The folly of ‘perpetuity’
By David A. Smith
4 min read
As Heraclitus said, all things change – including properties. Not only is perpetuity in affordable housing unattainable, questing for it can be harmful.
American home is owned 11 years. Your car? Americans average six years a ride. Your laptop? Three years and it’s obsolete. Your cell phone? Two years and it’s an object of derision.
As consumers, we value optionality in assets we own because our needs and resources change, yet when it comes to affordable housing, our programs kill optionality. For low-income housing tax credit properties, 30 years is our minimum continuity expectation, with some states requiring up to 55. For HUD properties, preservation tacked on 50 years’ restriction (70 total from completion). Public housing regulation is contractually perpetual.
In both politics and policy, perpetuity is actually a euphemism for one-way optionality – I the government have choices, you the private owner don’t. Policymakers justify this in two ways.
- Policy. Some legislators and many advocates believe the private sector to be bent on gentrification anytime, anywhere, ready to toss poor people into the street the instant they get the chance.
- Politics. Affordable housing program development is painful, so there’s a natural human desire to sign it and claim we’ve solved this problem for the next many decades.
Neither justification stands up to reflection. Both overlook the slow changes that occur over years and decades, all of which require optionality. These changes include:
- Configuration. Properties are exoskeletal; their structure is in their shell. Floor plans that made sense a few decades ago are obsolete today. Corridors are narrow; bedrooms and bathrooms are small; no one uses a dining room anymore; everyone wants a media room or home office. Restructuring the floor plan often means redesignating an apartment’s bedroom mix, which requires changing its regulatory agreements/rent levels.
- Physical systems. A building’s structural shell may last 50-60 years. Its major systems (plumbing, electrical, HVAC) might go 25 before overhaul. Appliances and cabinetry should be swapped out every 10 years. Carpeting’s lucky to make three years. In addition, we are in an era of rapid technological revolutions in living environments (media, information technology, and live-work spaces). These add up to major capital expenditures beyond annual replacement reserves capacity, because for all the great analysis that On-Site Insight and many other firms provide in capital needs studies, no one can anticipate technological upgrades.
- Operations. Rents and expenses never rise in lockstep. LIHTC rent caps rise on median income, expenses on CPI, and in stagflation or recession, they whipsaw.
- Financing. Lenders penalize those borrowing long term with a positive yield curve (long-term rates higher than short-term ones). As a result, developers seeking to make their economics work will accept balloon maturities 10 or 15 years hence. Debt that balloons while the property is still encumbered can become a neck tourniquet.
- Ownership. Owners are either individuals or entities; both can change, and not always for the better. People age; they lose their motivation; and they forget that yesterday’s market leader is tomorrow’s laggard. Companies of friends become intra-partner squabbles and lawsuits. So owners or controlling general partners sometimes need to be replaced. Meanwhile, post-Y15 investors have no tax mojo, and while some of them may fall on the Teflon sword and donate their interests, others will remain as economic zombies, occupying P&L space to no benefit.
- Affordability. Now and then, the policy environment changes and new preservation or rehabilitation incentives become available. A property with an extended use agreement may be programmatically ineligible even if deserving in every other respect.
Moreover, because our financing and regulatory structures are tightly underwritten (thin tolerances) and interconnected, any big capital expenditure requires opening up everything – physical, operational, financial, ownership, affordability. Thus I’ve long believed that properties should be comprehensively revitalized every 10 to 15 years. The longer a portfolio goes beyond this natural revitalization half-life, the more obsolete, market-disconnected, and cost-inefficient it becomes.
For proof, look no further than public housing (perpetuity) and just beyond it the Section 202 inventory (forty years plus). Well-built properties, dedicated people, but far behind the times and desperately needing upgrade and revitalization.
Want to kill a property slowly? Lock it up in perpetuity.
Want to keep the property, financing, and owner on its game? Give it a reset option every 15 years.
Want to refresh a property without losing affordability? Choose owners that are Mission Entrepreneurial Entities.
David A. Smith is Chairman of Recap Real Estate Advisors, a Boston-based real estate services firm that optimizes the value of clients’ financial assets in multifamily residential properties, particularly affordable housing. He also writes Recap’s free monthly essay State of the Market, available by emailing [email protected].
