Since the housing credit program was enacted in 1986, low-income housing tax credit (LIHTC) investments have demonstrated a highly predictable return for investors over their 15-year life. Housing credits realized by investors over the term of the investment have averaged 100 percent of the amount originally projected. In part, this result is a function of the many protections that were built into housing tax credit transactions to manage investment risk. This article analyzes the investment performance of this asset class against the incidence of eligible basis and timing adjuster provisions as well as construction and lease-up issues. The data utilized for this analysis came from Ernst & Young’s recently published Understanding the Dynamics IV: Housing Tax Credit Investment Performance (from which, unless otherwise noted, data in this report is taken).
Safety of the LIHTC investment
In general, housing credit properties exhibit strong performance. Ernst & Young surveyed the 2005 calendar year operating results of 13,986 properties, which reported a median 96 percent occupancy, 1.15x hard debt coverage ratio, and $240 cash flow per unit, indicating that these projects are generally self-sustaining.
Despite this generally favorable performance record, approximately onethird of properties operate with deficits in any given year. While this is an initially alarming statistic, several factors observed among these properties temper some of the concern regarding unfavorable property performance. First, these operating deficits tend to be short term. While 34.2 percent of the housing credit equity surveyed reported properties with negative cash flow in 2005, only 4.3 percent of those properties reported negative cash flow in each year from 2000-2005. In addition, operating deficits tend to be small in amount. Among all of the properties reporting deficits, 45 percent reported shortfalls of less than $400 per unit. Moreover, operating deficit guarantees, voluntary developer funding, as well as property-level reserves, were typically available to fund shortfalls. Should these provisions be exhausted, upper-tier and other investment-level protections, such as working capital reserves, commonly serve as an additional safety net.
Substantiating this, housing credit properties report only a 0.03 percent annualized property foreclosure rate, which is approximately 10 percent of the foreclosure rate reported at market-rate properties with less than five units, the next lowest asset class foreclosure rate among a total of nine classes surveyed across the real estate universe (source: ACLI Mortgage Loan Portfolio Profile, 1993-2005). Moreover, reported yield variance between 2000 and 2005, which is the difference between actual yield and projected yield, ranged between 0 and 137 basis points, demonstrating that property underperformance did not significantly impact yield realization.
While the character of operating deficits as well as the mechanisms for funding deficits explain some of the stability seen in the yield variance data, additional transaction provisions also help ensure yield realization. Basis adjuster provisions, which adjust the overall amount of investor equity based on overall credits expected, and timing adjusters, which adjust investor equity for delays in benefit delivery that may result from construction or lease-up periods that exceed initial expectations, are two such mechanisms. (Calls on investor capital contributions may also be delayed as a technique to preserve yield). These provisions are typically found in the local limited partnership agreement, operating agreement, or related documents.
Basis adjustments
Basis adjusters, which increase or decrease investment limited-partner capital contributions, arise due to variance in credit delivery due to changes in eligible costs, changes in the applicable tax credit percentage, and/or errant underwriting. These provisions are designed to ensure that the amount of equity contributed relative to the expected amount of housing tax credits over the life of the investment preserves the projected yield.
Based upon the Ernst & Young survey, small upward adjustments were observed more than half of the time. For conventionally financed properties, or properties that are not financed with taxexempt bonds, 57 percent of all properties reported positive basis adjusters (shown in Figure 1). This trend was slightly more pronounced in tax-exempt financed properties. On the whole, negative basis adjusters were required nearly half of the time; however, most of these adjusters were nominal in amount, between $0 and $100,000 per property, indicating a reduced risk to investors.
Timing adjustments
A direct source of tax credit delay and investor risk is attributable to delay in construction and/or lease-up. In this discussion, the construction period is defined as the period between the date when construction commences and the date when a certificate of occupancy is issued. Lease-up is defined as the timeframe between the date a certificate of occupancy is issued and completion of initial rent-up of the property. Housing tax credits are “earned” as each unit is occupied by a qualifying household paying no more than a certain maximum eligible rent, among other conditions. If occupancy is delayed, housing tax credits may be deferred to the end of the tax credit delivery period. Less frequently, the impact of leasing delays may include a portion of the credits being realized over 15 rather than 10 years, or more rarely, loss of all credits. Delays in construction completion can in turn delay leasing. Failure to achieve the placed-in-service deadline may result in loss of all housing tax credits. If the delays are material, timing adjuster provisions may be activated. Though timing adjuster data was not reported by a sufficient number of data providers in the latest Ernst & Young survey, information specific to the duration of construction and lease-up periods relative to expectations at the time of investment closing were reported.
Based on a survey of the performance of 2,167 properties, their construction and lease-up were reported to have been on schedule or ahead of schedule more than 50 percent of the time. However, 39 percent of properties reported construction delays, and 41 percent of these properties reported a lease-up delay (shown in Figure 2). This indicates a skewing toward delays (rather than ontime or ahead of schedule) for both construction duration and lease-up duration.
Of these delays observed, 23.9 percent of construction and 29 percent of lease-up delays were greater than two months, and 15.2 percent of construction and 11.7 percent of lease-up delays were shorter than two months in length.
In summary, both construction and lease-up are often delayed in housing credit projects, resulting in delayed credit delivery to investors in an otherwise stable investment. While adjuster provisions and other features preserve investment yields, these delays result in unpredictable credit delivery, particularly during the early years of the investment, making tax shelter planning and earnings forecasts difficult to predict during this period.
Jill Stonehouse is a staff member of Ernst & Young’s Tax Credit Investment Advisory Services [email protected]). Stonehouse graduated from Harvard College cum laude with a bachelor’s degree in economics and focuses on housing tax credit investor due diligence and renewable energy credits.
