The equity term sheet is a critical document for affordable housing developers that are taking on a new investor. Understanding the key points is important to a smooth equity closing. The deal is negotiated at the term sheet stage before documents are drawn up so everyone knows their respective roles and responsibilities throughout the life of the deal.
Before the discussions start, know your deal. What are you promising to the investor in the form of housing tax credits and losses and ultimately yield? Are there ways you can enhance the yield by accelerating the losses and credit or delaying the capital contributions? Many items in a term sheet look harmless, but they all have implications that the savvy sponsor has to understand. Here are five to focus on:
1. Credit delivery amount and timing. Timing and amount of the credits is always defined in the term sheet, and the delivery is subject to a guarantee to the investor. Analyze the construction timing and expected lease-up, and focus on delivering credit for buildings that are fully leased by year-end to avoid a two-thirds credit. A downward equity adjuster reduces the total equity, which could create a funding gap.
2. Guarantees. The common guarantees are construction completion, operating deficit, tax credit, and repurchase, among others. Read this section carefully, and confirm that it aligns with the current market terms across the various categories. Ideally, you want the guarantees to fall at the low end of the spectrum, understanding that you may not get the optimal terms if your organization is thinly capitalized or inexperienced.
3. Reserves. Replacement reserve and operating deficit reserves are most common, though other reserves may be necessary. Know when these reserves can be used and released and how they will be distributed. Determine if a reserve can be used to reduce or cap some of the guarantees above.
4. Year 15 exit options. The investor exit discussion should be included in the term sheet with an emphasis on the options, including a fair-market value sponsor buyout of the investor, investor put, and right of first refusal if applicable. Run the projections and sensitivity analysis for Year 15 to determine the potential fair market value and cost associated with each strategy.
5. Implied costs for third-party reports. Look for “unwritten costs” that may not be fully defined or assigned: construction reviews, environmental reviews, title reports, professional fees, and other third-party items. Developers should obtain estimates for these costs and determine whether the investor or lender will share in covering them and who can rely on them. Some of these items have a longer lead time, so focus on timing to prevent a closing delay.
All of the terms in a term sheet have implications, so it’s worth taking the time to develop a rock-solid understanding before anything is signed. Reach out to a trusted advisor for additional clarity as needed.
