From 2015 to 2020, approximately 650,000 of the two million affordable housing units in the U.S. will exit their tax credit compliance period as they near their "Year 15" anniversaries, according to government data. Most general partners have chosen to remain in the affordable program and the trend is likely to continue. However, those general partners may still face a number of issues, including how to manage refinancing, address partnership complexities and source new investment.
APPROACHING YEAR 15
General and limited partners of these properties need to analyze their options as they approach the end of their first 15 years under the Low Income Housing Tax Credit (LIHTC) program, as LIHTC is the most important resource for creating affordable housing in the U.S. today.
Despite heavy demand for affordable housing, as property values rise, property owners may be tempted to apply for approval to remove the 30-year IRS tax restriction, especially in the largest markets on the coasts and in major cities. The qualified contract process enables owners to convert properties to market rents if a state agency cannot find a buyer who would keep the property in the program.
The more likely scenario for these properties, however, based on studies and practical experience by affordable housing developers, is that a majority will stay affordable for the entire 30-year period as dictated by their extended LIHTC use restrictions.
A Department of Housing and Urban Development study released in August 2012, titled, What Happens to Low-Income Housing Tax Credit Properties at Year 15 and Beyond?, said most of the properties that have hit the 15-year period have stayed affordable and extended the affordability period for an additional 15 years. It also predicted that most projects would continue to operate as is, with modest improvements made in conjunction with property refinancings without applying for new tax credits for major renovations. A smaller percentage would be recapitalized by re-syndicating tax credits, issuing bonds or applying for other housing subsidies, and another small portion would apply for the qualified contract exemption.
This pattern is likely to continue because newer projects exhibit better occupancy rates and more cash flow than older projects. The study found that "the later year LIHTC properties appear to be at even lower risk of being repositioned as market-rate housing with unaffordable rents than the early year LIHTCs."
“I have not been involved in any deal that has taken advantage of the qualified contract option." said Marianne Votta, tax credit equity asset management executive for Bank of America Merrill Lynch. “Usually limited partners exit and the general partner has to keep the property affordable for another 15 years. I have heard of a few instances in South Carolina and Arkansas where they applied because market rates were close to LIHTC rents.
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Only 1%-2% of affordable housing loans foreclose, the 2012 study showed. Operating and maintenance budgets are typically tight, but in such a stable environment, with ever-increasing demands for affordable housing, it may be appealing for partners to put off developing a strategy for their properties as they approach the Year 15 mark. That may not be a good idea.
"Owners need to think proactively about what works best for their portfolio of properties,” said Ellen Rogers, senior vice president and market executive for the Southeast region for community development banking at Bank of America Merrill Lynch.
"Owners need to initiate discussions with their investor partners and think strategically in terms of their occupied properties."
Senior Vice President, Market Executive
Rewriting the original agreement requires close attention to the details. Each property has to be reviewed separately based on individual circumstances. Rogers added, "If you have 400 properties, do you know what's happening with each one? A lot of the early-executed documents are silent on key issues. That means there needs to be some dialogue on what needs to happen."
“The reality is, you start the disposition process when you sign your partnership agreement,” Votta advised. “What is documented in the agreement becomes the roadmap for the deal to unwind. You should refer to the partnership agreement prior to approaching your investor before disposition or any refinancing. There may be tax consequences involved, so it is advisable to contact your tax advisors.
Before approaching an investor about a disposition, or for that matter, any capital transaction, an owner should refer to the partnership agreement and confer with their tax advisor. It is important to remember that the partners’ capital accounts will play a key role in determining what an investor is entitled to collect. Many general partners make the mistake of looking solely to the “waterfall.” This will lead to expectations of exit splits that are not realistic. Many general partners look strictly to the real estate issues on exit and neglect the tax considerations of the deal which are explicit in the partnership agreement.
In most cases, the limited partners, having benefited from the tax credits, are looking to exit the investment and it's the general partners who buy them out. This is an opportune time to refinance the property with favorable interest rates, abundant capital and a borrowing base on a property value that may have increased significantly.
If the general partners do not assume total ownership, they can choose to re-syndicate new tax credit investments, thereby raising capital for property improvements.
Re-syndication has its own issues. The market for new credits is very strong, but the problem is getting an allocation as a preservation deal. Each state has a finite amount of 9% credits to allocate and each state has priorities on the types of deals that they want to allocate to, whether it's the type of property – family, elderly, special needs, mixed-income, mixed-use – or construction type. In many states, with other government subsidies cut or in some cases eliminated, LIHTC may be one of the only vehicles the state has to not only build housing but revitalize communities. Therefore, a preservation and re-syndication property may not get the credits.
An owner who wants to keep a property should assess its physical condition. If the property has generated healthy cash flow and kept up with physical needs, it may be able to go forward without a re-syndication. Although the property still has to maintain the affordability restrictions of the extended use program, the owner does not have to provide the investor reporting if the property does not re-syndicate. However, for properties with little cash flow that are in need of capital improvements, there may be no other option than to re-syndicate.
Post “Year 15" decisions will depend upon the property's condition, how it compares to comparable properties and local real estate market trends. Does the property need significant repairs or updates to compete? Is it cash-flow stable? Does local demand support conversion to market rate? Additionally, some government or quasi-government subsidy providers require long-term rental restrictions via subordinate debt or grants. Consequently, there isn't one strategy. Each property needs to be evaluated individually in order to structure an optimal Year 15 strategy.
According to the HUD study, after Year 15, properties take one of three paths: They remain affordable without recapitalization, remain affordable with a major new source of subsidy or are repositioned as market-rate housing.
"The cost of rehabilitating deferred maintenance is minimized if the GP has reinvested in the property as needed. The problem is that not all tax credit properties generate the cash flow needed to address all maintenance issues as they arise,” Votta said.
Keeping housing affordable while keeping up with the Joneses isn't easy. Developers have to find the capital to maintain appearances and meet evolving building standards. A 15-year-old building should not have the same issues and capital needs that a 40-year-old one does. Earlier deals that carried multiple layers of debt struggled to get reworked or refunded. And several years ago, when the earliest deals were underwritten, allocating agencies did not fund sufficient replacement reserves in fear of appearing to be giving developers unneeded taxpayer money. That's changed, Votta said: "Local governments are realizing these properties really do need reserves. They may need new roofs, new systems.”
Alongside a refinance, general partners can take over total ownership and re-syndicate the property with new tax credits. Fortunately, it's a good time to do that. In heavily banked areas, namely the largest 5O markets, demand for tax credits has pushed prices to par or at a premium of face value. Rural tax credits are still lagging as rural communities confront declining populations and weaker market conditions, but they have risen in price in recent years. “Usually given the current market for tax credits, most deals with credits get done,” Votta noted.
In 2013, Bank of America Merrill Lynch financed the construction and rehabilitation of a portfolio of 502 units spread across seven affordable apartment complexes in rural North Carolina. It was the second direct purchase of housing bonds – this one totaled $20.3 million in construction finance and $9.5 million in LIHTC – the bank has closed with the same developer. The properties were 96% occupied at the time of the transaction with project-based rent subsidies in place on 93% of the units.
"Many developers are using tax-exempt bond financing to recapitalize and enhance their Year 15 properties. Tax-exempt financing proceeds and tax credit equity fund repairs and upgrades, and enhance long-term cash flow,” said Sindy Spivak, senior vice president for community development banking at Bank of America Merrill Lynch.
"Often our clients initially seek acquisition financing to gain control of an asset followed by a request for debt and sometimes equity as part of a tax-exempt financing to recapitalize a property."
There is a strong market for affordable properties if limited partners want to exit, said BofAML bankers. Managing partners with strong development or property management businesses often seek to acquire control of their properties toward the end of the compliance period. That way, they can leverage opportunities for future development and economies of scale. Owners should also be smart about property values and practice good portfolio management.
Looking strategically at a portfolio allows a developer to identify immediate opportunities and plan for issues that all affordable housing developments face, such as uncertainty of funding sources and rising interest rates, Spivak said.
"In recent years, developers have been able to benefit from historically low interest rates. If interest rates rise, properties with rental restrictions could face challenges in refinancing and recapitalization. Availability of tax-exempt financing, LIHTC and preservation funds will become crucial to the future of properties ending their initial compliance period," Spivak added.
STRATEGIES AT WORK
For an example of how these transactions are working, in early 2016 BofAML completed the refinance of a 4% tax credit property in the Northeast that is approaching the end of its compliance period. The property requires a series of repairs to address deferred maintenance and upgrade the units. With FHA rates still attractive, a 223(f) mortgage insured refinance is the ideal tool to provide the capital needed for the exit as well as make critical repairs.
The bank has also assisted several clients with acquisition financing, including one in Houston recently that allowed the client to gain control of the property and stabilize operations while going through the process of applying for additional tax credits and bonds for permanent financing.
Not only is HUD focused on affordable housing, Freddie Mac and Fannie Mae are also stepping up to the table with a more competitive range of products. At the same time they still provide the necessary flexibility for affordable housing and Year 15 financing.
The future of affordable housing, even with its challenges, looks bright. Industry participants have worked together to educate the public and private sectors as to the benefits of LIHTC in providing quality, affordable housing for low- and moderate-income individuals as well as those with special needs.
Participants have also always faced change and challenges with creativity, adapting to new programs and regulations. The market continues to see increased innovation in the form of mixed-income developments, special needs developments, inclusionary housing, sustainable green technology and leveraging of government lending programs, all in a time of budget cuts and increased costs. Such creativity has allowed the LIHTC to remain one of the most effective programs in creating and preserving affordable housing despite various challenges.
Action Center Module
- When approaching the end of your compliance period, three primary options are to stay affordable, re-cap to stay affordable or go market rate
- Tax-exempt financing can help with funding repairs, making upgrades, generating fees and enhancing long-term cash flow
- The keys to a smooth Year 15 transition lie in owner preparedness and an experienced financial partner