A New Capital Structure for Affordable Housing

There are many complex reasons why this country has such a dire need for affordable housing. One that gets little attention is the fact that conventional real estate equity investment structures are directly at odds with the needs of renters to have predictable and appropriately priced housing costs.  How can apartment owners keep rental rates at their communities relatively “flat” to meet the economic needs of their residents when the equity investors in those assets require returns on their investments (over relatively short investment periods) that can only be met if owners push rental rates as high as possible?  

Recently, my colleagues and I worked with a group of impact investors and an impact entrepreneur to design, build and document a new investment structure that we call “Performance Aligned Equity” (PAE).  We designed PAE to create a vehicle for early stage investments in impact companies that, among other things, allows the investors to achieve a rate of return on and of their investments that is aligned with the company’s revenue stream; and enables the company’s founders to retain control of the company and safeguard its impact mission.  

PAE, in short, is a venture capital investment structure that better aligns the needs and missions of impact companies with the objectives of the venture capital investors from whom they receive needed equity funding.

PAE is an equity investment that acts like debt, but with redemptions rather than repayments.  Similar to interest payments required for a loan, the investors receive a stated and predictable rate of return on their investments based upon a defined schedule and from a fixed “dividend pool” that is funded through the investee company’s operating cash flow.  The timing for the establishment of the dividend pool and the first dividend distributions, as well as the amount of each distribution, can be customized to meet the company’s specific needs and cash flow projections.  With each scheduled payment of “dividends” from the pool, the investors receive both a stated return on their investments and a return of a portion of their investment through mandatory partial redemptions of their equity. 

PAE can be structured to afford the investors the right to participate in management of the company, through a board seat or other mechanism, but only for so long as they maintain a stated percentage of company ownership.  That percentage will automatically burn down as the scheduled redemptions of their investments occur.  The investors can separately be given evergreen rights to participate in select material decisions that could adversely affect their investments. 

 In practice, these rights might be triggered where the admission of additional investors of the same class would have a dilutive effect.  However, with PAE, the investors have no rights to force a sale, recapitalization or refinance of their investments, or any other form of exit by the impact company, keeping the founders in control of the impact company and preserving the company’s impact mission.

PAE investments would be relatively easy to structure for rental housing owners and developers, since the cash flow projections from these communities (i.e., the revenue that underpins PAE’s core rate of return and associated redemption terms) are routinely computed and reliably used for traditional real estate private equity transactions.  

Here are just a few circumstances where PAE investments might be useful:

• To close a gap in the capital stack for an acquisition or ground-up development transaction.
• To attract new types of equity investors, such as impact investors interested in supporting affordable and workforce housing, banks looking to deploy Community Reinvestment Act funds in novel ways, and private foundations focused on deploying program related investments that advance their housing-related missions.
• To fund current or deferred capital expenditures needed for apartment communities without taking on additional debt or increasing rents.
• To fund capital needed to build additional units within an existing apartment community that has available developable land.
• To defray unanticipated operating deficits and otherwise help owners through unexpected cash flow disruptions (such as those caused by pandemics).
• If integrated as a component of a sponsor’s or owner’s required equity contribution for a transaction, PAE can enable that sponsor or owner to retain a greater percentage of the ownership of a community, as the PAE is redeemed over time, thereby maintaining the affordable pricing for a longer period. 
• While this would require more evaluation and probably additional iterations of the PAE structure (and would present additional securities law and other legal considerations), PAE could be used as a vehicle to enable residents of a community to invest in the community and earn a return of and on their invested capital, creating a meaningful way for those residents to feel a sense of ownership over the communities in which they reside.

Pam Rothenberg is a partner in the Washington, DC office of Womble Bond Dickinson (US) LLP, practicing in the areas of commercial real estate, business and entrepreneurship.  She founded and leads Womble’s Impact Business Group, the first integrated multi-disciplinary impact offering established by a US law firm.