A 14.4-acre parcel of former will soon become the site of the island’s first major workforce rental project in decades.
The 324-unit Kaulana Mahina community will have nine 3-story buildings, a recreation center, pool, dog park and play areas. And 60% of its units will have regulated rents for households making between 80% and 140% of the area median income. That’s an annual income of $91,280 to $159,740 for a family of four.
The project comes with a big price tag: over $100 million. Its developers say the project is entirely privately financed, with a large share coming from private equity. Housing developers have relied on private equity for a long time, and many in the local community say it will play an increasingly important role in helping to solve Hawai‘i’s housing shortage.
A 2019 state study found that 50,000 new housing units are needed to meet demand between 2020 and 2025. Yet the number of residential permits authorized in 2020 and 2021 only makes up 16% of that amount.
“We haven’t even scratched the surface in terms of addressing that need,” says Colbert Matsumoto, former chairman of Tradewind Capital Group. “And while government has thrown millions of dollars addressing this, their capacity is limited.” Tradewind Capital, a Honolulu- based private equity and real estate investment firm, was an equity partner in the construction of two condo projects: 801 South in Kaka‘ako and Plantation Town Apartments in Waipahu.
Many government funding sources for affordable housing are insufficient to meet demand and projects targeting moderate-income households – “workforce housing” – aren’t eligible for them. “Without private sector funding, we’re not going to tackle the problem,” Matsumoto says.
Private Equity Basics
Financing the construction of affordable and workforce housing is complicated, to say the least. Putting together that capital stack takes mettle, perseverance, creativity, plus a deep understanding of tax laws, the private capital market, and building and zoning regulations.
Private equity is essentially an investment of money into a company or project. The money comes from pension funds, endowments, high net-worth individuals and other accredited investors. Those investors become limited partners in the project. This funding source is essential because it helps developers get loans from banks or other institutions, Matsumoto says.
The amount of equity needed varies by project, but Cayenne Pe‘a, principal of Honolulu-based Alaka‘i Development, says private equity generally makes up 40% of a project’s budget. Besides private equity, she says, few other funding sources can provide the tens of millions of dollars needed.
She and Jon Walenstrom developed the $140 million Kapolei Lofts and the $125 million The Element in West O‘ahu to target median-income renters. They say apartments targeting such renters are “sorely missing” in Hawai‘i, and that on the mainland, as much as 20% of new housing is directed toward them. Alaka‘i’s two developments added about 800 such units.
“It would not happen without private equity,” Walenstrom says. The two projects were later acquired by New York based private equity firm Blackstone.
One major way a project gets private equity is through low-income housing tax credits. The Hawai‘i Housing Finance and Development Corp. awards developers these credits to sell to financial institutions and corporations. The federal Low-Income Housing Tax Credit program has helped fund the construction and rehabilitation of more than 3.4 million rental units in the country.
Purchasers of these tax credits get to offset their federal and state income tax liability for a time in exchange for investing in affordable housing. The equity generated from these credits can make up 40% or 75% of a project’s development cost, depending on the type of credit used, says developer Stanford Carr, who has built a variety of residential communities on O‘ahu, Maui and Hawai‘i Island.
But demand for these tax credits in Hawai‘i greatly outpaces supply, and they’re only available to developers of rental units that target low-income households earning less than 60% of the area median income. That’s a maximum annual income of $78,360 for a family of four in Honolulu.
Developers of rental units targeting moderate-income households and for sale projects can’t use those tax credits. Instead, they often get their private equity through partnerships with investors.
The Kaulana Mahina apartments in Wailuku received 95% of its equity from Washington, D.C.-based PNC Realty Investors, says Kerry Nicholson, Hawai‘i senior managing director at Legacy Partners. The private real estate firm is based in California and has developed 78,000 apartment units in the country. The remaining equity came from Legacy Partners, Pacific Coast Capital Partners, Dowling Company and Pier Investments. Kaulana Mahina filled the rest of its budget with a loan from PNC.
PNC Realty Investors is the investment advisor for the AFL-CIO Building Investments Trust, a mixed fund of over 250 union pension plans that invests in commercial real estate across the country. AFL-CIO’s 76 Hawai‘i affiliates include all building and construction trades. Kaulana Mahina will be the trust’s first major workforce housing investment in Hawai‘i and, as a requirement for its financing, the project will use union labor for construction and maintenance.
Nicholson says private equity often makes up a larger share of a project’s budget compared with 20 years ago because interest rates are higher and construction budgets larger. Nationally, material and labor costs have increased 57% since 2000, according to the National Multifamily Housing Council.
“The financing structure for projects has changed, and so, oftentimes, developers are expected to come up with more equity in order to qualify for financing because as mortgage rates rise for forsale properties, the number of qualified buyers out there contracts,” Matsumoto says. “And so that increases the risk that a project won’t be able to sell out.”
Daniel Nishikawa is executive VP and commercial real estate division manager at First Hawaiian Bank. He says banks impose presale requirements on forsale projects to make sure there will be enough revenue to repay the loan. Loans for rental projects are also sized depending on the income generated from the projects after they’re completed.
Private equity has gained a reputation on the mainland for being profit-driven and Hawaii Business Magazine previously reported on the ways that a large private equity firm appeared to be squeezing profits from its O‘ahu rental communities. But the developers and equity partners we spoke with for this story say investors are often willing to take lower returns in exchange for the social good of providing much needed housing units in the Islands.
A little over 600 of the 1,005 condo units at the planned $619 million Kuilei Place project will be priced for households that earn 80% to 140% of the area median income. Alana Kobayashi Pakkala, executive VP and managing partner of Honolulu-based Kobayashi Group, says those units will meet 22% of O‘ahu’s need for for-sale homes for that income group.
She says Kobayashi Group couldn’t do that without a partner like Honolulu private equity firm BlackSand Capital, which is led by her brother, B.J. Kobayashi.
“We … had to put out an incredible amount of equity to get us at this point before we can start construction,” she says. “We need a partner … that is similar minded on the focus of a broader approach to investment in the state that isn’t just about necessarily the highest return as a singular focus.”
Tradewind Capital invests in a variety of housing projects, including mixed-income and luxury communities. Matsumoto says the firm has responsibilities to the community and to generate a return for its shareholders.
“Sometimes that means we won’t get the highest return on what we could invest our capital in, but we also have the satisfaction of knowing we’ve done something that is positive for our community,” he says, adding that the firm’s investments can also include buying low-income housing tax credits and making loans to developers.
But it still must make economic sense for the firm to invest in an affordable or workforce housing project. It can take years to secure land, get the proper entitlements, conduct environmental and traffic studies, and get financing before construction finally begins. During that time, the cost of capital and construction can change, and projects might face delays from community opposition or other issues.
That means there’s a lot of risk for investors to get involved in these types of projects, says Michael Costa, president and CEO of California developer Highridge Costa. He says that investors in affordable rental projects typically want a 13% to 16% overall return. Investors in market-rate projects, on the other hand, generally want overall returns closer to 20% to 25%. These are overall return targets from a share of the annual net cashflow once the project is leased and include proceeds from refinancing and selling the project.
“We could not have rent growth, we could have operating expenses go too high, and they could lose the opportunity to make that kind of profit,” he says. “So … we have to give them that type of a target to entice them to come into it.” Highridge Costa has developed and invested in affordable, mixed-use and market rate multifamily communities in 33 states, including Hawai‘i, where it helped develop two apartment communities and has five more in the pipeline.
Limited State Funding
Many project developers also rely on financing from the state’s Rental Housing Revolving Fund to help cover gaps between the equity they’ve raised and the amounts their loans will cover.
This fund typically serves rental projects with units for households earning 60% or less of the area median income. In 2022, it distributed a record $320 million and for the first time allocated a share to rental projects targeting households between 61% and 100% AMI. Its two tiers will help finance 2,100 affordable units across 15 projects.
However, this funding source isn’t big enough to meet demand. Denise Iseri-Matsubara, executive director of the Hawaii Housing Finance and Development Corp., says $100 million from the Rental Housing Revolving Fund will only help finance about 650 low-income units. Hawai‘i needs almost 15,000 rental units for those households, according to the state’s 2019 housing planning study.
“You’re going to need billions of dollars, and government could do nothing else if you wanted to build your way out of that,” she says.
Last year’s record distribution of Rental Housing Revolving Fund monies was made possible by a $300 million infusion from the state Legislature. The fund normally gets its money from a share of the state’s conveyance tax revenues, which is capped at $38 million a year. Bills moving through the state Legislature aim to remove that cap so that a larger share of the tax revenues can go toward rental housing.
Highridge Costa came up with an alternative financing structure to reduce its reliance on state gap funds. It’s made up of three layers of tax-exempt bonds and the structure allows for higher leveraging than conventional financing with bank loans, Costa says. His company will use this model for the middle-income rental tower in its Pohukaina Commons project.
“I think this is the way of the future because they recognize how oversubscribed our programs are,” Iseri-Matsubara says. “So they’re looking at this alternative financing structure, which is exactly the type of creative financing initiatives that we need to see to keep housing going.”