Longwell Riess 3/19/25 Longwell Riess 3/19/25

Affordable Housing vs. Market Rate Developments

This roadmap unpacks these contrasts step-by-step, covering pre-development planning, Qualified Allocation Plan (QAP), Low-Income Housing Tax Credits (LIHTC), other funding application requirements, design and construction regulations, operational practices, and risk management. Whether you’re an industry professional, policy maker or a curious reader, this roadmap illustrates the unique differences and nuances that shape affordable housing and market rate housing developments.

In the journey from vision to reality, affordable housing and market-rate developments take distinctly different routes.

This roadmap unpacks these contrasts step-by-step, covering pre-development planning, Qualified Allocation Plan (QAP), Low-Income Housing Tax Credits (LIHTC), other funding application requirements, design and construction regulations, operational practices, and risk management. Whether you’re an industry professional, policy maker or a curious reader, this roadmap illustrates the unique differences and nuances that shape affordable housing and market rate housing developments.

Site-Sourcing

Timing – Market rate projects have shorter timelines from land contract execution to closing. Because a market-rate developer can talk to their capital sources early on and do preliminary site feasibility analyses prior to executing the contract, timing becomes an important competitive element in getting a site under contract. Land sellers want to close as quick as possible. For affordable sites, the prospect of earning a funding award, even for the highest scoring sites, is still only 30% at best, thus very risky for developers to close on the purchase prior to receiving an funding award. Developers are forced to convince land sellers to let them hold the site under contract for long periods of time up to the point of receiving a funding award. This is very unattractive to land sellers, eliminates the possibility of a lot would be great affordable sites and often forces developers to pay more for a site than they would have otherwise and/or put more non-refundable money at risk. Overall, this adds inefficiency to the cost basis of affordable projects and limits the quality of the sites.

Market Feasibility – For market-rate sites, feasibility is observable in the present and understanding the future market risk is more discernible. The feasibility of affordable sites is more dependent on the QAP criteria which can fluctuate each year and is less observable to developers. This adds risk.

Number of Projects – A developer is not limited in the number of market-rate projects than can do. If they are able to secure 20 great sites in one year in a particular state, there will likely be enough capital to fund those projects. Development companies require a lot of overhead expense so the opportunity to spread the fixed overhead cost over more projects is more efficient. The affordable business inherently limits the number of project due to regulatory limits and due to the competitiveness of the funding process.

Size of Project – A size of a market-rate project is limited primarily by market demand. Capital resources will adjust their allocations based on that demand, so capital is not a limitation. For affordable projects, the size is dictated by the regulatory cap on funding per project which tend to be arbitrary (ie. No connection to market demand) and allocated thinly in a manner that forces very small projects. Small projects are inherently inefficient to build (ie. Fixed cost is a high percentage of total cost) and inefficient to operate (ie. Fixed expenses are a high percentage of total expenses).

Site inventory – because market changes in particular areas are more discernible, it is less risky for developers to own and maintain an inventory of land held for future development. Affordable sites rely on the QAP which evolves and changes in ways that are difficult to anticipate. Thus, holding sites in inventory for future affordable development is too risky.

Pre-development

Zoning and Entitlements – Apartments in general are tough to obtain approvals as zoning “by-right” is very limited and most municipalities are loathe to approve new MF projects. The combination of MF use and affordable housing is even less attractive to most municipalities. Regardless of the need, NIMBYism is high. This adds more risk to affordable sites.

Regulatory Hurdles – Government funded projects have more regulatory hurdles, whether environmental, weather resistance, code, accessibility, etc. These create more “at-risk” pre-development cost in terms of 3rd party studies and more opportunity for disqualification. This adds comparative risk to affordable projects.

Design – Affordable projects often have more design requirements that add cost and inefficiencies. Market-rate projects are market-driven with design responding to the rental market and capital market demands.

Construction and Capitalization

Fixed soft cost – Affordable projects have a lot more expenses for 3rd party reports, legal fees, financing fees, etc. which have to be spread over a small number of units and net rentable square footage. Market -rate projects are typically 3 times larger than affordable and can use larger unit sizes, thus, spread those cost more efficiently.

Hard Cost Efficiencies – Revenue on affordable projects don’t adjust on a per square foot basis but are capped by unit type. Thus, it is more economical for developers to build smaller unit sizes which means the more expensive and fixed cost components of apartment construction (e.g. kitchens and bathrooms) are spread around a lower amount of net rentable square feet. Additionally, fixed cost elements at the project level, like office/clubhouse, amenities, offsite cost, some site work components have to be spread over less units and NRSF on affordable projects. All of these make affordable projects much less efficient than market-rate projects to construct.

Financing Cost and Reserves – Although debt service coverage minimums are lower on affordable deals than market-rate, lenders allow this only because they also require reserves, which are essentially insurance premiums on operational risk. This is an extra cost to the affordable project that market-rate projects do not have.

Capitalization Risk – Even if a project earns a funding award, those funds comprise only a portion of the sources needed to support the project. At this point, a developer has spent hundreds of thousands of dollars and hundreds of man-hours that has both a direct cost and an opportunity cost. There is still a lot of risk that the project will not find all the sources needed, especially if market conditions have changed (e.g. cost inflation, HUD rent limit deflation, insurance and expense inflation, interest rate increases, etc.). These risks are inherent in market-rate projects as well, however, market-rate projects can more easily and quickly make adjustments to the project (e.g. design, size, unit mix, quality level, capital sources, etc.) to mitigate those negative market forces. Once an award is given, affordable projects typically have much fewer options to ensure financial feasibility.

Lease-up and Operating Risk

Lease-up - Affordable lease-ups tend to be less risky and quicker than market-rate, thus, tend to have less market-risk. However, they have more operational risk due to the income certification and more sensitive and prevalent fair housing requirements.

Operating Risk – Affordable projects tend to have less downside risk, if well managed, because in most areas, demand outweighs supply. Conversely, they have higher upside risk because rents are capped by an annual calculation performed by HUD that uses data that lag market conditions by 1-3 years. Market rate projects on the other hand can freely adjust rental rates to reflect current market conditions.

Compliance Risk – This is a downside risk market-rate projects do not have and affects both actual cash flows and liquidity.

Capital market Valuation – Overall, a comparison of capitalization rates demonstrates that investors view completed and stabilized affordable projects as slightly more risky than market-rate projects, i.e. affordable cap rates are slightly higher than like-kind market rate projects. In other words, each projected future dollar earned on an affordable project is worth less than each project future dollar earned on a market-rate project.

Profits and Return Profile

Time Value of Money – Developers of market rate projects can earn their full profit potential in 3 to 4 years, which can be re-invested into more projects. Since there is no cap on the number of projects and size of projects, those profits have the potential to compound much quicker and at much higher rates. On affordable projects, the profits, which are comprised almost entirely of developer fees, are earned partially upfront and the remaining over the following 15 years. The upfront fees primarily just offset overhead expenses and opportunity cost. The actual profit is earned through the deferred developer fees that come out of cash flow over the following 15 years and are subject to market and operational risk. In other words, to compare the profit potential of a market-rate and affordable project, one must compare the present value of the cash flow streams, not the nominal value of developer fees and profit potential included on the development budget.

Further Explanation of the 30-Year Compliance Period

All LIHTC developments have a compliance period of a minimum of 30 years.

Initial Compliance Period 15 years.
Extended Use Period 15 years.
Many developments elect to have additional years added to the Extended use period, thus can be longer.
- This is generally done on 9% deals for additional points. (Majority of 9% deals in Louisiana do this).
  - If this is done, they agree to waive their rights to opt out of the Extended use period after year 15.
After the end of year 14, developers, who have not waived their rights to a qualified contract (Per above bullet) can enter into a qualified contract.
- This allows the Agency to market the development for a 2 year period to find a buyer, for a purchase price calculated based on statutory language in the code.

If after 2 years, the Agency cannot find a buyer, the developer can start a process of taking the development out of the affordable program and eventually convert to market housing.

(There are some complex rules that existing tenants cannot be forced out for a certain period. (Beyond our scope)

As noted, in LA, most 9% deals take points for extended use out to 45 years and waive their rights to a qualified contract.

For All Developments:

Whether a developer opts to enter into a qualified contract or not, after the end of the initial compliance period (15 Years), they can sale the development to another taxpayer that plans on redeveloping the development into an acquisition/rehabilitation development and receive a new allocation of LIHTC’s on the deal and start the process all over again. (This is essentially keeping the development as an affordable development and not violating the compliance rules under the extended use agreement. (Although, they will have a new 15 year compliance period and a 15 year (or more) extended use period).
Under this scenario, they are able to receive a developer fee, just as they did on the initial deal, thus, if it is the same taxpayer, it is their second opportunity to make money. (15 years Later).
The original developer could also make money on the sale of the old development, but the profits are generally limited and subject to being shared with the initial Limited Partners, unless they have been bought out.

In Summary:

Only profits for developers in these deals is the developer fee (Some of which is paid out of cash flow during the 15 year compliance period). – For 15 years
After 15 years, some developers can enter into a qualified contract and eventually convert the development to a market rate deal. (Lengthy, costly and rarely happens in LA)
After 15 year compliance period, a deal can be sold to a new limited partner (Related or non-related party) and receive a new allocation of credits and start the process over again.

Overall Risk Comparison

When looking at the full continuum of the development process and the various risk elements at each stage of the process, affordable developments have a higher overall risk profile than market-rate projects. In other words, for each dollar spent (overhead cost + direct cost + opportunity cost) on the pursuit of an affordable project, the probability of earning a profit is much lower than market rate projects.

Many thanks to our research and support team, specifically Jeremy Mears and Jack Bonnette, The Brownstone Group, Inc.

Longwell Riess 9/30/23 Longwell Riess 9/30/23

Megan Riess to speak at Novogradac 2023 Fall New Markets Tax Credit Conference, Oct. 26-27, New Orleans

October 26-27, held at the Four Seasons New Orleans

Novogradac 2023 Fall New Markets Tax Credit Conference — October 26th to 27th, 2023 — at the Four Seasons New Orleans. Megan Riess will join her colleagues on forum panels to discuss the latest trends in New Market Tax Credit, affordable housing and community development.

https://www.novoco.com/events/novogradac-2023-fall-new-markets-tax-credit-conference