Journal of Tax Credit Investing

Inside the syndication process: initial underwriting

by Sam Shupe, Vice President, Raymond James Tax Credit Funds, Inc.

Experienced investors in low-income housing tax credit (LIHTC) partnerships pay close attention to the quality of the properties they acquire. They exercise very careful oversight to ensure that the syndicator acting as general partner in a tax credit venture has used a detailed set of standards to evaluate the projects in which it invests. Included in these standards should be guidelines pertaining to the property's competitive advantage in the market; the reasonableness of the operating budget; a review of the capital structure; and the experience of the development and management team. Investors should evaluate how these items are analyzed when choosing partners for tax credit investments.

Market and Demand

A market study, conducted by a qualified, independent market analyst, must support the development or rehabilitation of the property. A comprehensive rent comparability analysis, demand analysis, examination of demographic and economic trends, and unit absorption rates must be included in the study. The study should have been completed within the past six months for the subject property and its actual or proposed improvements.

The report must conclude a market rental rate for each type of unit. The other properties used to derive the market rental rate must be comparable to the subject property in design, amenity package and location. The market analyst should also identify the other LIHTC properties in the market and compare these properties' rents, amenities and occupancy history to the analyst's conclusions regarding the subject property. The report should also investigate proposed properties through discussion with the local planning and zoning departments and should use data from the state credit agency to determine whether additional LIHTC product is in the pipeline.

A clear rent advantage must exist. Projected rents must fall at least 10% below the market rent and should also be at or below the LIHTC rents in the area.

The market study should also include an appropriate capture rate based on the projected rental rates and consideration of specific market conditions prevalent in the area. Demographic trends, projected changes in population and employment, turnover rate of rental units in the market, rent overburden, and the level of substandard housing should be factored into the demand analysis. The analysis should also review the employment characteristics of the market to ensure that the area is not overly dependent on one employer or one industry, which could negatively affect local occupancy rates in the event of a downturn.

Ideally, capture rates should be less than 10% of the market demand. Higher rates can be acceptable for seniors properties or in markets where the study shows significant rent overburden or substandard housing stock.

The report should also conclude an expected absorption period for the property. The absorption rate should be based on the rates experienced by comparable properties that have been recently completed in the market. The analysis should also address the market occupancy level to determine whether excess vacancies in the market may affect lease-up.

Other Third-Party Reports

In addition to the market study, a Phase I Environmental Site Assessment (ESA) and a pre-construction analysis should be obtained.

The ESA should be conducted by an independent, qualified environmental professional and should describe any existing or potential environmental threats to the property. If the credits were awarded based on the rehabilitation of an existing property, the ESA should also address the potential presence of lead in paint or drinking water, asbestos-containing materials (ACMs) and radon.

The preconstruction analysis should be performed by an independent, qualified engineer or architect, and should address the reasonableness of the construction budget and projected construction period, the adequacy and completeness of the building plans and specifications, and conformance with applicable government regulations, including the Americans with Disabilities Act (ADA). If the credits were awarded based on the rehabilitation of an existing property, a needs assessment and scope of work should be obtained. These reports address all major components of construction and their current condition, describe the extent of the proposed rehabilitation, conclude whether the rehabilitation will be sufficient and estimate the remaining useful life of any components that were not rehabilitated.

Site Visit

A site visit should be conducted as part of the syndicator's due diligence process and should include a thorough inspection of the subject site and any improvements. A visit should also be made to all comparable properties and properties developed or managed by the subject's development team.

An inspection of the subject site should consider the surrounding land uses and how they may affect the marketability of the property. The site's accessibility should be reviewed, including its proximity to amenities such as retail facilities, schools, hospitals and potential employers.

Visits to the comparable properties in the market should confirm the conclusions made by the independent market study and verify that the properties used in the study are actually comparable. Discussions with leasing agents at those properties may also provide additional insight into the market based on their prospective tenant traffic flows and waiting lists.

Inspections of other properties developed by this team can provide insight into the construction and design detail employed by the developer and can also reveal how well the continued operations are run. Properties that are managed by the proposed management company should be assessed on the physical appearance of the properties as well as the competence of the on-site management staff.

Operating Budget

Detailed financial projections for the property must be prepared for the entire compliance period. Consider rental revenue and other sources of income, the vacancy and collection loss factor, budgeted operating expenses, and funding of replacement reserves. The developer's budget should contain sufficient detail for an in-depth review of each line item.

The property's projected rental revenue must be based on rents that comply with all tax credit and financing obligations and provide at least a 10% rent advantage over the market. Other revenue, such as laundry and vending income, should be supported by data from comparable properties. The revenue figures should also account for a vacancy and collection loss factor of at least 7%, based on a 5% loss for physical vacancy and a 2% loss for bad debts, concessions or other causes. This rate should be higher if market conditions (such as high vacancy rates at comparable properties or projected declines in employment levels) warrant.

Budgeted operating expenses should be supported by historic averages of other properties in the market and properties that are managed by this property's manager. The historical averages of properties that have been developed by the principals in the subject property should also be reviewed. The syndicator should also compare the expenses to similar properties in its database. If the property had been allocated credits based on the rehabilitation of an existing property, the historical operating expenses of the subject property should be strongly considered. Operating expenses such as real estate taxes, utility expenses and insurance costs should be verified by third-party sources. Replacement reserves of at least $200 for newly constructed properties and $250 for rehabilitated properties should be required.

Debt-Coverage Ratio

The debt-coverage ratio (DCR) measures the property's ability to meet its debt obligations and is calculated by dividing the subject's net operating income by the debt service. A DCR below 1.0x indicates that a property's income will be insufficient to meet the debt obligations, which could result in the foreclosure of the property. Investors should expect a DCR well in excess of 1.0x in order to provide a cushion and ensure that the property will be able to meet its obligations even if income is not as high as projected. Generally, properties should have a projected stabilized debt service coverage ratio of 1.20x (4% projects) or 1.15x (9% projects) when utilizing foreclosable debt.

Because the investor's hold period is 15 years (the compliance period), it is critical that the DCR thresholds are met throughout this period. If the DCR falls below 1.0x at any point during the compliance period, the property is at risk of foreclosure, which could result in a recapture or loss of credits. A 15-year pro forma analysis should be performed assuming level increases in rents and expenses. The rate of increase in revenues and expenses may vary, with many syndicators assuming a 2% to 3% increase in revenue and a 3% to 4% increase in expenses. Different market and property conditions may warrant different growth-rate assumptions.

Financial Structure

The partnership must have permanent financing in place prior to entering the partnership. This financing should be non-recourse so that none of the partners or the guarantors is liable for repayment. The loan should have a fixed rate of interest for the life of the loan, or at least through the 15-year compliance period. If there is floating-rate financing, it must have a maximum rate, or cap, and the property must be able to meet required DCR thresholds at the capped rate. Because the commitment for the permanent loan is issued prior to the start of construction, the lender may be unwilling to commit to an interest rate on the permanent loan unless there is a rate lock that sets the future interest rate prior to the start of construction. Investors should not be subject to interest-rate risk and should therefore require an interest-rate lock on all debt.

There are two types of debt used to finance tax credit properties. Hard debt is debt that has required debt-service payments. These loans are typically issued by conventional lenders such as banks, conduits and mortgage brokers. Soft debt is debt that has no required payments, or has payments only to the extent that there is sufficient cash flow. State agencies, local governments and nonprofit entities typically offer soft-debt loans.

Deferral of the development fee also provides a source of funds for the property. This is essentially soft debt because the repayment of this fee is made from cash flow. Deferred development fees may accrue interest, typically above the applicable federal rate. Regardless of whether the fee accrues interest, it must be able to be repaid within the 15-year compliance period. If the fee cannot be repaid, the investor runs the risk that this unpaid portion of the deferred development fee will be excluded from the tax credit basis and that the amount of tax credits will be reduced.

Background of Development/Management Team

A large part of the success of the development and operation of the property is based on the abilities of the development and management team. The background and experience of all members of the development and management team should be thoroughly investigated to ensure that they are reliable and qualified.

The contractor must have experience with comparable projects, meet all licensing requirements, and secure completion of construction with a letter of credit amounting to at least 15% of the construction amount or with a 100% payment and performance bond. In addition, a signed contract must provide for a guaranteed maximum on construction costs.

Property managers must have documented prior experience with the management of Sec. 42 properties in the property's market area. The staff hired must be adequate for the size and necessities of the property. A full set of management responsibilities, budget information, tenant qualification standards and review procedures, and proposed services or tenant programs must be outlined and presented in full detail.

Financial Standing of Partners and Guarantors

The general partner and guarantors have significant financial obligations to the properties and, by extension, to the investor. It is imperative that all parties involved in the project have the financial capacity and reputation to honor these obligations. The financial strength of all parties should be thoroughly investigated using the prior three years' financial statements and tax returns. The parties should also be able to demonstrate sufficient net worth and liquidity to meet their obligations to the property and investors. Current and contingent liabilities should be reviewed to determine whether there might be additional, competing claims on the financial capacity of the partners or guarantors. The credit standings of the parties should be verified by current 10-year credit and background checks, as well as by lien and litigation searches.

Conclusion

In the tax credit marketplace, consistency is the key to success. A solid investment is made when a property meets established standards. Every investor's goal should be to find a syndicator who understands these issues and takes every step necessary to ensure the safety of the investment.

Raymond James has sponsored affordable housing since 1974, including 700 LIHTC projects in 42 states. Raymond James Tax Credit Funds is part of Raymond James Financial (NYSE-RJF), with a net worth of $770 million and fiduciary responsibility for $88 billion in client assets.

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