Journal of Tax Credit Investing

Inside the syndication process: post closing

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

An active, knowledgeable syndicator that closely monitors and protects investors' interests - from the initial financial commitment through lease-up - is crucial to the success of a housing tax credit property.

Timing of capital contributions

Equity investments in tax credit properties are typically structured so that capital is contributed at certain points during the construction and lease-up process. The staged pay-ins lessen the investor's risk and provide an opportunity for the syndicator to monitor the property and to re-evaluate its original assumptions.

Tax credit equity may be contributed during construction and at several thresholds such as construction completion, funding of the permanent debt, full lease-up and stabilized operations. Generally, no more than 70% of the total capital contribution is contributed to projects prior to completion of construction, and no more than 85% to 90% of the total contribution and 25% of the development fee is paid prior to stabilized operation.

Monitoring capital payments

A large portion of the investor's capital is generally paid prior to completion. The tax credit equity is used to purchase the site (or existing building in a rehabilitation), pay soft costs such as architect fees and pay for a portion of construction or rehabilitation costs. If capital is paid during construction, the syndicator should set forth conditions for each construction draw, starting with a draw request form that has been certified by the contractor and project architect. The work should be reviewed by an independent construction consultant and be compared to the amount requested on each draw. Lien waivers evidencing payments to the contractor and major subcontractors should be obtained. Finally, the owner's title policy should be updated at each draw confirming that no liens have been filed.

Capital may also be contributed at the completion of construction or at the funding of the permanent loans. The amount of the construction debt usually exceeds the amount of the permanent debt. This structure is to the advantage of the investor as it reduces risk, improves yield through delaying the capital needed during construction, and increases the eligible basis (and therefore the amount of tax credits for which the property qualifies) because the interest accrued on the construction loan is includable in eligible basis. Prior to this capital contribution, the syndicator should obtain and review the permanent loan documents and the cost certification, which calculates the amount of tax credits for which the property qualifies.

The partnership agreement should include provisions regarding the payment of capital in conjunction with achieving stabilized operation. At a minimum, 10% of the investor's contributions should be withheld until detailed conditions are met. To receive the final payment, all of the tax credit units must be occupied by qualified tenants and the property should demonstrate economic viability by achieving certain debt-coverage parameters and by funding required reserves. In addition to meeting the operating targets, the as-built survey and final owner's title policy, updated through the funding of the permanent loans, should be obtained, and Form 8609s should be issued for every building within the property.

Construction review

The design and functionality of any property are key to its future success. As a consequence, the project architect and contractor are important members of the development team. The project architect should be licensed and carry errors and omissions insurance for at least 10% of the total construction cost. The contractor should also be licensed and should have a full payment and performance bond or a letter of credit in an amount of at least 15% of the total construction cost.

In addition to completing due diligence on the architect and contractor, the syndicator should employ, either directly or through the construction lender, an independent construction inspector - either a qualified architect or engineer. The inspector will perform a preconstruction review to determine whether the proposed improvements will meet all applicable codes and regulations, including the Americans with Disabilities Act (ADA). The construction inspector will also confirm that the construction budget is sufficient.

If the tax credit equity will be funded during construction, the syndicator must ensure that the stage of construction completion correlates to the amount of capital funded. The construction inspector should review the draw requests and determine that the amount requested is consistent with the percentage of completion.

At completion, the construction inspector will conduct a final inspection to ensure conformance with building plans and specifications, and to confirm an appropriate level of workmanship and the absence of deficient construction components that could cause future maintenance issues.

The construction review process is generally the same whether tax credits were awarded for rehabilitation or for development of a new property. However, in the case of a rehab, the construction inspector will review a needs assessment and scope of work rather than plans and specifications. The construction inspector will comment on the proposed rehabilitation's adequacy and also review major structural components that will not be repaired or replaced. Based on the review, the construction inspector will prepare a capital expenditure budget, which forecasts the timing and costs of repair or replacement of components that were not part of the rehabilitation. The syndicator should verify that the projected replacement reserve will be adequate to cover any future expenditures.

Cost certification

To obtain Form 8609s, which evidences the final allocation of tax credits, the developer must submit a cost certification, which is an audit of the costs to develop or rehabilitate the tax credit property. The cost certification is prepared by a qualified accountant and shows the total development cost, the portion of that cost that qualifies under Sec. 42 of the tax code as eligible costs, and the estimate of the final credit amount. The syndicator must review the cost certification to verify that the accountant has correctly calculated the eligible costs in calculating the amount of tax credit for which the property qualifies.

In addition to reviewing the eligible basis, the syndicator must confirm that the partnership accountant correctly calculated the depreciable basis. The depreciable basis is important because depreciation deductions can contribute a significant portion of the investor's overall after-tax yield. Items that are not tax-credit eligible may still be depreciable. The syndicator should confirm that the accountant allocated the cost components to the correct asset classes (5 year, 7 year, 15 year and 27.5 year). A correct allocation of depreciable basis among the various asset classes can ensure maximized return.

Insurance coverage

Proper insurance coverage must be maintained during the construction and permanent phases, and proof of insurance coverage must be documented with certificates of insurance and properly endorsed and certified policies. In the event the property is subject to special hazards such as flooding or seismic activity, flood and earthquake insurance should also be obtained.

During construction, the developer or contractor must have builder's risk insurance coverage, which insures against damage to the property during construction, and pay workers' compensation insurance, to protect against any liability arising from injuries incurred on the construction site.

Once the property is complete, all-risk, liability and rental-loss insurance should be obtained. The all-risk coverage insures against damage to the structure, and the policy should provide replacement-cost coverage. To offset rising premiums, many deductibles are $5,000 or more. The syndicator must analyze the property's reserve accounts to ensure sufficient funds exist to pay the deductible in the event of a casualty loss.

Liability insurance should be in an amount sufficient to protect the property. The liability coverage may be issued by a base policy plus umbrella coverage that provides adequate protection at a reasonable cost.

Rental loss insurance covers revenue lost from units that are out of service due to casualty loss. This coverage allows the property to remain current on its financial obligations even if some or all of the units have been damaged and are not rentable. The rental loss insurance should be sufficient to carry the property through the reconstruction period, typically at least six months.

Tax credit allocation documents

The final allocation of tax credits is evidenced by the issuance of Form 8609s, which should be reviewed by the syndicator for accuracy. In conjunction with the 8609s, the allocating credit agency will also record a Land Use Restriction Agreements (LURA) to evidence the restrictive covenants under the tax credits. If the property has received debt from a government entity, there may also be restrictive debt covenants. The syndicator should review the documents to verify that they are consistent with the rent restrictions assumed as part of the initial underwriting.

Permanent loan documents

Prior to the funding of the permanent loans, the syndicator should review the loan documents to verify that the terms conform to the syndicator's original assumptions about the amount of the debt, interest rate, term, amortization period and debt-service payments. To ensure that the investor will be able to receive the tax losses, the permanent loans must contain non-recourse language. The loan documents should also contain provisions such as a notice to the syndicator of any events of default and the right of the syndicator to cure any default, and should state that in the event of a casualty to the property, the insurance proceeds will be used to reconstruct rather than pay off the loan.

Tax credit compliance

It is extremely important that the initial tenants have incomes that qualify for the tax credit restrictions placed on the property. If they are not income eligible, or if their eligibility cannot be sufficiently documented, the investor may not be able to claim the tax credits for that unit.

It is not enough that the units are rented to income-eligible tenants. The tenant documentation must sufficiently demonstrate that the initial tenants were eligible under the income and rent restrictions placed on the property. Therefore, the tenant files must clearly document each tenant's income and assets and must include copies of the lease and the tenant's application.

The syndicator should ensure that the initial tenants are tax-credit eligible through an independent review of tenant files, which can be conducted by a third party engaged by the syndicator or by qualified employees of the syndicator. In either case, the personnel should be tax-credit certified by a nationally recognized compliance training organization. The compliance review may involve a representative sampling of tenant files, generally at least 20% of the files. A more thorough, and therefore better, analysis involves reviewing of all initial tenant files.

Because of the importance of the initial tenant files in supporting the property's use of the tax credits throughout the compliance period, the syndicator should maintain a copy of each initial tenant file for the entire 15-year compliance period.

Compliance with operating targets

The final capital installment is contingent on the property achieving certain operating targets, including occupancy parameters, debt-coverage ratios, and certain levels of reserves and working capital.

To demonstrate that the property can perform financially as originally projected, it must exhibit the ability to achieve "stabilized operation." Most definitions of stabilized operation require the property to post occupancy rates in excess of 90% for at least three consecutive months, and debt-service coverage ratio (net operating income divided by required debt service) of at least 1.20x for projects that qualify for the 4% credit and 1.15x for projects that qualify for the 9% credit. In addition to the operating targets, the property must demonstrate that all required reserves have been funded and that the property has sufficient working capital, including escrowed funds, to meet all short-term obligations.

Conclusion

In administering tax credit investments, consistency is the key to success. It is imperative that the properties perform as projected and that the investor's interests and capital are protected.

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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