A number of general partner interests in tax credit partnerships was offered to the market during 2007. Valuing these interests can be very complex and extremely tricky at best. In this article, I’ll explore some of the key elements to determining how to analyze general partner interests.
Billionaire Warren Buffett learned from his mentor, Benjamin Graham, that there is very clearly a difference between price and value. Price is what you pay, and value is what you get. It is critical to assess the relationship between price and value because failing to do so is simply speculation. Nothing could be truer than when viewing tax credit partnership interests.
The first step in the valuation process is to have a clear understanding of the terms and conditions of the limited partnership agreement. This agreement spells out how the waterfall of benefits flows through the partnership. Percentage of ownership seldom has much to do with the way the benefits pie is sliced. The general partner may have a miniscule ownership interest in the partnership yet receive a much higher percentage of the cash flow, another percentage of refinancing proceeds, and still another percentage of sale proceeds.
Other important factors to abstract from the limited partnership agreement include exactly what rights the limited partners have at the end of the initial Land Use Restriction Agreement (LURA) period to force the sale of the property; who is responsible for assuming the tax consequences of unpaid developer fees used in calculating basis; and what personal guarantees are being assumed on the part of the new general partner.
If the limited partner can force a sale at the end of the LURA, the purchaser of the general partner interest needs to decide what impact this can have on long-term strategy. Many projects have deferred developer fees, and at some point the Internal Revenue Service expects those fees to be paid. If they aren’t, the general partner typically has to contribute capital that is then repaid in the form of developer fees, but not without creating taxable income for the general partner.
Understanding the loans must also be on the checklist. What sort of pre-payment lockouts and penalties exist? Does the first mortgage mature simultaneously with the expiration of the initial LURA period? Are there soft second and/or third loans? Does the forgiveness of such loans cause a cancellation-of-debt issue from a tax perspective?
Looking at operations
The next step in the analysis is to scrutinize the historical physical and financial operation of the underlying asset. The best document for this purpose is the annual audit. Look at the last three years’ worth of audited financial statements. The first place to start is in the accompanying notes to the financials. The notes are a treasure trove of information, and can include gems such as the amount of deferred developer fee plus accrued interest; extraordinary income and expenses that may have been incurred; accounts payable; various debt provisions, which might be difficult to dig out of loan documents; and the status of equity installments still due from the limited partner. Ultimately the prospective general partner/purchaser wants to derive a clear picture of the cash flows that are generated by the property. Simply looking at financial statements without carefully reviewing the notes does not necessarily present the true picture.
Subsequently, a thorough understanding of the market will be necessary. Is the community growing or shrinking? What is the property’s reputation? Is it located in a good or bad neighborhood? Remember, you can fix a property, but you can’t fix a neighborhood.
What is the capture rate for the property— in other words, what share of qualified renters in the market does the property have to capture to achieve and maintain 100 percent occupancy? A 5 percent capture rate is very healthy for a family apartment community. A rate above 10 percent begins to raise eyebrows.
A look at historical occupancy rates for the subject property can cast light on how it has performed within the market. If the property has typically operated at 87 percent occupancy, why would anyone project future occupancy at a higher rate when valuing the general partner interest? Of course it might be possible to achieve higher occupancies as a result of better management or market conditions, but why would a prospective purchaser pay for this “blue sky?”
The physical condition of the property is an obvious piece of the valuation puzzle. What is the overall quality of construction? What is the current physical condition? How many carpets and appliances have been replaced? Have any roofs been replaced? What is the annual contribution to the replacement reserve and what is the current balance in that replacement reserve?
Do a comprehensive physical inspection with an eye toward estimating the remaining useful life of the major physical components—roofs, parking lots, sidewalks, HVAC equipment, carpet, appliances, cabinets, hot water heaters, windows—and the amount of funding needed over the next several years to undertake the necessary replacements.
Future cash flow
Eventually, cash benefit projections become the focus. In a traditional valuation model, a net operating income is derived and capitalized at a selected rate of return. The valuation of a general partner interest is not quite as straightforward. The most logical approach is to project the stream of cash benefits going to the general partner over a defined period of time. These benefits may include incentive management fees, cash flow allocations, refinancing proceeds, and sale proceeds. A significant portion of the benefits will be difficult to precisely calculate because they may not occur until far into the future—a sale for instance. And no one can really predict what market conditions will be at the time a sale is anticipated to occur. If the asset has been generating distributable cash each year, that income stream can be expected to be more durable. So what to do?
A discounted cash flow model is the fairest way to value the general partner interest. The challenge comes in determining what discount rate to use. One approach that has merit is to use more than one discount rate. For example, if distributable cash flow has been steady on a historical basis, then projecting it into the future would seem to be logical. Thus it may be assumed that cash flows are less risky than the property’s market valuation at sale.
The fact that many properties are subject to extended LURAs muddles the opportunity to sell in the future. There are many hoops to jump through to void the extended LURA, causing uncertainty as to when the property may actually be sold and for how much. As a result, a prospective purchaser of the general partner interest might use a lower discount rate for the annual distributable cash flows, and a higher discount rate for the projected benefits from a sale years into the future. Blending the discounted cash flows produces the amount that the general partner interest may be valued by a prospective purchaser.
Still, other issues need to be considered. What happens if the cash flows historically have been negative or leveled off? Does this mean that the general partner interest is worthless? If a prospective purchaser of the general partner interest is able to take steps necessary to produce positive distributable cash flow in the future, should any of that be incorporated into the value for the withdrawing general partner?
Another complication is the market itself. This is where price and value can definitely diverge. For example, the stream of cash benefits may indicate that the general partner interest should be valued at “X,” but the market in which the property is located has hot money pouring in and there is a possibility that someone would purchase the property at a price higher than its value. Intelligent investors will negotiate for the general partner interest on the basis of the true value, and if the price exceeds that value, then they will walk away.
At the beginning of this article, I mentioned the philosophy of Benjamin Graham and Warren Buffett. Another mantra of these two superstar investors is “margin of safety.”
Purchasing a general partner interest can be extremely risky. So how does one go about building an adequate margin of safety? Certainly, it’s up to the purchaser to perform extensive due diligence on the asset and the market. Beyond that, the purchaser must be conservative with future projections and also build a margin of safety into the discount rates being used. In fact, the discount rates (or rates of return) should reflect the appropriate risk premium for the operating scenario being acquired.
A tough asset in a tough market with a checkered past may be worth something, but only a small something when assessed a risk premium. How would a general partner interest in a property that is virtually upside down financially be worth anything at all? It all boils down to time. If the LURA expires in 12 months, if if there’s a high probability that the purchaser can opt out of the extended LURA, and if the market is such that the property could be sold and converted to conventional apartments at much higher rents, then a case could be made for a residual value. Purchasing general partner inte
rests can offer opportunity, but may be even more likely to turn into quicksand. A prospective purchaser must be ever vigilant while trying to match a fair price with a reasonable value that reflects the risks involved.
Beware of general partners who may be trying to unload portfolios of bad deals that they are tired of feeding. Be careful about paying for future benefits that are actually the sweat off your own brow. Look for every opportunity to fail and have a plan to mitigate each potential failure before taking the plunge. Once all of the caveats are understood, then and only then are you ready to fully exploit the opportunity.
R. Lee Harris, CRE, CPM, is president of Cohen-Esrey Real Estate Services, LLC, a Kansas City-based commercial real estate organization that has managed more than 53,000 multifamily units since 1969. The firm is active in 95 markets spanning 17 states and is involved in the management, development, and acquisition of conventional and affordable housing. An affiliated company, Cohen-Esrey Affordable Partners, LLC, purchases general partner interests. For more information, visit www.cohenesrey.com.