Little by little, getting new money into old Sec. 202 seniors properties keeps getting easier. Now, developers are finding ways to mix equity from low-income housing tax credits (LIHTC) into their deals.
It’s still difficult to use tax credits for these projects. The process requires a long list of approvals and exceptions from the Department of Housing and Urban Development (HUD). Also, the process typically only works for Sec. 202 properties built after 1974 — the hundreds of projects built before that date typically don’t receive rent subsidy and are still nearly impossible to recapitalize.
But for the thousands of Sec. 202 properties that could potentially benefit, experts have begun to close a steady trickle of deals. If HUD chose to streamline the process that worked for these transactions, then the trickle could become a flood.
Tax credits help Minnesota portfolio
CommonBond Communities, based in St. Paul, Minn., recently recapitalized a whole portfolio of Sec. 202 properties with tax credits and a mortgage funded with tax-exempt bonds.
The $60 million deal closed just before the end of 2005. CommonBond merged 17 projects into a single limited partnership. Before the deal, each of the individual developments had been owned by a separate single-purpose entity. Fortunately, CommonBond had been a major participant in each of these17 properties from their beginning, so the developer didn’t have to buy out any other owners to merge the properties.
The complicated deal also needed the approval of HUD officials, beginning with the transfer of ownership. HUD also had to approve the prepayment of the project’s old Sec. 202 mortgage, which took about one month. The use restriction on the properties also had to be altered so that if the worst-case scenario happened and the project lost its Sec. 8 rental subsidy, it could charge higher rents and avoid foreclosure.
But worst of all, before the ownership of the portfolio could be sold to a tax credit investor, HUD had to approve that new owner through the agency’s dreaded 2530 previous participation certification process. The process requires any new owners with more than a 25% interest in a HUD property to list other HUD properties they have owned and explain problems those properties may have had.
Fannie Mae was CommonBond’s tax credit investor, and squeezing them through the 2530 process required listing nearly every HUD property Fannie Mae had ever owned. “It often takes longer than you would hope,” said Joe Holmberg, vice president of CommonBond. In his case, the 2530 process helped push the closing of his deal from October to the end of December. If the process had taken even a few days longer, the portfolio could have lost its reservation of bonds.
The folks at CommonBond had to bite their fingernails through the long delay, even though they had strong advocates working for them at their local HUD office, which has the reputation of being one of the best in the country, according to Holmberg.
“We really do have a great partner in the local HUD office,” agreed Joe Fusco, a development officer with Enterprise Community Investment, Inc. Enterprise syndicated the portfolio’s tax credits to Fannie Mae, providing $16 million in equity to the project at a price of about 98 cents for a dollar of tax credit. Enterprise closed tax credit deals for 31 properties in 2005 including the Minnesota portfolio and two other portfolios. Enterprise hopes to match that volume in 2006.
The CommonBond portfolio also received a $33 million tax-exempt bond mortgage. U.S. Bank purchased the bonds and will hold the bonds itself rather than selling them to investors. As result, the bonds didn’t have to be rated or credit-enhanced, and the deal saved many thousands of dollars in closing costs.
“We didn’t have to pay S&P,” Holmberg said. The entire deal eventually generated a total of $3 million in transaction costs, which is relatively low, Holmberg said. The interest rate on the loan is a little less than 5.5%.
The biggest challenge to closing the deal was the difficulty of underwriting 17 properties sprinkled across Minnesota to create a single risk profile for the loan to the project.
“I spent a lot of time driving to the properties,” Fusco said.
More Sec. 202s using LIHTCs
A growing number of Sec. 202 properties are choosing tax credit financing to recapitalize. Tracy Peters, managing director of Red Capital Markets, Inc., has recently participated in recapitalizing six Sec. 202 properties with tax credits and is now working on closing nine more properties.
Sponsors of a Sec. 202 deal have several choices, according to Peters. They can hold on to the property and do nothing, especially if the property is not facing a crisis. They can also sell the property.
To bring new money into a property, sponsors could refinance the debt on their property. Simply by taking on a new, larger loan at a lower interest rate, sponsors may be able to raise enough money to do some significant repairs. (For more information on refinancing Sec. 202 properties, see Affordable Housing Finance, September 2005, page 38.)
However, if the project needs more significant rehabilitation, sponsors may want to consider LIHTCs. The projects Peters has worked on all mixed low-interest, tax-exempt bond financing with 4% LIHTCs.
Tax-exempt bond financing requires some expensive closing costs. But the average size of a Sec. 202 project built between 1974 and 1994 averages just 49 units. That’s about 100 units too small to support those heavy bond closing costs.
Many sponsors, such as CommonBond, merge several properties into one limited partnership, so that more units can be refinanced by a single bond issue. All of the Sec. 202 tax credit deals that Peters has worked on also involved several properties merged into larger portfolios.
Owners should be realistic about how much work the property needs because, especially after refinancing, the property may not receive another infusion of capital for decades. Also, make sure to talk to the state housing agency and the local HUD office. “That’s maybe one of the first conversations you should have,” Fusco said.
But many of the owners of Sec. 202 properties still hesitate to use LIHTCs. For many would-be sponsors, the conversation ends when they discover using tax credits would require them to sell 99.9% of the ownership of their property to a tax credit investor.
“They don’t really grasp that the general partner calls the shots,” said Carolyn McMullen, principal with Prudential Huntoon Paige (Prudential), based in Chicago. She would know. In 2005, her group helped recapitalize six old Sec. 202 properties. All six eventually decided not to use tax credits.
Most Sec. 202 sponsors need a strong financial motivation, like extensive capital needs at their properties, before they will consent to learn the complexities of the tax credit program, said Dee McClure, senior vice president for CWCapital, LLC, a leading Sec. 202 lender. Two of the firm’s recent 11 deals utilized tax credits, either to address capital needs or to lower the size of their debt.
Nonprofit sponsors also dislike having to pay property tax. But once a project is owned by a for-profit tax credit partnership, the taxes come due unless local officials give the property an exemption.
However, Prudential has high hopes that nonprofit boards may eventually come to accept tax credits, especially once McMullen has a few more successful deals she can use as examples of how the process works. In particular, nonprofit boards could benefit from the developer fee that comes with a successful tax credit deal. This fee could be used for practically anything, from services to new equipment for the project.
Lobbying for a better process
All of these Sec. 202 deals that have included tax credits have required a long list of special approvals from HUD, which has been in contact with advocates eager to help improve the process. A group of experts working with HUD hope the agency will soon make several of these special approvals standard operating procedure for recapitalizing Sec. 202 properties.
Advocates also hope that HUD will allow sponsors to receive income from the sale of Sec. 202 properties, so that nonprofits that don’t want to learn the complexities of tax credit management can sell to other nonprofits that do.
“We believe they [HUD] have the authority to do most of these things with a stroke of a pen,” said Bill Kelly, president of Stewards of Affordable Housing for the Future, based in Washington, D.C. “Much of it has no budget impact.”
However, the few changes would make mixing tax credits with Sec. 202s much faster and easier. “If we want to have it done at scale and efficiently we’re going to need this kind of help,” Kelly said.
Kelly also hopes that HUD will help Sec. 202 properties built before 1974 by providing them with Sec. 8 rental subsidy in the form of enhanced vouchers.