When it comes to the multifamily sector, a lot of capital gravitates to the safety of class-A, professionally managed assets. But given the overall state of housing in the United States and the need for affordable options, some investment managers are carving out a stake in workforce housing and attempting to attract affluent investors to the opportunities alongside institutions and private equity.
The Urban Land Institute defines workforce housing as affordable to households earning between 60% and 120% of area median incomes (AMI). It is a notch above where the more traditional affordable housing investors operate.
Developers in that segment are finding ways to build new apartments that will rent at prices affordable to renters who earn an average income—without large amounts of restrictive government subsidies. And private equity funds that focus on making an impact are still able to buy apartment properties with rents affordable to average renters in certain markets.
As with other parts of the real estate investment world, with higher costs of capital, participants are working to adjust to new pricing. That’s slowed activity. But some players anticipate that things could open up in the near future.
“I feel like later this year, the prices have to correct… given where the interest rates are and where that cap rates are, the cap rates have to move,” says Mehul Chavada, chief investment officer at Casoro Group, based in Houston. Casoro Group is a vertically-integrated multifamily real estate investment firm that operates a social impact fund and a private REIT. “That would be a generational opportunity.”
PE fund buys workforce housing
A growing number of firms are interested in buying older, stabilized apartments to operate as workforce housing. Revitate Cherry Tree, a private equity fund manager active in the Midwest, is taking that route.
“Our strategy is simply acquire and maintain those assets in a sound condition. This is not a value-added strategy,” says Chris Marsh, founder and CEO of Revitate Cherry Tree. “Many would not find buying 30-year old assets in the Midwest to be particularly glamorous—but as a cash-flowing vehicle for investors, it provides safe harbor in these uncertain times.”
Revitate Cherry Tree is preparing to launch fundraising for its second private equity fund. Its Fund II will target a 7% cash-on-cash return and a 14%-to-16% annual internal rate of return, a 2X multiple on investors equity, says Marsh.
Revitate Cherry Tree recently closed its seven-year, closed-end, $40 million Fund I and preparing to close the purchase of the last property in the fund. Fund I is on track to achieve 8% to 9% cash-on-cash returns, beating its initial target of 6%, according to Marsh. Its internal rate of return is likely to be more than 17%, beating its initial target of 13%. “Fund I was able to take advantage of lower interest rates,” says Marsh.
The overall need for housing and lack of available inventory has helped drive those returns.
“The supply demand imbalance leads to very sticky rent rolls,” he says. About 70% of Revitate Cherry Tree's renters renew their leases when offered the opportunity.
It also helps that capital markets remain open for these kinds of assets. Revitate Cherry Tree uses permanent Fannie Mae and Freddie Mac loans to acquire its properties. “Fannie and Freddie are currently very supportive of workforce housing,” says Marsh. “Especially with the discounts and the preferential treatment, few can match it.”
These discounts are small but significant. “I think we got five basis points off of our interest rate on our last deal,” says Marsh. In exchange, Revitate Cherry Tree can demonstrate that its rents are low enough to qualify as workforce house, though it does not fully qualify the incomes of its residents every year, which the agencies require to provide deeper discounts.
Agency lenders offer biggest discounts for bigger rent breaks
The agencies offer even better terms for properties that are willing to offer lower rents affordable to more people and certify the incomes of their residents.
“They have to sign a sponsor-initiated affordability agreement and they have to hire a third party compliance monitor,” says Jim Flinn, vice chairman of the debt and structured finance team at CBRE Affordable Housing.
In exchange, Fannie Mae’s Sponsor Initiated Affordability program can offer discounts of up to 30 basis points on interest rates and offer loan terms as long as 35 years with interest-only periods for the loans.
Through Freddie Mac’s Tenant Advance Commitment (TAC) program, each borrower commits to take out at least $100 million in Freddie Mac program loans to finance apartment properties where a certain percentage of the apartments are affordable to renters earning between 60 percent and 80 percent of AMI.
In January 2023, Comunidad Partners, a private real estate investment firm specializing in workforce and affordable housing in culturally diverse communities, agreed to take out $400 million in loans over the next 12 months through Freddie Mac’s TAC program. The firm expects to use the loans to finance more than 20 apartment properties with more than 4,000 units of workforce housing priced to be affordable to households earning 60% to 80% of AMI.
The first loan in Comunidad’s TAC will provide $21 million to Villas at Shadow Oaks in Austin, Texas. All of the apartments at the 176-unit property are rented at or below 80%of AMI, and half of the apartments are rented at or below 60% of AMI.
Comunidad offers prospective investors a variety of entry points including direct investments, co-GP Partnerships, developer partnerships and as well as equity recapitalizations, preferred equity and note purchases of workforce/affordable multifamily housing.
Casoro Group is also looking to buy older apartments to operate at workforce housing.
“It is taking a little time for the price to move. We are right now in a price discovery phase. There are not a lot of transactions,” Chavada says. The owners of many older apartment properties are still asking for the kind of high prices they could get in early 2022, before interest rates leapt higher.
Chavada anticipates the apartment price are likely to drop.
“If you think about it, $900 billion of loans are about to come due,” says Chavada. “Many owners took out high leverage loans to buy properties at low cap rates that are now likely to rise. “The banks are going to look at them and say ‘the values are not there.’”
Casoro is now in pre-development to create as many as 250 new workforce housing apartments on an 8.8-acre site in the Sunset Canyon area of San Antonio, Texas.
“We are bullish on that pocket of San Antonio,” says Chavada. The existing apartments around the site are mostly 1970's and 1980's buildings, but incomes average $65,000 to $70,000 in the area.
It is likely to cost Casoro $160,000 to $190,000 per unit to build its apartments in Sunset Canyon, or about $175 to $200 per sq. ft. says Chavada. That’s very inexpensive compared to the cost to the cost to build in coastal markets. In San Antonio, this development cost is squarely between the high prices seller ask for stabilized luxury apartment and the lower prices seller get for older apartments.
Casoro is currently finding both a construction lender and equity investors for the project. “It is hard to get financing in this market, both equity and debt,” says Chavada. “We do have relationships with regional banks, but the feedback we are getting is the now is not the time.
The firm can afford to take its time.
“In this market you need deep pockets and the ability to weather the storm,” says Chavada. “We own the site free and clears. Once you have the capacity to manage the land site and work on your pre-development, once the market resumes normalcy for debt and equity, you have the best capacity to capitalize on it.”
At that point, the firm will also be looking for partners to provide equity.
“The private equity shops are still deploying capital, but at a much lower rate, they are much more selective,” says Chavada. “The accredited investors who earn $200,000 to a $1 million, they are very skittish.”
Casoro is also looking to buy new places to build new workforce housing apartments. That’s includes looking in downtown Houston to buy older, vacant office buildings. Redeveloping an office property can be notoriously complicated. But because so few buyers are interested in older office property, any potential seller is willing (being forced) to give Casoro a long time to inspect any office building they consider buying to find any problems.
“Especially if you go to older office buildings, nobody wants it—people want offices with fitness centers and restaurants,” says Chavada. “The price is so low that it makes sense to spend money on due diligence.”
West Coast opportunities
In early 2023, Alliant Strategic Development started construction on four new workforce apartment buildings in the San Fernando Valley area of Los Angeles.
“Very few people can break ground in this market,” says Eddie Lorin, co-founder of Alliant, based in Los Angeles. “We are very proud of that.”
Alliant as looked at a subset of Opportunity Zones created by the Tax Cuts and Jobs Act passed in 2017 as one place for its investments in workforce housing. In Los Angeles, Alliant is building 750 apartments at four developments within a mile of each other. Of these, 20% will have rents affordable to households earning up to 60% of AMI. The rest will rent at market rates affordable to household earning 80% to 100% of the area median income.
“We are confident that we will fill up,” says Lorin. “We are targeting rents in the low $2,000s where in L.A. luxury rents are around $3,200. So, you are $1,000 below luxury rents.”
The four properties will cost a total of $240 million to develop—that works out to roughly $340,000 per unit—relatively inexpensive by Los Angeles multifamily development standards.
The apartments will average just 600 sq. ft. of space, starting with a 500-sq.-ft. one-bedroom unit. The building also does not include a basement. “When you dig a hole, that adds $50,000 right there,” says Lorin. Alliant is also building just half-a-parking space per unit. All four properties are close to bus stations or light rail stops or both.
“We’ve done some creative structures with our bank to make the cost of finance in the low 4%-range,” says Lorin. That’s far before the current cost of typical construction financing.
The four projects received low-interest, recycled, tax-exempt bond financing from the local municipal finance agency. The tax-exempt bonds had originally been issued more than a decade ago for affordable housing developments that have since paid their loans—these recycled bonds have a 55-year term. Because the bonds had been recycled, they did not include the federal low-income housing tax credits that come with new tax-exempt bonds. The low interest rate allowed the development to take on a loan covering more the 70% of the development cost that still meets the bank’s requirements for debt service coverage.
“We were expecting to get 90% financing, and we ended up getting a lot less because of the financing market,” says Lorin.
Alliant is targeting a 15%-18% percent annual internal rate of return with a 6%-7% percent cash-on-cash return for the equity invested in the development—that includes conservative assumptions for the income from the properties. “Everyone is putting rent growth to zero because they think the world is going to end,” says Lorin.
The developers used its own equity for the development. “We would love to have deals with other equity. We had to put in our own equity, because the market had dried up,” says Lorin.
Alliant is already planning future projects. “There will be more, because we paid a lot for the land… we can do better. And hopefully with everything on hold, contractors get a little panicked and become more accommodating. We have not seen that yet but we expect to.”