to commit to the project and under what terms and conditions -- a final offer is made. Provided that the agreement is satisfactory to both sides, papers are signed. 39 A common problem among affordable housing sponsors, however, is developing a relationship with a lending institution. If the sponsor does not understand how banks underwrite development projects or has unrealistic expectations about what banks can do, it may appear inexperienced or unwise in business matters. Problems can also occur if the sponsor does not involve the lender in the early stages of project planning (depending on a bank's predisposition to affordable housing, this may not be possible). Without a personal relationship with a lender, misunderstandings can occur over the nature of the dispute. The bank may feel that, based on its previous track record, the sponsor is incapable of handling the proposed project, whereas the sponsor may feel that the bank is simply unwilling to make loans in a certain neighborhood. Personal and cultural differences may cause these misunderstandings to escalate. Sometimes, the dispute may have nothing to do with the project at hand, but with past battles. If the previous negotiaton turned sour, both sides may assume a combative posture. CREDIT ENHANCEMENTS Faced with the above difficulties, how do CBDOs get banks to finance their projects? The greatest challenge CBDOs have in obtaining private financing is convincing lenders that they have the technical expertise to handle development projects. More times than not, lenders are willing to relax their underwriting criteria (especially borrower - centered criteria) if they have confidence in the capacity of the development organization. CBDOs, however, rarely do enough business with banks to build a relationship based on trust and understanding. Indeed, without such a relationship, the opposite often occurs. If the organization doing development is young and has been unable to establish . a development track - record, jit may have to start with smaller projects, to add respected development consultants to the development team, or to joint- venture with more experienced developers. The more projects a group Icompletes, the more willing banks are to make additional and increasingly larger investments. Alternative methods for reducing risk to the sponsor include arranging for secondary sources of subordinated financing or by obtaining third -party guarantees against operating shortfalls when 40 L L L i the debt coverage ratio is thin. An example of the former would be where the city is willing to finance $150,000 towards the development of a $1,000,000 project, with the CBDO putting up $50,000. Although the overall loan -to -value ratio is 95 percent, the bank's loan accounts for only 80 percent of value (we will assume that the appraised value and total costs are equal), which allows it to maintain its normal cushion against exposure. An example of the latter would be a situation where the city is willing to make payments to cover operating deficits in the first few years of operation. Other than adding capacity to the development team, securing additional forms of secondary financing, or obtaining third - party guarantees, almost all remaining forms of credit enhancements are no more than operating subsdies. For example, if income is not adequate to repay debt service, and assuming rents are restricted by tenants' ability to pay, subsidies will be needed to reduce operating or development costs. MODELS OF BANK INVOLVEMENT The previous heading looked at techniques available to affordable housing sponsors to make their projects more acceptable to lenders. Here, we ask the reverse, i.e., what can banks do to support affordable housing activities? Before answering that question, it is first worth considering why some banks participate in community development projects. We suggest that there are three reasons -- economic, philanthropic, and political. Economically, a bank may be motivated by the desire to develop a new credit market or to stabilize an existing one (such as outstanding home loans in a depressed neighborhood). Philanthropically, a bank may be motivated by a sense of public duty. While the return on a particular lending program may be marginal, the institution may feel that its participation is part of its wider corporate responsibility (it may also be true that participation improves the bank's public relations, which can have indirect benefits). Politically, a bank may feel compelled to participate because of pressure from local officials or community groups. Provocation may take a mild and subtle form or it may be the result of a heated CRA battle. The different motivations are not exclusive. In fact, there is usually an element of all three in any community development lending program. Understanding these motivations is important for at least two reasons. First, because of underlying motivations, one cannot 41 assume that a lending program underway in one community can necessarily be replicated in another. For example, a bank wanting to settle a huge CRA dispute may have agreed to concessions for which it otherwise would not have consented. Consequently, it would be difficult to duplicate this program elsewhere. The same can be said for programs that banks have gotten involved in that serve primarily a public purpose. Second, it is important to keep in mind that programs successful over the long -run are those that serve each bank's self interest. If a program is not economically beneficial, there must be compelling political reasons why banks would want to participate, otherwise their interest will wane. When a bank gets asked to participate in an affordable housing project being developed by a community -based development organization, it is usually the case that the project has many financial needs. For banks inclined to participate, there are any number of ways to offer assistance. A bank could, for example, agree to relax its underwriting criteria, reduce the fees it charges, or provide favorable financing. A bank could also grant the sponsor a recoverable pre - development loan, offer technical assistance, or purchase an equity interest in the project (especially if there are substantial'tax credits). One could devise a dozen or more methods to structure bank participation. The key, of course, is the willingness of the lending institution . to make that commitment. Most banks get involved in affordable housing projects in just this manner, which is to say that they are passive and dog not actively seek out development proposals. An increasing number of banks, however, are moving beyond the isolated project towards a more focused approach to community reinvestment. In the process, five different organizational models have begun to emerge -- lending consortiums, bank community development corporations, housing partnerships, community development lending units, and special efforts (a catch -all category). These models are described below and illustrated with selected examples. Lending Consortiums Many of the first lending consortiums were formed in the late 1960s and early 1970s to provide mortgages in neighborhoods suffering from disinvestment from mortgage lenders. Without access to conventional sources of credit, property values and conditions deteriorated. Consortiums have generally served four purposes. First, they 42 have spread perceived risks among participating lenders. Second, they have made it possible to generate enough volume of loans to effect change in a neighborhood. Third, they have enabled lending institutions to develop loan products that are tailored to community needs. Fourth, they have centralized originating and underwriting functions, thereby reducing overhead costs. Virtually every city has had some experience with lending consortiums, although most were of a modest scale and of a limited duration. The degree to which these programs are successful depends on the level of bank commitment and leadership. There are two different types of lending consortiums -- pools and federations. In a pooling arrangement, a group of banks agrees to pool their funds and share risk. The pool may be set up to fund a specific project, such as the rehabilitation of an inner -city apartment building, or for an on -going lending program, such as home improvement loans. In a federation, each bank originates its own loans and, thus, bears risk individually. Often times, federations have numerical goals for each bank to meet in terms of volume of lending. A federation might also have a multi -bank loan . review committee. - Lending consortiums are typically organized around a specific type of loan program, such as home mortgages, home improvement loans, and multi - family loans, although there are examples of consortiums that offer a range of loan products. The Philadelphia Mortgage Plan (PMP), in existence since 1975, is an example of a federated lending consortium. The objective of PMP is to enable more families in inner -city neighborhoods to become homeowners. To date, PMP has initiated more than 10,000 loans totalling in excess of $1 Borrowers have had an average income of $15,000. At the time of PMP's inception, Philadelphia's neighborhoods were suffering from widespread disinvestment and capital flight.. After major organizing efforts by community groups, the banks agreed to adopt more realistic underwriting and appraisal standards for applicants in targeted neighborhoods. For example, banks agreed to waive minimum loan sizes (some loans are as low as $3,000), drop full code compliance, acknowledge second incomes and government payments, and to overlook minor problems of credit history (called "reading into the credit "). Banks also agreed to make loans with downpayments as low as 5 percent, waive certain fees and points (banks generally charge just one point), and to write fixed -rate loans (adjustable rate loans can be problematic 43 for low- income families). And, because these loans could not be sold in the secondary market, the banks agreed to hold the loans in portfolio. A bank cannot reject a PMP loan without approval from a loan review committee, which meets weekly and is comprised of loan officers from participating banks. A report of loan activity is made public and issued quarterly. The banks also work closely with community groups to make sure that potential applicants are informed of the program and, if necessary, to assure that applicants receive homebuying counseling. Banks can approve an application on the condition that the applicant attend homebuying training. Although PMP mortgages have a high delinquency rate, the default rate is not' • high and the program is generally considered to be a success. It has proved that lenders can make loans in inner -city neighborhoods and still make a profit, although maybe not as much profit as other lending programs. The program has been essential in stemming the tide of disinvestment. The New York City Community Preservation Corporation (CPC), founded in in 1974 by New York's major commercial and savings banks, is an example of a pooled consortium. Unlike PMP, which has no staff (each bank performs its own underwriting), CPC is organized as a non - profit corporation with its own professional staff. It originates loans on behalf of banks and other lenders to preserve and develop apartment buildings. The board of the corporation is comprised of members of the participating banks. Since its inception, CPC has financed the rehabilitation and development of over 20,000 units, for a combined public and private investment of more than $350 million. CPC's initial focus was preservation, not new construction. At the time, New York's neighborhoods were suffering from neglect and abandonment; however, no lending programs existed that would enable owners to finance the rehabilitation of their structures in a way that was economical and did not burden renters. The solution was to form a pool of bank capital to finance basic rehabilitation of occupied units. With moderate rehabilitation, it was possibble to extend a building's useful life for 40 years at a cost of only $10,000 to $20,000 per apartment, which meant that the units could remain affordable to families making between $15,000 and $35,000. The sponsoring banks provided a line of credit -- now $52 44 Li '`? million -- for construction financing and $100 million in permanent financing. In 1984, CPC was able to attract funds from the New York City Police Pension Fund and the New York City Employees Retirement System, which today total $200 million. In 1986, CPC was also able to get seven major insurance companies to pledge an additional $50 million in condominium end -loan financing. Moreover, these insurance companies helped CPC create a secondary market, called the Housing Partnership Mortgage Corporation, for condominium end -loan financing. CPC's investment models fall into three basic categories -- the rehabilitation and development of rental housing with conventional financing; the rehabilitation and development of rental housing with subsidized financing (with funds from the the city's CDGB program); and the rehabilitation and construction of condominiums and cooperatives with conventional financing. CPC is not a social lending program. For its construction financing (except for its subsidized financing in conjunction with the city), CPC has a revolving line of credit (from the banks, pension funds, and insurance companies) which enables it to borrow at the prime lending rate. CPC then lends those funds at 2 points above prime. For its permanent financing, CPC uses advance commitments to purchase mortgages or mortgage- backed securities. Almost always, the permanent loans are insured by the State of New York Mortage Agency (SONYA) or the New York City Rehabilitation Mortgage Insurance Corporation (REMIC). To make it possible for residential property owners to rehabilitate their properties without displacement, CPC has, over the years, relied on four major sources of subsidy: (a) the Section 8 program, (b) a special New York City tax abatement program for elderly occupants in renovated apartments (which allows owners to deduct up to $50 a month in property taxes), (c) 1 percent loans from the city's CDBG program, and (d) the city's vacant building program, under which the city sells tax - foreclosed buildings to private developers for one dollar provided the units are used as affordable housing. Lending consortiums similar to CPC are underway in California, Chicago, Miami, and Deleware. HOUSING PARTNERSHIPS By housing partnership, we refer to a specific model of community -based development, one where special efforts are 45 L undertaken to aggregate resources and provide centralized technical assistance to community -based development organizations (this definition should distinguish it from merely advisory or review boards). With the loss in federal housing programs over the past eight years, there has been a proliferation in housing subsidy and finance programs, both public and private. Mostly, these programs are small in scale and must be used in combination with one another. Accessing these programs requires great time and skill. Housing partnerships are built upon two basic assumptions. First, by building the capacity of affordable housing developers, funders will be more willing to put money into low income housing. Second, by reducing the amount of time spent on packaging and fundraising, the productivity of CBDOs will improve. The Boston Housing Partnership (BHP) was an effort to link together the city, Boston -based financial institutions, private foundations, state agencies and a variety of community, -based organizations to preserve moderately priced rental housing and to reclaim low -cost units that had been lost to abandonment. At the time of BHP's inception, Boston had a strong network of community- development organizations. Few of these groups, however, had any substantial experience in building and renovating rental housing on a large scale. BHP was designed to make it easeir for CBDOs to get housing financed, funded, and built. The strategy of BHP was to aggregate all the financial resources in one place and also to provide CBDOs with the technical assistance they would need throughout the various stages of the development process. The first project, BHP -I, included the renovation of 700 apartments in more than 700 buildings citywide. Ten CBDOs participated in BHP -I. The second project, BHP -II, how underway, includes the rehabilitation of 1,100 formerly HUD - foreclosed units. Eight CBDOs are participating in BHP -II. Each project is structured so that the ownership of the actual properties is held by the CBDOs. In BHP -I, banks played three major roles. First, bank leadership was essential in galvanizing public support and in raising private and public funds. Second, four Bdston banks took the risk on the $23 million construction loan. Third, the same banks also issued a letter of credit in the amount of $4.5 million on the city's bridge loan. 46 In BHP -II, the Massachusetts Housing Finance Agency provided both the construction and permanent loan. However, the banks continued to play an important leadership role, without which funding from the federal government might not have been forthcoming. The banks also purchased many of the equity shares in the syndication (which the new tax law permits) and provided some bridge loans. The Boston Housing Partnership could not have been possible without the strong system of support for community -based housing in Massachusetts. The partnership was assisted by the state's CEED program, CDFC, CEDAC, and Greater Boston Community Development, among others. It should be noted that it would be extremely difficult to replicate BHP -I, particularly at the same scale. First, BHP -I required substantial amounts of public and private subsidy, resources that are simply not available in such quantities today. Second, when BHP -I began, Boston had a large supply of abandoned and tax -title property, which made it possible to acquire each unit for an average cost of $5,000. These same structures would cost six to ten times that amount today. The Wisconsin Partnership For Housing Development (WPHD) is a different kind of housing partnership. Created in 1985 to be a partner to developers of low and moderate income housing, it offers both technical and financial assistance. Technical assistance is provided either by WPHD staff or by private corporations that specialize in those services and that have agreed to offer those services at little or no cost. WPHD generally does not charge for its services unless a project gets built. WPHD serves as a lender and as a clearinghouse for other financial institutions. WPHD is in the process of developing four separate funding pools, including a revolving loan fund, a permanent mortgage financing pool, an equity investment fund, and a housing trust fund (which would serve as an annual revenue source for rental subsidies, WHP operating capital, or other housing related uses). WPHD differs from BHP in that it tries to be a one -stop source for funding. Housing developers come to it for whatever needs they have. A group attempting to build a transitional shelter, for example, may come to it for a bridge loan. Another sponsor might approach WPHD for share loans for a co -op project. 47 i BANK COMMUNITY DEVELOPMENT CORPORATIONS Generally, banks are prohibited from making direct equity investments in real estate or businesses not "closely related" to banking. However, to make it easier for banks to make debt and equity investments that serve predominantly a public purpose, both the Office of the Comptroller of the Currency (for national banks) and the Federal Reserve Bank (for bank holding companies) authorize and encourage banks to form their own community development corporations. In the past decade, over two dozen national banks and 15 bank holding companies have established bank Community Development Corporations (CDCs). Bank CDCs operate in much the same manner as any other community -based development organization. The major difference being that they are bank - owned. A bank CDC can be capitalized by one bank or a group of banks. The range of activities varies depending on the needs of the respective communities. In one community, for example, the emphasis may be on stabilization of the housing stock and, thus, on housing rehabilitation. In another, the CDC may concentrate on commercial revitalization. Bank CDC activities must, however, be designed to substantially benefit small businesses and low and moderate income residents. Banks CDCs must also include ample community participation in their operations. Once incorporated, the tools that bank CDCs use to produce housing or revitalize commercial districts are the same that any non -bank CDC would use. Bank CDCs work with local governments by leveraging CDBG and UDAG funds, tax- exempt mortgage programs, and other subsidy vehicles. Most of the earlier bank CDCs were established in neighborhoods where there was not already a community -based development organization or where there was not already an infrastructure for community -based housing. In a few instances where such groups existed, turf issues emerged. In recent years, there has been a trend away from bank CDCs as developers and in the direction of technical assistance providers and specialized lending units, complementing and assisting the local housing delivery system. Chemical Community Development Corporation (a subsidiary of Chemical Bank of New York) offers real estate financing and technical assistance to both private developers and community -based 48 development organizations throughout New York City and Long Island. CCDC is, in essence, a full- service real estate lender whose purpose is to assist communities in the building and maintenance of affordable housing. CCDC provides permanent mortgages, construction loans, captial improvement loans (for multi - family buildings that do not require total rehabilitation), one -to -four family mortgage loans, and home improvement loans. In addition, CCDC provides operating support grants to CBDOs, recoverable seed money (up to $15,000), and gives seminars on topics related to housing and community reinvestment. Bank CDCs have also been established by, among others, First Bank System Corporation in Minneapolis /St. Paul, Mellon Bank in Pittsburgh, Shorebank Corporation in Chicago, and Mercantile Trust in St. Louis. COMMUNITY DEVELOPMENT LENDING UNITS Although not specifically focused on affordable housing, there are a number of banks that have developed specialized community development lending units. The units are typically staffed by loan officers who have greater familiarity with small business and community development lending, including the wide rage' of government support programs. Rainier National Bank in Seattle, Washington, opened a Community Bus :.ness Loan Center in 1985, a specialized loan center for small businesses. Its mission is to meet the special needs of women and minority -owned small businesses and other small companies that may not have ready access to financial services. The Center provides prospective loan applicants with the individual attention to make their projects more bankable and to increase the sucess rate of start -up small businesses. The American Security Bank in Washington, D.C., has a community development lending unit within its real estate division, which it calls "The Community Development Group ". Since its establishment in 1986, the Community Development Group has originated $200 million in commitments in inner -city neighborhoods. It offers a variety of loan products, including pre - development and acquisition loans, construction financing, lines of credit, and letters of credit. In recognition of the fact that many small businesses, minority developers, and non - profit groups have limited capital, ASB utilizes what it calls "project -based underwriting ", wherein 49 it emphasizes underwriting criteria that primarily affect a project's cash flow and collateral. As part of this approach, ASB treats subordinated sources of financing as project equity and will calculate debt - coverage- ratios only on the bank's debt. SPECIAL EFFORTS In addition to what has been described above, and rather than simply respond to development projects on an as -come basis, there are a number of initiatives that banks can undertake to support affordable housing. These actions can include any of the following. a. Provide technical assistance and financial support to community -based development organizations, including community development corporations, Neighborhood Housing Service agencies, and housing development corporations. b. Provide financial support to organizations that support community -based development efforts, including the Local Initiatives Support Corporation, the National Cooperative Bank (which provides loans to sponsors of cooperatives), Community Loan Funds, Land Trusts, and other development intermediaries. c. Participate in special community development lending programs, usually in combination with public funds from the city, so that the blended rate is below market, and d. Invest in low- income housing equity funds, such as LISC's National Equity Fund. CONCLUSION With the decline in federal housing subsidies, lending institutions have been asked to play a larger role in the financing of affordable housing, often in conjuntion with community -based development organizations. Many of these organizations started as advocacy groups, but have grown in capacity to take on development projects. Still, getting their projects financed has never been easy and may grow even more difficult with the growth in large banking organizations. 50 Unfortunately, CBDOs generally do not have the opportunity to develop the personal relationships with lenders that are such an important aspect of the lending business. For most banks, involvement in affordable housing is episodic. It is not part of their routine lending programs, which means that they are often unfamiliar with the mechanics of affordable housing lending and the sponsoring agencies. Of necessity, more and more lenders are getting involved in community development activities and, as they do, are finding that good community endeavors can also be profitable. They are also finding, however, that more actors need to be involved in the process, which accounts for the public - private partnerships described in this section. 51 rTh j 1 These categories were drawn heavily Michael Wheeler, Massachusetts Institute of NOTES from, "A Handbook: Building Consensus for Affordable Housing ", by Technology, Center for Real Estate Development, January, 1987. The Revolution in Real Estate Finance, The Brookings Institution, Washington, D.C., which thrifts directly exchanged mortgages for the same amount of 2. Downs, Anthony. 1985. p. 237. These figures exclude "swaps" in mortgage - backed securities. 3 . Kollias, Karen. 1988. "Community Development Lending: Cutting Edge for Good Business ", American Security Bank, Washington, D.C.. Also see, Riesenberg, Charles E. and Lime, Carlyn P. 1988. "Principles and Practices of Community Investment Lending -- A Five Step Investment Model to Strengthen Bank Community Development Programs," First Bank System and Federal Reserve Bank of Minneapolis. 52 THE LOCAL HOUSING DELI VERY SYSTEM Like all communities, the resources available in Northampton for affordable housing are limited. The primary source of city funds comes from the Community Development Block Grant (CDBG) program and is administered by the city's office of Community Planning and Development. In FY 1989, the city received $800,000 in CDBG funds, down more than 25 percent from 1981. Of that, the city annually apportions about 20 percent for low - income housing initiatives, from operating grants to non - profits to site -work for affordable_ housing projects. In addition to its CDBG allocation, the city receives, subject to appropriations, around 10 -20 units annually in state or federal rental housing certificates, administered by the Northampton Housing Authority. Otherwise, all state or federal housing subsidies, such as HOP or SHARP, are awarded on a competitive basis to private or non - profit developers and not to the city itself. If a private ,developer proposes to build a SHARP or HOP project, which, for all practical purposes, are the only remaining housing programs, the city will frequently waive certain permitting and sewer fees or pay for certain site improvement costs out of its CDBG budget. If the project does not receive stiff opposition from the neighborhood, and if the competition in the funding round is not too intense, the project may get built. In the case of a SHARP project, no private financing is needed; in the case of a HOP project, the private developer is usually knowledgeable enough, and adequately capitalized, to find construction financing from a private lender. If the . subsidies cannot be obtained, the developer will in all likelihood not build the project, at least not as planned. The developer may instead build a more upscale product. In other words, the amount of affordable housing produced in Northampton is almost entirely dependent on the availability of housing subsidies. While the city can improve the feasibility of a subsidized project through various concessions, it does not have enough of its own resources to entice private developers to build affordable housing absent of state or federal subsidies. In part because of the vacuum left by the private sector, Which itself is a function of declining federal commitments to housing programs, there are now several community -based development organizations that operate in and around Northampton. These groups include Valley Community Development Corporation, Hilltown Community Development Corporation, and HER, Inc. Because of 53 intense competition for monies that are available to non - profits, these groups must devote increasing amounts of time and money away from producing housing to fundraising activities. Provided with a more stable funding base, and provided with greater access to - development capital, these groups could greatly increase their level of housing production. While CBDOs also compete for SHARP and HOP funds, they are generally at a disadvantage because their projects are of a much smaller scale (there is both a programmatic and institutional bias against small projects) and because they have less influence with funding agencies than more experienced developers. These groups, therefore, are left with projects that most private developers would not take on, including, for example, the preservation of a single -room occupancy hotel, the rehabilitation of an abandoned triple- decker into a limited- equity cooperative, or new construction on non - contiguous in -fill sites. Because of the very different projects that CBDOs develop, they need flexible sources of financing. The Western Massachusetts Community Loan Fund has attempted to fill this gap, but it cannot keep pace with the demand, particularly for subsidized financing. Other than WMCLF, several foundations have at times provided bridge financing for affordable housing, but overall there has not been much involvement beyond the traditional sources of financing. The Northampton Housing Authority is another major player in the local housing delivery system, but, like others, its activities, have been cut dramatically because of reductions in federal housing programs and the lack of development sites. CONCLUSION Given the limited availability of housing subsidies, it is not surprising that little affordable housing is getting produced in Northampton. Unless a private developer is able to obtain a funding commitment from the state for either SHARP or HOP subsidies, both in great demand, the production of affordable housing is left largely to the perseverance of Northampton's community -based development organizations -- the CDCs and non- profits. These groups, however, are small operations with limited resources. While they are beginning to establish relationships with one or more banks or funding sources, the process of financing affordable housing remains cumbersome at best. 54 RECOMMENDATIONS FOR COLLABORATIVE ACTION As it stands, Northampton's non - profit affordable housing producers are destined to achieve a modicum of success against great odds and with great effort. Without adequate support, they struggle to put the financing and other resources together to assemble a development project. Not only are they more likely to experience cost overruns and project delays (because they are so financially strapped), but, when those events do occur, the impact is far more consequential. Because these groups operate on such close margins, minor snags can become major problems. The intention of this study was to find ways for expanding lending institution involvement in affordable housing. To accomplish that objective, three events must occur: First, the capacity of Northampton's affordable housing developers must be-increased. With a more stable funding base, these groups can begin to hire the additional staff that they need to carry out development projects, to conduct long -range planning, and to obtain private financing. In years past, it was much easier for non- profits to use the proceeds from one project to keep them going until the next project. Because of the rising cost of housing and the loss of federal housing dollars, that situation no longer exists. Second, the amount of resources available for affordable housing must be expanded. It is simply not possible to increase the volume of affordable housing production without also increasing the amount of subsidies. Third, some mechanism must be put in place to coordinate housing policy and resources so that the process of producing affordable housing is made more efficient and routine. Currently, there is no coordinated effort to facilitate the production of affordable housing. Based on our analysis of local housing conditions, we believe that the most effective means for lending institutions to provide help for, support, facilitate, and finance affordable housing would 55 be to create a lending consortium. We make this recommendation for the . following reasons. o While the shortage of debt financing is only one of many obstacles that affordable housing sponsors face, it is clearly a problem that lending institutions are best suited to address. While some lending institutions have been modestly supportive of affordable housing projects, the overall level of bank involvement is small and the pattern of participation is uneven. A consortium would provide a routine and predictable structure for financing the preservation and construction of affordable housing. o A consortium would give affordable housing projects a priority consideration. Because affordable housing projects are perceived as unprofitable, banks typically treat them as they would other forms of charitable lending, which is to say not very seriously. A consortium would give affordable housing sponsors the confidence that their proposals would be taken seriously and handled expeditiously, something which is currently missing. A consortium would, therefore, stimulate added demand and not merely have a substitution effect. o A consortium would be a means of channelling funds into affordable housing. Right now, there is no organized way for employers, pension funds, insurance companies, philanthropies and others to invest in affordable housing. Also, by combining public funds with private funds, a consortium could lower the rate charged to borrowers. o A consortium can invest in developing the specialized skills required to make - loans to affordable housing projects, an investment that individual banks are often unwilling to make. With greater knowledge of housing programs, consortium loan officers could better differentiate between real and perceived risk. They could also help affordable housing producers package their loan products and find additional sources of capital. As the consortium develops, it 4 will also develop a greater understanding of its market and the special loan products of that market. A consortium can be extremely flexible, both with respect to the type of borrower (non- profit or for- profit) and the product offered (e.g., home mortgage loans, home 56 n tj r improvement loans, multifamily construction and permanent loans, co -op share loans, equity capital, or bridge financing). o Finally, because of its high public profile, a-consortium would help focus public attention on the need for affordable housing and help develop a clear housing agenda. A consortium does not directly solve the problem of capacity of affordable housing sponsors or the need for additional resources. We assume, however, that the consortium can begin to attack these problems indirectly. Funders are far more likely to make resources available to affordable housing if there is a stable and legitimate intermediary in which to channel funds. We also believe that the consortium can, by aggregating resources, help simplify the development process, which would make it easier for community -based developers to get housing produced. The benefits to banks in creating a lending consortium are (a) the banks can diversify their risk, (b) they can reduce the cost of originating loans that require specialized financing, and (c) they can better influence the direction of housing policy. CONCLUSION A lending consortium is not an answer to the affordable housing crisis, but it would make a major contribution. The greatest benefit that a consortium would offer is a reliable source of financing for affordable housing. At . present, affordable housing projects do not receive priority loan considerations. And, with such small volume, there is no incentive for banks to develop specialized lending units. A consortium could provide a more positive environment for affordable housing lending. Along the way, it could also help in building a more efficient housing development model. A consortium might, for example, be able to work with the city to strengthen the capacity of the entities undertaking development, to streamline the development process, and to centralize certain functions, such as financial packaging. Probably most important of all, a consortium would institutionalize a relationship between lenders and affordable housing sponsors. A consortium would not, and should not, be expected to write loans for projects that do not make good economic sense. However, a consortium would be better able to underwrite 57 projects based on substance and not perceptions. While there may not be enough demand to justify a consortium just for Northampton, sufficient demand is available for a consortium serving either the greater- Northampton area or western Massachusetts. 58