Low Income Housing Tax Credits 101 (and a little beyond 101) James Lehnhoff, Municipal Advisor 9/29/2017 1
Affordable Housing Need What is Affordable? Overview Why do affordable housing projects need financial assistance? LIHTC Basics: 4% and 9% tax credits Calculating LIHTC Equity Who are LIHTC Investors? The LIHTC Developer Mixed Income Projects 2
Affordable Housing Need: By The Numbers 0 the number of states, metropolitan areas, or counties where a full-time worker earning the prevailing minimum wage can afford an average two bedroom apartment -5.3% - decline in real wages for the bottom 10% of wage earners from 1979 to 2013 3.5% - average rent increase just in 2015 575,000 - people were homeless or living in shelters, of which nearly 50,000 were veterans and 216,000 were families with children 21.3 million households paying more than 30% of their income toward rent 11.4 million households paying more than 50% of their income toward rent 7.2 million shortage of affordable housing units 2.2 million number of LIHTC supported units with expiring affordability requirements between 2015 and 2025 89% - households receiving rental assistance are elderly, disabled, or include children 3 Joint Center for Housing Studies of Harvard University, 2015
What is Defined as Affordable? HUD Income Definitions: Low Income Household income at or below 80% of area median income (AMI) Very Low Income Household income at or below 50% of AMI Extremely Low Income Household income at or below 30% of AMI Affordability: Area Median Income (AMI): 60% AMI is maximum rent/income threshold for LIHTC Metro Median 30% 50% 60% 80% Household Income (Family of 4): $ 90,400 $ 27,120 $ 45,200 $ 54,240 $ 72,320 Monthly Affordable Rent (2 bedroom): $ 2,035 $ 610 $ 1,017 $ 1,221 $ 1,628 HUD 2017, Twin Cities MSA 4
What is Actually Affordable? It depends on the household! Many LIHTC developments, particularly the 4% tax credit projects, are at the maximum allowable rents LIHTC projects do not come with rental assistance LIHTC is not Section 8 Residents must be able to pay the listed rent (which still may be a stretch) 5
Why Do Affordable Projects Need Funding Assistance? Market Rate Project Mortgage: 60% to 80% of total project costs Equity: 20% to 40% of total project costs Financial Assistance: 0% to 10% Affordable Housing Project Less rental income but operating expenses and costs of construction are similar to market rate housing Lower Mortgage Potential Less Ability to Pay Investor Returns Deeply affordable rents (30% AMI) may not even generate sufficient cash flow to cover basic operating costs, utilities, and property taxes Funding Gap! 6
Financing: Market Rate and Affordable Example 100 Units Affordability Scenario Market Rate 60% AMI 50% AMI 30% AMI Rental Income $1,924,000 $1,392,000 $1,159,000 $695,000 Operating Expenses ($550,000) ($550,000) ($550,000) ($550,000) Net Operating Income $1,374,000 $842,000 $609,000 $145,000 Debt Coverage Ratio 1.2 1.2 1.2 1.2 Debt Payment $1,145,000 $702,000 $508,000 $121,000 Interest Rate 5% 5% 5% 5% Loan Term (years) 30 30 30 30 Potential Mortgage $17,600,000 $10,791,000 $7,809,000 $1,860,000 Project Cost $22,000,000 $22,000,000 $22,000,000 $22,000,000 Maximum Mortgage $17,600,000 (80%) $10,791,000 (50%) $7,809,000 (35%) $1,860,000 (8%) Equity (20% of Project Cost) $4,400,000 $4,400,000 $4,400,000 $4,400,000 Remaining Need (gap) $0 $6,809,000 $9,791,000 $15,740,000 7 Funding Gap! Traditional equity won t be available
How does the gap get filled? Generally Before 1986 Section 8 Rental Assistance provided additional rental income to allow projects to generate higher mortgages and returns An income solution Generally After 1986 LIHTC replaced traditional equity (and some of the mortgage) to allow a project to work with the limited rental income and forgoing traditional equity investment return expectations A capital funding solution 8
LIHTC Program Born in 1986 (Tax Reform Act) Happy 31 st Birthday! Section 42 of the Internal Revenue Tax Code Produced approximately 2.8 million affordable apartment homes since its creation: New construction (~62%) Rehabilitation (34%) Both (4%) Served more than 13.3 million residents Supports an estimated 100,000 jobs annually 9
LIHTC Program Generates ~$8 billion per year in equity throughout the United States to help finance rental affordable housing projects (new construction and rehabilitation) Largest federal affordable housing construction/rehab program in the nation. By comparison: Federal HOME Funding: $965 million (down 50% since 2010) Federal CDBG* Funding: $3 billion (down 25% since 2010) Federal HOPWA Funding: $301 million (down 9% since 2010) Federal Rental Assistance programs are flat or shrinking (e.g. Section 8, Housing Choice Vouchers, Public Housing, USDA) 10
What is LIHTC? Low Income Housing Tax Credit IRS Program = Lots of Regulations Section 42 of the Internal Revenue Tax Code Minimum Affordability Requirement: 40% of units must be affordable to households earning 60% of area median income (AMI) or less 20% of units must be affordable to households earning 50% of area median income (AMI) or less Affordable Rental Housing Funding Source Replaces traditional private equity LIHTC investors do not receive a typical annual return 11
Simplified LIHTC Process Developer Multi-family Rental Housing Tax Credit Allocator Minnesota Housing Finance Agency City of Minneapolis City of Saint Paul Dakota County CDA Washington County CDA 5. Developer uses tax credit equity, mortgage, and other funding to construct affordable housing! Tax Credit Investor Has federal taxes they want to offset with tax credits 12
Simplified LIHTC Math Developer Multi-family Rental Housing Tax Credit Allocator Minnesota Housing Finance Agency City of Minneapolis City of Saint Paul Dakota County CDA Washington County CDA 5. Developer uses tax credit equity, mortgage, and other funding to construct affordable housing! Tax Credit Investor Has federal taxes they want to offset with tax credits In this example, the investor nets $1,000,000 in tax benefits 13 In this example, Tax Credit pricing is 90 cents. Tax Credit pricing is a competitive market place and fluctuates with the broader economy (and politics).
LIHTC Reality Begin Project Concept Close on Financing; Start Construction
Flavors of LIHTC 9% Tax Credits Extremely competitive Extremely limited (e.g. 7 metro projects totaling 404 apartments in 2016 from 20 requests) Every state receives a limited allocation from the IRS each ear Provides 60-70% of capital funding to build a project Tends to have deeper affordability than 4% tax credit projects 4% Tax Credits & Tax-Exempt Bonds Historically considered non-competitive and unlimited Easier to get than 9% tax credits Provides 20-30% of capital funding to build a project Must also apply for (competitive) tax-exempt bonds* Tends to have rents at the regulatory maximum 15
4% Tax Credits & Tax-exempt Bonds Why must 4% tax credit projects use tax exempt bonds? Because the IRS said so! And, it effectively creates a limit on the 4% tax credit. How does a project get tax-exempt bonds? Every state receives an allocation of tax-exempt bonds from the IRS based on population each year. With a resolution of support from a City (the conduit debt issuer), the developer can apply for tax-exempt bonds at certain times of the year. Are tax-exempt bonds free money to a project? No! Tax-exempt housing bonds are basically another type of mortgage. The project must repay the bonds over a defined term with interest. The project is obligated to repay the bonds. The city is not obligated to repay the bonds. 16
LIHTC Allocation LIHTC Allocators Minnesota Housing Finance Agency: 9% and 4% Credits 9% Credit Sub-allocators: Minneapolis, Saint Paul, Washington County, and Dakota County (unique to Minnesota) Qualified Action Plan (QAP) Required by the IRS for every LIHTC Allocator Identifies policy priorities and related competitive scoring criteria Priority projects include such items as locally committed funds, TOD, mixedincome, green design, multi-bedroom units, etc. Updated bi-annually by Minnesota Housing; annually in Minneapolis, Saint Paul, Dakota County, and Washington County 17
LIHTC Allocation 9% Credits Annual Competition One chance per year! First Round Pre-application Applications Released Applications Due Awards Minnesota April/May April June October 4% Credits Pipeline (applications reviewed as they are submitted) Tax-exempt bond availability and allocation often defines the schedule 18
LIHTC Comparison: 9% and 4% Credits 9% Credits 4% Credits Availability One application round per year* Pipeline Competition Extremely High Lower(?) Tax Exempt Bonds n/a At least 50% of Depreciable Costs (basis) plus Land must be paid with bonds (the 50% test) Minimum Affordability Requirement 40% of Units Affordable at 60% of AMI OR 20% of Units Affordable at 50% of AMI Minimum Affordability Period 15 Years+15 Year Extended Use Period 15 Years* Equity Generated 60-70% of Capital Needs 20-30% of Capital Needs Credit Limit $1,100,000 per project No maximum; based on eligible costs Typical Project Size 45-65 Units 120+ Transaction Costs* Generally Lower Generally Higher Tax Credit Rate 9% Changes Monthly Policy Priorities in Minnesota Qualified Action Plan Access to Fixed Transit; Greater MN Workforce Housing; Economic Integration; Tribal Lands; Preservation; Permanent Supportive Housing; Deeply Affordable Housing; and, Cost Containment Age Restrictions in Minnesota (i.e. senior housing) Generally Not Permitted Permitted 19
Project Sources LIHTC Equity First Mortgage Gap Rents tend to be more affordable producing less cash flow to support debt 15% 20% 20% 55% 65% 25% Rents tend be maximized at the affordable limits to maximize debt 9% LIHTC 4% LIHTC Varies by project and market conditions 20
LIHTC Eligible Costs Can LIHTC equity pay for 100% of project costs? No. Only certain costs are eligible for LIHTC equity, and every projects will have costs that are not eligible. Why aren t some costs eligible? Because the IRS said so. The Developer can only request low income housing tax credits based on the amount of depreciable costs in a project. Not all costs are depreciable costs meaning additional funding sources are always needed. What are depreciable costs? Oh goodness. How much LIHTC equity can a project get? Well, it depends on several factors that depend on market conditions. 21
Warning The next four slides dive into the LIHTC weeds 22
Calculating LIHTC Equity Total Development Costs Depreciable Costs That Can Generate Equity: Existing Buildings (for rehab and adaptive reuse) Construction costs and contractor fees Design fees Developer Fee Permits and Impact Fees Construction Related Financing Costs Construction Loan Interest Costs before construction completion Some costs related to surveys, geotech, consultants, FFE Non-depreciable Costs Do Not Generate Equity: Land Permanent Financing Costs Acquisition related costs and holding costs Reserves Construction loan interest costs after construction completion Some costs related to surveys, geotech, consultants, FFE = Eligible Basis 23 But wait! There is more!
Calculating LIHTC Equity - Adjustments 30% Eligible Basis (equity) Boost if in a: Census Defined Qualified Census Tract (QCT); 9% and 4% State Defined Difficult Development Area (DDA); 9% only Applicable Fraction: Percentage of affordable units or apartment square footage area of affordable units For example, if a project has 100 apartments with 75 affordable units and 25 market rate units, the Applicable Fraction is 75% and only 75% of the depreciable costs are eligible for LIHTC equity Market rate units are not eligible for LIHTC equity 24
Calculating LIHTC Equity - Adjustments Applicable Percentage: 9% is fixed at 9% 4% floats with market conditions and can change monthly (3.21% for October 2017) Tax Credit Period (not the same as the affordability compliance period): 10 Years for the investor For example, if the total value of the tax credits $10,000,000, the tax credit investor actually gets $1,000,000 per year for 10 years 25
Calculation LIHTC Equity Calculation Example Example Project: 60 apartment homes; 90% affordable at 60% of AMI; New Construction; non-qct Total Development Costs $ 15,000,000 $ 15,000,000 Step 9% LIHTC 4% LIHTC 1 Total Eligible Basis (depreciable costs) = 13,400,000 13,400,000 2 Basis Boost x 0% 0% 3 Total Adjusted Eligible Basis = $ 13,400,000 $ 13,400,000 4 Applicable Fraction x 90% 90% 5 Total Qualified Basis = $ 12,060,000 $ 12,060,000 6 Applicable Percentage x 9% 3.21% 7 Annual Basis Credit = $ 1,085,400 $ 387,216 8 Allocated or Maximum Credit* = $ 1,000,000 n/a 9 Tax Credit Period (Years) x 10 10 10 Ten Year Gross Tax Credits = $ 10,000,000 $ 3,872,160 11 Tax Credit Pricing x $ 0.90 $ 0.90 12 Gross Equity Proceeds to Developer = $ 9,000,000 $ 3,484,944 26 *Varies by State; 9% credits only
Project Sources Rents tend to be more affordable producing less cash flow to support debt LIHTC Equity First Mortgage Gap STILL HAVE A FUNDING GAP! 15% 20% 20% 55% 65% 25% Rents tend be maximized at the affordable limits to maximize debt 9% LIHTC 4% LIHTC 27
Maximizing Mortgage Filling the Gap Deferred Loans from a public entity (e.g. city, county, state) Federal Home Loan Bank grants Grants (not common) Deferred Developer Fees Reducing Costs Tax Increment Financing Tax Abatement 28
The LIHTC Investor Who are the investors? Corporations, insurance companies, banks Syndicators represents a collection of different investors What is the role of the investor? Provides equity! Receives the tax credit to offset their federal income tax burden Involved in the ownership structure (kind of like a silent partner) Monitor performance and affordability compliance for the first 15 years (affordability period can be longer) Investor can lose their tax credit if the project is out of compliance Reviews all aspects of the project: underwriting, project costs, rents, management company, and so on.
Typical LIHTC Ownership Structure Project Owner: ABC Limited Partnership National Bank (LIHTC Investor): Limited Partner: 99.99% Developer/Owner Managing General Partner.01% If Applicable*: Co-General Partner *While there can be only one Managing General Partner, there can be additional Co-general Partners that can have similar ownership interests.
The LIHTC Developer For profit and non-profit developers The developer does not usually invest in their own tax credits Generally experienced with a demonstrated track record of performance; must be able to manage complex LIHTC regulations and have the capital to provide guarantees to lenders and investors Developer Fee Primary way of paying the developer for their time, staff, profit instead of through annual investment returns Generally $1 to $3 million (8%-10% of project costs) Frequently defers as much as 50% of the developer fee to close a funding gap; Deferred developer fee is repaid to the developer through future cash flow (if any) Usually wants to own 100% of the project after the LIHTC investor exits the project after 15 years What about ongoing cash flow from the project?
Order Common Cash Flow Waterfall Net cash flow after debt service can be distributed subject to the Limited Partnership and funder limitations. Distributed to: 1. Asset Management Fee to Investor - $5000-$25,000 per year 2. Tax Credit Deficiencies to Investor Variable (if any) 3. Replenish Operating Reserve to Minimum Balance (if needed) 4. Repay Limited Partner Loans (if any) 5. Repay Deferred Developer Fee to General Partners (if any) 6. Repay Deferred Loans (if required) 7. Repay General Partner Loans (if any) 8. Pay General Partner Asset Management Fees and/or Compliance Fees (if possible, maybe $15k/year) 9. Distribute Any Remaining Cash Based on Ownership Percentages: 99.9% to Limited Partner.01% to General Partner *For illustration purposes only, every project is unique
Mixed Income Projects Mixed income often promoted by policy LIHTC does not generate equity for unrestricted units and mixing equity with LIHTC equity is technically problematic Often reduces LIHTC investor interest due to risk If the market rate units don t perform, it can put the affordable units at risk Higher end amenities that help generate higher rents are often frowned upon by public funding programs Unrestricted units can have difficulty achieving true market rents May increase the project gap 33
Key Points Affordable Housing Requires Financial Assistance, largely because of limited cash flow to pay debt service and provide investor returns Two Types of LIHTC: 4% and 9% tax credits LIHTCs are competitive LIHTC Equity Is Different than Traditional Equity Investor gets a federal tax credit No typical types of returns (return on equity investment) Developer fees tend to be larger than market rate projects because ongoing cash flow is often limited 34
35 Questions
James Lehnhoff Municipal Advisor (651) 697-8552 jlehnhoff@ehlers-inc.com 36