Affordable Housing Finance

FINANCE

Tax Credit Equity

Gauging the 2010 Market

AFFORDABLE HOUSING FINANCE • January/February 2010

Developers reveal their expectations and plans

BY DONNA KIMURA

Several leading affordable housing developers are bracing for a tough year while holding on to expectations that the lowincome housing tax credit (LIHTC) market will improve in 2010.

The past year was one of exceptions, says Todd Sears, CFO for Indianapolisbased Herman & Kittle Properties, Inc. There were exceptional subsidies available. Any deal that closed was an exception, and live buyers with cash were an exception, he says.

“2010 will continue this pattern but with less severity,” says Sears. “The market is slowly adjusting to the new realities. Deals coming through the pipelines now are better designed to fit with investors’ yield requirements, level of due diligence, and risk mitigation So, that will make 2010 less severe, but it will not be a cakewalk.”

The LIHTC is the nation’s main program for producing affordable housing. It works by providing a federal income tax credit to corporations that invest in affordable housing developments. While demand for the credits has historically been strong, a big shift began to take place in 2008. Fannie Mae and Freddie Mac, two of the program’s biggest investors, left the market and other corporations have gone to the sidelines or reduced their investing as their profits declined during the recession. As a result, the investors who remain, mostly large banks, have their choice of deals, and prices paid to developers for the tax credits have fallen sharply.

Executives at Mercy Housing, one of the nation’s largest affordable housing developers and owners, are hearing that several large institutional investors are “getting the nod” to purchase LIHTCs this year.

“It seems that on one hand the banks will be buying tax credits, but on the other they will be very focused again on Community Reinvestment Act targets, utilizing 9 percent tax credits and in major markets,” says Brian Shuman, president and COO. “Pricing seems to be stabilizing, but investors are continuing to push on negotiable items such as the length of guarantees, the amount of developer fees that need to be taken at the end of the project, and reserves. All in all, I think the market will be slightly better in 2010 than in 2009, but not significantly.”

While nearly all developers contacted foresee gradually improving conditions, some are more reserved in their forecasts.

R. Lee Harris, president of Cohen- Esrey Real Estate Services, LLC, a developer and owner headquartered in Overland Park, Kan., expects to see a continuation of the soft market.

“If there is an extension of the exchange program or the Tax Credit Assistance Program funds by Congress, gap funding may be available to some extent,” he says. “When paired with lower credit pricing, it will allow for some projects to be completed.”

Preparing for battle

Going into the new year, developers need to be ready for what the market will offer. Even as overall economic conditions begin to improve, it will not be business as usual.

“Banks are under significant regulatory pressure,” says Harris. “Construction lending requirements will be much more stringent as a reflection of this pressure. Developers should be prepared to provide more in-depth information about their projects and their capabilities than in the past.”

Developers should brace for signifi cant negotiations with investors and be prepared with cash to take advantage of opportunities whether it is acquiring general partner or limited partner interests or simply joint-venturing with struggling developers, adds Shuman.

Developers will also need to adjust their perspective, according to Paul Sween, a partner at Dominium Development & Acquisition in Plymouth, Minn. “They need to think in terms of long-term ownership and not just cash fees,” he says.

The current market dictates that developers can no longer focus only on fee-driven projects. Dominium has approached deals more from the perspective of a long-term owner than a developer, explains Sween.

“The bottom line is that in this market you have to make realistic assumptions when underwriting and evaluating a deal, meaning confirm that the LIHTC pricing and loan interest rates are in line with the market,” he says. “At Dominium, we have also be especially conscious of our assumptions and level of interest in a deal when it comes time for checks to become nonrefundable.”

For many LIHTC developers, the biggest frustration has been having solid deals but few or no investors for the tax credits. A large bank is not going to suddenly make a bid on a single deal just because the yield is high when the bank hasn’t been bidding on any projects for the last six months, says Sween.

“The key is to be persistent and keep your projects in front of them so that when they do decide to invest again you will be at the forefront of their thinking,” he says.

What developers are doing

To cope with the market conditions, Cohen-Esrey has moved to a no-debt model involving the use of state and federal historic tax credits combined with federal LIHTCs, says Harris. The firm is also syndicating its own credits to raise equity for its projects.

The Michaels Development Co., a national developer and owner headquartered in Marlton, N.J., is doing the same. “We’re going to go out and improve our contacts with national and local banks because we’re syndicating our credits directly,” says President Robert Greer.

Michaels has also been buying other firms’ portfolios and building military housing. “That’s making a lot of activity for us and growing our portfolio,” Greer says.

At Mercy Housing, officials plan to focus on managing costs and optimizing recurring cash. “We will also be monitoring our deal flow very closely and making sure we have plans in place to manage costs should certain transactions not materialize,” says Shuman.

The firm also is looking at investing in several technology systems that could help improve efficiencies in development planning and management, human resources, accounting, and asset management.

Herman & Kittle diversified into other property types and started moving toward “vertical integration” a decade ago. Although other business lines also face difficulty, they have provided needed diversification and serve as a potential relief valve. “Having in-house property management has allowed us to emphasize third-party property management fees, general partner acquisitions, and receivership opportunities,” says Sears.

Moves to consider

Looking ahead to this year, there are several moves that developers might consider making to put their firms and deals in the best position.

One is providing guarantees to institutions instead of cash, says Sween. “The liquidity is not there to make the big cash fees, but this is a great time to purchase assets based on residual value and not on cash fees,” he says. “We have found in some situations that providing or assuming guarantees can be just as valuable as cash.”

Sween also stresses the importance of focusing on sound management practices to help weather the storm.

Harris of Cohen-Esrey suggests that developers consider approaching more direct investors, particularly those who may have a strong interest in a specific community or region.

Developers should also give careful consideration to the use of fixed-rate debt, according to Sears.

“If you think about expenses as a percent of revenue and include debt service as one of those expenses, a fixed-rate deal has fixed costs of about 60 percent to 65 percent of revenue,” he says. “A variable- rate deal has fixed costs of about 25 percent to 30 percent of revenue. If you think that your revenue is closely tied to short-term interest rates, and in the affordable world there are many reasons to think it is, then locking in your interest rate fundamentally changes your likely returns and risks. This is the big misunderstanding of fixed-rate debt—it doesn’t reduce risk, it changes the nature of risk by decreasing interest-rate risk and increasing cash flow risk.”