Impact investing as a category is attracting institutional investors with diverse goals to seriously consider adding impact to their portfolios. In the ESG landscape, there is an opportunity today to expand beyond the plentiful array of “environmental” funds to explore “social” impact—specifically, affordable housing as an investable asset class.
The question is, how can affordable housing lenders attract institutions to multifamily, affordable rental housing in a way that reflects fundamental requirements of institutional investors (from risk profile to financial performance)? Below are several criteria to consider.
CONSISTENCY AND TRANSPARENCY
Investors want to know what they are buying. To dedicate resources to an investment opportunity, institutions need scale and that means, more than big dollar amounts, replicability. It means that they look for assets with similar economic returns and risks. This allows the assets to be considered “similar” and allows investors to apply a consistent investment analysis to them.
Additionally, potential investments should have defined parameters that drive risk and return. This reduces uncertainty and provides a framework for evaluating the investment opportunity. For example, low-income housing tax credit (LIHTC) properties perform in similar ways to each other because, despite the geographic and property type diversity, the tax credit program provisions are a key driver of performance. This helped facilitate institutional investment as investors could apply consistent framework across investments and get comparable results.
Investors also want clearly defined legal and regulatory frameworks that provide transparency and clarity by articulately what rights exactly an asset owner is entitled to and what legal consequences/recourse there might be. A strong legal and regulatory framework takes time to develop as precedent is set in the courts and administrative rulings.
Just as institutions want similarity within an asset class, they want a new asset class they are considering to be distinct from other assets classes they are already invested in. Institutions look for low correlation with other asset classes for two reasons: 1) It improves the diversification of the overall portfolio, reducing the variance of returns and 2) it defines a unique stream of attractive risk-adjusted returns not available elsewhere.
Due to the strong provisions of the LIHTC program—namely recapture—the investment performance of debt financing for these properties doesn’t perform like traditional commercial mortgage debt. Debt on LIHTC properties has much lower variance and lower credit risk exposure. Permanent mortgage loans on affordable housing provide a unique stream of uncorrelated returns to investors needing to match long-term liabilities such as pension payments or life insurance contracts.
Institutional investors want to be reasonably assured that they can sell an investment in a reasonable time frame or receive additional return for not being able to transact quickly. Just as market-rate, commercial real estate saw an increase in institutional investment over the past 20-30 years, so has affordable housing investment. The growth of commercial mortgage-backed securities in the 1990s and 2000s led to the institutionalization of this market.
Additionally, the increased role of Fannie Mae and Freddie Mac brought significant liquidity to market-rate, commercial mortgage markets and affordable multifamily mortgages. These innovations brought additional liquidity to affordable housing debt investments which attracted institutional investors.
Rarely will an institutional investor allocate capital to a completely new asset class or first fund. Prudence is an important element of their investment process. To attract institutional capital a verifiable track record that supports the investment thesis is required. What does “past performance” mean in impact investing? Investors want to see results that serve both their worthy goals and those fitting an institution’s fiduciary responsibility. It took over a decade of LIHTC debt deals in the market before institutional investors grew comfortable and willing to invest.
Michael Lohmeier is chief investment officer for Impact Community Capital. Founded in 1998 solely to create purpose-driven investments, IMPACT has originated nearly $2 billion in income investments, including over $1 billion in first-mortgage financing for affordable housing development.