In many mixed-use affordable housing projects subsidized with low-income housing tax credits (LIHTCs), the residential and commercial space mix like oil and water: not at all.
That’s because many affordable housing developers and most investors work to separate commercial space from rental apartments, at least on paper, so that even though the spaces may be in the same building, the income from the spaces, and much of the risk, will flow to different entities.
“The investor is only concerned with investing in the housing component of the mixed-use deal,” said Leila Ahmadifar of PNC MultiFamily Capital.
Most tax credit pros now avoid the simplest structure for a mixed-use project if they can, according to experts like accountant Stuart Koch, partner with Koch Group & Co., an accounting firm with affordable housing expertise based in New York City.
This structure treats the project like any other affordable housing project subsidized by LIHTCs: A single entity owns the entire development, including the commercial space. Any income from the commercial space flows into the partnership along with the project’s income from apartment rents.
If the commercial space is successful, the developer may reap few of the benefits; if it fails, the investors will not be shielded from the collapse.
Developers must also be careful not to break the LIHTC program’s rules: The cost to construct the project’s non-residential space can’t add up to more than 10 percent of the project’s eligible basis.
Also, if the income from the commercial space ever grows to more than 20 percent of the total project’s income, then the project will suddenly be considered a commercial project and not a residential project by the Internal Revenue Service. The project’s rate of depreciation will slow down, producing fewer tax benefits per year for the project’s investors.
But developers have found a way to use the likely income from commercial space to help finance the construction of a mixed-use project – and even to keep some of that potential income for themselves – while managing to count the cost of building the commercial space as part of the project’s eligible basis for generating LIHTC.
Creating a “master lease” for the project’s commercial space doesn’t change the ownership of a mixed-use property. A single partnership still owns the whole project. Instead, the developer – that is, the general partner or an affiliate of the general partner – signs a master lease to gain control of the property’s commercial space. The developer becomes a tenant in the retail space at the property and pledges to pay the rent stipulated in the master lease to the partnership.
The developer then rents the commercial space out to its end user, such as a shop or a restaurant, hopefully for more than the developer agreed to pay under the master lease. The developer can keep the excess.
The partnership can also use the income promised in the master lease to justify taking out a larger loan to help build the property. However, to look convincing to the bank, the developer needs to be financially strong enough for the lender to believe that the developer will actually make the rent payments, even if the space has some vacancy, Koch said.
But if the income from the commercial space proves disappointing or nonexistent in the long term, the developer probably won’t have to default on the master lease. Instead, the partnership can usually work out an agreement.
For example, some of the developer’s already deferred development fee might stay deferred for a few more years.
“You don’t have an outside person you have to pay,” Koch said. “It’s like borrowing from your father.”
At the end of the project’s 15-year tax credit compliance period, when the master lease on the commercial space ends and the tax credit partnership dissolves, the commercial space is sold along with the rest of the project to whoever buys the LIHTC investor out of the deal.
This can put for-profit developers in an awkward position if the commercial space has been successful enough to increase the fair market value of the whole property. At best, if a for-profit developer is willing to leave the deal, the developer will receive some (up to a maximum of 80 percent) of the increased value when the tax credit investors sell the project.
But if the for-profit developer wants to buy back the property from the tax credit investors, the increased fair market value will only increase the price the developer must pay.
Nonprofit developers are, thankfully, spared some of these “year 15” worries, which makes the master lease structure especially attractive to them. At the end of 15 years, nonprofits have the opportunity under the rules of the LIHTC program to buy their projects back from tax credit investors for just the outstanding balance of the project’s mortgages, Koch said.
The third and riskiest choice available to developers is to split the ownership of the project into pieces. By “condominium-izing” the ownership of their project, the commercial space becomes totally separate from the rental apartments.
In this scenario, the developer can remain the sole owner of the commercial space, which will share no income or depreciation with the rest of the project. Also, the commercial space will not be sold with the rest of the project at the end of 15 years, unless the developer decides to cash in. The common expenses of the rental and the commercial projects will be shared based on a formula decided on when the project is split.
Unfortunately, this arrangement means the developer also has to finance the construction of the retail space and manage it without much help from the rest of the project.
If the income from the commercial space proves to be disappointing, the developer will still have to pay the debt owed on the commercial space – or default if it can’t be paid. “It’s the same thing as owning a building,” Koch said.
Increasingly, LIHTC investors like this ownership structure, because they are spared the difficulties and complexities of owning small commercial spaces, according to investors like David Kunhardt, senior vice president for the Community Investments Group at AEGON USA Realty Advisors, Inc., which invests in LIHTCs.
AEGON prefers that commercial space is split off into a separate condominium even when that space is highly likely to succeed, like the retail space at The Gilmore, a mixed-use project on one of the busiest corners in Seattle’s shopping district, in which a class-A tenant, a McDonald’s franchise, had already signed a long-term lease. And AEGON prefers not to own retail in more transitional areas.
“We try to get our developers to imagine that it is going to be 50 percent vacant,” Kunhardt said. “Based on actual experience in very real circumstances, we have reason to be skeptical of mixed-use.”