By Dani Evanson, Principal, Align Finance Partners.
In Beyond Wall Street Episode 6, Jan Brzeski of Arixa Capital interviews Dani Evanson, Managing Director of Align Finance Partners, about generating income from financing affordable housing.
Jan Brzeski: What do you do at Align and maybe a little more detail about the affordable housing financing that you're doing?
Dani Evanson: A few years ago we realized that private investors have a very difficult time accessing opportunities within the affordable housing sector. Affordable housing is traditionally financed and capitalized with a loan, and then other sources of capital like grants, bonds and low-income housing tax credits. So there really isn't an opportunity for private capital to access this particular space within real estate.
Jan Brzeski: So we're talking about apartments and that are affordable rents relative to market-rate apartments, right? So it's not necessarily a class C building. It can be a really nice building we're talking about, right? Are these mostly new construction buildings?
Dani Evanson: Most of the properties that we loan capital to will be newly constructed, affordable housing. Going back to the affordability factor and what differentiates affordable housing from market-rate apartment buildings is that the tenants are restricted to those that earn a certain income relative to that area.
Jan Brzeski: So this is exactly what all of our political leaders are talking about, housing that people in different types of jobs can afford as opposed to the rents on a new construction apartment building might be out of reach for a lot of people that live here. And you are aiming to generate tax-exempt or partially tax-exempt returns for your investors. How do you generate those returns?
Dani Evanson: We make a loan to a borrower that's building or buying affordable housing. When we make a loan, we split the loan into two pieces. Let's call that an A certificate and a B certificate. We sell the A at a lower rate than what we made the loan for. The difference between that low rate and the face rate of the loan goes to the B certificate holder, which are our investors. The B certificates are high yield debt investments for our investors on a tax-exempt basis.
Jan Brzeski: So let's go into the details a bit. Let's find a sort of sample project. If you could think of one, maybe give us an example of how many units it is and where it's located. And we can go into some details using an example.
Dani Evanson: Projects are typically over 100 units. Let's stick with 100. I just think it's an easy mathematical number to equate the rest of the math that we're going to be using in this example. The location can be anywhere. I mean, affordable housing can be literally anywhere in the nation. For us, we tend to focus on submarkets that have a minimum population of 100,000. Those are not relatively enormous cities, but we tend to stick with qualified cities that have work centers and employment and a healthy vibrancy to it. We're also looking for projects that have affordable rents that are substantially different from market-rate rents.
Jan Brzeski: Give me an example of a couple of cities where you've done projects and financings in the last year. What types of cities are we talking about?
Dani Evanson: We've recently lent in Seattle, which is a very strong market, and Riverside, California. We're looking at Los Angeles and San Jose. So really quite urban, dense markets.
Jan Brzeski: So someone's building a 100-unit project in Seattle or Riverside, California. And they've found the land. They have their bank loan all setup, right? They've probably won some tax credits as well to help with the financing. So where do you fit in? What's the financing that you're providing?
Dani Evanson: We're equivalent to bank financing. We're a construction lender and a permanent lender for once the project is stabilized and the construction loan is closed.
Jan Brzeski: Okay. So the total cost of the project is whatever it is. What percentage of the total cost is coming typically from equity and tax credits? And then what percentage is coming from the loans that you're involved in?
Dani Evanson: Let's use an example of 100 units. Let's just assume for a second that they're each going to cost $1000 to build. Let's pretend we're playing a Monopoly game for a moment and using numbers that obviously are so unrealistic. But for mathematical reasons, if the project costs $100,000 to build, we're typically lending on average between $50,000 to $60,000. The tax credits that are earned by virtue of having an affordable project being built is going to represent the delta, the difference. If we're going to be lending up to $55,000 - $60,000, the tax credits will get you to about $40,000 to complete the construction. If there's a gap, meaning between the credits and the loan, there's still money that needs to be raised, they'll get local grants or other donated money to complete the project.
Jan Brzeski: That sounds like a very attractive position. If you're the lender at 50 to 60% of the cost of the project, that seems like something that our viewers would be very interested in because our viewers tend to be interested in income and alternative investing and attractive returns, but in many cases, trying to not take too much risk. So you provide that financing and then it sounds like there are two phases, right? There's the construction phase. And then once all the tenants are in and there's cashflow in place, you're going into a permanent loan. Walk us through, where do you end up once it's stabilized? What's your position in the capital stack of the project?
Dani Evanson: Affordable housing is not like market-rate multi-family and apartment buildings. It's dramatically different. It's funded differently, it's tenanted differently, and it's valued differently. Just hitting on the risk profile, one of the most interesting things that we were attracted to when we first entered into affordable housing 11 years ago, was that the default rate, meaning the loan default rate, in affordable housing is 0.01%. It's the lowest default rate in all real estate credit, credit being lenders who are making loans. The default rate is very, very low and the reason for the low default rate is because the rents are predictable. The communities, the bankers, borrowers, we all know the rent is going to be projected, and we can see, and it has a very low volatility over a long period of time. That's really important. You know your income stream and you can see it out 10 years. There's going to be a little bit of fluctuation, but not a lot. This helps lenders like us get comfortable with the operating income that's available to service the debt.
Jan Brzeski: So in our example, the finished property was worth $100,000 and your loan originally was 50 to $60,000. After it's stabilized and permanent financing is in place, is your loan still 50 to 60,000 or is there a different permanent loan from a bank in place or is your loan the permanent loan?
Dani Evanson: We call ours full term - that's through construction to permanent financing. Our loan term can be as high as 18-year paper, which is very long term. In affordable housing, there is a minimum 15-year compliance period once you stabilize the property and have it with tenants. The construction period's roughly two years to three years, and then you have a 15-year compliance. As a result, we must term our paper to an 18-year paper. It's a long income stream for owners and holders of that paper.
Jan Brzeski: How long would the investors expect to stay invested in this strategy? Do your investors need to be prepared to be invested for 18 years as well?
Dani Evanson: I wish they were that patient, but I don't think any investor has the appetite to have almost two decades worth of an investment with a single strategy. Align’s fund in particular has a 10-year life. At the end of the Fund’s term we intend to sell the portfolio of B certificates. We believe that if the portfolio of B certificates has a high yield coupon, we'll be able to liquidate that in the market. We do not intend to hold beyond the 10-year term.
Jan Brzeski: Got it. And I know that in the market rate apartment area, apartment loans are very low-cost today. 3% or maybe even lower. What is the rate that the borrower pays on the permanent loan once the property is stabilized?
Dani Evanson: Like most lenders, we are subject to the market - the market interest rates. Right now our permanent financing is approximately 4.0% - 4.25%. That's a tax-exempt interest rate.
Jan Brzeski: I see. So the borrower is paying, they are paying a bit higher rate than what the market rate permanent financing would be.
Dani Evanson: They're getting a fixed rate for 18 years. While market-rate projects are going to have potentially sub-3% or 3.5% rate, it's typically for a shorter term. The max term you're going to get on a multifamily market-rate project is a 10-year term. We're effectively almost doubling that term with a slight premium in rate. The benefit to investors is that our paper, versus market-rate multi-family paper, is our interest is tax-exempt.
Jan Brzeski: So let's say that you've got a 4.5% or 4.25% rate, what does that end up meaning for the investor? What kind of return are they getting and how is that income treated from a tax perspective?
Dani Evanson: Well, before I go to the returns, let me talk about tax treatment because I think that's really, really important. That's what differentiates investing in debt that's for affordable housing versus any other type of debt. The tax treatment for having invested in debt instruments for affordable housing is tax-exempt at the federal level. Let's use California as an example. If the project is based in California and the investor is also a California resident, it is state tax-exempt as well. For residents that are in high-income state taxes like California, finding investments in debt for affordable housing is a home run from a tax efficiency perspective because you're now federally and state tax-exempt for that stream of income. Really important. If you're an investor in California and the projects in Oregon or Colorado, then you will have California state tax level income implications, but you will have a federal exemption.
Jan Brzeski: Does the investor get to choose which projects they want to participate in, or are they going to participate in a portfolio of projects, some of which may be in their home state and some of which are outside?
Dani Evanson: For this strategy, it is in a portfolio because not all individual investors will qualify to hold tax-exempt bonds. Align created a fund for investors with smaller capital allocations to access this strategy. The truth is you're going to have a wide variety of states, and you're not necessarily going to have an entirely California-focused fund.
Jan Brzeski: What kinds of returns are possible for the investor in general? And I think tax exempt in California, as you say is very special. And with federal rates probably going up, it's probably going to become even more appealing. So what kinds of net returns have investors gotten in the past, in these types of strategies?
Dani Evanson: In general, if it's 4.5% tax-exempt bonds in a fund structure, the investor will probably net, take home, somewhere between 2.5 and 3% yield, tax-exempt, depending on if it's state-level or not, what we just went over. But what we do and what we specialize in at Align is selling tranches. We will sell a senior piece and keep the residual. This creates a high yield B piece. So for us, we're targeting a higher yield by virtue of selling a lower risk, lower coupon to Wall Street. We're selling what we call A certificates to other banks and financial institutions that are looking for core, very stable, lower risk-return instruments. If I have a 4.5% interest loan and I can sell to institutional buyers a lower leverage tranche for 3%, Align can take the delta and put it to the B piece for the high yield.
Jan Brzeski: And the high yield being, what type of range has traditionally, has that B piece traditionally been able to earn for the end investor? Just a range would be fine.
Dani Evanson: They're ranging between 8% and 12% right now.
Jan Brzeski: And that's with the favorable tax treatment that you were talking about.
Dani Evanson: Yes.
Jan Brzeski: Okay. That's really pretty remarkable because that is indeed a high return. And they're getting quarterly distributions, is that right?
Dani Evanson: We provide quarterly distributions, but other lenders and other lending platforms might do monthly. It's really at the election of the fund manager.
Jan Brzeski: So you're ending up investing in the smaller part of the loan, but it's still at a reasonable loan to value. And you're getting a higher yield because Wall Street is taking the bigger part of the loan. They're getting a lower yield and you're keeping these B pieces which have a high yield and favorable tax treatment. Is that pretty accurate?
Dani Evanson: That's accurate. The one thing I would say is that we want to make sure that when we're talking about loan to cost and loan to value, they're two different things, especially in affordable housing.
Jan Brzeski: So loan to value is, value can be lower than cost in affordable housing. But you don't end up owning it unless there's a default, what would cause a default?
Dani Evanson: Well, there's a lot of a belt and suspenders when it comes to defaults. The reason for that is because you have tenants in a property that need housing. The eviction process is very complicated. For us, a default by the borrower means we're going to replace the borrower. We're going to replace the management. We're going to replace the operations to make sure that somebody's in there who knows how to operate affordable housing. It's extremely rare that you'll have a default because of a property issue, because it was recently constructed with building permits and consultants and all sorts of other people involved to make sure that it's being built to the quality and standard that's required.
Jan Brzeski: What's the hardest part of your business right now, if you had to single out one thing?
Dani Evanson: Deal sourcing. Being attractive compared to agencies and large banks that have a nearly 0% cost of capital, where any private lender like ourselves has a cost of capital that we must contend with, and we have to be fairly aware of.
Jan Brzeski: So getting that 4 to 4.5% rate that you're looking for, there might be a lot of projects going on, but it's only a subset of those that can, and that want to, and are able to pay the 4 to 4.5% rate. And the banks are kind of undercutting you a bit. So there's a chance that you could end up with less than your 8 to 12 target returns. But it's still tax-exempt with a very low default rate. Tax-exempt based on what we described earlier. So it's not a risk of loss of principle so much as just lower tax-exempt returns than you thought.
Dani Evanson: I would agree with that. I would say the risk in a strategy like this is not meeting your high yield target, whether that be 7% to 10%, 8% to 12%, that's all-high yield. When you don't execute the second part of the strategy, which is selling the A and keeping the B subordinate position, you can’t deliver the high yield.
Jan Brzeski: What's the single biggest risk to your strategy? We've talked about a couple of areas where there are some risks, but how would you describe the single biggest risk?
Dani Evanson: I think the single biggest risk in our strategy is not getting to the high yield paper. That's our business model, our business model isn't to provide low 3 to 4% interest tax-exempt interest investments, it's to offer high single-digit tax-exempt yield. In order to effectuate, you really have to execute not only on making the loan, but selling off that A piece to retain the B high yield.
To hear the entire interview: https://beyondws.com/interviews/bws-episode-6-doing-well-while-doing-go…
About the Author:
Ms. Evanson is a Principal of Align Finance Partners, Managing Director of Regis Metro Associates, Inc. and a member of the investment committee. She is responsible for Align’s operations, investments, investor relations, and strategic direction.
Ms. Evanson has over 25 years of experience in real estate, with a background in finance, acquisitions, dispositions, leasing, portfolio management, and accounting.
Prior to forming Align Finance Partners and joining Regis Metro Associates, Inc., Ms. Evanson served as a Real Estate Director at a Los Angeles-based family office. Ms. Evanson was primarily responsible for investing and managing a $500 million real estate portfolio valued at over $2 billion consisting of investments in commercial properties, investment funds, joint ventures, and real estate operating companies. Ms. Evanson is a current board member of Abode Communities, one of Los Angeles’ largest non-profit affordable housing organizations.
Ms. Evanson holds a B.S. in Business Administration from the University of Washington. She is a licensed Certified Public Accountant in the State of California (inactive), Certified Management Accountant (inactive) and California real estate broker.