An Introduction to the Housing Tax Credit Program - Part 1

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2 An Introduction to the Housing Tax Credit Program - Part 1 Moderator: Diana McIver, DMA Development Company, LLC Panelists: Christine Richardson, Locke Lord LLP Michael Celkis, CohnReznick LLP

3 What Today s Session Will Cover Morning Session The Basics of the Housing Tax Credit Program History Two types of credits What can be built/who can live there Legal Issues & Working with an Attorney Ownership Structures Partnership Structures Legal Considerations in the Life of a Tax Credit Deal Accounting Issues & Working with an Accountant Eligible Basis, 10% Test, and other accounting rules Coupling bonds with Credits and the 50% Test The Ta C edit P og a at 3 Afternoon Session The Tax Credit Program in Texas The QAP/Threshold & Scoring Two Case Studies The Specifics of Developing with Tax Credits both from the Developer standpoint and the Investor perspective. Two developers will each walk through a case study on a tax credit deal. Two investors will evaluate the transactions, providing feedback to the developers.

4 History of the Housing Tax Credit Program 1986 Congress through the Tax Reform Act, enacted Section 42 of the Internal Revenue Code. Section 42 created the Low Income Housing Tax Credit (LIHTC) to provide incentives to the private sector to invest in affordable housing. Credit is a dollar-for-dollar tax reduction. Credit is based on the Cost of Construction or Rehabilitation The Tax Credit program is 32 years old and is the oldest (longest lived) supply side housing program. More than 2.5 million units have been built under this program Congress made the LIHTC program permanent TDHCA e o ed the o ds Lo I o e f o the p og a a e. No i Texas it is called the Housing Tax Credit (HTC) Program Congress enacted the Housing & Economic Recovery Act of 2008 (HERA) with the most significant changes since 1986.

5 History, continued 2009 Congress enacted American Reinvestment and Recovery Act of 2009 (ARRA) which created the Tax Credit Assistance Program (TCAP) and Tax Credit Exchange (Exchange) on a temporary basis Tax Cuts and Jobs Act aka Tax Reform (December 2017) preserved housing tax credits and private activity bonds; created Opportunity Zones 2018 Omnibus Budget Bill (March 2018): 50% cap increase (over 4 years) in the 9% program and added income-averaging.

6 Two Types of Tax Credits 9% Credit Also known as the 70% present value credit In Texas, these credits are awarded annually on a competitive basis. 4% Credit Also known as the 30% present value credit A aila le /ta e e pt o ds th ough the tate s Volu e Cap Allo atio.

7 What is a 9% Credit? Each State receives a per capita allocation, adjusted annually. In 2017, the amount was $2.35 per capita. In 2018, that jumped to $2.70 per capita thanks to the Omnibus Bill. Approximately $76,677,700 is available in 2018 for Texas. 10 Year Credit (longer compliance period) New construction or substantial rehabilitation If rehab, building acquisition costs qualify only for a 4% credit

8 What is a 4% Credit? 4% Credit is used in tandem w/private Activity Bonds. States have $105 per capita limit on ALL Private Activity Bonds, also called Volume Cap. Texas receives annual allocation of approximately $2.97 billion Eligible Uses are many from sewage plants to student loans to affordable housing Approximately $654 million is reserved in Texas for multifamily housing bonds, to be issued by TDHCA, TSAHC, and Local Issuers When used with Private Activity Bonds, the 4% Credit is a 10 year Credit (Compliance is 30 years).

9 4% Credit, continued. Issuers of Bonds can be Housing Finance Agencies, Housing Authorities, Public Facility Corporations, Texas State Affordable Housing Corporation (TSAHC) or TDHCA, but only TDHCA can award the 4% tax credits and application must be filed timely. New Requirement (effective 9/1/13): Must have local resolution of NO OPPOSITION, regardless of bond issuer. No TDHCA scoring applies to 4% Tax Credits, but must meet Threshold Requirements of the QAP, including notifications, design, amenities, etc. Te as Legislatu e has esta lished de elop e t e ui e e ts fo tie s of o petitio based on affordability factors, and also provided a system for allocating bond cap throughout the 13 Regions. Undersubscribed for past nine years, but OVERSUBSCRIBED in The amount of the credit floats monthly and is not fixed at 4%.

10 Affordability Requirements 40% of the rents based on 60% Area Median Income (AMI), or 20% of the rents based on 50% AMI Must keep project affordable for at least 30 years (some states may require longer). In Texas, extra points are awarded to 9% HTC developments for keeping the housing affordable for 40 years. Credits are only awarded on the units that meet the long term affordability test. Although Market Rate units are allowed, no tax credits are available for these units. NEW: With the new income averaging, a development can get tax credits on units with rents based on 80% AMI; however, the average throughout the development cannot be greater than 60%.

11 What Can Be Built? Housing Types can be multiple types (both new construction and rehab) but must meet the definition of ualified eside tial e tal p ope t Multifamily Rental, e.g., family, workforce housing Senior Rental (age 55+) Single Room Occupancy (SROs) for Homeless

12 Who Can Live in a Tax Credit Community? Individuals or Families or Seniors or Persons with Disabilities with incomes at or below 80% of Area Median Income will soon be eligible to live in Tax Credit Housing however, since there is no rent subsidy, they must be able to afford the rent. (Existing developments will continue to have 60% AMI restrictions.) A resident with a voucher from a housing authority can live in Tax Credit Housing and pay 30% of their income for rent.

13 How Is a Tax Credit Rent Calculated? Two Bedroom Rent assumes 3 person family (1.5 persons per bedroom) Imputed income at 60% of AMI: $36,000 Multiplied by: x30% Maximum Annual Rent: $10,800 Divided by (months): 12 Maximum Monthly Rent: $900* *must include both rent and utilities e.g., if the utility allowance on 2BR is $120. Max rent would be $780.

14 Structuring a Tax Credit Deal: Legal Issues and Considerations

15 Ownership Structure The housing development is owned by a limited partnership (LP) or limited liability company (LLC). Must be a pass-through for federal income tax purposes.

16 Ownership Structure HOUSING DEVELOPMENT Owner Entity, LP or Owner Entity, LLC General Partner (for LP) Managing Member (for LLC).01% Investor Limited Partner (for LP) Investor Member (for LLC) 99.99%* *An affiliate of the investor will often act as a special limited partner/ member for administrative oversight and protection of the i esto s rights.

17 Ownership Structure: General Partner/Managing Member In an LP, the general partner is the controlling party and is responsible for the construction and operation of the housing development. In an LLC, the managing member is the functional equivalent of the general partner. General Partner/Managing Member is often structured as an LLC (but can have another form, such as a corporation, etc.) The general partner or managing member is typically an affiliate of the developer/guarantor. Compensation is usually structured as fees or distributions paid from cash flow.

18 Ownership Structure: Investor Limited Partner/Investor Member Investor limited partner in an LP; investor member in an LLC. Purchases the tax credits by making capital contributions to the Owner. Has consent rights over major decisions in order to protect its investment. Typically receives an asset management fee as compensation for its oversight activities.

19 Ownership Structure Ground Lease Used in transactions with housing authorities in order to obtain a property tax exemption. Same LP or LLC ownership structure, with key differences: The housing authority has legal title to the land and ground leases it to the LP/LLC owner LP/LLC owner develops, owns, and operates the project. Typically includes a special limited partner or member that is an affiliate of the developer/guarantor.

20 Ownership Structure (Ground Lease) Ground Lease HOUSING DEVELOPMENT Owner Entity, LP or Owner Entity, LLC General Partner/ Managing Member (Affiliate of HA).01% Investor Limited Partner/ Investor Member 99.98% Special Limited Partner/Member (Affiliate of Developer/Guarantor).01% Land owned by housing authority Fee Interest Housing Authority 100%

21 Developer Responsible for coordinating all aspects of a tax credit deal from inception through stabilized operations. Receives a developer fee (typically limited to 15% of eligible basis). Often an affiliate of the general partner/managing member (but not always). Also responsible for guaranties, either directly or through affiliates. Multiple developers can be structured as co-developers or through a fee sharing arrangement.

22 Legal Considerations In The Life of a Tax Credit Deal Site selection Tax Credit application Selection of financing partners Equity/debt closing TDHCA compliance Permanent loan closing Property disposition/year 15

23 Legal Considerations In The Life of a Tax Credit Deal Site selection Review/negotiation of purchase contract Title review Tax Credit application QAP/Rules issues Appeals Deal structuring considerations Selection of financing partners Review equity/debt term sheets Equity/debt closing Review/negotiation of financing documents Due diligence Legal opinions

24 Legal Considerations In The Life of a Tax Credit Deal TDHCA compliance Required submissions (10% test; cost certification, etc.) Compliance matters Permanent loan closing See equity/debt closing Property disposition/year 15 Structuring considerations Review/negotiation of documents TDHCA change of ownership LURA amendments

25 Trusted Advisor Project Team Role of Accountant Financial Projections analysis Deal Structuring Tax Planning Exit Strategy Keeping up with changes in the industry (Federal and State Level)

26 Compliance Role of Accountant, Cont. Audits/Tax Returns 10% Test Report (9% deals) Cost Certification Bond Specific Reports (50% test, 95/5 test, arbitrage calculation) Project Specific Requirements (cost segregation, lease testing, credit adjuster, DSCR report, qualified contract pricing) of AMI.

27 The 10% Test What is it? A 10% Test supports Basis Incurred in a project. Basis incurred must be at least 10% of the Reasonably Expected Basis of the project on a specific date. Basis Incurred: Total osts i u ed to date hi h ep ese ts a p oje t s depreciable basis plus land. Reasonably Expected Basis: A p oje t s dep e ia le asis plus la d osts. This amount is generally stipulated by the Owner as part of the Carryover Allocation. * Note: 10% tests are only for 9% competitive credits

28 The 10% Calculation 10% Basis Incurred (land + depreciable basis) Reasonably Expected Basis (total expected land + depreciable basis)

29 Cost Certification What is it? CPA s audit of p oje t osts. Re ui ed Housi g C edit Age HCA to e tif eligibility for low income housing credits. Each HCA has specific information required to be included. Typically required: Schedules of total and eligible costs by project and building. Calculation of credits. Sources and uses of funds. Gap analysis. Project Proformas. Upon acceptance from the HCA, the Agency issues Form 8609

30 Eligible Basis Eligible Basis = adjusted basis of building at end of 1 st year credit period Includes common areas 30% Boost in QCTs or DDAs Projects located in HUD-designated Qualified Census Tracts or Difficult to Develop Areas receive a 30% increase on eligible basis.

31 Eligible Basis, Cont. Costs that ARE included: Building acquisition Engineering and architecture Appraisals Construction costs Furniture, Fixtures & Equipment Impact fees/permits Inspections Depreciable land improvement Developer fee Interest during production

32 Eligible Basis, Cont. Costs that ARE NOT included: Land Permanent loan fees Marketing and lease-up costs Tax credit fees Reserves Syndication fees Commercial or income-producing space

33 Eligible Basis, Cont. Costs that MIGHT BE included: Tenant relocation Accounting Legal Acquisition Interest Construction loan fees Real estate taxes Environmental

34 Specific Tests for Tax Exempt Bonds 50% Test The 50% Test is calculated by dividing the Bond Proceeds by the Aggregate Basis of the Project. For these purposes: Bond Proceeds: Include only the amount of bonds used to finance the acquisition, hard construction and soft costs of the project. Generally this will equal the mortgage amount. Bond Proceeds include interest earned on the bonds or bond reserve funds. Aggregate Basis: I ludes the p oje t s dep e ia le asis a d la d osts.

35 Meeting the 50% Test If the project meets the 50% Test, the project may claim 100% of the 4% credits on the total amount of eligible basis. EXAMPLE Volume Cap Bonds $10,000,000 Aggregate Basis $19,900,000 50% Test Ratio % Land in Aggregate Basis $2,000,000 Eligible Basis $17,900,000 Eligible Under 50% Test % Final Eligible Basis $17,900,000

36 What Happens if the 50% Test Fails? If the project does not meet the 50% Test, the project is limited to 4% credits on the amount of eligible basis times the final ratio. This has a severe impact on the available credits! EXAMPLE Volume Cap Bonds $10,000,000 Aggregate Basis $20,100,000 50% Test Ratio % Land in Aggregate Basis $2,000,000 Eligible Basis $18,100,000 Eligible Under 50% Test % Final Eligible Basis $9,004,975

37 Other Bond Rules The project must meet the 95/5 Test. This test is ofte alled the good ost / ad ost test a d is t pi all pe fo ed a i depe de t a ou ta t. Fo these purposes, some examples are: Good Costs: Building and land, common space, resident recreation and parking facilities related to the rental residential units. Bad Costs: Commercial space, financing fees, bond issuance costs.

38 Credit Adjuster Occurs when project does not meet negotiated credit delivery amounts Spelled out in the partnership/operating agreements Generally will reduce LP final equity payment Typically there are two types of adjuster calculations (Permanent and Timing)

39 Permanent Adjuster -Occurs when there is a change in eligible basis or tax credit percentage. -Can be adjusted upward or downward depending on the LPA. -A small variance in basis allocated over the life of the credits can mean a large variance between actual and expected contributions made by the investor. Federal Tax Credit Downward Basis Adjuster: Projected Aggregate Federal Tax Credits 750,000 Actual Federal Tax Credits 700,000 Variance 50,000 Adjusted for 10 years 500,000 LP ownership % 99.99% Net Variance to LP 499,950 Downward Basis Adjustment Factor 0.90 Permanent Credit Adjuster 449,955

40 Timing Adjuster Federal Tax Credit Downward Timing Adjuster: Projected Adjusted Total Estimated Credits to investor in first year 750, ,000 Actual credits delivered in first year 350, ,000 Variance (350,000) Timing Adjuster Fraction Downward Timing Adjuster (227,500)

41 The Housing Tax Credit Investment and Operating Performance Study Mike Celkis, CPA CohnReznick LLP

42 Origin of Our Performance Study So You want to see the track record? The first study was undertaken by CohnReznick professionals in 2000 when 6,250 properties were surveyed.

43 Over 22,000 properties surveyed in 2016; representing approximately 70% of actively managed LIHTC properties and $83 billion in total credits. 50 U.S. states, Guam, Puerto Rico, and U.S. Virgin Islands 92% of U.S. MSAs Data contributed by 35 participants including every active LIHTC syndicator.

44 Acknowledgement Formerly known as Great Lakes Capital Fund

45 Tenant Income Profile 46% of Tenants earned less than 30% of AMI, 35% earned between 30% and 50% of AMI, and the remaining 19% earned no more than 60% of AMI. 19.0% 46.0% 35.0% 50% to 60% AMI 30% to 50% AMI Less than 30% AMI

46 Portfolio Composition (% of net equity) By Developer Type By Tenancy Type 3.6% 2.5% 36.0% 26.5% 64.0% For Profit Non Profit 67.3% Family Senior Special Needs Other By Development Type By Credit Type 2.4% 2.0% 29.0% 35.7% 59.8% New construction 71.0% 9% credit 4% credit Acq/Rehab Historic Rehab Other

47 Occupancy Performance High occupancy continued Occupancy levels in LIHTC properties have been remarkably consistent from one year to the next. Performance Median Physical Occupancy Performance Median Economic Occupancy 98.0% 97.5% 97.0% 96.5% 96.0% 97.2% 96.4% 97.5% 96.9% 97.7% 97.0% 97.9% 96.9% 97.5% 97.0% 96.5% 96.0% 95.5% 95.0% 94.5% 96.3% 94.6% 96.6% 95.3% 96.9% 96.0% 97.0% 95.6% 95.5% % National TX National TX

48 Physical Occupancy by Credit Type

49 Underperformance (under 90% occupancy) Underperformance - Physical Occupancy Underperformance - Economic Occupancy 12.0% 10.0% 8.0% 6.0% 4.0% 9.9% 7.5% 8.5% 5.7% 6.7% 5.6% 4.6% 4.7% 25.0% 20.0% 15.0% 10.0% 22.6% 15.5% 15.5% 11.7% 13.1% 13.3% 10.0% 9.0% 2.0% 5.0% 0.0% % National TX National TX

50 Cash Flow Performance Improved cash flow performance sustained De t Co e age Ratios DCR s ho e ed et ee. 3 a d. 5 fo a significant portion of the last decade, before rising to 1.21 in Performance Median DCR Performance Median Per Unit Cash Flow 1.45 $ $800 $700 $698 $775 $660 $800 $ $600 $597 $571 $ $ National TX National TX

51 Per Unit Cash Flow by Credit Type:

52 Underperformance DCR under 1.0 Underperformance - DCR Underperformance - Per Unit Cash Flow 20.0% 15.0% 10.0% 18.4% 18.0% 16.9% 13.8% 14.7% 14.3% 9.9% 12.0% 25.0% 20.0% 15.0% 10.0% 20.0% 19.3% 17.8% 15.0% 15.4% 14.9% 10.5% 12.3% 5.0% 5.0% 0.0% % National TX National TX

53 Total Housing Credit Equity Volume In recent years, roughly 75% of all housing credit investments were acquired through syndication.

54 Average Capital Stack: All Credit Projects since 2012

55 Housing Tax Credit Equity Market: CRA vs Economic Volume

56 Cumulative Foreclosure Rate

57 Annual LIHTC Foreclosure Rate vs. Conventional Multifamily

58 Performance by Property Age Ninety-six percent of the properties in the portfolio were 20 years or younger.

59 Median 2016 Per Unit Operating Expenses by Development Type

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62 Key Takeaways Incredible strength in affordable housing demand exists in virtually every part of the country. LIHTC property performance is strong, with all basic metrics continuing to improve. The risk profile in housing tax credit investments has fallen to an historically low level. The industry has come a long way at improving underwriting and asset management practices. Due to the fact that housing tax credit properties are, by design, underwritten with a narrow margin for error, aggressive underwriting, unexpected market condition or improper management can still result in property failures.

63 63 And thus, dear students, we have arrived at the formula for understanding the Housing Tax Credit Program...

64 Questions & Answers? Diana McIver, DMA Development Company, LLC Ch isti e. Ch is i ha dso, Locke Lord, LLP crichardson@lockelord.com Mike Celkis, CPA, CohnReznick, LLP Mike.Celkis@CohnReznick.com