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Subsidized real estate finance operates similarly to non-subsidized real estate finance. The difference is that the federal government, by way of local governments and agencies, reengineers key elements such as leverage, cost of capital and taxes to create a public good. In the right situation, government incentives offset lost revenues as illustrated in the diagram below:
Thorobird invests in a variety of subsidized real estate project types including housing, office and retail. For simplicity, we illustrate the mechanics of subsidized real estate through a housing example, which compares a market-rate project to a subsidized project.
Market-Rate Housing Example
A 7,500 square foot residential is available for $1 million where 30 thousand square feet are buildable ($33.3 per buildable square foot). You plan to build a 30-unit multifamily building. You’ve estimated $6 million hard costs and $3 million soft costs for a total development cost of $10 million. After expenses, you think that you will net $36 per square foot for an annual net operating income of $1.08 million. You can finance 80% of the development cost at 8% over 30 years for a mortgage payment of $710 thousand. The table below shows the market-rate return analysis:
| Net Operating Income |
$1,080,000 |
| Mortgage Payment |
$710,000 |
| Cash flow after financing |
$370,000 |
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| Return on Assets (ROA): $1,080,000/$10,000,000 |
10.8% |
| Financing Cost (FC): $710,000/$8,000,000 |
8.9% |
| Return on Equity (ROE): $370,000/$2,000,000 |
18.5% |
As shown above, a 10.8% return on assts (ROA) with 8.9% financing costs is positive leverage and results in an 18.5% return on equity (ROE). Let’s look at this as subsidized housing project.
Subsidized Housing Example
Given the acquisition and development costs above, you decide to pursue an affordable housing strategy. You discover that your best subsidy program limits your net operating income to $24 per square foot for a total of $705 thousand (a $375 thousand deduction). However, the program offers low-interest-rate gap financing that effectively reduces your cost of debt from 8% to 4%. Also, this program allows for higher leverage levels at 90% loan to cost (LTC), significantly higher than the 80% LTC above. The table below shows the subsidized return analysis:
| Net Operating Income |
$705,000 |
| Mortgage Payment |
$520,000 |
| Cash flow after financing |
$185,000 |
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| Return on Assets (ROA): $705,000/$10,000,000 |
7.1% |
| Financing Cost (FC): $520,000/$9,000,000 |
5.8% |
| Return on Equity (ROE): $185,000/$1,000,000 |
18.5% |
As seen in the hypothetical example above, public subsidy makes it possible to achieve competitive equity returns even with the exsistence of capped rents for the benefit of low-income tenants and investors. An added benefit is diversification. The equity investor that placed $2 million with the market-rate project could have invested in two of the subsidized projects, reducing concentration risk and increasing risk-adjusted returns.
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