The strength of the low-income housing tax credit (LIHTC) market boils down to the depth and diversity of investors. That’s why broadening the investor base next year will be critical to ensuring a healthy equity market in 2013, according to industry veterans.
It is clear that investor interest has been waning as a result of low yields in recent months, setting the stage for an interesting year ahead.
“2012 is going to be end up being an overall strong year with a very weak ending,” says Fred Copeman, who leads the tax credit investment services practice at CohnReznick, an accounting and advisory firm. “Our best estimate is that we will close 2012 with roughly $9 billion in new investments. That will effectively put the market close to where it was in 2006 in terms of volume. That said, equity demand started to lose steam about mid-year, and it looks as if the market may have to limp over the finish line.”
Many insurance companies had already begun to leave the market by the end of 2011, and that trend continued all year. There are now just a handful of life company investors still around, and they are not doing much, according to Copeman in October.
“That is not a healthy development because it means we have returned to a market that is comprised at least 90 percent by the Community Reinvestment Act (CRA)-motivated banks,” he says. “That is too thin a market, and we have learned how dangerous it is to be overly reliant on a small number of investors.”
The recent message from insurance companies and other investors is they are not going to invest in multi-investor funds unless the after-tax internal rate of return goes back to at least 7 percent. One investor reported that some recent deals in the West have yields below 5 percent.
“Even the banks seem to have lost much of their enthusiasm either because of yields or because they met their investment targets months ago,” Copeman says. “John McDonald at Beacon Hill Capital told me that he views the market as suffering from ‘malaise,’ and I think he’s got it right.”
Marc Schnitzer, president of R4 Capital, also points to the significance of the recent low yields.
“The headline about the tax credit market in 2012 would be the run-up in pricing and the significant drop in yields that started in 2011,” says the veteran LIHTC syndicator. “Tax credit yields have probably dropped close to 100 basis points over the course of the year and are now heading back up.”
As economic buyers exited the market, the withdrawal of equity began to cause prices to fall and yields to begin to creep up in recent months, Schnitzer says.
The question then becomes what will be the state of the market in 2013.
“It will be important for the market to find a good equilibrium that results in yields that are attractive enough for economic buyers to be enthusiastic about participating,” Schnitzer says. “That probably means fund yields in the 7s. It could be low 7s, but somewhere in the 7s.”
Sought-after CRA deals create a unique market in their regions, but the broader tax credit market needs to find a balance that “enables a maximum number, or at least a comfortable number, of economic buyers to be enthusiastic about investing,” Schnitzer says.
Copeman is already starting to see a shift. “I think we are clearly at the front end of a repricing period, which usually takes about six months to play out,” he says. “The syndicators have already started going back to their developer clients to try and roll pricing back a bit. I am told that they are getting push back, but that is what you would expect during the first phase of any repricing. Eventually developers will get the message so that by the end of the first quarter of 2013, pricing should have adjusted, and we anticipate a slightly more robust market.”
A number of factors—a new Congress, tax reform efforts, the economic recovery—could influence the LIHTC industry in the months ahead. The list also includes Basel rules.
The Basel Accords represent an international agreement among the Western nations to set uniform standards for capital adequacy in the bank sector. Under the latest iteration of those accords, Basel III, a new rule has been adopted with respect to what are called “deferred tax assets,” which we would refer to as tax credit and loss carry-forwards, explains Copeman.
The new rule provides that if a bank does not expect to be able to use its deferred tax assets within the next 12 months, those assets come off your balance sheet for purposes of measuring capital adequacy.
“For banks that have been investing solely for CRA purposes, this is a bitter pill to swallow,” Copeman says. “This is one of the contributing factors that has led to a new round of secondary-market transactions, a market that has been dead for the last couple of years. It appears that there is something on the order of $2 billion in secondary sales in the pipeline—deals that have either already been closed or are in process and a number of the sellers could be described as ‘Basel banks.’”
It is worrisome if a small group of existing investors swallows up these deals. However, Copeman thinks that some of the secondary-market volume may be acquired by investors who have not been in the market for some time either because it is a shorter-term investor or because the yield is attractive.
“So we have a couple of trends that are developing as parallel events,” he says. “There is a repricing process under way as well as this re-emergence of the secondary market. As far as the repricing is concerned, the good news is that prices don’t need to move all that much to give us better yields. I think the market will get back to yields that are close to 7 percent, which allow for a deeper investor base.”
Union Bank is a longtime tax credit investor, with its activities focused on the West Coast in California, Oregon, and Washington.
California is facing a set of unique challenges, including the loss of hundreds of local redevelopment agencies. That means the loss of key financing for affordable housing projects, says Annette Billingsley, senior vice president and head of community development finance at Union Bank.
“As we move into 2013, our clients will still have many projects in the pipeline,” she says. “However, we may see development slow down in 2014.”
Billingsley is starting to see clients bring more deals involving the resyndication of older tax credit properties. She points out that this trend may continue as early LIHTC properties age and funding gets tighter for new construction projects.
Another wrinkle that has emerged is a U.S. Court of Appeals ruling in the Historic Boardwalk Hall case, which found that an investor was not entitled to historic tax credits because it lacked a meaningful stake in the deal. Whether this decision has consequences for the larger tax credit industry still needs to be determined.
These issues will be key in 2013 and will determine the depth of the investor pool and how robust the market will be.