Economic fundamentals bode well for continued stable performance in the U.S. public finance housing sector. Favorable financial conditions due to a lowered chance of recession, expected low rates through the end of the year, modest inflation, steady labor force participation, and continued wage growth--most importantly even for lower wage workers--provides a solid foundation for the sector to remain on largely stable ground during 2020.
The U.S. municipal housing sector can be characterized by three primary categories: mission-driven lenders including housing finance agencies (HFAs) and community development financial institutions (CDFIs) and their borrowings; mission-driven owners and operators of affordable housing including public housing authorities (PHAs) and other social housing providers; and securities backed by affordable housing mortgages. Each of these sectors will continue to benefit from the economic landscape, while mission-driven lending and ownership organizations will remain committed to work to address housing affordability and other community challenges experienced throughout the country. As a result, we expect to see increased capital market financings as HFAs continue their issuance of mortgage revenue bonds and more CDFIs and PHAs enter the public markets. While we anticipate isolated volatility in stand-alone affordable housing transactions, we expect HFA, PHA, and CDFI ratings to remain stable through the year. Much like our 2019 outlook, this year's outlook reflects these organizations' financial metrics that are stable or improving, including asset growth, revenue diversification, and resilient strategy and management.
As illustrated in chart 1, the majority of housing ratings remain in the 'A' or 'AA' categories, comprising 81% of ratings. Chart 2 shows that that as of the end of 2019, 86% of ratings have a stable outlook, which supports our view that the outlook on the sector as a whole is stable. Of the total rating actions in 2019, 73% were affirmations, 22% were downgrades, and 5% were upgrades (see chart 3). Downgrades and speculative grade ratings have been generally focused on stand-alone affordable housing transactions; speculative grade ratings in this subsector grew to 7.8% of ratings, from 6.6% in 2018.
What We Are Watching
Economic backdrop: lower, steady growth
S&P Global Economics recently lowered its expectation of a U.S. recession over the next 12 months to 25%-30% from 30%-35%, largely based on the economy's performance. Easing trade concerns and the three Federal Reserve rate cuts in 2019 have helped to lower recession fears and stabilize credit markets. S&P Global Economics in December increased its estimate for expected 2020 real U.S. GDP growth to 1.9% from 1.7%, though still indicating an anticipated economic slowdown in comparison to our expectation for 2019 GDP growth to reach 2.3%.
The continued, albeit slowing, economic expansion has been a positive for individual households as the U.S. has experienced steady labor force participation growth and increases in aggregate hours worked; November 2019's unemployment rate of 3.5% was a 50 year low. Year-over-year wage growth increases of 3.1%, which have broadened to include lower wage workers, have exceeded inflation and provided real wage gains. Household balance sheets reflect this picture, as discussed in "What Key Macrofinancial Indicators Tell Us About The U.S. Nonfinancial Private Sector's Vulnerability To Shocks," published Oct. 17 2019, on RatingsDirect. In the aftermath of the financial crisis, households have deleveraged, with aggregate indebtedness dropping to levels not seen since 2001. Similarly, households' debt service ratio, (DSR)--measured by debt service payments as a share of disposable personal income--has fallen even faster and largely eased the debt burden of U.S. households. The DSR stood at its record high of 13.2% in late 2007; as of the second quarter of 2019, the DSR of 9.7% was at its lowest point in available history. This relatively low ratio bodes well for households' ability to tolerate financial shocks and should support stable loan repayment performance.
However, affordability continues to be a challenge nationally with home price increases outpacing income growth, exacerbated by the overall shortage in housing availability: demand has outpaced supply, with only 1.1 million housing starts compared to the formation of 1.4 million households. Recent statistics portend an improving landscape. Building permits jumped by 5% month over month to 1.46 million annualized in October, a 12.5-year high, due to increases in both multifamily and single-family permits. Furthermore, growth in building permits has outpaced starts in recent months, pointing to a sizable pipeline of new housing units. As shown in chart 4, the Rust Belt is leading the forecast for 2020 housing starts. While an increased supply of housing can help mitigate housing price increases, we note that these statistics do not specify whether the new housing starts and permits will continue the trend of building larger homes and apartments or increase the supply of affordable housing options.
The millennial generation, projected by the Pew Center to number 73 million in 2019, is moving into prime household formation and home buying age. While millennials generally have been slower than earlier generations to marry, have children, and establish their own households, their sheer numbers create significant demand for housing. According to the National Association of Realtors' 2019 Profile of Homebuyers and Sellers, 33% of all buyers were first time buyers, the same percentage as in 2018, but remaining below the historic norm of 40%. The report also noted that the age of first time buyers increased to 33 in 2019, up from a low of 28 in 1991. The Federal Reserve Bank of St. Louis reported the seasonally adjusted homeownership rate returned to its upward climb; third quarter 2019 homeownership rate was 64.7%, up from its low of 63.1% in 2Q 2016 and still well below the high of 69.1% set in 2Q 2004. Long considered to have a dampening effect on homeownership, 24% of all buyers had some amount of student debt.
Positive outlook for sector growth, but challenges ahead
Environmental, social, and governance (ESG) factors are increasingly a market focus. "When U.S. Public Finance Ratings Change, ESG Factors are Often the Reason," published March 28, 2019, highlighted that 60% of housing rating actions taken in the prior two years, were due to governance factors--both positive and negative. We continue to view the majority of HFAs, CDFIs, and PHAs as benefiting from strong, proactive, and strategic management with long-term planning efforts to identify and address risks and opportunities. In contrast, we continue to observe weak management and strategy in certain Section 8 and unenhanced affordable housing projects which we note jeopardizes stable financial performance and has caused rating deterioration.
Environmental factors could affect the housing sector as climate related events such as storms and fires can potentially disrupt occupancy in a specific location and thereby threaten financial performance. The ability to withstand these events and maintain credit stability highlights the importance of strong management. In March 2019, S&P Global Ratings affirmed its 'A+' rating, but assigned a negative outlook to, the Housing Authority of County of Butte, California (HACB) in the aftermath of the Camp Fire. HACB was directly affected by the fire, which started in northern California on Nov. 8, 2018, destroying more than 95% of the towns of Paradise and Concow and causing significant damage to the surrounding communities. While we believe HACB has appropriately planned for best- and worst-case scenarios that may unfold in the aftermath of the fire, near-term financial performance remains uncertain. In 2019 we also took rating action on a stand-alone affordable housing transaction after two of the four properties in the portfolio sustained significant damage due to natural disasters that included a hurricane and tornado. The damage at the properties was not quickly addressed due to an insurance dispute, insufficient funds, and the owner's lack of experience with major capital repairs. All of this led to a significant drop in occupancy and lowered debt service coverage resulting in a significant multi-notch downgrade.
While we are not aware of any housing-related organization experiencing a cyberattack, increasing dependence on technology makes cyber risk an increasingly important concern sector-wide. Most rated organizations have strengthened their internal cyber training, risk evaluations, and other protocols to protect their operations and have purchased cyber insurance to provide some coverage on losses if needed. However, as cyberattacks become more frequent and sophisticated, S&P Global Ratings will continue to monitor organizations' evolving cyber-related strategies and evaluate their risk management capabilities.
The U.S. government, through its HUD programs, Treasury programs, GSEs, and policy has significant influence on the housing sector. Headwinds from federal policy changes which diminish support of housing programs have the capacity to disrupt the operations of housing-related entities. In September 2019, Fannie Mae's implementation of risk-based pricing for its Home Ready and HFA Preferred products curtailed HFAs' loan origination activities. The U.S. Treasury proposal to make the Federal Housing Administration, the Department of Veterans Affairs, and the Department of Agriculture the sole sources for low-downpayment borrowers and also move to risk-based pricing could prove detrimental to HFA programs. The plan's proposal to privatize the GSEs would likely also limit HFAs' flexibility and options for loan executions.
The proposed changes to the Community Reinvestment Act have caused concern in the market for their potential to dilute banks' investments in the communities they have historically supported. Such a move could lower their support of CDFIs' activities and lower the pricing of low-income housing tax credits--a critical source of housing capital.
While HFAs and CDFIs have demonstrated their resilience in past shifts in the housing finance system and lending landscape, this possible narrowing of options and support has the potential to limit growth.
Last year was an active one for HFAs and we expect that 2020 will bring more of the same as HFAs continue to access the bond market, adding assets to their balance sheets. This continues the trend from 2018, when HFAs reported a 10.9% increase in average assets to $3.4 billion. On the heels of three HFA upgrades in 2019 as a result of improving balance sheets, we expect ratings to remain stable through 2020.
Housing bond issuance has increased significantly in the last seven years. As quantitative easing supported low conventional rates, HFAs expanded their funding sources to include the to-be-announced (TBA) market, though bond market sales have increased in recent years, up 18.3% from 2018. Single family bond issuance increased by 27.4% in 2019 and represents a larger percentage of total housing bond issuance--55.75% vs. 52.65% in 2018. Chart 5 illustrates the more than 150% increase in housing bonds issued annually since 2012. Meanwhile, HFAs responding to our recent survey indicated their expectation that TBA will represent 56% of financing sources in 2019, indicating a long-lasting shift for HFAs as they diversify their funding execution options.
Largely as a result of HFAs diversifying their funding sources, there has been a corresponding diversification of their revenue streams. Average income from loans decreased to 48% of revenues from 50% in 2017 and 60% in 2014. The remaining components include investment income, which increased to 12% of revenues, and non-interest income which increased to 40% of revenues in fiscal year 2018. While this is due primarily to profits on TBA sales, a number HFAs have developed other sources of income by, for example, expanding their operations to service loans for other HFAs. HFA net income increased by an average of 66.6% but since assets also increased significantly, profitability, measured as return on assets, and net interest margin remained steady at 1.5% and 1.6% respectively, the former the highest level seen in the prior five years.
The latest available fiscal year results (2018) shows average equity for HFAs increased by over 20% to $965.6 million, up from $798.9 million in fiscal 2017. We expect equity to continue trending upward in fiscal 2019 as liabilities are paid down and assets continue growing. In our opinion, increases in long-term interest income from both loans and investments will further bolster the rise in HFA equity as asset bases continue expanding. At the same time, asset quality has shown signs of consistent improvement, dropping to 2.3%, an all-time low.
We expect the favorable employment, housing and demographic trends to continue, benefitting HFAs. Millennials are entering the housing market, which should strengthen housing demand across the U.S. As housing affordability continues to challenge buyers--especially first time homebuyers--HFA downpayment assistance (DPA) has proven to be a critical resource for accessing home ownership. HFAs have expanded their DPA programs and are more frequently funding their programs with bond proceeds and requiring repayment (vs. grants) on these second loans. Our recent survey of HFAs indicated that an overwhelming majority (84%) of HFA mortgage lending included DPA.
Public housing authorities across the country, but most notably on the West Coast, have moved purposefully to diversify their revenue streams. Though HUD operating and capital funding in the last several years have been stable, volatility in prior years and an expansion of the Rental Assistance Demonstration program, among others, have encouraged PHAs to pursue options to redevelop their housing stock and seek development opportunities that support and broaden their mission. As a result, PHAs have evidenced both increased revenues and improved asset quality. It has also resulted in additional PHAs seeking ratings, primarily to support their development activities through bank and capital market borrowings. Two new PHAs were rated in 2019--Denver, Colo. and Stark Metropolitan, Ohio--following two additional PHA ratings in 2018. We expect stability among PHA ratings in 2020 as these trends continue.
Federal fiscal year 2020 continues the generally stable government funding of PHAs. The recently enacted budget includes a $94 million (2%) increase in public housing capital funds, a $104 million (3%) decrease in public housing operating funds, and increases in both the housing choice voucher (6%) and project-based Section 8 programs (7%). As these revenue streams can prove to be volatile year-to-year, some rated PHAs have pursued a slow-and-steady approach to reducing their dependence on the federal government. The median percentage of non-HUD funding was 22.4% of total revenues in fiscal 2018, a slight increase from 22% in fiscal 2017.
For the past several years, most PHAs have demonstrated year-over-year EBIDTA growth. In the most recent year, average EBIDTA grew a whopping 45.5% from 2017 levels, driven primarily by the larger PHAs actively pursuing multiple mixed income development opportunities while continuing to serve low income households. At the same time, PHAs incurred more debt--primarily to finance their development activities--increasing an average of 18.8% and also increasing as a percentage of EBIDTA to 8.56% from 7.7% in fiscal 2017. To date, EBIDTA growth has outpaced debt growth, and leverage has remained low, but we will continue monitoring PHAs' debt profiles for any change in these trends or in their strategies.
In addition, 18 out of 21 rated PHAs have undertaken new construction efforts in the last two years, focused primarily on providing mixed income housing, which typically has at least one-third of the units reserved for low-income tenants whose income is less than 30% of the area median income. Asset growth reflects this activity with an increase of over 7,300 units reported in the latest fiscal year.
CDFI ratings span a narrow range, from 'AA-' to 'A-'. Two additional CDFIs sought ratings in 2019, bringing the rated universe to 10. We expect ratings will remain stable in 2020, as fiscal 2019 audited and unaudited information indicate that CDFI balance sheets have begun to substantially slow their growth trajectories, or even decrease their loan balances. There had been some deterioration in 2019, driven in part by several years of aggressive growth; on average, loan balances increased by 26% in fiscal 2018. Similarly, while the ratio of total loans to total assets grew 2% year-over-year to 69%, available information is indicating a flattening in 2019. Several factors are contributing to this slowing growth. CDFIs are expanding their lending platforms to include off balance sheet participation loans and are also selling loans opportunistically to monetize their assets and reduce risk on their balance sheets. At the same time loan pipelines are shrinking in part due to a more competitive landscape nationwide and among particular asset classes. We expect these dynamics to continue into 2020.
Overall, we see rated CDFIs' financial performance stabilizing in 2020. Most metrics indicate a flattening in fiscal 2019 results, with slowing rates of change. We believe most CDFIs are approaching their steady state due in large part to the slowdown in loan growth mentioned above. Fiscal 2019 information indicates a decrease or stabilization of leverage ratios. The slowing growth rate is due in part to a shift to using bond proceeds to refund existing debt as opposed to prior trends of using proceeds to fund new lending activities.
Capitalization levels, measured by equity over total assets, declined at the slowest pace in the last three years (6% year-over-year decline vs. a 9% decline in 2017). Average equity over total assets for 2019 based on available financial information indicates that this ratio is showing signs of stabilization.
Though CDFI net interest margins (NIM) continue to decline, they remain strong at an average of 3.28%, with indications of minimal incremental decline in 2019. NIM peaked in 2014 at 3.8%. The decrease in NIM is attributable to a more competitive national lending landscape as well as the low interest rate environment. However, CDFIs are also diversifying their revenue streams through loan sales and off balance sheet lending which generate servicing, commitment fees and one time revenues. Furthermore, asset quality remains extremely strong for CDFIs: non-performing assets increased incrementally to 1.18% in 2018, roughly a third the rate of 3.69% from 2014 and lower than most other lending portfolios.
Affordable Housing Properties
Chart 6 shows the current rating distribution for multifamily affordable housing ratings. These ratings continued to experience notable volatility in 2019 as indicated in charts 7-8. Downgrade actions (76), which can include multiple downgrades of one credit, continue to be driven by financial and operational vulnerability in Section 8 and unenhanced affordable housing, including senior housing transactions. Section 8 and certain unenhanced affordable housing property owners have exhibited weak governance effectiveness, which has affected property level quality and cash flow stability. In 2019 S&P Global Ratings downgraded by multiple notches several transactions due to significant operational declines. We also note weakness in transactions tied to certain conduit issuers. We have proposed new criteria which emphasizes debt service coverage and adjusts management and governance assessments, which we expect would mitigate such rating transitions.
There were also several multi-notch downgrades among senior housing transactions in 2019. These properties suffered from the combination of declining revenues as overbuilding in the sector led to occupancy declines and increasing expenses due to labor cost growth. Data suggests that new supply is starting to ebb, which may lead to higher occupancy in the next several years as more Americans age into their mid-80s, the typical entry age for senior housing. However, in the interim, maintaining target occupancy remains an issue for property owners and a concern for the sector.
As indicated in our "Request For Comment: Methodology for Rating U.S. Public Finance Rental Housing Bonds," published Nov. 4, 2019, our testing indicates the possibility of further rating deterioration based on the proposed criteria. Assuming that the obligations maintain their current credit characteristics, testing indicates that approximately 60% of the ratings would be unchanged; up to approximately 10% would be raised, generally by one notch; and up to 30% would be lowered, generally by no more than three notches, and in rare cases, up to six notches. We expect downgrades, primarily among stand-alone transactions backed by affordable multifamily housing and age-restricted housing. Ratings most likely to be lowered are those on transactions where deteriorating financial performance has led to a tight DSC ratio, as well as those backed by smaller-scale properties.
Military housing has made the news recently for concerns about asset quality and other issues. The National Defense Authorization Act for fiscal year 2020, signed into law in December, includes several provisions which add additional oversight to the Military Housing Privatization Initiative program and create a tenant bill of rights for residents. S&P Global Ratings rates 87 military housing transactions, ranging from 'AA' to 'BB'. Most military transactions include multiple tranches; of these, 67 have a stable outlook, 11 are positive, and nine are negative. Most of the downgrades in 2019 resulted from local area basic allowance for housing decreases which caused lowered debt service coverage.
This report does not constitute a rating action.
|Primary Credit Analyst:||Marian Zucker, New York (1) 212-438-2150;|
|Secondary Contacts:||Alan Bonilla, San Francisco + 1 (415) 371 5021;|
|Aulii T Limtiaco, San Francisco (1) 415-371-5023;|
|Contributors:||Ki Beom K Park, New York (1) 212-438-8493;|
|Daria Babitsch, New York;|
|Prasad Patil, Mumbai + 912240405927;|
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