In the first part of this article we discussed the challenges and difficulties of implementing and executing Year 15 disposition strategies; custom crafting the right strategy to fit each property and each market; balancing limited partner, general partner, and community priorities; the difficulties of valuing Year 15 properties; the protracted approval and closing times; and the uncertainty of regulatory changes, including the new qualified contract process. Someone in my office said that part one had a negative tone. I admit the list of issues is daunting and the process can be painful. However, these challenges are the stuff that make Year 15 so interesting. Easy is boring. So let’s look at some challenging, but effective, exit strategies for Year 15 properties.
At CharterMac, our experience and focus has been primarily with pre-1990 properties with no extended use, or properties that have been released from extended use through the qualified contract process. For these properties, five good exit strategies to consider are:
• Operate “as is”
• Convert to market rentals
• Recycle with 4 or 9 percent tax credits
• Partner with or sell to a nonprofit
• Convert to condominiums
Operating “as is”
This strategy is simple and often overlooked. Some affordable properties can effectively compete with market properties without extensive rehab. The ability to lease to anyone after Year 15, including formerly over-income tenants, tenants with mixed living situations, and students means that properties can achieve higher occupancy and a higher leasing “hit” ratio. A wider pool of qualified tenants can result in increased occupancy and eventually higher rents that are regulated only by what the market will bear. A good market analysis can quantify the amount of additional revenue that can be generated versus the costs to achieve incremental revenue.
Last year I was trying to negotiate an extensive, complicated tear-down and redevelopment purchase agreement with a buyer/developer. While I negotiated, the smart property manager simply implemented an aggressive leasing program. Occupancy climbed from 91 percent to 97 percent, and she increased rents by $100 per unit per month. Based on this success, we made some minor capital improvements and other rent increases followed. The eventual sale price, to a cash flow buyer, equaled the offer from the redevelopment buyer, and entailed significantly less risk. Her simple strategy trumped a complicated one.
Converting to market
Benefits: In this case, the property has already been accepted by the community, so permitting and approvals are in place, thus reducing development risk. Rehab construction risk is relatively low versus new construction, and the income stream in place further reduces costs and risk. Acquisition and financing underwriting is easier and more accurate due to the 15-year history of operations. And as multifamily housing, the property still qualifies for many of the financing programs, such as Fannie Mae, Freddie Mac, and Department of Housing and Urban Development (HUD)-insured loans, that are available for affordable housing.
Risks: Lease-up may be slow and rents may not meet projections if renters see a formerly affordable project as less desirable than other market-rate properties. Years ago, I was called in to do a distressed sale of a portfolio of Sec. 8 properties that a group of investment bankers had tried to convert to market. A low-cost debt and equity participation structure created great capital synergy. Our bankers cancelled the Sec. 8 contracts and performed a modest rehab. A slow and painful lease-up proved the properties still had the stigma of affordable housing, and the elusive market rate tenants would not pay as much as the old Sec. 8 contract. Eventually the properties plateaued at 70 percent occupancy, with 50 percent of residents made up of former Sec. 8 tenants who were now using vouchers, and 20 percent made up of market-rate tenants. Our bankers had created a hybrid vehicle that was neither affordable nor market, and it drove them to foreclosure. To effectively convert to market, you must know your competition and understand all of the objective and subjective market dynamics.
Recycling as affordable
Benefits: Most markets need affordable housing. In many hot markets, public policymakers provide incentives, such as tax relief and low interest loans for preservation. Most Year 15 properties are eligible for new 4 percent or 9 percent tax credits and most properties do need renovation and recapitalization to meet the next 15 years of service. Development risk is reduced because the tough anti-development and anti-affordable NIMBY issues have been resolved. Qualified tenants are in place and the property has an operational track record to make financing and underwriting easier.
Risks: Buyers and sellers must be aware of the many overlapping and tangled restrictions and rights of first refusal that were put in place long before anyone thought of disposition issues. This includes state and federal laws to protect tenants from displacement and laws that may give tenant groups and nonprofits rights of first refusal. Beware that in some states there is sentiment against using scarce tax credit resources to recapitalize Year 15 properties. On the capital side, there is not much investor interest in “first generation” tax credit properties, which tend to be smaller and rural or in distressed urban areas. The participation of any current partner (including investors) is limited by the 10 percent rule. With fewer and larger corporate investors in the industry, this is becoming a serious issue when the same investors turn up in the selling and buying entities. Also be aware that a poor purchase or sale structure may blow the 10-year ownership rule and jeopardize your acquisition credits. Those great tenants that you put in 15 years ago may be income-qualified at 140 percent of area median income, but they are over-income for a new placed-in-service use and you cannot get new tax credits on their unit.
Sale to or partnership with nonprofit
Benefits: The industry has many programs to encourage and support partnerships with and property sales to nonprofits. They can often provide more “sources” to a deal through increased access to grants, soft loans, and to some HUD programs. In many states, valuable real estate tax abatement programs exist, and some states have set aside loans or credits for nonprofit preservation. On a small 140-unit deal we recently recycled, the benefits available to the nonprofit buyer were grants, predevelopment loans, and real estate tax abatements, which resulted in an additional $1.5 million in funds for the project. Plus, nonprofits can be highly effective in dealing with tough properties that need community resources for a turnaround.
Risks: Most nonprofits are not well-capitalized and cannot shoulder the risks of development. Unfortunately, there is a misconception that nonprofits are good buyers for projects that are not economically viable. These transactions rarely close. And though nonprofit participation brings the potential tax benefits of debt forgiveness and charitable contributions, from my experience these are more problematic than beneficial for public fund and corporate fund sellers.
Benefits: A conversion can meet two important goals by turning tenants into homeowners and returning significant amounts of capital back to the investors. In Puerto Rico, first-time homebuyer grants and low-cost financing programs make conversions a viable sale option. Most of our sales of Year 15 properties have been to affordable condo converters. If the choice is an immediate sale versus a more profitable sale to a converter with staged future payments as units sell, many investors are willing to take longer payouts and more risk for greater returns. In most markets, the analysis of renting versus owning is an easy calculation and if ownership costs are equal to or less than current tenant rents, then it’s a viable candidate and the existing income information on your tenants will let you know how many will qualify for home ownership.
Risks: For properties without extended-use agreements, first-time homebuyer programs are critical to the success of affordable condo conversions. In addition, affordable properties may have a stigma attached to them, making it more difficult to judge market acceptance. Conversion risk can be mitigated by offering units for sale at a below-market base price, and using a cooperative lender who is committed to underwriting loans to first-time homebuyers. Timing of the conversion is critical because there are significant legal issues to be resolved, and meanwhile today’s condo market cycle seems to be unsettled. To make affordable condo conversions a standard exit strategy for the post-1990 extended-use properties, states and agencies must be willing to trade extended-use provisions that protect affordable rental for affordable homeownership. Turning renters into homeowners, and allowing investors to recoup their capital for new affordable housing investment, is a difficult but achievable goal.
A growing number of affordable-housing industry veterans are recasting themselves as specialists in buying, selling, and repositioning Year 15 assets. With creativity, hard work, and a realistic assessment of risks involved, you can develop and implement your own strategies that will turn your Year 15 properties into profitable success stories. Remember, easy is boring. The challenges and uncertainty of dealing with Year 15 properties will get your adrenaline and your creative juices flowing.
—Stephen D. Roger is a senior vice president of CharterMac and team leader of the Capital Transactions Group that is responsible for all dispositions for the CharterMac portfolio. CharterMac, through its subsidiaries, is one of the nation’s leading full-service real estate finance companies, with a strong core focus on the multifamily sector. The company’s fund management subsidiary, CharterMac Capital (formerly Related Capital Co.), is the nation’s leading sponsor of investment funds for low-income housing tax credits.
Editor’s note: This is the second half of a two-part series. For part one, see Affordable Housing Finance June 2006.