The first wave of low-income housing tax credit (LIHTC) properties to come out of the initial 15-year compliance period hit the industry in 2003. The full impact was felt in 2004 and 2005. Some investors and syndicators rode the wave well; others ended up underwater, bloodied and bruised. The affordable housing industry is now better prepared for the annual wave that hits each year on Jan. 1. Everyone’s experience with Y-15 has been different, and I can only offer very broad advice and suggestions for surviving the wave. Here are the lessons I have learned.
Creating maximum value
Large syndicators of tax-credit investment properties must contend with an annual wave of anywhere from 60 to 90 properties. Each property has a future highest and best use that must be determined in the context of a local market, available resources and investor interest. Smart sellers explore all of the available options, but it’s hard work. Yesterday’s successful disposition strategies may already be obsolete due to the changing regulatory environment. The qualified contract process, discussed below, is now in effect and significantly impacts the disposition process for many properties.
Portfolio transactions are more efficient, but are underwritten conservatively and do not maximize individual property values because of significant differences in the various underlying properties. Investment bankers eagerly view the huge volume of expiring LIHTC properties, certain that there is a wonderful capital markets solution. But when they attempt to underwrite the actual portfolios, they find uncertainty and lack of control due to having multiple local partners, different types of debt and subsidies, and different restrictions and regulatory agreements. Their common refrain is, “Don’t you have any other types of deals?”
How investor priorities differ
A syndicator like CharterMac represents the limited partners in a LIHTC fund and generally has little economic stake in the fund or particular investments. The firm creates exit value because that is its duty to its investors. In the meantime, it hopes to get repaid for its efforts through increased investor confidence in the company’s ability to properly invest, manage and recoup capital, and provide returns as promised. An investment program that ends with a successful exit will attract future capital for new tax credit developments.
All partners in an exit must understand that residual value belongs to the limited partners, and syndicators are not empowered to give away that value. Many partnership agreements crafted 15 years ago require that upon a disposition or sale, limited partners get a return of their invested capital and a return on capital before any profits go to the general partner. Some general partners have attempted to renegotiate existing partnership agreements for more residuals as compensation for their 15 years of efforts, and for the loss of management contracts going forward.
But all parties and public agencies must understand that individual investors in public tax credit funds do not necessarily have a commitment to affordable housing, and many corporate investors cannot simply donate their property to keep it affordable since they have an obligation to their shareholders. Yes, investors received tax credits, but like homeowners who invested for tax deductions, investors in tax credit properties are reluctant to give away their capital appreciation.
Property valuation difficulties
An appraisal is one indicator of a property’s worth, but may have limited usefulness for expiring tax credit properties since each property must be valued in light of all possible future uses. This becomes a difficult, time-intensive exercise. Valuation must be performed with extensive knowledge of market dynamics as well as all potential subsidies and other incentives, such as first-time homebuyer programs, available in the local market. The simple fact is that the affordable housing market is not a true “free market.” It is heavily influenced by various public sector programs to encourage affordability. A buyer who has better experience and connections may be able to get soft debt forgiven, subsidies extended, reserves released, rents increased, and operating expenses lowered – all elements that significantly impact residual value and cannot be easily appraised.
Full exposure to the open market through a broker can bring what appears to be the highest offer for a property, but if it’s for affordable housing, that does not ensure that the buyer is experienced enough to get the approvals to close the transaction. For sellers, potential property prices must be weighed against the various risks of execution.
Long closing times
Maximizing value may require a long contract period with closing contingent upon specific approvals such as a successful new tax credit application, the Department of Housing and Urban Development and agency approvals, or a condo plan approval. It’s crucial to know a buyer’s experience with the proposed strategy and the relative possibility of a successful closing.
There are no shortcuts to understanding property value and risks of an execution. Smart sellers and buyers must have a thorough understanding of a property’s operations and encumbering regulations, its position in the market, and achievable rents and occupancy levels prior to going under contract. Equally important is knowledge of the capital markets: What is an appropriate cap rate, what debt programs are available, and what lenders work in that market? Uninformed buyers and sellers are in for difficult, and many times fruitless, negotiations as they negotiate positions based on ignorance or false information.
Sellers take on risk by tying up an asset worth millions of dollars in a rapidly changing market. The seller must understand how a buyer determined their price and how it relates to the proposed execution before they make a decision to go under contract. The affordable market is flooded with well-capitalized buyers who have been priced out of the conventional market and want to invest in the affordable properties, but with little understanding of the regulatory environment. They are willing to tie up a seller’s property in hopes they can get restrictions lifted and rents increased.
Extended closings, however, can provide all parties time to clean up all of the issues left unresolved over 15 years including locating missing regulatory agreements, lost permits and approvals, resolving soft debt issues, and hundreds of other issues not contemplated when the first Sec. 42 properties were placed in service.
The profile of tax credit properties themselves has changed. The first generation of LIHTC properties were often urban and heavily subsidized, like moderate-rehabilitation properties, or smaller and more rural, such as those under the Farmers Home program. As the industry matured, properties became larger with more new construction than rehabs, and more suburban locations with amenities that matched market-rate properties. For example, some of the first generation properties are now considered obsolete and out of favor with investors, and cannot be recycled with new tax credits, thus narrowing the disposition options for those properties.
There have also been continual regulatory changes to the Sec. 42 program over the years that preclude a standard disposition strategy for most properties. The most significant is that the affordability compliance period changed from 15 years (pre-1990) to 30 or more years. Add to that public fiscal constraints and changing priorities resulting in changed or terminated federal loan and grant programs. At the state level, nearly all states have modified their housing programs over 15 years, and state preservation programs for recycling tax credit properties range from non-existent to progressive. To effectively sell or buy expiring tax credit deals, you must understand each program and how it impacts the individual property.
To add even more uncertainty, the qualified contract process is now in force. That process requires owners to offer the property to a buyer who will keep it affordable, and if no such buyer exists, the owner may be able to exit from affordability restrictions. The interpretation and enforcement of the qualified contract process will be left to individual states, and therefore will have a significant impact on property value and length of time needed to implement a disposition strategy.
Despite the challenges inherent in expiring 15-year properties, there are tremendous opportunities for buyers, sellers, preservationists, and market-rate investors.
In our next article, we will explore some of these opportunities and successful strategies for expiring tax credit properties. In the meantime, patience, perseverance, and Prozac will help you get through the next wave.
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. For more information, visit www.chartermac.com and www.chartermaccapital.com.