By all accounts, there may be no better time than the present to be an investor in the multifamily rental market. Rents are soaring, vacancy rates are plummeting, and yields are stronger than average as more households choose renting over homeownership.

Yet, at a time when the multifamily space is flush with capital, a critically important asset class remains at risk of extinction: rental housing serving low- and moderate-income households—essentially anyone making below the area median income (AMI) of his or her city.

The reasons for this worrying trend are varied and complex. Properties subsidized by tax credit programs may be reaching the end of their affordability horizons, while other “naturally  occurring” affordable properties—unsubsidized but affordable due to their age, physical condition, or location in less affluent neighborhoods—are being converted into market-rate or luxury rentals. Also, projects funded through tax credits are not typically delivered in a timely fashion since developers must meet a number of regulatory requirements before breaking ground.

When these factors are combined with stagnant wages, the mismatch between what low- and middle-income people can afford to rent and what is available to them in the market becomes clear. While low-income renters continue to be cost-burdened, spending more than 30 percent of their income on rent, middle-income renters—those making between 80 and 100 percent of AMI—are increasingly cost-burdened as well, according to Harvard University’s Joint Center for Housing Studies.

Some housing advocates and investors are proposing a market solution to increase the supply of affordable rentals. Rather than relying on tax credits or subsidies to preserve affordability, why not do it by investing private equity—cash, in other words—in these properties and guaranteeing a return to investors? While the yields are likely to be lower than those associated with market-rate or luxury product, they will be competitive—and have the added bonus of creating social impact.

So goes the logic of several private equity vehicles profiled in Preserving Affordable and Workforce Housing, a new report released by the ULI Terwilliger Center for Housing and NeighborWorks, a nonprofit network of more than 240 community development organizations. Each vehicle takes a unique approach in creating value for investors while also preserving long-term affordability. While private equity is not exactly a newcomer to affordable housing finance, it has achieved greater momentum recently as cities experience the limitations of state and federal housing subsidy programs.

Some of these vehicles invest in properties that have subsidies and rental restrictions attached to them, while others aims for Class B or Class C properties that offer market-based or natural affordability. Regardless of its approach, each vehicle is serving a growing segment of the workforce that is finding market-rate rentals increasingly out of reach.

Creating Financial Returns with Minimal Rent Increases

Market-rate multifamily properties generate value for investors through rental increases that result from capital investments in the asset or through market forces. On properties where some, if not all, of the units are rent-restricted, value must be generated through other means.

Avanath Capital Management funded major upgrades, including a brand new basketball court, at Northpointe Apartments, a 528-unit affordable and workforce community in Long Beach, California.

Avanath Capital Management has focused on making strategic investments in properties that cut down on expenses and increase operational efficiency, says Daryl J. Carter, Avanath’s founder and CEO, former ULI trustee, and chairman of the National Multifamily Housing Council. Launched in 2008, Avanath has acquired nearly 30 properties—many of them built through the low-income housing tax credit (LIHTC) program—and preserved over 2,200 affordable units in markets across the United States. Properties in its portfolio tend to be mixed-income environments where a majority of units are intended for households making between 40 and 80 percent of AMI.

Daryl J. Carter

“We tend to buy a lot of tax credit properties, and in many cases these properties hadn’t been operated efficiently,” Carter says. Avanath reaps cost savings in the form of energy efficiency retrofits, consolidating trash facilities, and low-maintenance landscaping. “You have to be more efficient in the affordable space because the margins are so low,” he adds.

Because it is not competing for tenants paying market rates, the firm is careful not to engage in what Carter calls the “capital improvements arms race”—piling on improvements simply to extract higher rents. By staying focused on creating safe, clean, and attractive environments for its residents, Avanath avoids cosmetic upgrades that have little bearing on a tenant’s quality of life. For example, it will install in-unit washers and dryers rather than removing 1960s-era “popcorn” ceilings that look outdated. “If it doesn’t add value to our residents, then we won’t pursue it,” Carter says.

Due to the high demand for affordable housing, Avanath’s properties maintain occupancy rates close to 100 percent and experience low turnover rates—another source of value creation. The firm spends minimally on marketing its properties since each has a waiting list with hundreds of names. Partnerships with local nonprofit organizations have led to on-site after-school child care, exercise classes, and other programming at several properties—giving tenants more reasons to stay put.

“Most of our residents are gainfully employed, and are pursuing the American dream just like anyone else,” Carter says.

Avanath’s approach seems to be paying off. The two funds it has closed on—one in 2010 and another in 2013, totaling $320 million—each yielded a 6 to 10 percent cash return. “We do this to make money,” Carter says. “Because there is such a demand for affordable and workforce housing, we think our portfolio offers better risk-adjusted returns than traditional multifamily funds. We’re not sacrificing yield to our investors. Our returns are competitive.”

Defining Value to Include Social Impact

To be clear, the institutional investors that place their money with socially minded private equity vehicles are seeking more than financial returns. Take the Urban Strategy America Fund (USA Fund), set up by the New Boston Fund in 2004 to stimulate housing and economic development in urban neighborhoods.

Kirk Sykes

The fund has developed a dozen social metrics by which it evaluates prospective investments. They include housing across the income spectrum, environment sustainability, job creation for local residents, and amenities, retail, and services to underserved populations.

When the $190 million fund started, it attracted the capital from several sources: banks, which needed to invest in low- and middle-income neighborhoods as a requirement under the Community Reinvestment Act of 1977 that outlawed redlining; city and state pension funds that wanted to stimulate growth in their own markets; and insurance companies looking to unlock returns unavailable to the average investor, says Kirk A. Sykes, president and managing director of the fund and member of the ULI Boston/New England advisory board.

“This was a niche strategy that a normal investment fund would not have necessarily pursued,” Sykes says.

OneGreenway, a mixed-income development that is part of the USA Fund portfolio. (Credit: Black Dog Pictures)

As a result, the USA Fund has approached each deal a little differently and opted for new construction of mixed-income communities rather than preservation or rehabbing of older LIHTC properties.

“Everybody likes a blend of current cash flow and future appreciation,” Sykes says. “That’s why we have gotten more into ground-up development and not as much into existing apartments.”

With its development partner, Asian Community Development Corporation (ACDC), the fund recently celebrated the opening of One Greenway, a 362-unit mixed-income, mixed-use project that seeks to restore the urban fabric in Boston’s Chinatown. Previously owned by the Massachusetts Department of Transportation (MassDOT), the site had been taken for highway construction in the 1960s and sat vacant for decades. When the ACDC sought to restore it to the community in 2000, it partnered with the USA Fund to buy the land from MassDOT at a subsidized rate. Affordable housing was one of the requirements for MassDOT to dispose of the land.

“We were leveraging the desire for a specific outcome—the creation of mixed-income housing—to get the land at a lower basis point,” Sykes says. “We couldn’t have built One Greenway and achieved affordability objectives if we had paid market rate for the land.”

Along with 217 market-rate rentals, One Greenway includes 95 permanently affordable units and will soon break ground on 50 affordable, for-sale units to offer homeownership opportunities to those who need to build wealth and home equity.

REITs Offer Possibility of Scaling Up Efforts

The Housing Partnership Equity Trust purchased and refurbished Woodmere Trace, a 300-unit affordable apartment community in Norfolk, Virginia.

While the stream of private equity into affordable rental housing should give advocates and public officials hope, the fact remains that demand far outstrips supply. For example, the ACDC received nearly 4,400 applications for the 95 affordable units in One Greenway.

“The capital flow into this space is appalling—a dribble, in fact—compared to the need that is out there and the opportunities to make money,” Carter says, expressing a sentiment echoed by Sykes: “There needs to be some innovation in this space. The real question is what you could do on a larger scale.”

Socially minded real estate investment trusts (REITs) may offer an answer. The Housing Partnership Equity Trust (HPET) is a for-profit REIT that grew out of the Housing Partnership Network (HPN), a membership organization for nonprofit housing providers. The HPET is composed of 12 of the HPN’s member organizations, which have access to capital provided by the trust’s investors to acquire naturally occurring affordable properties serving households making above 60 percent of AMI.

These dozen housing providers are well established in cities across the United States, have strong relationships with municipalities and housing finance agencies, and are coming across deals all the time that don’t fit neatly into the parameters of an LIHTC project, says Drew Ades, president and CEO of the HPET. Among the providers that belong to the trust are Mercy Housing, Eden Housing, and BRIDGE Housing Corporation.

The HPET is purposefully going after properties that serve households making more than 60 percent of AMI precisely because this income group does not qualify for housing built under the tax credit program. Because the properties do not need to go through the tax credit allocation process, they can be acquired faster and more efficiently—but also require a quick deployment of capital. “We’ve created a way for [our 12 members] to execute on those deals,” Ades said.

Since launching in 2013, the HPET has acquired more than 2,500 units in its portfolio and recently paid out its first round of dividends—a total of $1.32 million to its investors, which include Citi, Morgan Stanley, and Prudential Financial Inc. The HPET also benefited from startup capital from both the MacArthur Foundation and the Ford Foundation.

The fact that the HPN has over 80 other nonprofit housing providers that could potentially become members of the trust hints at HPET’s capacity to scale its preservation efforts. “If you look at the markets with the greatest affordability crises, that’s where you are going to find the most sophisticated nonprofits that operate in this space,” Ades says. “There are some significant players that aren’t even in the REIT, but could potentially make a real impact if they were. The key is expanding our membership, which will allow us to do more deals.”

To learn more, go to Preserving Multifamily Workforce and Affordable Housing, a new report released by the ULI Terwilliger Center for Housing.