Is it Time for HUD to Settle on a Consistent Method to Determine the Income Limits Cap?

Published by Michael J. Novogradac and Thomas Stagg on Wednesday, July 5, 2023

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Maximum rents for low-income housing tax credit (LIHTC)-financed properties are based on area median income(AMI) limits released annually by the U.S. Department of Housing and Urban Development (HUD). HUD calculates the income limits for each area using Census data, subject to various rules and adjustments. One adjustment is actually a national limit: Irrespective of the underlying income data, HUD limits the percentage increase in a given area based on a national cap.

In 2022, HUD unexpectedly changed the formula for determining the national cap and used the altered formula again in 2023. The national cap for 2023 was 5.92%, which generally meant that no area would see an increase in its income limit by more than 5.92% over the prior year. The 5.92% national cap is much lower than would have existed had the pre-2022 cap methodology been adopted and came at a time when the average inflation rate for 2022 was 8.0%.

This lower cap translates into lower rent for many properties and significantly fewer income-eligible households–a combination that discourages the production and preservation of affordable rental housing in many areas.

Historical Background

Before 2022, the national cap limited the increase in incomes for a small subset of all areas across the nation, usually about 10%, but never more than 20%. The new methodology greatly expanded the breadth of areas affected by the cap. Novogradac estimates that in 2022 about 56% of areas were affected and in 2023 the percentage of areas affected increased to 86%. The lower cap for 2023 means that property owners could lose as much as $50,000, or more, per year in achievable rents for a 100-apartment complex and the lower cap also excludes roughly 2 million families from being income-eligible for LIHTC housing.

The change in methodology in 2022 was due to the combination of the COVID-19 pandemic, its economic consequences and the highest rate of inflation in a generation. Had HUD used the traditional (but not statutory) formula for caps in 2022, the cap would have been 25%, five times higher than the 2021 cap and more than two times higher than the historical highest cap. Instead, HUD made some adjustments, the first time HUD varied the formula for the cap in 12 years. The 2022 cap was 11.89%.

In evaluating a cap of 11.89% in 2022, followed by a cap of 5.92% in 2023, one might quickly conclude it means nearly all properties experienced a compounded increase of 18.5% in income limits over two years. Comparing the 18.5% combined cap to a 14.5% change in the consumer price index (CPI) over the same period, one might then conclude that the cap isn’t adversely affecting the operating income of tax credit properties. That conclusion would be wrong: A notable number of properties had increases in 2022 income limits of less than the rate of inflation, and for those properties, the cap in 2023 means that their income limits have not kept pace with inflation over the last two years. Furthermore, many expenses at many tax credit properties are increasing at rates much faster than CPI.

After the unexpected change in the cap calculation for 2022, followed by confusion in 2023 as to which cap methodology would be used, it may be time for HUD to establish a process to avoid confusion in the future. A predictably consistent formula for the cap would encourage the development of more affordable rental housing.

HUD Income Limits 101

Section 42 of the Internal Revenue Code, as enacted in 1986, provides that income limits are to be set “in a manner consistent with” how HUD sets limits for Section 8. This led Treasury to give responsibility for setting income limits (and, thus, caps) to HUD. For the first two decades of the LIHTC, HUD used a complicated formula that included more than a dozen factors, including the decennial census, Bureau of Labor Statistics (BLS) information, local median income, state median income and other factors, adjusted by a trending factor. To most LIHTC practitioners, the income limits formula was largely a “black box”–a mystery that was only revealed when HUD annually announced new limits.

Before 2010, HUD had a blanket hold harmless policy to not allow the income limit for an area to decrease from year to year, largely due to the damage decreased rents would do to LIHTC developments. Before the addition of annual American Community Survey (ACS) data to the formula, HUD would receive actual household income survey data only during the decennial census. In the years between the decennial census, HUD would use other data, including BLS data, to estimate the annual increase in incomes for an area.

The release of the 2000 Census revealed that for many areas HUD’s estimated income limits were notably higher than the income reflected in the 2000 Census. To avoid a potential decrease in rent, HUD held the income limits for these areas at the higher previously estimated amount. Novogradac issued a white paper on this issue that showed many areas would have flat income limits for multiple years, until the underlying measured incomes recovered to their previously estimated amounts. This meant that many tax credit properties would not be allowed to increase rents for many years, even though operating expenses would naturally be expected to rise.

To address the concern about flat rents for many tax credit properties for several years, Congress created special income limit rules in the Housing and Economic Recovery Act (HERA) of 2008 for properties placed in service before 2009. Fourteen-plus years later, these HERA properties have a special income limit calculation that is not subject to HUD’s cap on increases and thus allows qualifying properties in these areas to increase qualifying income levels and rents irrespective of the cap. These are referred to as HERA-special properties.

HERA also created a hold harmless policy for LIHTC, which led HUD to explore doing away with its regulatory hold harmless policy. With the publication of the 2010 income limits, HUD discontinued its hold harmless policy and introduced the floors and caps on income limit changes. At that point, HUD began calculating the cap at the greater of 5% or double the change in national median income.

For the first 12 years of the cap, HUD calculated the change in national median income by considering the historical ACS data, trended forward by using a CPI trend factor.

In 2022, HUD changed the methodology and used only the ACS national median income change from three years earlier, without the CPI adjustment. That change has particular weight in an era of high inflation like the past two years. Until 2022, there had rarely been significant issues with the income limit caps, but in 2023, the cap took center stage.

Road to 2023 Limits

The 2023 income limits were perhaps the most discussed such limits in history.

Since the 2023 limits would typically use 2020 ACS data, questions arose as soon as it was apparent that the COVID-19 pandemic would have a major impact on the economy. The question of what HUD would do with the pandemic-affected 2020 ACS data became moot in July 2021, when the U.S. Census Bureau announced there would be no standard one-year 2020 ACS data release, due to collection issues. That began the 16-month discussion of how HUD would calculate income limits for 2023.

That debate seemingly ended in December 2022, when HUD announced it would use 2021 ACS data for 2023, which meant the release date for income limits would be delayed by six weeks, from April 1 to May 15. However, the assumption was that HUD would revert to the previous cap methodology and therefore CPI would be included, so when the Congressional Budget Office’s CPI estimate was released in February, Novogradac estimated a 6.89% increase in the national median income from 2022 to 2023. In that scenario, the cap–again, generally the greater of 5% or twice the change in national median income–would be nearly 14% in 2023.

That didn’t happen. As in 2022, HUD removed the CPI factor, meaning that the income limits (which include the CPI factor) and the cap used different formulae. The result was significant. The most obvious example is that, as noted earlier, historically, about 10% of areas were capped (and never more than 20%). In 2022, 56% of areas were capped and for 2023, 86% are capped.

Implications of the New Limits

A Novogradac estimate of the financial cost of the 2023 cap when compared to a 14% cap if HUD used the traditional formula, reveals that an average of roughly $35 per month in rent would be forgone per apartment available for tenants earning 50% or less of the area median income (AMI) due to the lower cap. For apartments available to tenants earning 60% of AMI or less, that figure is roughly $42 per month. Stretched out over a full year for a 100-apartment development and the propertywide annual loss would be roughly $42,000 to $50,400, depending on the AMI mix.

Lower caps may be financially beneficial short-term for existing tenants since they limit rent increases. However, the combination of lower rent caps and higher expenses could limit LIHTC development over time, which would mean fewer available apartments for those tenants.

Also, in addition to the lost rent, the number of families eligible for assistance drops significantly under the 2023 cap. Roughly 48 million of the 133 million American families can qualify under the 5.92% cap. If the cap were 14%, 50 million families would qualify–an additional roughly 2 million families (4%), which comprises 1.6% of the total U.S. population.

The lower cap reduces allowable rents and reduces the number of families eligible for government assistance.

Need for Predictability

HUD did an outstanding job of early messaging around the lack of 2020 ACS data and how it would impact 2023 income limits and fair market rents. However, the change in cap methodology for 2022 and its continued use with modification for the lack of 2020 data was not clearly communicated and the lower caps caught many stakeholders off guard.

Predictability is a major issue for investors. One reason the LIHTC has been America’s most successful affordable housing production vehicle is that there is predictability: Developers can confidently estimate income and expenses for construction and operation of LIHTC-financed properties, giving assurance to investors.

The past two years of change in the cap formula introduced a wild card for LIHTC properties. After a decade-plus of reliably estimating income based on predictable HUD income limits and caps, the past two years have seen a change. With the risk of inflation (which affects labor costs, operating expenses and more), a lack of predictability in the cap formula makes financing tougher for developers, which makes less development likely.

The income limit cap issue is also troubling for owners of existing properties, who may face operating expenses that increase at or beyond the rate of inflation, while having income limits capped at a level below that.

The solution? A dependably consistent HUD-determined cap methodology.

What’s Needed

This year’s cap numbers were a surprise. Without advanced notice of how HUD would determine the cap, many stakeholders assumed a return to the pre-2022 method and expected a cap of nearly 14%. When HUD announced the 5.92% cap, it was a financial shock amplified by the lack of preparation.

More challenges could be coming. If inflation cools and HUD retains the 2022 and 2023 formula for determining caps, we could see those caps increasing at a rate that outstrips the cost-of-living increase. That’s a separate problem.

HUD could use a variety of formulas to determine income limit caps:

  • A return to the previous method of calculating the change in national median income using ACS and trended forward by the CPI factor. With the issues from the 2020 ACS past us, this may be the simplest solution.
  • Set the cap at double the change in CPI for the previous year. This would allow HUD to identify outliers.
  • Place the cap at a percentage that only limits the top 10% of areas with the greatest increase in AMI. This also provides a specific definition for outliers: The 10% of areas with the greatest increase.

Whether HUD uses one of these options or something else, the affordable housing community–developers, potential developers, property managers, investors, syndicators and tenants–would benefit from the stability that comes from a predicable method to determine the income limits cap.

The 2023 cap reigned in rent increases at a figure that helps tenants. But unintended consequences–creating financial challenges for existing properties, discouraging developers, making 2 million families ineligible for assistance–are such that HUD should at least consider a more transparent, predictable methodology to calculate the annual cap.

If you’re interested in amplifying your voice in this issue, the Novogradac Income Limits Working Group regularly discusses this and shares its views with HUD. Visit the Novogradac website for more information. 

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