Commentary: Affordable housing debt is an ‘acyclical’ fixed-income exposure

In a market starved for yield, many traditional fixed-income strategies either aren't producing the desired income in a low-rate environment or seem to be fraught with risk as corporate debt levels balloon.

Institutional investors are challenged to meet rising liabilities as overall return expectations trend lower. As the economy attempts a cold start after the COVID-19 outbreak, fixed-income investors find themselves confronting a "lower for longer" interest rate environment. Affordable housing debt is an area many neglect to consider in their hunt for current long-duration income and asset preservation. Those with an ESG lens also won't object to the social impact of a strategy addressing such a pressing societal need, one that only became more acute amid a pandemic that has disproportionately affected lower-income communities.

At first blush, the affordable housing asset class may not seem like an obvious choice for fixed-income investors. The investment thesis, characterized by stability and attractive yields, isn't as intuitive as more traditional categories, such as bond funds or municipal bonds. Representing just a sliver of the mortgage-backed securities market, the largest fixed-income managers have little or no exposure to the sector.

Those who take the time to understand the opportunity will discover that affordable housing debt represents a unique and uncorrelated fixed-income exposure. It provides immediate current income and stable cash flows, with returns generally comparable to investment-grade bonds, albeit without similar levels of credit risk. Some may view affordable housing debt as a countercyclical strategy, but these assets are better described as being "acyclical" due to the demand that exists in both good times, when real estate prices climb, and bad, when economic distress becomes widespread.

The biggest hurdle for prospective investors remains prevailing misconceptions. Most assume these investments belong in either real asset, infrastructure or dedicated impact allocations, all of which are not necessarily unwarranted. But this creates a paradox. It's typically the real estate specialists who best understand the risk/reward characteristics of real estate credit — marked by cyclical income and yields for class A or B properties — but the long-duration attributes of affordable housing debt are better appreciated by fixed-income professionals.

Affordable housing debt, for the uninitiated, is characterized by diversified pools of commercial mortgage loans for properties providing homes to tenants earning less than 60% of the area median income. These are properties with significant government support via subordinate financing with favorable terms and low-income housing tax credits, or LIHTC. These are properties with institutional-quality developers and professional property management firms. The loans are originated by national banks and finance companies under strict underwriting standards used by Fannie Mae and Freddie Mac. The loans can be securitized with investment-grade credit ratings, allowing institutional asset owners to invest at scale.

Other misconceptions also stand in the way. Some are surprised to learn affordable housing debt is not public housing or investments in tenement buildings. It's also not single-family MBS in designated low-income areas. And, notably, affordable housing loans are not the same as subprime investments associated with 2008's financial crisis.

In fact, the muted risk of affordable housing debt is reflected by a foreclosure rate that hasn't exceeded 1% over the past 15 years. In fact, the most recent cumulative foreclosure rate for LIHTC-eligible loans, according to CohnReznick's latest report on housing tax credit investments was 0.65%, while the median debt-coverage ratio stood at 1.4 and physical occupancy rates at 97.8%. Collectively, these metrics should underscore the stability of the segment and discipline of participants within it. By comparison, the global corporate default rate eclipsed 4% during the 2009 recession, according to S&P Global Ratings.

The compelling market opportunity stems, in part, from an exaggerated imbalance between supply and demand. According to data from the National Low Income Housing Coalition, the gap between the supply of affordable rental homes and the demand (characterized by households earning 30% or less of area median income) is currently 7 million. At the present pace, in which an average of 107,000 affordable housing units are rolled out annually across the country according to U.S. Department of Housing and Urban Development data, it would take nearly seven decades to satisfy just the existing shortage.

One might assume the gap would moderate as the cycle turns, similar to other segments within real estate. But strong demand for affordable housing produces shortages regardless of the environment. During bull markets, higher real estate prices drive demand, particularly in larger metropolitan areas. Renters in Los Angeles, New York and Miami, for instance, account for more than one-third of severely cost-burdened middle-income and higher-income renters, according to the NLIHC. During downturns, as unemployment escalates, demand is driven by residents facing financial distress, moving from market-rate class A and Class B properties into more affordable housing options.

From an investor's perspective, this "acyclicality" translates into consistent net operating income across cycles. It also explains why affordable housing debt delivers consistent market-rate returns.

Affordable housing has key barriers to entry that helps to keep the investment universe less competitive: a steep learning curve for inexperienced fund managers and the limited size of the overall market. While the market has grown over time, affordable housing debt remains a niche with less than $2 billion in annual originations based on IMPACT Community Capital's internal analysis of the broader market. Fund managers also must understand a panoply of government programs to source small individual deals — often through esoteric transactions — and repeat this at scale in order to provide institutional-quality investment portfolios. It requires significant market knowledge and experience to source, underwrite, pool and securitize affordable housing loans.

The inefficiencies in the affordable housing debt market produce consistent and attractive spreads over time (see chart), as shown by IMPACT's affordable housing properties, going back to 2008. Risk is further mitigated by strong call protections that limit prepayment pacing.

Affordable housing debt provides low-volatility, low-correlation, long-duration exposure with predictable and consistent performance across economic environments. This appeals to investors with predictable liabilities, such as insurance companies or pension funds.

The payoff, beyond an investment thesis that helps address an insatiable demand for affordable housing, is an acyclical alternative within fixed income, whose current yield and stable cash flows stand on their own merits. In a sense, affordable housing debt can be a safe haven, whether looking through an investment or impact lens.

Michael Lohmeier is chief investment officer of IMPACT Community Capital, responsible for developing and executing investment strategy and structuring new funds, based in San Francisco. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.