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Creative Financing to Create Affordability

By Morgan Mercer
6.21.2019

For nearly a decade, a corner lot along University Avenue in St. Paul sat empty. Over the years, developers had shown interest in the site—it was right off the freeway, near the University of Minnesota and on the border of Minneapolis and St. Paul—but nothing materialized. However by 2014, the landscape around the vacant area started to change. Construction workers ripped up chunks of concrete and sections of the street in preparation for the new METRO Transit Green Line, which would run up and down University Avenue, connecting the downtowns of Minneapolis and St. Paul. Thanks to the expansion, the empty lot found itself at the center of a flurry of activity, with a new light rail stop—the Westgate Station—on its block.

The anticipation of the Green Line reignited interest in the empty corner.

A group of community organizations, including the city of St. Paul and the Twin Cities office of the Local Initiatives Support Corporation (LISC), had their eyes on the site. The up-and-coming area was ripe for a luxury apartment building, but they were committed to exploring if the lot could support a development that included affordable housing, too.

“We saw this as an opportunity to create affordability in a neighborhood where rents were increasing and would soon be out of reach for many households,” says Tina Homstad, a program officer with Twin Cities LISC, an organization that works with community partners to transform neighborhoods through affordable housing, arts and culture, economic development and financial coaching.

“Having a place to live is foundational to everything else: where we work, where we shop, where we go to school and where our relationships and supports are.”

While city governments and nonprofit organizations often tout the merits of mixed income projects, they’re far less common in practice. That's because they’re complex. The financing can be hard to find and difficult to piece together. More often than not, investors who understand the market-rate side of a project can’t wrap their heads around the affordable side, and vice versa. All this leaves many developers convinced that mixed-income housing projects simply don’t work, or aren’t worth the effort.

Still, the need is there. Since 2000, median rents in Minneapolis and St. Paul have climbed by about 15 percent, while the incomes of those same renters have dropped. This widening gap makes it increasingly difficult for the more than 50 percent of residents in Minneapolis and St. Paul who rent to find and keep a place to live.

“We have an affordable housing crisis,” says Andriana Abariotes, the former executive director at LISC Twin Cities. “Mixed-income projects are becoming more common, but how they get built is still a challenge.”

Despite the challenges, LISC and the City of St. Paul were determined to see the idea stick at the corner of University Avenue. To make the seemingly unimaginable come to life—an apartment complex with a mix of market-rate and affordable units—LISC joined with the National Equity Fund (NEF), BMO Harris and Indiana-based developer, Flaherty & Collins Properties. Together, the team dreamt up an approach to financing that hadn’t been tried in the Twin Cities, or anywhere else in the country, before.

Building the Mezzanine

Blending the worlds of affordable and market-rate financing can often feel like trying to mix oil with water. The combination of market-rate and affordable units means developers have to approach these kinds of jobs as two distinct projects. On the affordable side, the risk is fairly low for investors. Thanks to the high demand for affordable housing, investors know the units will fill up and generate income to pay off the loans they’ve given to the project. 

The market-rate side is riskier, especially at 2700 University where market-rate units outnumbered affordable units four to one. Investors had to trust that Flaherty & Collins would be able find enough tenants willing to pay the rents it predicted for the site. If the developer couldn’t produce that kind of cash flow, the project would go south and investors would lose their money. 

“Financing markets stick to what they know. It took finding a capital source that had a different motivation than solely making a return,” says Austin Carmony, the vice president of development at Flaherty & Collins. “When I got LISC and National Equity Fund on board, that's the piece that connected all the dots. They saw the need for this development, so they attacked it on both  [the affordable and market rate] ends to make this project a reality.”

Both LISC and NEF had the same goal: get affordable housing on the corner of 2700 University next to the new light rail stop.

Yet making that mission a reality wasn’t as easy as just putting money toward the affordable side of the project. NEF, an affiliate of LISC, invested $5 million in low-income housing tax credits on the affordable side, but that still left a $6.26 million gap on the market-rate side. Without that capital, neither side of the project could move forward. However  philanthropic organizations and other public institutions were reluctant to give Flaherty & Collins more grants or subsidies to fill the gap since the market-rate side of the project could ultimately generate a significant profit for the company. 

That’s where LISC stepped in. “We like to get creative and do the hard stuff when it meets our mission,” says Amy McCulloch, deputy director at Twin Cities LISC. On paper, putting a financial investment toward the market-side of the development might not look like the right move to boost affordability in a desirable neighborhood, but it took that kind of unconventional thinking to fill in a critical piece of financing that might have otherwise derailed the entire project.

“We shouldn't be subsidizing market activity in places where you don't need it,” says Andriana. “We knew the rents would be able to pay for the facility operating long-term, but there was a space in between what it cost to get it constructed and that cash flow operations point. This project needed a bridge.”

So LISC employed a unique financing tool called a mezzanine loan, which up until that point had been a nearly nonexistent strategy in the affordable housing and community development worlds. If you get a mezzanine loan from a private equity group or individual investor, the rates are high—anywhere from 12 percent to 20 percent. That’s because of the risky way the capital in the loan is structured. If a project forecloses, mezzanine investors are some of the last in line to get repaid. With all that risk, comes higher interest rates. For community development projects that often generate lower profits, those kind of rates are prohibitive to repay. For Flaherty & Collins, the same held true at 2700 University. Higher rates from a traditional provider would have driven up the cost of construction to such a point that the economics of the development would have been infeasible.

“A mezzanine loan was one type of bridge that nobody else could quite build,” says Andriana. “We're one of few, if not the only, that could have pulled it off because of our national resources, relationships and expertise.”

Yet even for LISC, loaning the full $6.26 million from its national revolving loan fund felt like too big a gamble. To reduce the risk, LISC partnered with BMO Harris. LISC provided 60 percent of the capital at a six percent interest rate, while the bank provided the remaining 40 percent of the loan at a 13 percent interest rate. That gave Flaherty & Collins a blended rate of nine percent on the $6.26 million loan—numbers that allowed the Indiana-based developer to move forward with construction. Unlike traditional investors who often raise mezzanine funding rates to match the risk of a project, LISC considered the mission of the project along with the risk when deciding how to loan capital to Flaherty & Collins. Ultimately, LISC kept its rates lower because it knew Flaherty & Collins was an experienced developer, and because it believed in the benefit the development could bring to the neighborhood and its future residents.

Out of the money LISC contributed, 20 percent of that came from a CDFI Award it received from the Department of Treasury. “It acted as the first loss,” says Amy. Essentially, it was money LISC wasn’t required to pay back if the project fell through for some reason. That award, paired with financial support from BMO Harris and Flaherty & Collins’ solid reputation as a developer, made the mezzanine loan a reality.

“We all took this risk together,”
— says Amy McCulloch, deputy director at LISC Twin Cities, of the partners behind the deal.

“There was a gap in financing that needed to be filled for the project to get off the ground, but no one else was willing to put more money in the deal. Everybody wants the top of the stack because you’re going to be paid back first, but not everybody can be. I think the role for LISC is to be in that space that nobody else is willing to take.”

Today, the apartment complex at 2700 University stands five stories tall. It has a salt water pool, a 20,000-square-foot courtyard that doubles as an outdoor living room and easy access to public transportation that allows people to get to jobs, schools and stores across the Twin Cities. When the building opened, the affordable housing units filled up immediately, with hundreds of individuals applying for the 50 spots. While the financing of the project took work to pull together, LISC hopes its success will prove to other investors and developers that mixed income projects aren’t impossible. With the right mix of partners, enough market-rate units to offset the cost of a mezzanine loan and the creative will to see a project through to the end, it’s possible to do again.

Story produced by Pollen Studio
Photography by Ryan Stopera 
Illustrations by Violeta Rotstein
Words by Morgan Mercer