Affordable assisted living.

With too much upscale product in the marketplace, developers are turning their attention to the needs of the middle class.

WHILE OVERBUILDING AND LEASE-UP of upscale projects remain a challenge in many markers, there is still substantial unmet demand for truly affordable assisted living.

Although about 40 states have existing or planned Medicaid waiver programs, most are pilots that can accommodate only a small numbers of residents. Still, if every state were to follow the lead of those states that have implemented waiver programs covering as much as $2,000 a month for assisted living costs, the industry could look forward to a greatly expanded market.

Until then, developers have to think along other lines. One way to lower the cost of assisted living is shared occupancy between two unrelated parties. Presently, much effort is being expended to create prototype models that afford some element of privacy, while yielding a 40 percent reduction in the monthly fee. Sunrise Assisted Living has set up a foundation to come up with affordable approaches to assisted living. Its principal strategy is to utilize various approaches to shared occupancy.

Another public company, Alternative Living Concepts, has been able to provide affordable assisted living by minimizing frills and extensively participating in the Medicaid waiver and other federal and state entitlement programs.

But these formulas are largely untested. The fact is there's only so much you can do to reduce the cost of construction or operations. Creating an affordable assisted living project comes down to reducing your cost of capital. The only way to do that is by tapping a variety of government-subsidized financing programs.

It is noteworthy that while private-pay, high-end product initially was the focal point of the for-profit assisted living industry, greater competition and increased market saturation has resulted in significant interest in affordable alternatives. Meanwhile, many not-for-profits have a more mission-oriented reason for targeting middle- and low-income seniors.

The two principal tools used to launch affordable assisted living projects are the federal Low Income Housing Tax Credit (LIHTC) and tax-exempt bond financing, typically referred to as indirect subsidies.

The LIHTC is normally available as either a 4 percent or 9 percent credit. However, the availability of the 9 percent credit is tightly controlled by each state, which utilizes an allocation process based upon a per capita formula. In fact, in many states, availability of 9 percent credit allocations runs our shortly into the new year. However, the 4 percent credit is considered available virtually "by right," subject to meeting the many regulations.

With use of the 4 percent credit, the opportunity to also use tax-exempt bond financing remains available. To qualify, certain rent and income restrictions must be met. Either 20 percent of the units must be occupied by residents whose income is 50 percent or less than the area median gross income, or 40 percent of the units must be occupied by residents whose income is 60 percent or less. Also, the gross rent of the residents in the low-income units can't exceed 30 percent of the median gross income.

It is important to note that the LIHTC is a residential rental program that excludes projects defined as "health care facilities" pursuant to Treasury regulations. A CCRC could qualify for the LIHTC for its independent living and possibly assisted living components.

In addition, to satisfy federal regulations regarding tax-exempt housing bonds under Internal Revenue Code (IRC) Section 142(d) and to maintain the residential status of the facility, nursing, medical, and psychiatric services may nor be offered on a "continuous basis." These restrictions must be maintained for a minimum of 15 years to preserve the tax-exempt status of the bonds.

Another new type of multifamily tax-exempt bond is the no-profit bond, where a project will be owned by a not-for-profit entity under IRC Sec. 501 (C) (3). Such bonds (not to be combined with the LIHTC) can be issued under IRC Sec. 145 by state and local housing finance agencies and housing authorities.

Complicating use of the LIHTC for assisted living is the requirement that maximum rents must include the cost of all required services, but not optional services. To qualify a resident for an affordable project, it is therefore vital to "detach," or make optional, the various service components that would typically be offered at an ALF. In addition, many states require that "affordability" be maintained for 30 years.

While tax credits and tax-exempt bonds are considered indirect capital subsidies, developers normally couple these with direct subsidies such as government or private grants or low-interest loans. Examples include federal programs such as Community Development Block Grant funds (CDBG), HOME (Home Investment Partnerships Program), the Federal Home Loan Bank Affordable Housing Program, HUD, and sundry state and local government sources.

HOME funds are allocated through states, counties, and cities and must include "very low-income" residents--typically defined as 50 percent of area median income. CDBG loans are also allocated by the states and often require a local partner. While HUD financing is advantageous from a pricing and leverage point of view, and its 40-year amortization period for new construction or expansion is particularly desirable, the process can be difficult and time-consuming. Teaming up with a nor-for-profit entity as a project partner can be helpful in obtaining HUB financing. Frequently, such applications from such alliances get handled in a more expeditious manner. Finally, there are certain property tax abatement programs that are often eligible for projects, particularly when owners are not-for-profit entities.

Roy B. Smolarz is senior vice president-investment banking at The GMS Group, a subsidiary of Gruntal & Co., member New York Stock Exchange.