A number of the mistakes made by developers are the same that have been made for years. And with the current challenges faced by the affordable housing industry, there are some new ones as well. So, let's examine the common pitfalls in the development process.
Failure to procure equity
Obtaining equity for low-income housing tax credit (LIHTC) developments has not been an issue for the past 10 years. And then the financial markets experienced a meltdown in the third and fourth quarters of 2008.
With the trials and tribulations of Fannie Mae, Freddie Mac, and a number of the larger banks, an industry that consistently raised $8 billion a year in equity became a less than $4 billion industry almost overnight. Many developers are still spending time, effort, and money trying to crank out projects without a clue where the equity will actually be procured.
In addition to conventional sources of equity, developers need to focus on nontraditional possibilities as well. We're in an environment where creativity is a must. Direct investors must be cultivated—and educated.
The Housing and Economic Recovery Act of 2008 made it possible for investors to utilize tax credits as an offset to the alternative minimum tax generated by passive income.
Developers who rely solely on traditional methods significantly reduce their chances of obtaining the equity that they need.
Too much deferred developer fee
Unfortunately, a number of state housing finance agencies are pushing developers to defer a portion of their development fees. The practice of deferring developer fees is just plain bad business.
For developer fees to be eligible for basis, they must actually be paid at some point in the life of a development. Many developers defer fees because it earns them points when applying for a credit award—or because state agencies force them to do so.
In many cases, they mistakenly believe there will be adequate cash flow from which they can pay their deferred fee. Too often this never happens, and the developer ends up faced with having to pay taxes on the fee deferral.
Developers must work harder to find enough sources of funds to enable the payment in full of the developer fee when a project has been placed in service and the operation has been stabilized. And, as an industry, it is imperative that we help state agencies understand how the developer fee fairly compensates the developer for the considerable risks that are taken in the development process.
Inadequate sources of funds
An age-old problem for many developers is projects that do not have adequate sources of funds. Tax credit pricing at lower levels not seen for years makes this an even more critical issue. Fund sourcing comprised of federal LIHTCs, a Federal Home Loan Bank Affordable Housing Program loan, and 40 percent deferred developer fee is not a sound deal structure.
Once again, developers must be more creative. State and local sources of funds must be found. Purchasing historic buildings and twinning LIHTCs and historic tax credits can be a successful strategy.
Misunderstanding of capture rates
Ask 10 developers how they calculate a capture rate, and you'll most likely get 10 different answers. There doesn't seem to be any sort of industry standard for determining a capture rate, and this can be a real problem, especially in smaller, rural markets.
One of the biggest mistakes is using a geographic area that is too large. Many developers fail to think like a renter in this respect. Just how far does an apartment resident want to drive to get to work? Suppose that the property is to be located in a small town of 5,000 people. Does it make sense to stretch the geographic area beyond the town limits for capture-rate calculation purposes? Do you really want to build a project where you must capture 25 percent of the eligible renter population within a reasonable trade area in order to reach and maintain high levels of occupancy?
Guarantees
Even though the development community has become more sophisticated over the years, there still seems to be a propensity to pay little attention to the various guarantees that are required by syndicators and investors.
Developers generally are focused on getting the deal done and bravely assume that while they have made guarantees, their project will be successful and the guarantees will never become an issue. This is a naïve and dangerous way of thinking.
Development deficit guarantees, operating deficit guarantees, and tax credit compliance guarantees are just the Big Three of guarantees—there are more. What about the guarantee of the annual asset management fee that must be paid to the syndicator in the event the project doesn't have adequate funds to do so?
Overly optimistic occupancy, income, and expense expectations
Sadly, we developers are still making some of the same mistakes that have been made since the beginning of the LIHTC program. We tend to be too optimistic about stabilized occupancy percentages, how much we can raise rents each year, and how low our annual operating expenses may be. Think about it.
Suppose you project that your income and expenses will increase at 2.5 percent per annum and your occupancy will be 95 percent. Also assume that your beginning rent is $500 per month and your initial operating expenses are $3,500 per unit. After your project is built you find out that while you can achieve initial rents of $500 per month, you can only increase them 2 percent per annum. Let's also assume that your beginning expense factor is $3,600 per unit rather than $3,500, expenses actually increase at 3 percent instead of 2.5 percent, and occupancy stabilizes at 93 percent instead of 95 percent. Over the 15-year life of your project, you will realize 25 percent less net operating income. I don't know of too many deals that can remain viable with this much variance in net operating income.
Avoiding the pitfalls
The best way to avoid the pitfalls common to tax credit development is to undertake an Opportunities to Fail exercise. Think of every possible way your assumptions are wrong and then figure out how to mitigate the risk. This requires significant planning and removing the rose-colored glasses to face cold hard reality. If you are willing to do this and to be creative in the process, you may be able to succeed where so many others in the industry have failed.
R. Lee Harris, CRE, CPM, is president and CEO of Cohen-Esrey Real Estate Services, LLC, a Kansas City-based commercial real estate organization that has managed more than 56,000 multifamily units since 1969. Active in 95 markets spanning 17 states, the firm is involved in the management, development, and acquisition of conventional and affordable housing. Other business units are involved with construction, commercial development, medical properties, and tax credit syndication.
