(co-authored with Andrew Gibbs)

Note: This newsletter was initially published by Governing Magazine on February 21, 2024

As we start 2024, it won’t come as a surprise that most of the traditional metrics underpinning housing affordability are moving in the wrong direction. Despite improvements in long-term interest rates and a slowdown in multifamily rent growth, rental affordability reached an all-time low in 2022. Based on the U.S. Census, an estimated 22.4 million renters now spend over 30 percent of their income on rent.

While more recent market-rate multifamily data indicates that in 2023 income growth outpaced rent growth, rent-to-income ratios still remain above pre-COVID levels and this data is largely skewed toward upper- and middle-income households. Even with the recent decline in interest rates, homeownership affordability also remains at historic lows, with home prices 7.6 times median incomes (reflecting an increase over the prior peak of 6.8 times in 2006).

The dominant explanation by policymakers, developers and advocates is that limited housing supply and the lack of sufficient building are the key impediments to affordability. That is true in the aggregate. During the past decade, there have been nearly 16 million households formed, yet only 12 million new homes were added to the market, suggesting a need for nearly 4 million new homes.

Yet this consensus conceals some counterintuitive dynamics and some potential interventions. While the U.S. remains undersupplied at the aggregate level, these headline numbers often overshadow pockets of oversupply and undervalue potential affordable housing bright spots.

As of December 2023, nearly half of major U.S. markets have seen significant new multifamily supply, pushing apartment vacancy rates to over 7 percent, according to CoStar, a commercial property analytics firm. A total of 87 markets (22 percent of the nation) have vacancy rates above 10 percent. Across the U.S., new supply has translated into 1.5 million vacant apartment units, with another 950,000 units under construction. As noted by RealPage, a real estate technology platform, in 2024 multifamily new construction as a percentage of existing inventory is expected to increase at the fastest rate since 1974.
From a developer’s perspective, this couldn’t come at a more challenging time, as multifamily owners slowly begin to accept the new reality: Higher interest rates may be here to stay and a 15 percent decline in valuations may not be sufficient to bring investors back into the market.

Despite increases in rental supply, the recent multifamily boom has yet to have a material impact on affordability because an overwhelming majority of these new units are built for upper-middle income and high-income earners. Unsurprisingly, these are the only segments of the development market that can earn a sufficient return without subsidized capital. According to the National Low-Income Housing Coalition, when focusing solely on affordability, the U.S. is facing a 7 million unit affordable housing deficit and a 2.2 million deficit for workforce housing.

While not a new idea, the quickest and most affordable way to help fix this imbalance may be hidden in plain sight: Incentivize the conversion of market-rate units to affordable homes through government subsidies. With construction costs still far too high, new multifamily properties may be acquired at a material discount to replacement cost. By coupling these discounts with additional incentives such as property tax abatements and below market-rate loans, cities could unlock billions of private capital that can be used to convert hundreds of thousands of market rate units into deed-restricted affordable housing.

In parts of the country, this is already happening. The Cambridge Housing Authority has for years been buying apartments or extending affordability periods for homes that are about to convert to market rate. In 2015, Texas enacted a law that allowed nonprofits to purchase and lease back properties with a tax exemption, as long as 50 percent of the units were reserved for households making 80 percent or less of Area Median Income (AMI). Montgomery County, Md., has been purchasing multifamily properties through its right of first refusal policy, and preserving affordability by selling properties to affordable housing operators with rent caps tied to AMI.

As with most fiscal policy interventions, achieving these affordability objectives in a way that balances deployment speed with efficient capital allocation is no easy feat. For example, in 2023 Texas’ state law was adjusted to prevent abatements from subsidizing above market rate returns. The Fiscal Policy Institute estimated that solving New York state’s housing crisis through tax abatements would cost local municipalities $2.8 billion per year, which could cause unintended problems in terms of funding city services on which many low-income households rely.

Building on these hard-earned lessons, cities should develop a playbook to take advantage of the current once-in-a-decade housing opportunity as follows:

First, cities should size their hidden housing market. Local municipalities should understand how the recent shift in capital markets has impacted multifamily valuations to help measure the cost difference between purchasing recently completed inventory and new construction. This analysis should be done across property classes to identify which vintage properties and neighborhoods might be suitable for acquisition and affordable conversion.

For example, the influx of luxury multifamily products offering rent abatements is likely to incentivize households living in older products to move up the ladder to newer homes. This may leave opportunities to acquire slightly older Class A multifamily at a material discount to new construction. One of the key advantages to this strategy is that it gives cities the ability to make targeted acquisitions in high-opportunity neighborhoods that are often challenging to redevelop.

Second, armed with market-specific information, cities should survey their current multifamily stock to understand the minimum amount of subsidy required to offset revenue declines from converting market rate to affordable homes. This analysis should be undertaken using data from various income levels, so governments can weigh the tradeoffs between adding more housing at higher income levels (i.e., households earning 80 percent of AMI) versus less affordable housing at lower income levels (i.e., households earning 30 to 50 percent AMI).

As noted above, a critical component of this analysis includes quantifying how much of an abatement can be tolerated, given budgetary resources. Understanding that many cities are facing budget headwinds with the recent decline in commercial property tax revenue, partnerships that rely strictly on tax abatements may be costly to implement.

However, when viewing abatements within the context of other subsidized grant equity or low-cost capital earmarked for affordable housing, tax abatements may have a higher return on investment when measured by dollar spent per affordable home created. For example, if a relatively new product can be purchased at a material discount to replacement cost, then the opportunity cost of tax abatements should be less relative to providing grant equity for new construction.

In some cases, particularly with Class B and C properties, the level of tax abatement may be minimal, as some market rents may be close to their natural affordability levels. These are opportunities that should be prioritized given the little cost to local governments, particularly if governments can provide low-cost acquisition loans.

Much of the multifamily distress is expected to occur in older vintage products that utilized higher leverage bridge loans to undertake capital expenditure plans. With private lenders pairing back refinancing proceeds due to higher interest rates, these older products may be strong candidates for affordable conversion if public lenders can provide gap financing at below-market interest rates (preventing the need for additional, unfunded equity investment).

Depending upon the return profile of these investors, distressed market rate units could be acquired with rent caps tied to increases in AMI levels, or in some cases slightly below. If long-term incomes could rise faster than rents, this would help the U.S. grow its way out of the housing affordability crisis (as the federal government did with the decline of its high U.S. debt-to-GDP ratios during the 30-year period following World War II).

Finally, to obtain scale, long-term investment funds should be set up that can raise institutional capital to take advantage of more tactical shifts in the market. Most municipalities do not have enough capital or a sufficient balance sheet to completely solve their local housing problem. A public-private housing fund would be a strong complement to cities’ strategic housing plans that often focus on zoning and permitting relief.  Innovative capital tools such as public equity capital that takes a first loss position could be further utilized to reduce risk premiums (and return requirements), attracting more institutional equity investors that have been gravitating towards market rate preferred equity investments.

To take advantage of this opportunity, in sum, cities and states need to think counter to the private markets and move fast before the opportunity gets more expensive. With supply pipelines drastically fading, it won’t be long before market rents pick back up and drive higher valuations. Noting that each property will have unique characteristics that will impact the subsidy requirements, it’s important that cities have some flexibility to unsure that abatements are not subsiding above-market returns, or alternatively are too low to achieve sufficient returns. It will be critical to design policies that provide this flexibility, without imposing additional burdens that slow down execution.

In short, while the past year has been a challenging capital markets environment for investors, 2024 could be a strong year for cities and their respective housing authorities to make a sizable dent in their local affordable housing crisis through property acquisitions.