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Financing work-force housing: funds set up to build middle-market housing in inner-city neighborhoods are coming on strong. They make a lot of sense for developers, investors and moderate-income urban workers.

BANKS AND SAVINGS AND LOANS ARE increasing their investments in work-force housing in urban areas. Unlike pension funds, insurance companies, endowments and other investors in work-force housing, banks get a three-for-one benefit from investing in work-force housing, or market-rate housing for middle-income workers. [??] They earn a competitive yield from work-force housing, an asset class that has been underserved by the capital markets. They have an opportunity to cross-sell other services, primarily construction lending and end loans to the properties in the investment portfolio. Finally, they earn Community Reinvestment Act (CRA) credits because many of the work-force housing investments they finance are in areas that qualify for such credits. [??] While urban areas offer attractive lifestyles, middle-income workers have had difficulty buying or renting market-rate housing in these areas because housing costs have been increasing faster than their incomes. To address this issue, fund managers such as Phoenix Realty Group LLC (PRG)--a private real estate firm based in New York, Los Angeles and San Diego--have partnered with community-based developers to develop market-rate for-sale or rental housing that middle-income workers can afford. To accomplish this, PRG creates and manages smart-growth equity funds.

Because of their experience in urban markets, these developers are able to acquire comparatively low-cost land for development. However, their projects typically are not of the scale to attract direct investment from banks and other institutional investors. PRG and others in this niche have institutionalized this market by aggregating such projects, financing them with equity capital from the funds they manage and raising capital for the funds from banks and other institutions.

Investing in these funds not only provides banks with attractive returns, but also has a positive social impact. Developers benefit from being able to access institutional capital through these funds and thereby have access to capital that can be used to finance larger projects or multiple projects.

Widespread need

The need for work-force housing is broad and deep. Despite low interest rates and the availability of a variety of loan products, many middle-income workers cannot afford to own homes in the cities where they work. A 2004 study by the National Association of Home Builders (NAHB), Washington, D.C., Where Is Workforce Housing Located?, found workers who provide vital community services, such as police officers and firefighters, are struggling to find affordable housing in the nation's top 25 metropolitan areas.

The high cost and lack of choices in urban housing have forced many of these workers to buy homes in distant suburbs far from employment centers. Far too often, the price of an affordable home is a longer trip to work.

"Longer commutes are one clear sign of a growing problem," Richard F. Syron, chairman and chief executive officer of Freddie Mac, said at a September 2004 national forum on workforce housing. "But the work-force housing issue is really much broader," he added.

Among other issues, workers have less time for family, friends and community service. Companies in areas with high housing costs have difficulty recruiting and retaining workers. Increases in commuter traffic put stress on aging transportation systems and worsen air pollution.

If they could find affordable housing, some middle-income workers now living in the suburbs or exurbs would buy or rent housing in the cities, closer to where they work. An equally important market is the worker who currently lives in the city. Many of these workers are young and just beginning to start families. They have a strong commitment to their neighborhoods and are helping to improve local schools. If new, market-rate for-sale or rental housing were built for these workers, they might be able to buy their first homes or move to newer rental units within the communities where they now live.

In short supply

Work-force housing is in short supply for several reasons. They include regulatory hurdles, rising land prices, a shortage of available land, opposition to new development and other factors. For example, the San Diego region's population increased by 7.2 percent between 2000 and 2004 while the number of new housing units grew by only 5.1 percent, according to a 2005 report of the San Diego Association of Governments, Population Growth Outpaces Housing Construction.

"Homebuilders have been unable to meet the demands of a growing population," the report stated. As a result, the region's housing costs continue to climb, more people are living together under one roof and workers are commuting greater distances.

Nevertheless, some community-based developers that are skilled and experienced in building urban housing have managed to find relatively affordable land, acquire or gain control of properties and obtain entitlements to develop work-force housing. These properties include former industrial sites, in-fill properties, land that requires environmental cleanup, and class-B and class-C buildings as well as land located in low- and moderate-income census tracts and redevelopment areas.

To obtain construction financing for workforce housing, these developers usually are required by lenders to invest equity equal to 20 percent to 30 percent of total project costs. They have turned to family, friends and small private investors for equity funding, but they typically have not been able to tap the institutional market for capital. Work-force housing projects are relatively small, requiring equity investment of $3 million to $10 million, but institutional capital sources usually are trying to place $15 million or more in equity in a project. That has limited community-based developers in scaling up to larger projects or increasing project volume.

To bridge the equity gap, fund managers such as PRG have institutionalized the market for urban work-force housing development. PRG raises equity capital from banks, life insurance companies, pension funds and other institutional investors for investment in work-force housing funds that, in turn, invest in urban areas beyond central business districts (CBDs).

These funds serve what might be called the "three middles": middle-sized investments in middle-sized housing projects for middle-income people. The PRG-managed funds provide community-based developers and investors with institutional capital for the construction or acquisition of for-sale or rental housing for workers making between 80 percent and 200 percent of a metropolitan area's median income. This typically includes police officers, firefighters, teachers, middle managers, government employees, nurses and other middle-income wage earners. These workers generally earn more than people who qualify for affordable housing, but are still underserved.

Working in Southern California

PRG currently manages the $100 million Genesis Workforce Housing Fund in Los Angeles, a leading 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 help workers earning from $47,000 to $109,000 annually, or 80 percent to 200 percent of the area's median income, to acquire housing priced from $200,000 to $400,000--which in California is considered entry-level housing.

The fund's investors include Citibank Community Development (CCD), a business unit of Citigroup Inc., New York; Washington Mutual, Seattle; MetLife Inc., New York; and The Northwestern Mutual Life Insurance Co., Milwaukee.

In investing in middle-market work-force housing, PRG targets urban markets where housing provides the most value for homebuyers and renters based on location, affordability, neighborhood services and amenities, lifestyle choices and other criteria. In its first investment, the PRG Los Angeles fund invested $6 million in Puerta Del Sol, a development of 165 affordable condominiums that AMCAL Multi-Housing Inc., Agoura Hills, California, an experienced housing developer, is building in Los Angeles' Lincoln Heights neighborhood, adjacent to a transit line connecting Los Angeles and Pasadena. The units will range from 700 square feet to 1,800 square feet and will be priced between $210,000 and $375,000.

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

PRG also is the fund manager of the $90 million San Diego Smart Growth Fund, which is financing work-force housing development and in-fill commercial projects in urban neighborhoods in the San Diego metropolitan area. PRG has assessed other U.S. markets where urban living offers housing-cost advantages and lifestyle benefits for the work force. Based on that analysis, PRG has targeted capital for investment in a work-force housing project in the northeast and mid-Atlantic. Other managers include Canyon-Johnson Realty Advisors LLC, Los Angeles, and Shamrock Holdings, Los Angeles.

Appealing to banks

Investing in work-force housing in urban markets is attractive to banks for a number of reasons:

* Banks receive an attractive yield.

* Banks have opportunities to provide construction financing for work-force housing projects in which they invest. This is because managers of work-force housing funds generally have the right to designate and/or approve construction lenders for projects. Banks typically account for one-third of the investment in a work-force housing fund. For example, if the total equity invested in a fund were $100 million, banks would invest about $33 million. If the banks also are the construction lenders, their $33 million of equity would generate approximately $400 million in construction business, or a ratio of 1,200 percent.

* With for-sale projects, banks may also have opportunities to provide an additional $400 million in mortgage financing to homebuyers.

* Banks can receive Community Reinvestment Act credits because work-force housing often is located in census tracts that qualify for them. They may also receive CRA credits for loans to first-time homebuyers.

* Banks are experienced in financing taxcredit housing development in urban markets. Development of work-force housing for middle-income workers is a logical extension of that.

* Banks require short-term to intermediate-term investments, and work-force housing development falls within these parameters. The life cycle of a typical work-force housing development is about three years.

"We are very interested in fostering work-force housing as a component of community development," says Evelyn Kenvin, director of investments for Citibank Community Development. "It increases the housing stock, creating a positive impact on underserved neighborhoods, and also produces attractive yields."

"Work-force housing enables us to expand our successful track record in urban investing," says Myron Perryman, vice president and community investment manager at Washington Mutual. "Washington Mutual Bank has not made end mortgage loans on the Phoenix Realty projects to date. However, we plan to do so in the near future with a couple of projects that will be coming online by 2006. In other similar fund investments with other fund managers, we have leveraged our investment into residential mortgages, and intend to follow that pattern with our Phoenix Realty investment."

Risk management

As with any type of development, fund managers, investors, lenders and developers of work-force housing are concerned with mitigating development risk, protecting their investments and meeting their return requirements. These risks include:

Location: When considering a proposed work-force housing project, developers must decide whether the location makes sense and whether the project is feasible based on the cost of the land. There are trade-offs. A site may be in an established residential area suitable for in-fill development, but the cost of the land may be relatively high. Another site may cost less, but is in a commercial area that is beginning to incorporate residential housing. It's a value proposition: Given the quality of the location, is the developer delivering housing at a competitive cost?

Market risk: Substantial changes in housing prices or rental rates will affect the profitability of work-force housing portfolios. However, PRG's investments are among the highest value and lowest price points in their markets, and potential competing housing faces barriers to entry in in-fill locations. Therefore, while PRG investments are not immune to price changes, they are somewhat insulated because of limited competition in their price range.

Interest-rate risk: There are three types of interest-rate risk. The first is the interest-rate risk of carrying the asset while in construction and lease-up. PRG mitigates this risk by underwriting at 100 basis points above current market.

The second risk is the interest-rate impact on affordability. Buyers of for-sale housing are sensitive to large interest-rate changes that increase their mortgage payments and total monthly housing costs. To offset interest-rate increases, buyers choose fixed-rate loans with different terms or adjustable-rate loans.

The third risk is the impact of interest-rate changes on selling prices. As with the first risk, PRG has a modest amount of price competition at its price points and it tends to have pricing that is well below the next rung of housing prices in a given urban area. PRG's price points mitigate sales-pricing compression.

Construction: To mitigate construction risk, fund managers invest with developers that meet PRG's net worth and liquidity requirements. PRG requires its contractors to provide guaranteed maximum-price construction contracts. In addition, PRG requires contractors to be bonded (or some equivalent) and the development budget to have significant construction-contingency reserves. PRG also allows only experienced construction lenders.

Entitlement process: PRG makes a point of understanding the issues and time frames involved in achieving zoning and building permits. This stems from the local presence PRG has in the markets where it operates. PRG requires that developers, for their part, build and maintain good relationships with cities.


Regardless of economic cycles, demand for market-rate housing for middle-income households will continue to grow, and so will the need for equity and debt financing for work-force housing projects.

By investing in such projects and providing construction financing, financial institutions have the opportunity to expand their existing lines of business and increase their revenue. Investing in a diversified portfolio of work-force housing funds enables banks and other investors to realize stable returns in a variety of market conditions. In addition, financial institutions are afforded cross-selling opportunities: A $10 million investment can generate approximately $250 million of construction and end-loan business. Finally, banks are able to facilitate socially responsible investments that provide a measure of CRA credit.

Keith B. Rosenthal is president and co-founder in New York, Los Angeles and San Diego-based Phoenix Realty Group LLC's New York office. Jay Stark is managing director of Phoenix Realty Group's Los Angeles office. They can be reached at and
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Title Annotation:COMMERCIAL
Author:Rosenthal, Keith B.; Stark, Jay
Publication:Mortgage Banking
Geographic Code:1USA
Date:Oct 1, 2005
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