CREJ - Multifamily Properties Quarterly - August 2016
As the economy continues to recover nearly 10 years after the mortgage meltdown, the costs of land, building materials and construction continue to rise. As Americans, many of us take for granted clean running water or a warm, dry place to sleep. There are segments of our population that are economically disadvantaged. The double-edged sword of a free market society is that some are unable to attain the American dream without assistance. As the greatest country in the world, all Americans deserve opportunities for safe, clean and affordable housing and this can be accomplished with economic development incentives. Mayors in many cities across America, including Denver, Houston, San Francisco, Chicago, New Orleans and others, have affordable housing initiatives, which act as a wake-up call for municipalities, developers and housing authorities to work together to deliver quality housing stock to our fellow Americans in need. Affordable housing often is financed through tax credits – low-income housing tax credits, or LIHTC – and associated financing sources. These financial mechanisms are a tool that private developers, as well as public housing authorities, can use to create affordable housing options. Often, these two groups form joint ventures to execute projects and, other times, they work independently. The need for affordable housing is greater than we realize. Here is an abbreviated list of the diverse populations that are underserved with affordable housing: • Divorced single parent households • Millennials with mounting student debt • Lower-income workforce • Seniors • Veterans • Medically disabled • Families with a single income • Civil servants • Schoolteachers Types of low-income housing tax credits include 9 percent and 4 percent. The 9 percent LIHTC typically provides approximately 70 percent of a project funds with the remaining 30 percent made of debt or other sources. The 4 percent LIHTC provides 30 percent of a project’s funding and the balance of funds is made up of other sources including debt. The 9 percent applications are very competitive and only the best projects are awarded funding annually. While the 4 percent applications are noncompetitive, they do require other sources of capital to finance the project. The challenge developers face with any LIHTC project is the rents charged to tenants are at a maximum of 60 percent of the area median income, or AMI, and go down from there. Hence, the reason the tax credits were invented was to provide the available funding necessary that otherwise would require developer’s equity. Clearly the financial returns on owners’ equity for a tax-credit deal is not enough to incentivize the private sector like a market-rate deal. The credits come from large corporations that have a tax obligation and, instead of the tax, they invest in affordable housing tax credits, which is how funding becomes available and helps monetize these much-needed projects. What do tax credits finance? Tax credits can finance new construction and rehab projects; acquisition, in some cases; housing for families, special-needs tenants, single-room occupancy and the elderly; urban, rural and suburban locations; and additional projects in high-cost or difficult-to-develop areas. There are many reasons to use tax credits as a financing tool. The credits can be monetized and used as a source of capital for a project, or as an instrument that can be sold to a syndicate or bank at 80 to 100 percent on the dollar. The credits create opportunity for other funding sources to round out the capital stack, such as grants, low-interest government loans, community development block grants and other contributions from municipalities and nonprofits. As previously noted, typical debt and equity financing does not work economically for rents that are controlled based on a percentage of AMI, and thus part of the incentive to use a tax-credit form of finance is that there is less financial risk to the sponsor due to nonrecourse debt funding. When using tax credits as a financing tool, occupancy rates typically are high due to demand. Lastly, a benefit to the sponsor is that developer fees range from 8 to 15 percent. How do tax credits work? Rental units are leased to tenants earning no more than 60 percent of AMI, while investors earn dollar-for-dollar credits against their federal tax liability and can received tax benefits from losses generated by the property. Generally, tax credits are received up front for the first 10 years of operation, and these credits essentially cover the equity capital needed to fund the project. The tricky part of the structure is that some tax credits may be recaptured by the IRS if the project does not comply for 10 years of the life of the tax credits; however, the other part of the structure is that the affordable housing land-use restriction remains in effect for 15 years. This obligation essentially requires periodic audits of tenant income to ensure no tenant is understating income levels and they remain in compliance of 60 percent AMI or less. Failure to comply has serious tax recapture penalties to the developer sponsor and partners, which is why compliance with IRS regulations is critical. As mentioned, a 9 percent LIHTC deal provides approximately 70 percent of a project’s funding with the balance picked up by debt, soft funds (nonrecourse) and/or owners’ equity. A 4 percent LIHTC deal provides approximately 30 percent of a project’s equity with the balance picked up by other soft funds and/or owners’ equity. Are other funds or incentives available? Another source of funds when applying for LIHTC projects is the basis boost. The basis boost increases the eligible tax-credit basis by 30 percent if a project is in a qualified census tract, a difficult-to-develop area or a state-designated difficult development area. They do not apply to tax-exempt financed projects. The basis boost is an additional funding source that can help a developer overcome financial impediments to project finance. For example, where construction costs may be higher, such as a market like San Francisco or New York City, could be a difficult-to-develop area. It also can be used for locations where affordable housing opportunities are limited (qualified census tract) and there is an underserved suburban market in a good school district versus poorer neighborhoods and, thus, additional funding incentivizes the developer to build a LIHTC project in the area. The following are a variety of sources of capital for affordable housing projects 9 percent LIHTC and 4 percent tax-exempt municipal bonds: • State department of housing – funding • Financial institution or insurance company (syndicator) – equity • City/county affordable housing funds • Public agency housing funds • HUD low-interest loans • Local housing authority • Housing choice vouchers • Community development block grants • Regional employers (i.e., resorts and factories) • Financial institution or insurance company – debt What are the financial risks? Tax credit projects do come with some financial risks. The first is the upfront costs to put together the application for submittal to the state. There are also costs associated with architecture, engineering feasibility, market studies, legal counsel as well as tax and financial consultants. These costs can be recovered if the applicant is successful in winning a 9 percent award. However, in a 4 percent application, while the applicant can recover these costs, the downside is that developers are required to piece together other funding in order to achieve the same 70-percent-plus funding described in a 9 percent deal. Both of these options require an experienced design, tax and legal team. Aren’t affordable housing proposals fraught with neighborhood objections? Affordable housing shouldn’t be considered a negative land use or only for poor people. LIHTC developments provide a much-needed resource to our nation’s housing stock and a diverse population. The 9 percent LIHTC project, while very competitive, requires high-quality design, amenities and LEED compliance. In order to receive tax credits, the applicants are required to develop quality projects. If either a 9 percent or 4 percent tax-credit project is properly designed, the economic status of the residents is undetectable between “affordable housing” and “market-rate housing.” In fact, often, they are blended because of various inclusionary housing provisions embedded within local zoning codes throughout the nation. Additionally, blending affordable and market-rate housing diversifies the unit mix and tenant makeup, which improves profitability while maintaining compliance with complex tax requirements. For these reasons, at least 10 percent of the units in an affordable housing development should be market rate to avoid compliance issues if tenants understate earnings for AMI compliance. The parties in a tax-credit syndication work together with the State Housing Finance Agency, acting as the compliance entity that approves the eligibility of the tax-credit application as well as ongoing review of a developments annual compliance with property management, tax reporting, adhering to tenant AMI rules and associated Department of Housing and Urban Development rules. The typical cast of actors in a LIHTC deal often are much like a market-rate project and are as follows: Development team • Developer • General contractor • Architect • Attorney • Accountant and tax consultant • Property manager • Consultants Lenders • Construction lender • Permanent lenders • Lender attorneys State housing finance agency (works with) • Syndicator • Underwriter • Fund manager • Attorney What are the benefits to private developers? The opportunities for developing affordable housing are numerous, not the least of which is the ethical construct of conscious capitalism, which states, “One can do well financially by doing good.” Other more specific points include the fact that 8 to 15 percent of the developer fees are up front at the time of development and, after 15 years, the developer owns the property rights free and clear and either can refinance the debt or sell the property to others who invest in affordable housing projects. The program offers essentially free equity for the project via a tax-credit program that realizes 10 years of tax credits paid up front to fund the development. Developers are required to put down little to no equity, and they receive before-tax cash flows after expenses. And, occasionally, free land for the development of affordable housing is available from local sources. Developers also receive a portion of property management fees and there are low-debt requirements after the tax credits and other soft funds. Additionally, nonrecourse funding and the reimbursement for initial project expenses is available, which include upfront costs to put together the application for submittal to the state, architecture and engineering feasibility studies. The road to getting all of your documentation in order for LIHTC is no easy feat because the rules are complex; however, the benefits outweigh the obstacles. This article is intended to highlight the opportunities, however a much deeper analysis of the rules and regulations governing LIHTC projects is critical in determining if this development strategy is right for you, which is why an experienced team of design, tax and legal professionals is imperative to your project success.