Effects of High Inflation on Development, Financing and Operation of Tax Credit-Financed Housing
Published by Michael J. Novogradac on Tuesday, March 1, 2022
The annual U.S. inflation rate for 2021 was 4.7%, nearly a full percentage point above the previous peak (3.8% in 2008) in the years since 1993, when the low-income housing tax credit (LIHTC) became a permanent part of the tax code.
More frighteningly, the year-over-year consumer price index (CPI) rate in January 2022 was 7.5%–the highest for any month since June 1982, according to data from the Bureau of Labor Statistics. The CPI rose 0.6% in January alone.
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.
Is this higher inflation rate transitory or more enduring? It’s not clear: there’s no consensus among economists as to whether we’re entering a period of significant inflation or if this is a short-term aberration from the trend of the past three decades. Regardless, the possibility of enduring inflation means the affordable housing community needs to assess how higher long term inflation would affect LIHTC development, financing and operations.
Higher inflation affects other tax incentives as well, including renewable energy tax credits, historic tax credits, new markets tax credits and opportunity zones. While this column focuses on affordable housing, due consideration in these other tax incentive areas is needed as well.
The rate of inflation affects affordable housing development, financing, operations and tenants in many ways, which makes this an important topic to discuss. We can hope higher inflation is transitory, but should prepare for it to be more enduring. This month’s column is intended to start the dialogue–to discuss some of the factors and encourage others to dig deeper and wider.
The effect of higher inflation on the direction of individual factors is easier to assess than the magnitude of those effects. The further aggregation of each identified directional and depth effect on each factor is even harder to assess. But assessments should be made and actions taken to respond and build robustness in developing, financing and operating affordable rental housing.
On the development side, higher inflation translates to ever-rising development costs.
On the financing side, inflation translates into higher cost of funds, meaning higher interest rates and lower tax credit equity prices–which means greater financing gaps, a greater need for tax credits and more soft financing. Inflation impacts the availability of state and local resources.
For operations, the immediate effect is higher operating costs. Higher inflation also affects revenue, via area median gross income changes and effects on utilities allowances, albeit on a delayed basis.
For tenants, inflation tends to hit living costs before wage increases, worsening the economic pinch on lower-income households. Fortunately for LIHTC tenants, rent increases also trail increases in other costs of living, which can somewhat soften the blow of rising prices.
In looking at developing and operating affordable housing, one trend is clear: inflationary increases in costs and expenses generally precede inflationary increases in revenue and financing sources.
Let’s unpack these factors in a bit more detail.
1. Development Costs
Inflation has a direct, immediate effect on the cost to build affordable housing (as well as other construction), but the uptick in these costs isn’t new. Since the COVID-19 pandemic hit nationally in March 2020, construction costs have generally been increasing.
There are a variety of factors driving construction cost inflation: a shortage of workers, supply chain disruptions and rising economy-wide inflation. According to the National Association of Home Builders, the cost of building materials alone increased 14.1% in 2021–with lumber and steel both seeing major increases. A labor shortage–the construction industry needs more than 2 million more workers over the next three years to keep up with demand, according to the Home Builder Institute–means that labor costs will also likely continue to increase. The labor shortage is unlikely to end anytime soon, as the median age of those in the labor market continues to increase.
Labor and building materials aren’t the only issues that need attention. At the Novogradac Affordable Housing Developers Conference in January, Shannon Tutor, a regional manager for Beacon Property Management, shared the story of an appliance provider being unable to provide enough appliances for a property at the time it was due. That resulted in Tutor having to visit multiple area appliance providers to attempt to complete the job by finding appliances with the right energy efficiency and right price.
2. Financing Costs
Interest rates generally rise as inflation increases. Short-term interest rates are more closely tied to the current rate of inflation, with long-term interest rates more dependent on expectations of future inflation. The 10-year Treasury is often used as a benchmark for longer-term inflation projections. That rate was about 1.9% in mid-February 2022, up from 1.3% in mid-February 2021–an increase of about 50%.
The practical financing effect of higher long-term interest rates is less debt proceeds, all other factors being equal (which they never are). For every full 100 basis point rise in interest rates, borrowing proceeds decline roughly 10%. The cost of equity capital also rises when longer-term projections of inflation are higher, again all other factors being equal. For a given stream of tax credits and tax losses, investors will invest less equity.
The good news regarding LIHTC housing is that the annual allocation of tax credits for allocating agencies increases every year by an inflation factor, as does the annual private activity bond allocation issuance authority. While these resources increase as CPI rises, they do so on a one-year-plus trailing basis. Note, the 9% credit generally covers only a portion of the costs they are helping to fund, so this annual increase is generally not sufficient to fully offset all inflation-driven cost increases.
The 4% credit is a function of project depreciable costs, so, generally, as project depreciable costs rise, so does the 4% credit. This helps offset a portion of the higher costs, but generally less than 50% of the inflation-driven cost increases. Furthermore, properties financed by PABs and 4% LIHTC equity generally have more debt, meaning they are affected more by increasing interest rates.
3. Operating Expenses
Whether it concerns budgets for properties under construction or addressing the needs at existing properties, steady inflation means higher current and projected operating expenses. This adversely affects forecasted operating results for properties under development and the operations of existing properties.
Simply put, a 10% jump in the cost of electricity or an 8% increase in staff salaries due to inflation would have a significant impact on an existing property’s overall operating expenses, as well as the projections for a property under construction.
There are many operating expense categories for which, unfortunately, this isn’t new. For instance, the Novogradac 2021 Multifamily Rental Housing Operating Expense Report (which used data from more than 145,000 LIHTC units) showed an annual increase of 20.1% for property insurance costs for LIHTC developments that were in both the 2019 and 2020 Novogradac data sets. That’s a trend that’s been steady over the past few years.
But for all properties, there was a compounded annual growth rate of 3.0% in overall operating expenses, a number that would presumably be exceeded if the inflation rate continues at the current pace.
High inflation creates difficult scenarios for owners and managers of affordable housing properties because (as we’ll see in the next section) inflation-driven rental income increases generally lag at least a year behind expense increases. LIHTC developers and owners should note this.
In addition to higher prices, inflation generally brings higher wages. For LIHTC properties, that would mean higher income and gross rent limits.
Regarding higher gross rent levels, we know the delay is at least one-plus-years, since income levels are released annually. But the delays could be longer. Gross rent is based on trailing three-year family income levels, so as inflation raises nominal wages, the higher nominal wage income levels included in AMGI calculations are always three years behind. For example, the U.S. Department of Housing and Urban Development (HUD) uses data from the Census Bureau’s American Community Survey to set income limits, but the ACS data is from three years prior–so 2022 limits are based on 2019 data.
However, these trailing three-year family income levels are adjusted for inflation, which helps offset the delayed increases in the base family income levels. The Novogradac Income Limits Working Group is working to assess the longer-term effects of higher inflation on property rental income (e-mail [email protected] if you are interested in joining).
There’s an additional reason for concern this year: When 2022 income limits are released (around April 1), there is concern that inflation adjustments used by HUD will not adequately reflect the current economic environment. HUD looks to the CBO for those estimates and updated amounts will most assuredly be higher than prior published estimates. But what will HUD do if CBO hasn’t released updated inflation numbers in a timely manner? If HUD uses the prior CBO releases, then income and rent inflation adjustments for 2022 income limits will be based on inflation estimates notably lower than the current environment.
Such a result could be compounded by a different issue HUD is facing in determining 2023 income limits. Due to difficulties in data collection, the Census Bureau will not publish the 2020 ACS, so HUD, if history is a guide, would use five-year ACS data to determine 2023 income limits–a decision that Novogradac research indicates could result income limits that will grow at a rate 3.5% slower than they would be under a one-year ACS. In other words, an area that would have had a 5% increase in incomes would instead have a 1.5% increase–which will affect income limits for properties in those areas.
As mentioned earlier, tenants obviously will also feel the effects of inflation, but the built-in delay in rent and income limit increases will provide some time for wage increases to help offset potentially higher rents.
For property owners, utility allowances can be adjusted to reflect energy cost increases, but will trail to a certain extent the higher increases, given the time delays in adjusting utility allowances, depending on the method a property is using. There are delays of at least a year on average.
We don’t know whether the current high inflation is transitory or endemic. That said, it’s wise to prepare for the effects of enduring high inflation. This column is a start, as we all begin to estimate the direct effects on various components of affordable housing development, financing and operations. Considerable thought should be given to the directional effects, their magnitude and their iterative effects within a given property and across a portfolio, with the goal of creating development and operating policies and assessments that make every property and portfolio of properties more robust to withstand the vagaries of the future.