State LIHTC Funds Prepare for Tough Year

AFFORDABLE HOUSING FINANCE • June 2008

BY DONNA KIMURA

Low-income housing tax credit (LIHTC) prices are down from a year ago, the financial markets are stressed, credit is tight, and the short-term economic outlook is gloomy.

How’s an affordable housing developer to survive?

For some help in these difficult times, AFFORDABLE HOUSING FINANCE asked several experienced developers to offer guidance on how to deal with today’s market.

First, they point out that the LIHTC market has not disappeared. There is still investor demand for tax credits, but it’s going to take more work to earn their money.

The developers offered several tips for making it through the LIHTC market.

Prepare for more work up front

It’s no longer enough to just have a LIHTC allocation letter. A developer needs a complete package for investors and lenders that saves them time and effort, and must be responsive with follow up.

“More of the construction cost needs to be bid out prior to closing, the proposed rents need to tie to the market study, the expenses need to be based on historical or comparables, and soft money needs to be committed rather than hoped for,” said Todd Sears, vice president of finance at Herman & Kittle Properties, Inc., in Indianapolis.

Verify the numbers

Update your construction loan, permanent loan, and equity terms to make sure you still want to do the deal in today’s market, said Sears. In other words, be certain your deal remains feasible.

The market has changed quickly. “Equity pricing has dropped from the $1 range to the 80-cent range consistently, and construction loans have moved from 175 basis points over the London Interbank Offered Rate (LIBOR) to 200 to 250 basis points over LIBOR in about the last six months,” Sears said at the end of April. The LIBOR rate was about 2.99 percent at the end of April compared to 5.3 percent a year earlier.

Prepare for the worst, hope for the best

Developers should be conservative in their LIHTC pricing expectations. It would be great if prices come in higher, but planning for lower numbers lets developers know that their deals will still work if prices are down. It pays not to be too optimistic in these times.

Lock in with an investor

Usually a two-week period exists between the time developers know they are going to receive a LIHTC award and the day they actually receive it. In many states, developers have up to 20 days to accept an award. “We have allotted for certain tax credit pricing on each of our projects, and our plan is to lock in with an investor between the time we know we are going to receive an award and acceptance,” said Caleb Roope, president and CEO of The Pacific Cos. in Eagle, Idaho. “We are only going to lock in with people whom we know are going to honor their letter of intent. If we don’t get the pricing we need for the deal, we are prepared to not accept the credit reservation. The key is getting the investor on board prior to the award.”

Roope said it is better to turn down the reservation of tax credits than it is to accept it and have to return the credits. Many states have consequences for failing to use allocated credits. It could result in the loss of a reservation fee, which can be sizable. For a $1 million reservation, the “penalty” may be as much as $40,000.

In some states, a developer who fails to use his tax credits can also be slapped with negative points. This could knock the developer out of the competition for future awards.

Bridge equity

With equity prices down and construction loan rates the same or lower because of a lower LIBOR, bridging equity has become feasible again.

“The best bet is to keep it simple— super-size your construction loan to exceed your perm loan, use more of the construction loan during the construction and lease-up period, then pay off the construction loan with a combination of perm loan proceeds and the delayed equity contributions,” said Sears.

The more a developer can delay equity pay-ins until completion of the construction by using a super-sized construction loan, the better the pricing because later pay-ins lower the risk to the equity provider.

Quality matters

With reduced investor demand, the remaining players are going to be in a position to make sure what they are buying is of high quality. That means investors can zero in on the strongest markets and the strongest developers, said Michael Massie, housing development manager at Jamboree Housing Corp., a nonprofit developer based in Irvine, Calif.

It also means that developers shouldn’t cut corners on their projects, because quality will be emphasized by investors.

Rob Hoskins, president of The NuRock Cos. headquartered in Alpharetta, Ga., also noted that less equity is chasing more deals. As a result, “sponsorship and the ease of the transaction will become more and more important,” he said.

Nurture relationships

Debt and equity providers are going to be drawn to developers who have a good reputation and strong relationships. They are going to focus on the developers they know.

But these are also the days to cultivate new relationships, according to Alexander Roberts, president and CEO of Community Housing Innovations, Inc., a nonprofit developer in White Plains, N.Y.

Now is a time to cast a wide net and take a look at a broad range of syndicators and underwriters. “You have to go outside of the circle that you are used to dealing with,” Roberts said. The partners that you find in these uncertain time will likely be the ones you will do business with for years to come, he said.

The direct route

Developers should also study their options when it comes to selling their tax credits this year, said Massie, a former syndicator. “Syndication is not the end-all be-all,” he said. There are some direct LIHTC investors in the industry. The benefit of working with a direct investor is you are likely to receive higher pricing because there is not a syndicator load. One downside is that direct investors will likely be more selective in the projects they will invest in.

Get creative with gap funding sources

With lower tax credit prices, deals are facing larger financing gaps. As a result, developers need to be more creative in filling these budget holes. R. Lee Harris, president of Cohen-Esrey Real Estate Services, LLC, in Overland Park, Kan., offered several possible strategies to consider.

“Try working out a deal with a small community to give you the land rather than paying for it,” he said. “Land doesn’t count toward eligible basis and is a cash outlay. A number of smaller communities may be willing to facilitate this approach.”

Tax abatement can help through improving the net operating income and potentially providing more loan proceeds. However, in the current debt environment this may not be much more than a way to offset more conservative underwriting, Harris said.

In addition, he said developers may want to consider using tax-exempt lower floater bonds for larger transactions, with a Freddie Mac or Fannie Mae swap. The result is extremely low interest rates and a long-term fixed-rate loan. A lower floater bond is a variablerate bond. The variable rate is then swapped for a fixed rate.

Developers could also team with a community housing development organization or a nonprofit organization in order to tap into soft loan sources that may be available.

“They will need to be a partner in your deal, but if the chemistry of the relationship is right, this can be an excellent method for filling the gap,” Harris said.