Developed for the National Council of Housing Market Analysts By: Rob Vogt (Vogt Strategic Insights), November 2019
A recent revision to Section 42 of the Internal Revenue Code (IRC) found in the Consolidated Appropriations Act of 2018 creates a third minimum set-aside (MSA) election to meet the qualified low income housing tax credit (LIHTC) project requirements referred to as the “Average Income Test.”  Prior to this revision, IRC 42(g)(1) established minimum eligibility thresholds as either:
- 20–50 test – The project meets the requirements of this subparagraph if 20 percent or more of the residential units in such project are both rent-restricted and occupied by individuals whose income is 50 percent or less of area median gross income.
- 40–60 test – The project meets the requirements of this subparagraph if 40 percent or more of the residential units in such project are both rent-restricted and occupied by individuals whose income is 60 percent or less of area median gross income.
The creation of a third election in the Act provides greater flexibility for eligibility by meeting the MSA through the Average Income Test.
- AVERAGE INCOME TEST —
- IN GENERAL.—The project meets the minimum requirements of this subparagraph if 40 percent or more (25 percent or more in the case of a project described in section 142(d)(6)) of the residential units in such project are both rent-restricted and occupied by individuals whose income does not exceed the imputed income limitation designated by the taxpayer with respect to the respective unit.
- SPECIAL RULES RELATING TO INCOME LIMITATION.— For purposes of clause (i)—
- (I) —The taxpayer shall designate the imputed income limitation of each unit taken into account under such clause.
- (II) AVERAGE TEST.—The average of the imputed income limitations designated under subclause (I) shall not exceed 60 percent of area median gross income.
- (III) 10-PERCENT INCREMENTS. —The designated imputed income limitation of any unit under subclause (I) shall be 20 percent, 30 percent, 40 percent, 50 percent, 60 percent, 70 percent, or 80 percent of area median gross income.
The revision allows LIHTC owners to serve households with incomes up to 80 percent of area median income (AMI). These higher income households can occupy LIHTC units, so long as the overall Average Income/AMI rent limit in the property remains at 60 percent or less of AMI. Owners who make the Average Income election must also commit to at least 40 percent of the units in the property having an average income level of no more than 60 percent of AMI. The rents for these units must not exceed 30 percent of the qualifying income level. The average of the designated imputed income limits cannot exceed 60 percent of AMI.
Determination of whether this election is met is made on a unit‐by-unit basis with income designations made in 10 percent increments ranging from 20 to 80 percent of AMI. This enables owners to offset lower rents for very low‐income households, by charging higher rents to households earning above 60 percent of AMI. This provides developments the ability to maintain financial feasibility, while providing a level of affordability that may not be otherwise possible and further promoting mixed-income housing. The 80 percent of AMI level is consistent with long‐standing federal affordable housing policies that define “low‐income” as households with incomes at or below 80 percent of AMI.
To be successful, Average Income properties should be sited, zoned and structured to maximize cash flow, as is true of all other affordable housing properties. Developers and underwriters must also consider whether LIHTC rents across the subject property are achievable in the market and demand is sufficient to capture an optimum amount of income eligible families who can also afford the proposed rent.
Allowing for higher income levels within LIHTC developments is a step towards facilitating mixed-income housing in communities by broadening the range from top to bottom. However, as is always the case, unique considerations are required in structuring, compliance and valuation. While numerous papers have been published with focus on eligibility, structuring and compliance, this paper serves to provide guidance related to unique valuation considerations for LIHTC properties utilizing the Average Income election.
Factors to Consider in Evaluating Average Income Rents
The Average Income election allows a property to offer higher and lower rents than traditional 20-50 or 40-60 properties. Understanding the specific characteristics of the subject property become more important because the highest rents proposed at Average Income properties often approach area market rents. In some instances, the highest Average Income rents (not to exceed 80 percent of AMI) may exceed some of the highest rents collected at properties within the subject property’s Primary Market Area (PMA). Tenants who consider both the subject property’s and other market-rate alternatives will likely income-qualify for both the existing market-rate alternatives and the subject property and will often complete a process of assessing the value of conventional market-rate rents and the rents at the subject development.
Achievable Rent Levels:
Since prospective tenants will be assessing rent value, the analyst must have a thorough understanding of the subject property. This is critical for those properties with the higher rents under the Average Income election since every amenity offered will contribute to the perception of value. While this is an important exercise for all affordable properties, it becomes more important for properties with Average Income since they compete directly with market-rate properties. In addition to a detailed unit and subject property description including unit sizes and bath configuration, the analyst must have a detailed unit distribution by proposed rent levels. This information is important to the process of evaluating achievable rent levels and unit specific capture rates.
According to NCHMA’s definition, market rent is the rent that an apartment, without rent or income restrictions or rent subsidies, would command in the open market considering its location, features and amenities. Market rent should be adjusted for concessions and owner paid utilities included in the rent.
The selection process of the comparables should become more rigorous since the selected comparables are also likely to be a competitive property as well. A comparable property is representative of the rental housing choices in the subject property’s PMA and is similar in construction, size, amenities or age to the subject. These may be either market-rate or rent-restricted properties.
A competitive property is comparable to the subject property and competes at similar rent levels, and tenant profile, such as age, family or income. It is at the competitive properties that higher income households will consider who also will qualify for the higher 70 and 80 percent rents.
Once the achievable market rent has been established for the subject, the proposed rents for the subject property are compared to the comparable/competitive market-rate property rent. It has been the general practice that 60 percent rents should be set at least 10 percent below the calculated achievable market rent. For those properties making the Average Income election, the 70 and 80 percent rents can be closer to market rents since the income of the tenant will be higher and they could qualify for either an affordable property or a comparable/competitive market-rate property.
There may be markets where 70 and 80 percent rents can approach or equal the achievable market rents if:
- A market area is one in which demand exceeds supply (as evidenced by the performance of the existing properties);
- The capture rate for those specific Average Income units is low (see the following discussion);
- Household growth is positive; or
- The subject property’s quality and features exceed the market-rate standard for the PMA.
The best practice for the analysis of affordable properties generally is establishing the achievable LIHTC rent of the subject property, which compares the characteristics of the subject property to those of the comparable LIHTC properties. This comparison should be done for those units at the same AMI level as the subject property to render a direct comparison. In markets where there are no or few properties employing a rent structure with 70 and 80 percent of AMI rents, a complete achievable LIHTC rent analysis across all AMI levels may not be feasible. However, the analyst should conclude an achievable LIHTC rent based on other data contained within the report.
Average Income Capture Rate:
The subject property’s capture rate is one of the most critical calculations when establishing the potential market success of a LIHTC property.  The lower the capture rate, the higher the probability that the rents are achievable assuming they are a reasonable rent value. With the addition of the Average Income election there may be more units offered at lower, different AMI levels. Properties will serve a wider base of support than the traditional 20-50 or 40-60 properties thereby likely reducing their overall capture rate due to the inclusion of more income qualified renter households.
A separate capture rate calculation is required for each income band targeted including those rents set at the 70 and 80 percent levels, which will provide insight into the subject property’s ability to achieve these higher rents.
Because Average Income properties often offer few units at the highest rent levels, the capture rates for these units tend to be among the lowest. With fewer units and lower capture rates, the proposed rents can be closer to the achievable market rents.
Affordable properties in rural markets often have higher capture rates than similar properties in urban areas. They can achieve the higher capture rates since they often represent the only affordable alternative. Similarly, the 70 and 80 percent rent capture rates can be relatively higher since those units may represent the only housing choice in that market.
There are several other factors the analyst should consider when evaluating the 70 and 80 percent rents of a property making the Average Income election. Overall market performance provides critical insight into the ability to achieve the higher income levels. For example, a market that is performing at a high level (aggregate occupancies in excess of 96 percent) indicates that demand exceeds supply and the 70 and 80 percent rents that approach comparable market rents are more likely to be achievable in that market.
Markets that exhibit high renter household growth, particularly at the income levels targeted by the subject property, are more likely to support the higher rents in an affordable property making the Average Income election. While this trend is also true for any affordable property, it is an issue that should be evaluated for those 70 and 80 percent rents that approach comparable market rents.
The actual number of units at the proposed 70 and 80 percent rent levels within the proposed affordable property should also be considered. If there are a low number of units with 70 and 80 percent rent levels proposed, it is likely those rents can be closer to comparable market rents since there are fewer units that need to be rented.
In some cases, the analyst may need to identify regional properties outside of the PMA to provide a realistic assessment of market rent levels. This may be particularly true when a senior restricted property is being assessed due to the limited supply of such properties.
Rural markets should be given special consideration. In many rural markets, it is likely the proposed 70 and 80 percent rents at the Average Income property will represent the highest quality and the highest rents in that market. Rural markets generally do not offer newer conventional rental development due to high construction costs that, if built, would yield rents well above what is currently achieved in that market. Due to scale, these conventionally financed properties need to build more units at the higher rents than what would be offered at the property electing Average Income. The capture rate is critical to understanding the area’s ability to support the units with higher rents in properties electing Average Income.
Similar to the red flag discussion in the NCHMA white paper, “Demand and Capture Rate Methodologies,” inappropriate market areas, sole reliance on capture rates, the use of threshold criteria, property level capture and/or penetration rates and a lack of discussion of pipeline properties are all factors that will impact the concluded support of the higher 70 and 80 percent rent levels.
Caution should be recognized for those capture rates based exclusively on the overall range of rents in Average Income properties. For those properties that offer a few units at low rent levels (countered by the few units at higher rent levels), the range of affordability is exaggerated. For example, in an 80-unit property that elects Average Income, the developer may propose two units at 40 percent of AMI. This is balanced by two units at 80 percent of AMI. In this example, the remaining 76 units are offered at 50 and 60 percent of AMI. The income range dictated by the rents set at 40 and 80 percent of AMI will show a broad range of households that can afford the property. However, since income band is based on those four units (at 40 and 80 percent of AMI), it will lead to a misleadingly low capture rate. For this reason, the analyst must calculate a capture rate for each of the proposed AMI levels. In instances where a high proportion of three- or four-bedroom units are proposed at 70 or 80 percent of AMI, the analyst should consider calculating capture rates by bedroom type to ensure that there is an adequate number of income-qualified renters.
The achievable market rent calculation is an effective tool to measure perceived value of the higher rents. The analyst should present a replicable methodology for this calculation. Lack of legitimate comparables, large adjustments and comparables from well outside the PMA are all potential red flags.
Because the 70 and 80 percent rent levels proposed at the affordable property under consideration often approach the rent levels at the highest quality properties in a market area, the pipeline property that may compete with the subject property in the future becomes more important since the new market-rate property may offer similar rent levels. The timing, location and quality should all be considered for their potential impact on the subject property.