Is Projecting 3% Annual Growth for Operating Expenses and 2% Annual Growth for Revenues of LIHTC Properties still the Best Course of Action?
When underwriting low-income housing tax credit (LIHTC) properties, credit allocating agencies and lenders commonly use 3% annual growth for operating expenses and 2% annual growth for revenues as benchmarks.
Data from the Novogradac Multifamily Rental Housing Operating Expense Report has historically found this to be an accurate rate of growth for expenses. However, in the 2021 edition of the report, Novogradac’s data shows that expenses increased by 5.4%.
Regarding revenue growth, the compounded annual growth rate (CAGR) from 2011 to 2021 of the national area median income (AMI) is 2.2%. By comparison, the CAGR on two-bedroom LIHTC properties in Novogradac’s data set for the same time period is 3.0%. Finally, the CAGR from 2011 to 2021 for market-rate rents is 3.4%, according to CoStar Group. AMI is a critical component to revenue growth as AMI is used to set rents for LIHTC properties. Therefore, as AMI increases, so do rents at many properties. However, the fiscal year (FY) 2022 national median income is $90,000, a 12.5% increase over 2021.
The consumer price index (CPI) for housing grew at a compounded growth rate of 2.2% from 2010 through 2020, according to the Novogradac 2021 Multifamily Rental Housing Operating Expense Report. This measure captures the prices of rents, fuels and utilities, and household furnishings and operations. By comparison, the report found that LIHTC properties’ expenses grew at a compounded rate of 3.0% from 2010 through 2020. Over time, LIHTC expense growth has slightly outpaced CPI for housing in every year from 2010 through 2020. It’s unclear how recent inflation trends will affect the comparison between expense growth and CPI.
The question arises: Is using the traditionally standard 3% growth of operating expenses still the best estimate of growth?
The first factor to consider is inflation.
The United States is experiencing the highest rate of inflation since the LIHTC became a permanent part of the tax code. The annual U.S. inflation rate for 2021 was 4.7%, nearly a full percentage point above the previous peak (3.8% in 2008).
The CPI for July 2022 was 8.5%, down slightly from its peak of 9.1% in June, according to data from the Bureau of Labor Statistics. The last time the CPI exceeded 9.1% was in November 1981 when the CPI was nearly 9.6%, according to Federal Reserve Economic Data.
The continuation of significant inflation would be a change from the past few decades. As evidence, each year from 2012 through 2020, the annual rate was 2.4% or lower.
Speaking of change, the U.S. Department of Housing and Urban Development (HUD) posted FY 2022 income limits in April. The limits are used to determine eligibility for HUD-assisted programs, such as for public housing, Section 8, Section 221(d)(3) and Section 236 properties. HUD also published Multifamily Tax Subsidy Projects income limits to determine eligibility for LIHTC and tax-exempt bond properties. Income limits are effective immediately and must be used within 45 days of release, which was June 2.
Income limits are another factor to look at when forecasting operations of LIHTC properties.
FY 2022 data revealed several interesting changes. The FY 2022 national median income is $90,000, a 12.5% increase over 2021, according to a recent Notes from Novogradac blog. Among the 2,602 areas for which HUD publishes limits, fewer than 1% (24 areas) will have a decrease and only one area has no change. The remaining areas will see increases. The average change nationally is a 10.5% increase, which is heavily affected by HUD’s cap methodology. In a change from recent trends there was no significant difference in the average increase in metro and non-metro areas. Both increased by 10.5%.
However, there is a cap on income limits.
One of the adjustments is the cap on year over year changes. Income limits are capped at the greater of 5%, or two times the change in national median income. This cap on increases has been in place since HUD FY 2010 and HUD has always used two times the change in year over year national median income.
For 2022, however, HUD changed the way they are calculating the cap on income limits. Instead of using the change in national median income, it is using the change in national median income from the 2018 American Community Survey (ACS) to the 2019 ACS. Read more about this change in a previous Notes from Novogradac blog.
Despite expenses increasing at a slightly faster rate than income, LIHTC properties’ net operating income increased by 4.3% in 2020, to $4,063 per unit, according to the 2021 edition of the Novogradac Multifamily Rental Housing Operating Expense Report. That increase is primarily attributable to the fact that rental income increased $462 per unit, while expenses increased $292 per unit.
Overall, LIHTC properties’ net operating income in 2020 was the highest in the 11 years for which Novogradac has data, at $4,058 per unit, a 6.0% increase over 2019. It was the second-straight year in which the set of all properties in the Novogradac survey posted a record net operating income.
Industry Practitioners Weigh In
For LIHTC properties to operate most efficiently, rents must cover expenses and debt obligations. While a sufficient debt coverage ratio provides room for expenses to outpace rent, long term disproportionate expense growth could be problematic. LIHTC property managers and owners commonly use a 2%/3% fraction, meaning as rents grow 2%, expenses grow at 3%. While this model could create a long-term disproportionate relationship, the robust debt coverage ratio often allows properties to remain feasible.
Would adjusting that equation make a difference? Most LIHTC stakeholders don’t think it would, at least not a notable difference.
Nate Wamser, vice president, assistant director of business development at U.S. Bancorp Community Development Corporation, thinks when talking about the long-term, say 15 to 16 years of increases, 2%/3%, on average, still makes sense, assuming long-term inflation will still be targeted at around 2% by the federal government.
Wamser doesn’t see much of a difference between 2%/3% compared to 4%/6%, as the net effect on the projected net operating income over 15 years will be about the same. However, Wamser said it becomes an issue if the spread in the ratio between the two is increasing, meaning expenses are growing much faster than rents and/or rents are artificially capped to increases at a rate much slower than the increase in expenses, for example by a soft lender.
John Hallstrom, vice president, director of real estate feasibility at Raymond James Affordable Housing Investments, agrees. Hallstrom now expects that the 2022 AMI and income limits increases will offset and ward off concerns about inflation impairing operating expenses going forward, at least for this year. Hallstrom said that the important thing is to not be aggressive modeling net operating income, and for this purpose, 2%/3% is not too different from 3%/4% or 4%/5%. And Hallstrom thinks that reversion to the mean may get the industry back to something closer to 2%/3% actuals in a couple of years as inflation declines.
Hallstrom found that the more practical aspect is that investors generally use the 2%/3% for consistency purposes when comparing investments presented by competing syndicators and/or internal producers. Many investors would have problems comparing competing investments or comparing the same investment from different syndicators if there are differing escalation rates baked into the assumptions.
Does the Industry Need to Change its Forecasting Standards Now?
Some in the market feel like this discussion is for another day.
Hallstrom’s investor clients have not raised questions on this issue, as investors are primarily focused on inflation potentially impacting construction cost overruns, construction contingency reserves, and interest costs on variable rate construction loans on new proposed developments. So far Hallstrom’s investors haven’t asked about considering something like 2%/4%, 3%/4%, or 3%/3%.
Hallstrom went one step further and said, these issues may be a distraction for investors, the inflation issue is expected to bleed over into operating budget concerns.
Wamser also is focusing on similar industry challenges in the short-term.
Wamser said the industry is focused on construction costs and interest rate increases, as opposed to thinking about how best to trend investments over 15 years.
While rising costs for goods, payroll and services coupled with changing income limits may be affecting LIHTC property operating expenses, the industry standard 3% growth of operating expenses and 2% growth in revenues remains a safe course of action. However, for specific questions, please consult Novogradac’s Government Consulting and Valuation Advisory (GoVal) Group.