Housing stock: some life insurers are investing in funds that finance or develop affordable urban housing.

America's urban areas, long starved for capital and suffering from a flight of people and businesses to suburbia, have been rediscovered. They once again are attracting people, companies and businesses, and investment capital. The capital markets have targeted urban real estate investments, and insurance companies are beginning to invest in funds that finance or develop housing affordable to middle-income workers in urban areas.

While urban areas offer attractive lifestyles, middle-income wage earners have difficulty moving to these areas because homeownership and rental costs have been increasing faster than their incomes. To address this issue, fund managers such as Phoenix Realty Group, a private real estate firm that creates and manages equity funds, have partnered with community-based developers to develop housing that middle-income workers can afford to buy or rent.

Experienced in urban markets, these developers have acquired relatively low-cost land for development, but the capital required for their projects is too small to attract direct investment from institutional investors including life insurance companies. Phoenix has institutionalized the market for work-force housing by aggregating such projects into portfolios and financing them with equity capital from the funds it manages.

Financing Work-Force Housing

Work-force housing--market-rate housing for middle-income households--is in short supply primarily because of regulatory hurdles, rising land prices, a shortage of available land and opposition to development. Work-force housing projects are relatively small, requiring equity investment of $3 million to $10 million, but institutional capital sources typically want to place $15 million or more in equity in a project. Phoenix raises equity capital for work-force housing in urban areas beyond just the central business districts.

For example, Phoenix manages the $100-million Genesis Workforce Housing Fund in Los Angeles, the first institutional source of capital to invest in for-sale and rental housing for middle-income wage earners. The fund provides equity and mezzanine investment for the development of work-force housing in the metropolitan Los Angeles area. It is designed to be affordable to workers earning from $47,000 to $109,000 annually to acquire housing priced from $250,000 to $450,000, which in California is considered entry-level housing.

Insurers as Investors

The fund's investors include MetLife, John Hancock Life Insurance Co., New York Life Insurance Co., Lincoln National Life Insurance Co., and Northwestern Mutual Life Insurance Co. as well as Washington Mutual and Citibank Community Development. "This fired gives us the ability to realize competitive returns by accessing a marketplace we could not otherwise have reached as an institutional investor," said Dennis White, director of private placements for MetLife. "Among our key questions [prior to investing] was whether Phoenix and its developers have the experience and networks to get control of sites and build this kind of housing."

John Seifert, director of real estate for Northwestern Mutual, said, "We have been an investor in tax-credit housing for several years, and this is a logical extension. We spent quite a bit of time underwriting the sponsor. We also analyzed the local housing market to determine whether there was significant demand for workforce housing."

Concept Grows

The Phoenix Los Angeles fund also invested approximately $2.5 million in equity financing for Pan American Lofts, the conversion of an historic commercial building in downtown Los Angeles into 40 live/work loft homes. The project's developer, Urban Pacific Builders LLC., also is converting the historic Bank of San Pedro Building in downtown San Pedro into 89 loft-style homes, with the Phoenix Los Angeles fund providing $5 million in equity for the project, known as the Bank Lofts at San Pedro. All told, the Phoenix Los Angeles fund will invest in approximately 15 to 20 for-sale or rental properties in the Los Angeles area, creating 2,000 traits of housing at a total development cost of more than $500 million.

Phoenix also is the fund manager of the $90-million San Diego Smart Growth Fund, which finances workforce housing development and in-fill commercial projects in urban neighborhoods in the San Diego metropolitan area. In addition, Phoenix has targeted capital for investment in urban housing-based funds in the Northeast and mid-Atlantic.

After conducting extensive due diligence, these insurers not only approved the Phoenix Los Angeles fund investment but also approved work-force housing as an allocated investment class for repeat investment.

Asset Class

One reason for Phoenix's extensive discussions with the insurers was that they wanted to establish work-force housing as an asset class, develop the investment criteria and risk parameters for investing in this asset, and obtain internal approvals of work-force housing as an investment category. They look at work-force housing as a long-term investment opportunity that complements their overall real estate investments and enables them to diversify their investment portfolios.

Among the other reasons workforce housing funds have attracted insurer investments:

* Risk-adjusted returns are competitive with direct property investments.

* Insurers could use some of their capital allocation for socially responsible investing, provided that such investments meet their return requirements, helping them address the demands of state insurance regulators for such investments.

* Many insurers have long and successful experience in investing in low-income housing tax-credit programs in urban markets. Work-force housing funds enable them to leverage that experience and provide an alternative to yields that have been bid down in low-income tax credit investments.

* While many insurers are experienced in investing in existing properties, some are new to investing in new real estate development. Fund managers experienced in development stage real estate allow investors to invest at cost with the fund manager managing the construction risk.

* Fund managers can identify and evaluate investment opportunities, evaluate prospective developers and projects, and structure and manage investments. In looking at potential investments, for example, Phoenix decides against investing in a majority of prospective projects for various reasons. For quality control, Phoenix maintains centralized investment approved and asset management, not raising more capital than it can invest over a three-year period.

* Insurers can cost effectively outsource to fired managers the operation of the fund, including recruiting individual fired managers and staff; dealing with developers, lenders, public officials and others; financial reporting and accounting--all under the oversight and direction of the insurance company's managers.

* Investing through funds provides accounting benefits vs. direct investing. If insurers invested directly in work-force housing, and leveraged their investments with debt, they may have to consolidate the debt onto their balance sheets in conformity with Financial Accounting Standards Board Interpretation 46 (FIN 46), Consolidation of Variable Interest Entities.

The need for market-rate housing for middle-income households will continue to increase, driven not only by housing price considerations but also by the benefits of urban neighborhoods and lifestyles. This will create more opportunities for life insurance companies and other institutional investors.

* The nation's largest insurance companies are investing in new middle-market urban housing.

* Equity funds have begun institutionalizing this market by aggregating urban housing portfolios at ground floor development costs on a scale attractive to institutional investors.

Contributors J. Michael Fried and Keith B. Rosenthal are chief executive officer and president, respectively, of Phoenix Realty Group and the company's founders.