At least 5.5 million units of naturally occurring affordable rental housing exist in cities across the United States, according to newly released data from CoStar, a leading provider of data and analytics for the commercial real estate industry.

Naturally occurring affordable housing (NOAH) is housing that is affordable without being supported by public subsidies such as low-income housing tax credits. NOAH’s market-rate affordability derives mainly from its age—most units were built 40 to 50 years ago—and lack of amenities: it is no-frills, functional housing that is nonetheless safe, secure, and inhabitable.

CoStar identified 5.5 million units of naturally occurring affordable housing—or 36 percent—within the multifamily rental market.

CoStar identified 5.5 million units of naturally occurring affordable housing—or 36 percent—within the multifamily rental market.

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Shaw Lupton, managing consultant with CoStar, presenting at a Washington, D.C., symposium jointly sponsored by the ULI Terwilliger Center for Housing and the National Association of Affordable Housing Lenders.

“The CoStar data provides probably the most detailed look yet at an underappreciated but critically important real estate asset class—the existing supply of naturally occurring affordable market-rate apartments,” said Stockton Williams, executive director of the ULI Terwilliger Center for Housing, which commissioned the CoStar report.

In addition to the number of NOAH units that exist in the marketplace, what is most striking is their ubiquity: they make up 36 percent of all the rental units CoStar tracks and exist in nearly every metropolitan area. Using its proprietary five-star rating system for buildings, CoStar determined that one- and two-star properties—defined as utilitarian apartment buildings with minimal architectural finishes, amenities, and certifications—account for nearly 76 percent of all multifamily properties in its database of nearly 335,000 properties. CoStar’s one- and two-star properties are considered equivalent to Class B and C buildings.

The CoStar database constitutes one of few attempts to quantify what housing leaders view as a critical supply of housing for middle-class workers in a wide range of professions that enable local economies to function. The firm presented its data earlier this month at a Washington, D.C., symposium jointly sponsored by the ULI Terwilliger Center for Housing and the National Association of Affordable Housing Lenders (NAAHL).

In addition, CoStar determined that one- and two-star properties constitute 75.4 percent of multifamily properties it tracks.

In addition, CoStar determined that one- and two-star properties constitute 75.4 percent of multifamily properties it tracks.

“Anyone who spends time around the real estate market probably intuitively understands that there are a lot of these one- and two-star buildings out there,” said presenter Shaw Lupton, managing consultant with CoStar and cochair of the ULI Boston Real Estate Technology Council. “When you look at this at the building level, about three-quarters are one- and two-star properties, so we see a vast opportunity in this segment of the market.”

Attended by more than 60 housing development and finance leaders—fund managers, lenders, developers, advocates, and public officials among them—the symposium took up the question of what new capital structures and strategies must be mobilized to maintain the nation’s inventory of NOAH units, which many consider a vital national asset as well as a significant business opportunity for equity investors.

In an age of dwindling public subsidies for affordable housing, NOAH is gaining currency as affordability pressures escalate across the United States and commuting times and costs rise for a growing percentage of Americans who cannot afford to live near where they work.

Nationwide, NOAH stock is under tremendous market pressure as the demand for market-rate multifamily housing continues and investors in search of value-add opportunities convert NOAH to market-rate or luxury product. The influx of foreign capital, while targeting mostly four- and five-star properties, is also adding pressure to NOAH’s affordability. While modest, NOAH still has ongoing maintenance and capital needs to ensure that properties do not fall into disrepair. These improvements must be funded by rent growth that is less aggressive than that for other segments of the market.

“The investable segment of the one- and two-star housing stock is significant in size, exists in many markets, and constitutes a generational double-bottom-line opportunity,” said Williams, one of the symposium’s discussion leaders. “There are substantial opportunities to deliver competitive economic returns—while still preserving the current affordability—in much of this inventory.”

At left, Ethan Vaisman, real estate economist with CoStar, speaking at a Washington, D.C., symposium jointly sponsored by the ULI Terwilliger Center for Housing and the National Association of Affordable Housing Lenders.

At left, Ethan Vaisman, real estate economist with CoStar, speaking at a Washington, D.C., symposium jointly sponsored by the ULI Terwilliger Center for Housing and the National Association of Affordable Housing Lenders.

A Stable, Yet Endangered Asset Class

One barrier to broader institutional investment in NOAH properties has been the lack of data on and insight into a misunderstood asset class. Through granular data, CoStar researchers Lupton and Ethan Vaisman portrayed one- and two-star properties as both affordable across a wide range of metro areas and constituting a singular market opportunity mainly due to supply constraints and very low vacancy rates.

“Thirty years ago, when the low-income housing tax credit was created, nobody thought of subsidized housing as a real estate asset class, but now they do,” said Buzz Roberts, president and chief executive officer of NAAHL. “Robust institutional investment in unsubsidized one- and two-star properties is necessary for this type of housing to remain affordable.”

One metric of affordability is whether a household’s rent is 30 percent or less of its monthly income. In major metros across the United States, middle- and lower-income households are increasingly cost burdened, meaning they exceed that threshold. On average, the rents on one- and two-star properties constituted just 16.5 percent of average median incomes in metro areas nationwide as of August 2016, according to CoStar. Rents in four- and five-star properties, on the other hand, constituted 26.4 percent of average median incomes.

Affordability of one- and two-star properties is relative, of course, and highly location dependent. In high-cost markets such as San Francisco, New York City, and Los Angeles, rents for one- and two-star properties take up more than 20 percent of median income, whereas across the Sun Belt and Midwest, rents take up a smaller percentage of incomes—less than 15 percent in some markets.

“One- and two-star rents differ vastly by metro,” said Vaisman. “In San Francisco, they can be as high as $2,500 per month”; in dozens of other markets away from the coast, they can be less than $1,000 per month.

For private and institutional investors, investable NOAH stock in one- and two-star properties represents a stable, income-producing asset with decent rental growth, according to Lupton and Vaisman.

Vacancy rates in these properties have hovered between 3 and 4 percent over the past year due to constrained supply. “Nobody builds one-, two-, and three-star properties,” Lupton said. “So today, the vacancy rate is about half of what it is in four- and five-star properties.”

Rent growth, while not as aggressive as for market-rate properties, is not insignificant, particularly when coupled with consistent occupancy rates. CoStar reports an average of 5 percent rent growth in one- and two-star properties since 2013 and a 6.4 percent growth among four- and five-star properties. Yet, looking at results year after year, one- and two-star properties outperform their four- and five-star counterparts on average rent growth—4.3 percent versus 3 percent.

“Overall, the combination of very low vacancies, solid rent growth, and not a lot of volatility . . . leads to very strong fundamentals,” Vaisman said. David Smith, chief executive officer of the Affordable Housing Institute, likened investing in one- and two-star properties to “scuba diving in bad weather: on the boat it can be rocky, but if you go 15 feet below the surface, it is a lot smoother. This stock is insulated from a whole lot of market volatility. It is a durable asset that is essential.”

Preserving NOAH: Challenges and Solutions

The discussion following CoStar’s presentation made one thing clear: while possessing reliable data on NOAH as an asset class is a positive first step, determining how the stock’s affordability and quality can be maintained to serve middle-income, working households remains a significant challenge for policy makers and advocates.

A key insight shared by CoStar was the sheer number of local and regional owners of NOAH properties. It is not an asset class that has experienced a major influx of institutional capital—yet. Thus far, these properties have been owned and managed by smaller, private players that may or may not have received incentives to keep rents affordable.

One strategy for preserving affordability is for these properties to be acquired by nonprofit, mission-oriented developers and asset managers, such as Mercy Housing, a Colorado-based affordable housing organization that manages 17,400 units in 290 properties across the country. Cindy Holler, Mercy’s senior vice president of real estate development, said the smaller owners of NOAH units “are the people we are competing with” and wondered what incentives would motivate them to sell their properties, particularly when they are seeing healthy net operating income from them.

NOAH “exists and it needs to be preserved as national infrastructure,” Smith said. “Absent action, the market will systematically take it away, and we’re not replacing it. My pitch is if you think that quality affordable housing is invaluable, then somebody needs to figure out how to purchase, reposition, and preserve it.”

The good news is that several firms in the marketplace are doing just that: preserving the nation’s NOAH stock through innovative capital strategies with a specific focus on workforce housing for middle-income families that are poorly served by the housing market. Three approaches were shared by symposium participants who are on the front lines of preserving NOAH stock:

  • Enterprise Community Investment recently closed on a $35 million conventional equity fund that has preserved 13 properties across the United States that serve a range of incomes. Enterprise acts as a limited partner, jointly investing in properties expected to generate returns of 9 percent at the end of the fund’s life—typically eight to ten years, according to Chris Herrmann, vice president, syndication. While banks are a major source of capital, Enterprise is seeking out more high-net-worth individuals and social impact investors to diversify the fund. “Growing that tent of investors is the most pressing issue,” Herrmann said.
  • Jonathan Rose Companies, a New York City–based development and investment firm, launched its $51.6 million Rose Affordable Housing Preservation Fund to preserve affordable and mixed-income properties with expiring subsidies and income restrictions. The company takes an aggressive approach to energy efficiency and green retrofits. The fund concentrates on developing successful pilot projects in high-opportunity, transit-oriented neighborhoods to educate investors and correct misperceptions about workforce housing, said Nathan Taft, director of acquisitions.
  • The Irvine, California–based firm Avanath Capital Management invests in mixed-income apartments across the United States with the goal of maintaining affordability for those earning 40 to 60 percent of the area median income while also generating competitive returns. The firm’s strategy is to purchase assets in high-job-growth areas where incomes are rising and to cross market tax-credit properties that are adjacent to NOAH properties the firm owns, said John Williams, president and chief investment officer.