QMy low-income tax credit investor has asked for a residual value analysis. What is this, and why do they want it?
A A residual value analysis is a projection of the hypothetical sale value of the project at some point in the future, usually the due date of the debt. Investors typically want to know if it is reasonable to assume that the debt can be paid off when it comes due. They also want to decide whether the debt will be characterized as debt for tax purposes or if it may be designated as something else, like equity or a grant.
Q Can you give an example to show how it’s done?
A In a typical analysis, you would determine the hypothetical sales price based on the net operating income (NOI) capitalized using a market rate. For example, assume that the project has two loans. One loan fully amortizes in 30 years, and the second has a 40-year term with interest accruing at a market rate. The interest is paid from cash flow available after debt service on the first mortgage and is due when the loan matures in year 40. Estimating the balance of the second loan is challenging because no one really knows how much interest will be paid over the term and how much will accrue. To project cash flow, the owner will calculate the rental income over the 40- year period, taking into account expected market conditions, assumed inflation rates, and rent restrictions agreed to in the low-income credit land use restriction agreement (LURA). Operating expenses are projected out in the same way. In this example, there should be substantial cash flow after the first mortgage is paid off in year 30. Determining the sales price in year 40 requires a bit of professional judgment. If the income and rent restrictions in the LURA are gone by year 40, then the owner would assume that the property is sold as a market-rate property. A reasonable method to estimate market-rate NOI in year 40 is to determine what it would be today, and to trend that amount using a factor like the consumer price index (CPI). Operating expenses would exclude costs associated with the provision of services that may be required in a low-income property. The CPI can be estimated by looking at the CPI for the local market over the last 40 years. The capitalization rate to apply can be obtained from a broker who knows the location and is familiar with sales of similar multifamily properties. This analysis does not require that the owner choose the most realistic or most likely set of assumptions, just reasonable assumptions that could be defended should an Internal Revenue Service auditor ask why the assumptions were used.
QWhat do you do if the approach discussed does not show sufficient value to pay off the debt?
A An alternative analysis that may yield a higher value is to look at the property as a potential sale for condominium conversion. Another option is restructuring the debt. In many cases, the secondary loans are coming from a federal source, so they bear interest at the applicable federal rate. This market rate of interest on the soft financing allows the owner to claim the 70 percent present-value credit, assuming there is no other federal financing, like taxexempt bonds. If the loan is not from a federal source then it may be possible to negotiate a lower interest rate. Another way to reduce the interest that is accruing is to use operating reserves and affordability reserves to pay down the interest at some point after the reserves are no longer needed.
