Changing financial markets, rising insurance premiums, and other issues can make the underwriting process tough on developers.
To help, low-income housing tax credit (LIHTC) syndicators share several important guidelines to mitigate risk and keep housing credit deals on track, especially in this environment when development and operating expenses have been on the rise.
1. Be Conservative
When underwriting a LIHTC transaction, it’s important to be conservative, offer several syndicators. “Be realistic about a project’s strengths and weaknesses. Consider larger operating budgets to account for increases in insurance and other costs and high reserves and DSCRs (debt-service coverage ratios) to account for future uncertainty,” says Carla Vasquez-Noriega, investor relations manager at Merritt Community Capital Corp.
Also, be conservative on pricing expectations at the application stage and try to leave a cushion in the deal to allow for changes and updates that take place between receiving a housing credit award and closing, adds Mark Gipner, director, fund development, at CAHEC.
“Keep underwriting variances to a minimum and avoid if possible,” he says.
Executives at one firm note that they continue to see forecasted operating expenses that are optimistic based on recent trends.
It’s also a good practice to be realistic or conservative when it comes to the placed-in-service delivery timeline. And, “ensure that operating expenses are supportable, especially insurance costs,” says David Leopold, senior vice president and head of affordable housing, at Berkadia.
Developers also need to be realistic about the time it takes to receive necessary project approvals.
“It’s important to recognize that municipal and federal agencies have been impacted by increased turnover and retirements, resulting in a decrease of staff and increase in workloads,” says Catherine Cawthon, president and CEO of the Ohio Capital Corporation for Housing. “Approvals, environmental reviews, permits—everything that historically occurred in the 90 days prior to closing—are now taking closer to 180 days so it’s important to factor that into project delivery projections.”
2. Confirm Details and Be Ready
Another good practice is to confirm key elements of your deal as you move forward, including readiness to proceed. “Is your deal really ready to move forward and close on your proposed timeframe?” asks Paul Cummings, senior vice president, capital markets, at the National Affordable Housing Trust. If the answer is yes, it could help with a project’s equity pricing and closing a deal. Being confident about a project’s construction and operating costs—especially insurance, staff, and overall operating expense budgets—is also important.
Cummings also encourages developers to confirm market conditions to fully assess the demand for a project’s units so that rent targets and vacancy rates can be justified.
Do what you can to be shovel-ready when approaching your LIHTC syndicator, agrees Stephanie Kinsman, managing director, investor relations, at Red Stone Equity Partners. “Especially in times like these, it is better to have all financing and development partners in place working toward a quick closing versus conducting a bid auction for a deal closing in 12 or so months,” she says.
“Truing up assumptions before seeking financial partners is essential to ensuring an efficient closing process and avoiding surprises and/or delays,” adds Tammy Thiessen, managing director and co-head of originations and sales at RBC Community Investments. “The world of multihousing finance and development has moved so quickly in recent years, so make sure you can back up your assumptions with recent data. Also, understand the broader development pipeline in the market early on, especially in disaster relief areas.”
R4 Capital’s risk management team works closely with its acquisitions team and developer clients to underwrite LIHTC transactions, notes Jason Gershwin, managing director. “Current best practices include running operating sensitivities with different levels of insurance cost inflation,” he says. “In the short term, it is very unlikely we’re going to see 3% cost inflation for insurance in most markets. So, it is important to understand what the downside risk is by inflating insurance costs at higher annual growth percentages. It does not solve the problem, but it keeps everyone focused on costs and how to address the challenge proactively.”
Furthermore, another best practice R4’s risk management team implements is physically going to visit the local tax assessor to fully understand and accurately underwrite the anticipated real estate taxes.
3. Prepare Your REO Schedule
Syndicators also say developers should focus on their real estate owned (REO) schedule. “Make sure it is fully up to date and be prepared to answer questions about any underperforming deals in your portfolio,” says Josh Ghena, senior vice president, syndication funding, at Cinnaire. “If you have deals that are facing significant challenges, be proactive by having an action plan ready to share with potential partners. Additionally, highlight any improvements in your portfolio over the last 12 months, even if the current performance isn’t ideal. Showing progress and a clear path to overcoming difficulties can instill confidence in your development’s long-term viability.”
Have your REO, contingent liabilities, and guarantor financials ready to go, adds Matt Reilein, president and CEO of the National Equity Fund. “If your REO is struggling due to the macroeconomic factors affecting us all, prepare a great story and a strategy for improving it.”
Reilein adds, “Sign your letter of intent quickly and be realistic about closing dates.”
4. Review Reserves
Syndicators point out the importance of having adequate reserves in their deals. Provide six months of operating reserves whenever possible, says Katie Balderrama, executive vice president, affordable equity, at Walker & Dunlop. That’s a guideline recommended by industry groups.
Interest reserves are another area to consider. “The stress of higher rates should be subsiding as the Fed begins to lower rates this year,” says Catherine Such, head of Regions Affordable Housing. “However, developers should be realistic with expected rates and terms. Some developers don’t accurately estimate the time to loan conversion and can find their interest reserve is underfunded.”
Anil Advani, executive vice president, originations and finance, at WNC, also notes the need to build in a cushion for underwriting of interest rates. “While there is a downward trend, most syndicators are still requiring substantial buffers,” he says. “In addition, insurance costs, being what they are currently, have to be underwritten with a cushion.”
5. Communicate
It’s important for developers to communicate regularly with their finance partners about the deal, says Julie Sharp, executive vice president at Merchants Capital. This includes updates about timelines and inquiries about how closing delays could impact a deal.
She also encourages sponsors to “sensitize project operating budgets to determine if they can support larger year-over-year increases in operating expenses, particularly insurance premiums, while remaining in compliance with DSCR requirements.”
It is more critical than ever to keep an open line of communication with syndicator and investor partners, particularly as unforeseen issues come up that could put a deal’s budget out of balance and jeopardize the closing timeline, according to Tony Bertoldi, co-president of CREA.
