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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   November 2006

Examining the Affordable Housing Market

A thorough market study is key to funding projects that use Low Income Housing Tax Credits

c_2006-11_harris_spotAffordable housing that uses Low Income Housing Tax Credits (LIHTC) through Section 42 of the Internal Revenue Code has become much more than a niche play for the lending community.

More than a million multifamily units have been delivered to the market using LIHTC since the program launched in 1987. Construction and permanent financing for LIHTC properties presents a variety of underwriting issues not found with conventional apartments.

One of the more-complicated issues for brokers and lenders is understanding the probability for a property’s success in the market. Unlike conventional apartments, LIHTC properties are governed by specific federal regulations that restrict the income levels for residents. As a result, the pool of prospective residents is typically smaller for LIHTC properties than for conventional apartments.

The key to understanding a property’s likelihood for success starts with the market study. Market studies are important when underwriting any property for a loan, but they are particularly critical to LIHTC properties. Most state agencies that award tax credits to developers require preparation of a market study. Lenders and brokers should understand what to look for when reviewing this study.

The capture rate

First, it is important to know who can live in LIHTC apartments. The law permits residency for individuals or families who earn 60 percent or less of an area’s median income. The median income calculation increases if more family members or roommates occupy the apartment. Rental rates will then be 30 percent of the median income.

Capture-Rate Calculation

Market/demographic information

  • Subject property size: 48 units
  • Monthly rental rates for subject property: $420 and $500
  • Renter population within three-mile radius of subject property: 2,800
  • Median income: $38,333

Tax-credit info

  • Minimum monthly rent-to-income ratio for tax credit: 35%
  • Minimum monthly household income required ($420 divided by 35%): $1,200 
  • Minimum allowable annual income (monthly income multiplied by 12): $14,400
  • Maximum allowable annual income: $23,000 (60% of median income)

Assuming 53 percent of the rental population has an income of between $14,400 and $23,000, we can calculate the capture rate.

  • Eligible renter households (53% of renter population): 1,484 households
  • CAPTURE RATE (48 units divided by 1,484 eligible households): 3.2%

The market study should contain a calculation known as a capture rate. A capture rate is the segment of sales in a real estate market sold by one project. It looks at the percentage of the market that a project will have to “capture” to be successful.

In the case of LIHTC apartments, the capture rate looks at the percentage of qualified renters that a LIHTC property must attract from the eligible renter pool to achieve full occupancy. For example, if a project consists of 100 units and there are 2,000 eligible renters within a reasonable radius of the property, the capture rate is 5 percent (see sidebar).

Unfortunately, the problems with the potential loan begin when developers (and the consultants who prepare market studies) expand the market area to include a larger region than is realistic. For example, in a nonmetropolitan community with a population of 7,500, it would probably be inaccurate to consider the entire county as the market area. Will a working family in a small community move to an affordable project 21 miles away just because it’s within the same county? It’s unlikely, unless affordable housing is in such short supply throughout the area that long daily commutes are the rule.

In metropolitan areas, the primary market area should be within a three-mile radius of the subject property. There may be special circumstances, however, that could justify expanding this radius to four or five miles. For example, in a major market, a large employer such as an auto-assembly plant may attract employees from farther away. In smaller communities, the city proper may constitute the market area.

Lenders should also beware of another common mistake made with capture rates — the failure to determine the qualified-renter population. Some capture-rate calculations assume that all households in the community that fall below the maximum allowable income should be the denominator for the capture rate. Instead brokers must calculate the lowest income allowable— generally, the rent would be 30 percent to 35 percent of monthly income. This does not apply to calculating the capture rate for senior projects, however.

When the capture rate is 5 percent or lower, the project has a good chance to succeed based on achieving stabilized occupancy and rental rates. Between 5 and 10 percent, there is still a reasonable chance for success. When it gets to be more than 10 percent, the chances for failure increase. Projects with capture rates as high as 45 percent can spell certain disaster.

Demographics and economics

The market study should also address questions about the population. What is the population trend in the subject market? If it’s in decline, what is the reason?

A declining population is a warning signal. As time passes, a declining population could produce an increasing capture rate. This means that a project will need to capture a higher percentage of eligible renters than when the developer completed the initial lease-up. There are usually solid reasons why a community is losing population — and rarely are the reasons good news.

A high-quality market study will explore the dynamics of the local economy. Too many developers fail to look for potential volatility in the local economies in which they are locating projects.

A town may be growing at a rapid pace with a clear need for more affordable housing, but on what foundation is the local economy based? Is there a primary industry or institution, such as a military base, on which the town is totally dependent? What happens if the base closes, or if the major employer dominating the market closes operations and outsources work?

Is there a historical employment pattern that can be identified? If a dominant employer is in a highly cyclical industry, what will happen to the apartment market if that employer lays off several-hundred workers?

If a lender can’t be comfortable that the local economy is adequately diversified and insulated from wild swings in employment, then a loan likely will not be underwritten.

Other study elements 

Other important components of the market study should include:

  • Employment rates and trends;
  • Employment concentration by sector;
  • Identification of major area employers;
  • Demographic characteristics; and
  • Rental rate comparisons among various comparable apartment communities.

High capture rates, declining population and local economies that are volatile or heavily dependent upon one industry are danger signals. Lenders that fail to pay attention to or understand the market study make loans on LIHTC properties at their own peril.

The sliver of the eligible renter pool on which LIHTC apartments rely can be so small that there is no margin for error. Lenders and brokers must be familiar enough with these aspects of a market study not only for interpretive purposes but also to determine if the methodology is accurate. 


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