Property Tax Incentives for Affordability
The National Housing Crisis Task Force proposes that more localities implement property tax incentive programs to subsidize new and preserved affordable units. To support this expansion, we propose the creation of a flexible Underwriting Model paired with a standardized methodology to analyze and compare local incentive programs. This approach would establish a new set of standard metrics that account for differences in incentive structures and how they affect the various measures that are important to the public sector and to developers. Our initial proposed Underwriting Model is Excel-based and relies heavily on a number of assumptions that any given locality or developer would need to input. While this provides a foundation for understanding underwriting fundamentals, it serves primarily as a first step toward bridging the knowledge gap between developers and public entities regarding project finances and subsidy valuation. It is not intended to replace customized underwriting, and there remains the risk that local nuances may not be fully captured, or that developers may still have a different read of the project’s finances.
We envision a much more accessible and usable model as this project’s final output. A final model would be open-source, with standardized, dynamic, reliable data (such as rents, median incomes, and local tax rates) rather than relying on user assumptions. The model would be hosted online and accessible to anyone. Data sources would update constantly and automatically via API.
The proposed model would allow any public sector official or developer, almost anywhere in the country, to automatically evaluate a proposed incentive program. It would also guide users towards target key metrics. For instance, if the public sector knew it had a distinct need for mixed-income developments with a certain number of units at a moderate Area Median Income (AMI) level, the model might guide it to offer a partial tax abatement to achieve the metrics that would incent a developer to perform.
Production of the final online Underwriting Model will require additional budget to develop and a permanent home for hosting and updating. The National Housing Crisis Task Force’s initial Underwriting Model should serve as the testing ground for this more ambitious model.
A Background In Housing Finance
Understanding the basics of housing finance is essential to understand the value and tradeoffs of subsidies that localities can offer the private sector. While priority methodologies and inputs will always vary from place to place and developer to developer, the private real estate industry does adhere to some basic, consistent practices.
Revenues: Net Operating Income
Among the most important metrics underpinning real estate analysis is Net Operating Income (“NOI”). NOI is indicative of a project’s recurring revenues (e.g., rents) and is essentially calculated by summing rents and other revenues (e.g., parking) and subtracting typical operating expenses such as maintenance, utilities, insurance, and property taxes.
Revenues Compared to Costs: Yield on Cost
NOI, however, does not account for the substantial costs of developing or purchasing a property. To compare these costs to NOI, the real estate industry calculates “yield on cost.” To determine yield on cost, NOI is divided by total construction and / or acquisition costs. For example, a 7% yield on cost implies that a developer’s NOI will yield 7% on their total investment each year once the project is leased up.
Sale Price: Cap Rates
Capitalization rates or “cap rates” represent another important metric for project revenue. While NOI is an indicator of a project’s recurring revenues (e.g., rents), cap rates are an indicator of the property’s ongoing value and potential sale price. Cap rates represent, effectively, a desired yield for a stabilized project; in a traditional development environment, an investor should be willing to accept a lower yield once a project is built and leased because there are fewer risks related to construction delays or leasing the property. Cap rates are used to drive a proposed valuation or sale price. Like yield on cost, cap rates are a percentage yield metric representing NOI divided by valuation.
Putting it all Together: IRR
NOI, yield on cost, and cap rates all help determine the developer’s return on investment in a housing development. The most commonly used metric used to evaluate this return is called Internal Rate of Return (“IRR”). IRR is calculated by summing the cash flows (money spent or income received) each year. Generally, this consists of acquisition and development costs up front, less NOI while the project is leased out, and sale proceeds determined by the market Cap Rate at exit, also accounting for the impact of debt financing. These cash flows are then time-weighted to calculate IRR. These “leveraged” (including the effect of debt) Internal Rates of Return are targeted in the double digits for more stable assets and above 20% for the riskiest new developments.
Affordability has a distinct effect on these metrics. Rents are one of the most important components of NOI (and, as a result, on cap rates), and affordable housing units typically generate lower rents. If rents dip low enough, developers and investors may choose to walk away from a potential housing development. In exchange for lowering rents, the public sector can reduce operating costs (e.g., through a tax incentive like an exemption, abatement or tax increment financing (TIF)) to increase NOI or reduce development costs (e.g., through free land, grants or low interest loans) to lower the total cost denominator; either of these offsets can get the developer back to a market-rate yield on cost. While every project has dozens of moving pieces, understanding precisely how these incentives affect a developer’s finances is critical to understand which incentives to provide, and how deep they should be for maximum effect.