Unconventional funding is key to developers' ability to build.

THE dilapidated bungalows in the heart of L.A.'s Koreatown weren't much to look at, but when developer Frank Fonseca found the half-acre property, across the street from Hobart Elementary School, he knew it would be ideal for low-income housing.

There was a big hurdle, however: To make a below-market rate project work, his Redondo Beach-based firm, American Community Builders Inc., needed federal funding. And to get that funding, Fonseca had to purchase the land in advance and have the project approved--a nearly $2 million investment.

"Therein lies the big dilemma for affordable housing developers," he said. "The sites we're chasing are very expensive and getting subsidies is very challenging and very limited."

For many affordable housing developers, for-profit and non-profit alike, Fronseca's problem is a familiar part of making a subsidized low-income apartment project pencil out.

Compelled by federal regulations to keep rents for affordable units pegged to a percentage of the neighborhood's median family income, these developers don't have the luxury of passing along--and marking up--each penny of the hard and soft costs they incur.

Their challenge in keeping costs down starts with the price of land--easily $1 million or more for just a small parcel in Los Angeles County. Then there are construction costs, which cover, among other things, a "prevailing wage" pegged to higher union-negotiated wages required in California for projects with public subsidies. That can raise the cost of a project by as much as 20 percent.

In the end, even the profit that a developer of subsidized housing can make is regulated. The federal government mandates maximum fees for developers of 15 percent of the project cost, capped at $1.5 million.

Chasing money

Fonseca's experience in Koreatown illustrates the hazards--and opportunities--of developing affordable housing. He started out two years ago by buying the land through a one-years year, $1 million loan at 7 percent interest from non-profit lender Century Housing Corp. That allowed him to go into escrow on the property.

But he still needed nearly $3 million in additional funding to cover the cost of hiring an architect, gaining entitlements and covering various holding costs. Last month he reached an agreement for a $2.7 million loan from the city's $100 million Affordable Housing Trust Fund. And finally, two weeks ago, American Community obtained more than $7 million in federal tax credits, which it will use to leverage construction, set to begin this fall.

"You do it because you believe in what you are doing and we've gotten pretty expert on it," Fonseca said of the bureaucratic process. "It's our mission statement, something we really believe in doing."

In the end, Fonesca projects that the firm will make $440,000 over the four years it will take to replace the boarded-up bungalow with a 47 units will rent for between $300 (one bedroom) and $875 (three bedroom), although those prices could be adjusted up or down based on a family's income.

"There's certainly no big windfall in this--that goes to all the guys selling condos," Fonseca said. "It's not a function of what the market bears, it's a function of what these programs can afford and allow."

Cutting corners in construction is not an option in the affordable housing world. Developers receive no breaks on building and safely requirements and are subject to the same discretionary approval process as market-rate projects.

"We have to complete an (environmental impact report) just like any other developer," Fonseca said. "When out project is done, you won't be able to tell it apart from a market-rate project."

Relying on government

More challenges: Unlike market-rate and high-end projects, developers of affordable housing can't just walk into a lender's office and secure a construction loan. In fact, financing these projects often involves more than five sources. All hinge on tax credits issued by the Department of Housing and Urban Development.

Twice a year, HUD issues two forms of credits created as part of the Tax Reform Act of 1986, one equal to 4 percent of construction costs, the other equal to 9 percent. Both credits are good for 10 years.

For a project that costs $10 million to build, that means the 9 percent tax credit, equal to $900,000 per year for each of the 10 years, would be worth $9 million.

But since the developer is in need of immediate cash to fund the development, and not a long-term tax break, a market has evolved where financial institutions buy the credits for about 85 percent of their total value.

The Federal National Mortgage Association, the giant mortgage investor, is also the nation's largest buyer of such credits. Fannie Mae and other banks typically purchase developers' credits and use them to decrease their own tax liability or to set up tax shelters.

Credits are allocated among the states based on population, and the 9 percent credits, because they're more lucrative, are hardest to get. California is allocated 45 of the 9 percent credits each year and receives five applications per allocation.

"It's like manna from heaven," said Steve Peeler, director of structured finance with nonprofit lender Century Housing Corp. "It's the ideal financing solution out there."

By selling the 9 percent tax credits, even at a discount, developers gain the cash needed to pay for construction and subsidize the rents.

The developers are then required to hold the building for at least 15 years before selling--during which time they would collect rents. Those rents must remain "affordable" over a 55-year period.

In selling the tax credits, which are allocated to projects on a per-unit basis, developers are able to take a 70 percent equity stake in the development. The balance of construction funds come from short-term, or "bridge," loans from local and state governments, Peelor said.

Taking out a conventional mortgage isn't difficult, lenders said, because even the below-market rents are enough to cover the loan for 30 percent of the property's value. And unlike some market-rate projects, full-occupancy is rarely an issue in affordable buildings.

"At that point it's a pretty safe investment," said Sandra McBeth-Reynolds, president of Brentwood-based United International Mortgage Bank Inc., which has made several mortgages on affordable housing projects. "There's never going to be a shortage of people in Southern California who need affordable housing."

As for Fonseca: "We're in it for the long run. Presumably there will be some additional value after 15 years, but that will be less than the market because of the building's affordability requirements."

Affordable Financing

Developers can source loans to subsidize construction of low-income housing.

Department of Housing and Urban Development

Administers tax credits authorized by the Tax Reform Act of 1986. Developers sell the credits to fund up to 70 percent of construction costs.

Century Housing Corp.

Private agency provides short-term loans of about $1.5 million at 7 percent interest to fund predevelopment costs, enabling developers to buy land, get entitlements and qualify for federal and state financing.

Affordable Housing Trust Fund

City account formed during Riordan administration, funding goal set at $100 million by Mayor James Hahn Provides flexible-term loans at zero to 3 percent interest for bridge financing, contingent upon securing other funding from state or federal sources.

LENDERS

Sandra McBeth-Reynolds

President

United International Mortgage and Investment

"WE finance large projects through construction loans and what's called take-outs, where we write a mortgage for the borrower who's also the end user. We've done projects in Chicago, Houston and Los Angeles. We just worked with a developer to build a 400-unit complex in Yucca Valley.

"The problem of getting more affordable housing built in California is that all we have left is infill development. All you're left with is tearing down and building some units that way, and that is challenging in this market.

"One of the biggest problems we encounter is finding solid financial statements of developers. Some of the smaller developers are challenged with their financial statements. We always like them to bring in an equity partner who can help them finance the project.

"These days, many times you find developers will partner with their lender to build. They will offer the lender a participation in the project in order for the lender to bring funds to the table."

G. Allan Kingston

President and Chief Executive

Century Housing Corp.

'WE do acquisition and pre-development financing, which is too big of a risk for other lenders to take. We do a lot of short-term financing, which is a need we have recognized that affordable housing developers have.

"We're willing in some cases to come in early and say, 'OK, we're willing to make this happen.' We also get involved in a lot of gap financing as well.

"The Los Angeles metro area is now the most crowded in the United States. It exceeds every other city in the density of its population. I know most people find that hard to believe but it's true.

"We also know the L.A. region is probably 200,000 units behind in the affordable housing it needs. The regulatory barriers are still very long. It should not take two to three years for entitlements to happen, especially in a large city where you have government officials who are willing to be flexible and work quickly."

Ralph Esparza

Assistant General Manager

Los Angeles Housing Department

'THE mayor and the City Council in February 2003 voted to have the Housing Department manage the multifamily housing development aspect of the city's Affordable Housing Trust Fund.

"Already, we have done three solicitations and had different levels of funding in those rounds. So far we've committed around $31 million from the trust fund for 18 projects representing 1,010 units.

"The key to the program for building multifamily is that the trust funds can only be used if other sources of funds have also been committed. They get a letter of commitment that they can use to help secure other sources of financing, but if those other sources don't materialize, we don't issue the loan.

"The basic premise of the trust fund program is real simple. It's leverage the money with other funding sources and only for projects that are ready to go. In order to be competitive, you have to have site control, the entitlements and some architectural planning and drawings done.

"The interest rates are very soft, ranging from zero to 3 percent. We want as much affordability as possible and the city has the objective of serving the lowest income families first. To do that, we want to give developers the greatest flexibility to make these developments as affordable as possible."

--Andy Fixmer