plus/minus epsilon

I’ve been curious for a long time about how nonprofit organizations play a role in the housing market so today I decided to read the published financials of Mercy Housing, one of the largest nonprofit developers in the US.

Mercy’s charitable purpose is to provide housing to families, seniors, and those with special needs who lack the economic resources to access safe housing opportunities themselves. They separate their activities into four arms:

1. Capital Partnership. Mercy can provide grant fundraising assistance as well as help raise money from investors for the development of low-income housing projects.
2. Housing Development. Mercy both engages in new construction housing development, as well as purchasing and renovating existing properties. When developing for external parties Mercy is compensated by fee, computed as a percent of project cost.
3. Property Management. Mercy provides management services to their own buildings, as well as on a contractual basis to owners of residential rental real estate. These services include leasing, accounting, and compliance with regulation. When managing properties for external parties Mercy is compensated by fee, computed as a percent of rental income.
4. Resident Services. Depending on the type of housing project, Mercy provides resident services such as senior care, career services, mental health care, so on.

They originally caught my interest because they seemed to have either built or been managing a surprisingly large number of buildings that I just happened to notice, usually because they’re particularly nice. Here’s the list of properties they manage in San Francisco alone (with ones that I already knew about in bold),

Name	Address	Type	Units	Status
Mission Creek Senior	225 Berry	Senior	140	Referral Only
Tahanan	833 Bryant	Supportive	146	Referral Only
	290 Malosi	Family	167	Waitlist Closed
Sister Lillian Murphy Community	691 China Basin	Family	152	Waitlist Closed
	455 Fell	Family	72	Waitlist Closed
Madonna Residences	350 Golden Gate	Supportive	70	Referral Only
Edith Witt	66 Ninth	Senior	107	Waitlist Closed
Bill Sorro Community	1009 Howard	Family	67	Waitlist Closed
	1100 Ocean	Family	71	Waitlist Closed
	1180 Fourth	Family	150	Waitlist Closed
10th & Mission	1390 Mission	Family	136	Waitlist Closed
Vera Haile Senior	129 Golden Gate	Senior	90	Waitlist Closed
Presentation Senior	301 Ellis	Senior	93	Waitlist Closed
Polk Street Senior	1315 Polk	Senior	72	Waitlist Closed
Open House	55 Laguna	Senior	40	Waitlist Closed
Notre Dame Senior	347 Dolores	Senior	66	Waitlist Closed
Monsignor Lyne	118 Diamond	Senior	20	Waitlist Closed
Mercy Terrace	333 Baker	Senior	158	Waitlist Closed
John King Senior	500 Raymond	Senior	91	Waitlist Closed
Francis of Assisi	145 Guerrero	Senior	110	Waitlist Closed
Dorothy Day	54 McAllister	Senior	100	Waitlist Closed
All Hallows	1711 Oakdale	Senior	45	Waitlist Closed
	345 Arguello	Senior	69	Waitlist Closed
	1880 Pine	Senior	113	Waitlist Closed
	2698 California	Senior	40	Waitlist Closed
Westbrook Plaza	227 Seventh	Family	49	Waitlist Closed
Natalie Grubb Commons	255 Freemont	Family	119	Waitlist Closed
Padre Apts	251 Jones	Family	41	Waitlist Closed
Padre Palou	3400 Sixteenth	Family	18	Waitlist Closed
Midtown Park Apts	1415 Scott	Family	140	Waitlist Closed
JFK Tower	2451 Sacramento	Family	91	Waitlist Closed
Heritage Homes	243 Rey	Family	148	Waitlist Closed
Columbia Park	21 Columbia	Family	50	Waitlist Closed
Carter Terrace	530 Carter	Family	101	Waitlist Closed
Britton Court Apts	1250 Sunnydale	Family	92	Waitlist Closed
	111 Jones	Family	108	Waitlist Closed
	1101 Howard	Family	34	Waitlist Closed
	1028 Howard	Family	30	Waitlist Closed
Fourth & Channel	1180 Fourth	Supportive	7	Waitlist Closed
Mercy Commercial	1360-1372 Mission	Supportive	25	Waitlist Closed
The Dudley	172 Sixth	Supportive	75	Referral Only
The Rose	125 Sixth	Supportive	76	Referral Only
Junipero Serra House	926 Fillmore	Supportive	25	Waitlist Closed
Marlton Manor	240 Jones	Supportive	151	Waitlist Closed
Derek Silva Community	20 Franklin	Supportive	68	Referral Only
Bayview Hill Gardens	1075 Le Conte	Supportive	73	Referral Only
Arlington Hotel	480 Ellis	Supportive	154	Referral Only
Arc Mercy Community	1500 Page	Supportive	17	Waitlist Closed
	205 Jones	Supportive	50	Waitlist Closed
Mercy Family Plaza	333 Baker	Family	36	Waitlist Closed

That’s a lot, huh? The total is about 4,100 rental units which means they manage 1% of the entire housing stock in San Francisco. They divide their properties into family, senior, and supportive. Family housing is for working families so it doesn’t provide additional services, senior housing provides assisted living services, and supportive housing provides services targeted toward a specific need like mental illness, physical disability, addiction recovery, or HIV/AIDS care. All three types are considered affordable housing, which means tenants pay 30% of their income in rent+utilities and the rest is subsidized.

The proportion of different housing types, at least in San Francisco, are roughly equal. Mercy states that nationally, 70% of their residents are low-income families, 21% are seniors, and 9% are special needs.

Looking at their balance sheet, they own roughly $3 billion in property with $2 billion in long-term debt, leaving Net Assets of $1 billion. Note that nonprofits have “Net Assets” instead of “Shareholder Equity” because nonprofits don’t have shareholders. Digging down further:

Their assets overwhelmingly consist of buildings and land. A small amount of their debt consists of revolving credit lines from various banks, and a larger chunk of construction loans due in the next 2 years. However, the vast majority is plain mortgage debt maturing over the next 60 years. Mercy also states that they have a small number of swap contracts for the purpose of converting any of their adjustable-rate debt to a fixed-rate.

Mercy’s income statement is fairly typical of a real estate company, with the majority of income coming from rent and the expenses largely just consisting of staff, debt, and maintenance. But while it might look like they’re losing money, given that they have a net loss, this is really just a fluke of how subsidiary accounting works when different organizations partner together on projects. While Mercy’s partnerships seem more likely to lose money (and as we'll discover later, this is intentional), Mercy themselves is profitable. Over the past 10 years they’ve grown at an average 7% per year, some years as high as 14%, which seems to be a normal pace in real estate.

They maintain a consistent liabilities-to-assets ratio of 2:3, which means that every $1 of growth in Net Assets is immediately leveraged into $3 of housing. The question then is: what drives their Net Assets growth?

Historically, they’ve raised an average of $115m in equity capital per year, had a consolidated operating loss of $59m, and grown net assets by $60m. Initially this looks pretty weird – nonprofits can’t raise equity? And they’re definitely not supposed to distribute profits. However, a nonprofit can own a for-profit that does those things, and it can back the for-profit with the nonprofit’s resources as long as it has a controlling interest. A controlling interest ensures that the for-profit uses those resources “charitably.” A weird thought.

Mercy creates LLC subsidiaries and raises capital by offering Low-Income Housing Tax Credits (LIHTC). This is a program that allows investors who put money towards a low-income housing project to reduce their federal income tax by an amount equal to a fixed percent of the project’s cost each year for 10 years. However private investors don’t have to pay the entire cost of the project to be able to claim the full reduction. Projects are allocated credits by the government with certain properties (what the percent of the project cost can be credited, and usually also a maximum value if the project is over budget), and investors bid up their price in a competitive market. In general a $1 tax credit sells for 85-95 cents, so for example, an investor will put down $85,000-$95,000 in exchange for a $10,000/yr reduction in federal income tax each year for the next 10 years ($100,000 total).

That’s similar to an investment with a 1-4% internalized rate of return. I decided to model it by looking at one scenario where we simply pay our $10,000 income tax bill every year and put $75k into a compounding 3% investment, and another scenario where we negate our tax bill in year one with an LIHTC and invest the saved money from the 9 following years into a 3% compounding investment.

This ends up being a pretty good decision. Particularly if your investments are already in the 1-4% return range, then the slight reduction in tax rate frees up more capital for investment later which compounds the benefit further. Partnering with Mercy very likely has further benefits that are harder to determine from the outside – for example, capital partners can claim the operating loss of a property which would further reduce taxable income, despite not actually contributing to the operation of the property.

Conclusion

This largely gets to the end of my understanding of Mercy Housing’s operations:

1. They raise capital by offering tax credits to private investors
2. They leverage that capital into construction and mortgage loans
3. Raised capital and loan proceeds are put into low-income housing projects
4. Government-subsidized rental income largely pays for the long-term debt, maintenance, and services at those properties.

Admittedly it’s disappointing that tax revenue is the primary source of funding. Government regulation is the main restriction on market-rate housing in the first place, and then the government is paying the inflated development and rental costs that it itself caused to house those that were priced out. It seems unfortunate to not be able to spend that money on people that need services, but also just wildly unsustainable.