Investment capital for economic development in America's "emerging markets" began flowing this summer under a program that was initiated by Speaker of the House Dennis Hastert and former President Bill Clinton.
At press time, community development entities (CDEs) were rushing to meet the Aug. 29 deadline for the first $2.5 billion in New Markets Tax Credits (NMTC). Investors, especially community banks, were receiving applications from the entities urging them to put money into the program. Some investors, like Fannie Mae, were preparing to issue letters stating their tentative intention to invest.
The New Markets program was created by Congress as part of the Community Renewal Tax Relief Act of 2000 to stimulate investment in low-income communities. The core rules are relatively simple: the Community Development Financial Institutions Fund (CDFI Fund), part of the Department of the Treasury, will allocate the credits to CDEs. The CDEs sell the tax credits to investors and use that money to make loans and equity investments in businesses located in low-income neighborhoods.
To become a CDE, an organization must be certified by the Treasury Department. Hundreds of groups have been certified including well-known subsidiaries of the Local Initiatives Support Corporation (LISC) and the Enterprise Foundation, and more CDEs are signing up every day.
The CDFI Fund published its Notice of Allocation Availability (NOAA) for the program in the Federal Register on June 11, 2002. The notice included guidance from the CDFI Fund on much of the program. IRS regulations governing compliance were expected to appear alongside the notice, but were still in the works at press time. Thus, investors were relying on temporary rules issued in December 2001 for guidance. Experts close to the program now believe that the final IRS regulations won't be published until as late as next March.
The CDFI Fund's NOAA also included application forms for CDEs for the program's first-ever allocation round, which closes Aug. 29.
The CDFI Fund will conduct the substantive review of each application in accordance with the criteria and procedures described in the NOAA and the allocation application, with the following scoring criteria:
- Business Strategy (25 points)
- Capitalization Strategy (25 points)
- Management Capacity (25 points)
- Community Impact (25 points)
In addition, five priority points may be awarded for prior experience in providing capital or technical assistance to disadvantaged business communities and five priority points may be awarded for investing in businesses whose owners are unrelated to the applicant.
Winning the maximum points for capitalization strategy will require specific details on investments or investment commitments the CDE has received. The CDFI Fund should declare the winners around Thanksgiving.
After the credits are allocated to a CDE, the entity has five years to sell the credits and invest the proceeds in communities. So, assuming that the IRS releases its final rules soon after the credits are allocated at the end of this year and that the winning CDEs do not run afoul of those rules, the program's first round should run smoothly.
Over the summer, investors were still analyzing the pros and cons of NMTC investing. Several interested investors stressed that CDEs will need to work hard to fund businesses that can generate strong economic returns in addition to the tax benefits. New Markets credits will help make a marginally profitable business worth investing in, but they will not make an unprofitable venture worthwhile, they stressed.
The net present value of the NMTC is about 30% of the amount invested, taken over seven years. In addition, the credit reduces the basis of the investment, so it exposes investors to additional capital gains tax liability upon disposition of their interest, experts said.
CDEs are promising potential investors a range of yields, depending on the investment and its risk. Entities dealing, for example, in mezzanine debt on commercial real estate investments are expecting yields in the low- to mid-teens - less than the yields in the high teens and twenties offered by commercial real estate equity funds, but still more than the 7% yield now offered by housing tax credits.
Returns could be depressed to some degree if investors demand third party guaranties to support CDEs that don't have strong balance sheets. Such requirements would have "a significant impact of the internal rate of return," warned Oliver Wesson, president and chief executive officer of LISC's The Retail Initiative of New York City, a certified CDE.
Other investors, such as pension funds and venture capitalists, are not participating in the program because of problems in the program rules issued so far by the Treasury Department.
However both Boston Capital Corp. and Citigroup, among many other investors, are reading applications from CDEs and offering feedback. "I believe that by the time we will have to make a commitment, the rules will be out," said Evelyn Kenvin, director of Citigroup's Center for Community Development Enterprise. "We don't mind working with the preliminary regulations for now."
CDEs are pitching hard to investors in the low-income housing tax credit (LIHTC), especially banks with an obligation to lend in underserved areas under the Community Reinvestment Act. These banks can now make loans in these areas through a CDE. The tax credit subsidy would allow the CDE to offer favorable loan terms, which allows the bank to reach a broader range of business borrowers.
Investors also receive the benefits of improved community relations and a more diversified portfolio of community development investments.
"The area is going to be a very good area for bank investors," predicted Tom Tracy, managing director of KHC New Markets, a certified CDE and a joint venture between Hunter Chase & Co. and Key Global Capital. According to experts like Fred Copeman, a tax lawyer for Ernst & Young, LLC, Tracy's CDE is at the forefront in finding innovative, viable ways to use the credit. At press time, Tracy was preparing for a whirlwind series of pitches to banks.
Tracy is also talking with Fannie Mae about a $50 million fund designed to make mezzanine loans for land acquisition, according to Tracy. He also plans a second $50 million single-investor fund with Fannie Mae to make mezzanine loans and equity investments in commercial real estate projects that qualify for historic restoration tax credits.
In part, Fannie Mae is attracted to the program by the opportunity to approach its core mission of building housing from a new angle. Though rental housing projects appear to be forbidden under the program regulations and mixed-use projects that include rental housing are very limited, Fannie Mae plans to invest in single-family homebuilding. When a New Markets investment like a home is sold to a homebuyer, the credits must be reinvested within a low-income census tract within a year--but Fannie sees this tough requirement as an opportunity to re-use the credits many times within the seven-year compliance period.
However, Fannie is also stopping just short of commitment. "We might be willing to give a letter of interest, but that does not obligate us to anything," said Wayne Curtis, vice president of the American Communities Fund at Fannie Mae. "Until we get absolute clarity on the rules, we cannot release the money."
The National Community Investment Fund (NCIF) is another CDE planning innovative New Markets investments (see story: JTCI Spring 2002, page 10). It points out that the NMTC will be very helpful in enhancing the return banks can get on commercial real estate investments, given that these have higher economic yields and fewer recapture issues than operating loans.
The preliminary IRS compliance rules state that most of the business activity subsidized by credits should happen within qualified census tracts. But until the final IRS regulations come out, investors don't know how forgiving the IRS will be if a business subsidized by the New Markets credit moves out of its census tract or hires staff from wealthier areas.
For now, investors are concentrating their energies on real estate investments, especially retail and office developments, because unlike a shop or a restaurant that can relocate or hire managers from outside the tract, a retail development or office building can't move. In addition, retail or office projects are more financially stable than many small businesses, which suddenly might be purchased or go out of business.
The compliance question is especially threatening because unlike the housing and historic restoration tax credit rules, which penalize projects that fall out of compliance in phases, New Markets investors risk losing their entire allocation of credits, including credits that have already been used, if they fail the program's compliance tests. As a result, all potential investors are checking the track records of CDEs, and many favor entities with experience handling tax credit compliance.
Experts predict that once the final compliance regulations are released, the range of viable New Markets investments will explode, spreading far beyond real estate because investors and CDEs will feel more safe by knowing just how far they can stretch the rules.
Another investor concern is whether NMTC investments can be bifurcated, so that tax benefits like losses, depreciation and the tax credits go to one investor while the economic benefits of the investment go to another. At press time, it appeared that bifurcation would not be possible and that tax benefits must be split proportionately among investors, forcing investors without a tax burden to pay for benefits they can't use.
Advocates hope that the bifurcation rule will change, though it is presently unclear even which part of the Treasury Department has the authority to rule on the issue. The hold-up is especially sad because pension funds, which already invest heavily in commercial real estate, are natural New Markets investors.
Meanwhile, venture capitalists are staying away because of the punishing compliance rules for investments they control. Businesses in which investors hold more than a 33% interest must pass several extra compliance tests each year. The Small Business Administration has written a letter condemning the "controlled investments" rule, and advocates hope for change.
Finally, it's unclear whether the NMTC can be blended with the federal historic restoration tax credit. The regulations already clearly rule out mixing the NMTC with the LIHTC. Advocates like Tracy, of KHC New Markets, are especially hopeful that this issue will be resolved because the historic restoration of commercial real estate seems to fit squarely into the mission of the New Markets program.