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Author: Roman Petra

Helping to develop over 2.8 million housing units and supporting over 100,000 jobs annually….LIHTC

Helping to develop over 2.8 million housing units and supporting over 100,000 jobs annually….LIHTC

The Low Income Housing Tax Credit (LIHTC), pronounced “lie-tech,” program was created by Congress in 1986 to raise private equity for new construction and rehabilitation of affordable housing by allocating federal tax credits to the development. The private equity subsidizes the development, allowing for either some, or all of the units to be rented at below-market rates to low income tenants.

The LIHTC program has become an integral tool for developing affordable rental housing.  The LIHTC program has stimulated the new construction and rehabilitation of nearly 2.8 million affordable homes and supports over 100,000 jobs annually.  Today, as much as 30 to 40 percent of all new multifamily construction is subsidized using LIHTC.  Up to 90 percent of the cost of a rental complex, with the right mix of low income units, may be returned to the owner in federal tax credits.

The LIHTC program is a proven success, allowing rental housing developers to raise private equity by selling federal tax credits. The annual amount of the federal tax credits is determined by multiplying (i) a building’s qualified basis, by (ii) the applicable tax credit rate (9 or 4 percent).  The qualified basis of a building is the product of the qualified cost of the building (known as the eligible basis) multiplied by the percentage of the building that is occupied by low income tenants.  The eligible basis may equal the cost of acquiring an existing building (but not the cost of the land), plus for new buildings or rehabilitation expenditures to an existing building, the construction and other construction-related costs to complete the development.  After a building is complete and the owner certifies the eligible basis, the building will qualify for federal tax credits upon rental of the units to low income individuals and families.

Generally, LIHTCs are delivered over a 10-year period (the “credit period”), with each year making up 1/10th of the total tax credit award. Generally, the yield of the 10-year credit stream has a present value equal to 70 percent of the qualified basis of any new building not financed by tax exempt bonds, and a present value of 30 percent of the qualified basis of any building that is financed by tax exempt bonds. Rehabilitation expenditures are treated as a new building for this purpose, and an existing building may qualify for the 30 percent present value credit only.  The state agency allocates the tax credits using a competitive application process for new and existing buildings not financed by tax exempt bonds, while for buildings financed by tax exempt bonds the qualification for tax credits depends generally on 50 percent or more of the aggregate cost of the land and building being financed by tax exempt bonds that receive a volume cap allocation from the issuer.

LIHTC are typically allocated by the owner to either a third party investor or investors in return for equity contributions. The affordable housing development is commonly owned in a partnership or limited liability company for tax purposes.  Tax credits are more attractive than tax deductions as they provide a dollar-for-dollar reduction in a taxpayer’s federal income tax, whereas a tax deduction only provides a reduction in taxable income equal to the highest marginal tax rate of the taxpayer.  The owners of interests in a project owner claim LIHTC and tax losses generated by the project buildings. Today, almost all interest owners in a project owner generating LIHTC are widely-held corporations, because of the “passive loss limitations.”

Traditionally, one of the interest owners in a project owner is also the developer, but there are instances where a landowner will hire a developer (known as a mercenary builder) to build the housing for the project owner. A developer looking to receive LIHTC for new construction or acquisition/rehabilitation of a housing project that is not financed by tax exempt bonds typically submits an application with the state housing agency where the property is located. If the developer application receives an allocation of LIHTC, then in order to claim the tax credits the developer must (i) complete construction or rehabilitation of the project, (ii) certify the construction costs, and (iii) meet the minimum lease-up percentage of low income tenants, as stipulated in the application.

Prior to starting construction, the developer will have secured an investor to buy the LIHTC. Similar to the NMTC and HTC, the price for the LIHTC is driven by the investor’s desired yield. The developer’s objective, however, is to maximize the tax credit price while the investor seeks to buy the tax credit for the lowest possible price. The investor will pay in its equity by making “capital contributions” for an ownership interest in the project owner’s entity, which will be either a partnership, or limited liability company.  The investor is also able to increase its yields by delaying the delivery of the capital contributions.  The developer’s objective on the other hand seeks to accelerate the delivery of the capital contributions, because it eases concerns whether the funds are available and it also allows the developer to defer paying accrued interest on advancements under the construction loan.  Typically, the investor remains in the deal for the duration of the compliance period, which is 15-years starting with the first (1/10th) year of the credit period. Once all the credits are received by the investor and the compliance period is over, the investor typically sells its interest ownership back to the developer, affiliate, or third party.

Failure to comply with the applicable rules, or a sale of the project or an ownership interest before the end of the 15-year period, could lead to partial recapture of the credits previously taken and the inability to take future credits. The IRS requires the property maintain the designated number of units rent restricted for at least 30 years after construction; however, some state agencies may require that housing maintain its rental restricted status for more than 30 years.  However, due to tax law changes in 2008, recapture is inapplicable if the project continues as a low income housing project for the 15 year compliance period after the sale of an interest in the project owner or the project itself.  Thus, an investor may sell its interest in the project owner after the end of the 10 year credit period and not incur partial recapture of the credits previously taken provided the project remains a low income housing project throughout the compliance period.

To encumber the property for the 30 or more years, the owner records a Land Use Restriction Agreement (LURA). The LURA is recorded after or before the development is completed, but before the tax credits are ultimately determined by the state agency. Under the LURA, the project is required to meet the particular development’s low income requirements for a 15-year period, known as the “compliance period,” and after the initial 15-year period, the property is subject to the “extended use period,” which can either be for another 15-years or longer.

Location, location, location very much applies to LIHTC projects.  For successful LIHTC projects the golden rule of real estate applies…locate the project in an area that lacks affordable housing, but has a constant pool of qualifying tenants.  While the federal tax credits will not make a bad deal good, it will certainly make a good deal better.  However, it is possible that a bad project is able to further reduce the debt burden by seeking additional federal, state, and/or local subsidies.  Moreover, if located in a designated area, the eligible basis will be increased by 30 percent and the additional LIHTC will reduce the debt burden further.  The key is utilizing the federal tax credits to help create and carry the project in an up-and-coming market such that when the affordability period expires, the owner is left with a very low leveraged piece of real estate in a prime location.  Typically, developers look for apartment sites with high visibility, good traffic, and with infrastructure necessary for the development.  The objective is that the housing promotes growth within the surrounding area.  The LIHTC program allows great opportunities for the owner and investor to earn profit and develop quality housing to benefit low-income residents.

The Misconception about EB-5 money…

The Misconception about EB-5 money…

Many developers/sponsors look for private equity to plug gaps in their capital stacks. It is not uncommon to see private equity finance anywhere from 20-40% of a project’s cost. Depending on the type of project and the developer/sponsor’s experience, EB-5 financing may be a better alternative to traditional private equity, keeping in mind that EB-5 financing is private equity, albeit, non-traditional.

There seems, however, to be a belief that it is easier to obtain traditional private equity than EB-5 money. Generally, that may be correct if a developer/sponsor is not working with an experienced EB-5 group. Often, however, an experienced EB-5 group, through its network, is able to obtain capital relatively quickly, and in some cases, within the same period of time as traditional private equity. It is surprising how even the most experienced developers/sponsors believe that obtaining traditional equity takes significantly less time and effort. That may be true for the few developers/sponsors who have a go-to source. The problem is that (because of the common and widely-held misconceptions) many developers looking for private equity do not even attempt to pursue EB-5 financing.

There are those experienced developers/sponsors that either replace a significant part of, or all, traditional private equity with EB-5 financing. The main difference between EB-5 versus traditional private equity is the cost of funds. EB-5 investors are generally not yield investors, whereas, traditional private equity are all about the yield. EB-5 investors generally have two primary objectives, obtaining a green card, and the return of capital; otherwise, any return on capital would be advantageous. However, obtaining a green card is the main return on capital sought.

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The Devil is in the Details, so be Careful When….

The Devil is in the Details, so be Careful When….

… using a Letter of Intent.

Depending on the sophistication of a transaction, the parties may decide to prepare a letter of intent before proceeding in earnest. The letter of intent is designed to lay out the core terms of the deal among the parties. Generally, a letter of intent is non-binding, except if the parties intend otherwise, either with respect to the agreement as a whole, or with respect specific provisions or terms. There are those who believe that spending any time on a non-binding agreement is a complete waste of time, while there are those who believe that the letter of intent is a good place to start. The idea of using a letter of intent has its value in that it allows the parties to “hash out” the substantive terms that are important to the deal. The process of negotiating the key terms quickly lets the parties know if there will be a meeting of the minds.

Often, the agreement is handled without lawyers. After the agreement is finalized, the terms are set for the lawyers to start drafting final document(s). There are some parties who negotiate letters of intent in great detail, which leaves little for lawyers to do. However, even with sophisticated parties, it is rare that all the issues are addressed. Depending, however, on the complexity of a deal, the lawyers may get involved in preparing and/or reviewing the letter of intent.

The parties to an agreement need to decide whether it is worth focusing on the details early. If so, it may be worth engaging the attorneys earlier on in the process. If the attorneys is engaged after the letter of intent is finalized, they may have limited ability in assisting their clients. If the idea is that the letter of intent is non-binding, then the parties may not want to spend too much time negotiating every detail because it could be “all for nothing.” If, however, the parties intend that the letter of intent is binding in any way, it may be advisable for lawyers to be involved early in the process while the parties are “hashing out” the terms. Before agreeing to spend too much time negotiating a letter of intent, make sure to understand the purpose of the letter of intent.

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Why Assign the Contract?

Why Assign the Contract?

In real estate deals, the original parties to a purchase and sale agreement (the “PSA”) may not always be the same when the property is sold.  It is common to see an assignment of a PSA in commercial transactions, but assignments do appear in residential deals too. In practice, PSAs are generally assignable, but it must state so in the agreement.

Allowing a PSA to be assigned means that a party assigns (the “Assignor”) his/her/its rights to another party (the “Assignee”). It is most common, in the context of a PSA, that the buyer is the Assignor. There are a few instances in which the seller will assign, but that is rare. The Assignee is not an original party to the PSA, but, rather, the Assignee comes in after the PSA is executed. The Assignee assumes the rights and obligations of the Assignor. It is important to note that unless the PSA states otherwise, the original Assignor may still remain obligated to the other party to the agreement (generally the seller). One of the reasons that an Assignor may want to assign his/her/its rights to an unrelated third party is because he/she/it see an opportunity to make profit. If the purpose of assigning the PSA is to make a profit, in that case, the Assignor simply finds the property, ties it up using the PSA, and then transfers the rights to purchase to the Assignee. The Assignor may get paid as soon as the assignment of the rights and obligation happens (or when the Assignee purchases the property). It is common that the Assignor assigns his/her/its interest to a related  party; in which case, it may not be done to generate a profit (but this is not out of the question). An assignment to a related party is generally done because the Assignee may not yet exist (e.g. forming a new entity) at the time the PSA is executed.

In most cases, a seller is not inclined to permit an assignment of the PSA. That is especially true if the Assignor would be released from their obligation under the PSA. A seller wants to make sure that the buyer can close the transaction. The concern is that the buyer has the capacity and ability to comply with the terms of the PSA. If the Assignor is not released and there are no additional burdens placed on the seller, then it may not be an issue. However, a seller should not be too quick to permit an assignment of the PSA. On the other hand, a buyer would be interested in having the right to assign the PSA to another party. That gives the Assignor the right to assign his/her/its rights and obligations to another person, which may or may not happen. With that said, if the assignment happens, the ideal situation is for the Assignor to be released from further obligations under the PSA.

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Controversy Over the Location of Billions

Controversy Over the Location of Billions

The EB-5 program is a multi-billion dollar/year industry. The EB-5 program allows foreign investors to  obtain green cards, leading to permanent residency. In order to obtain a green card under the program, the foreign investors need to make  an investment that leads to job creation. The benefit of the E5-5 investment is that the cost of funds is minimal compared to mezzanine financing. Also, the key is that the EB-5 investment must be “at risk,” which means that if the project fails, the EB-5 investors lose his or her money, and, more importantly, the conditional green card is lost. This program gained mainstream recognition when the market collapsed and the capital markets froze. Developers, not able to tap prior sources, scrambled to find alternative ways to finance projects. Prior to the 2008 collapse, the EB-5 program was obscure to many developers. However, there were a few developers who did use the program for project financing. Now, there are over 20,000 investor applications pending with USCIS. The demand for the EB-5 visa is strong, bringing billions of dollars each year in investment capital to the U.S. No matter the location of the a real estate project, EB-5 financing has become familiar to most sophisticated real estate developers.

Most EB-5 investments finance real estate development projects. Most foreign investors prefer marquee projects, like the $20 billion Hudson Yards development in Manhattan because of notoriety and the perception of less risk. The Hudson Yards development spurs $150 million each month in construction costs alone, creating thousands of jobs. Depending on the location of the investment, a foreign investor will either make a $500,000, or $1,000,000 investment. Over 98% of the investments are at $500,000 mark. In order to qualify for the lesser amount, the investment must be made to a targeted employment area (TEA). A TEA is an area which includes a census tract, city, county MSA, or state that has an unemployment of a least 150% of the national average at the time of the investment. Generally, the industry uses census tracts because the data is readily available and reliable. The high unemployment census tracts are considered distressed.

Because the EB-5 program was not intensely legislated, it allowed the industry to set many of the rules for the program. For example, the EB-5 program allows geographies (generally census tracts) to be gerrymandered, which means that if a specific area does not quality as a TEA by itself, then adjoining geographies are allowed to be joined to that non-qualifying TEA for the purpose of meeting the unemployment rate of 150% by aggregating and averaging the employment numbers of the joined geographies. The number of geographies that can be aggregated is determined locally in each state (not necessarily by the state). In some states, there is a limit to the number of geographies that can be aggregated while in other states there is no such limit. It is important to keep in mind that most states see little benefit in limiting the number of geographies that can be aggregated because the foreign investment spurs economic growth without cost to the state.

The ability to gerrymander geographies (census tracts) is controversial. The problem with gerrymandering is that the geographies (census tracts) that are distressed lose out because many EB-5 projects are located in wealthier areas. Areas that are distressed and need access to capital are unable to compete against wealthy census tracts, which in some cases have an average income of 200% (double), or more, of the overall median household income. The issue is that wealthy census tracts have available capital for investments, whereas distressed census tracts starve for needed capital. It’s important to consider that even though the EB-5 program benefits non-distressed census tracts, the EB-5 program is a necessary catalyst that allows certain real estate projects to happen. The need for cheap, non-recourse financing makes it possible for some projects to get off the ground. It is often the case that land and labor costs are more expensive in wealthier census tracts, which may thwart development.  The way the developers are able to mitigate the higher costs is through the use of the EB-5 funds to source part of the development costs.

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Selling Houses Quickly for Greater Profits and Risk

Selling Houses Quickly for Greater Profits and Risk

By 2006, flipping houses was at a fever pitch; approximately 8.6% of all home sales were flips. When the markets cratered and the capital markets froze, it crushed many house flippers. Today, with robust home prices and readily available capital, the speculators (i.e. flippers) are back.

In the last quarter of 2016, flippers made about $60,000 on each house, up from about $20,000 in 2009. A decade ago, banks were actively lending money directly to home flippers. Today, there are non-banking intermediaries who are receiving money from the banks and who, in turn, lend the money to the flippers, making revenue on the spreads. Banks, knowing that their loans to the intermediary companies are being re-lent to flippers, are carefully examining how the intermediary companies underwrite and approve loans.

Loans to flippers are short-term, with interest rates ranging between seven and twelve percent (7% – 12%). Generally, the short-term loans last several months. Flippers are having to put more capital to qualify for the financing. On occasion, they are having to come up with as much as sixty-five percent (65%) of the purchase price.

A flipper’s objective is to find homes selling for as big of a discount as possible, generally around thirty percent (30%). The goal for a flipper is to do as little as possible to a house, while making it salable at market prices in the shortest amount of time. Recently, however, in some areas, flippers are buying at smaller discounts of around ten percent (10%), which becomes problematic as the market softens.

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Headwinds on the Horizon for Real Estate?

Headwinds on the Horizon for Real Estate?

One of the biggest issues that many U.S. homeowners faced in the past decade was that their homes were underwater; this limited their ability to sell.  However, according to the S&P/Case-Shilling 20-City Home Price Index, in September 2016, U.S home prices surpassed what was set a decade ago.  With home prices surpassing their previous highs, more homeowners should be encouraged to put their homes on the market.  However, there is reason to believe that prices will soften because the cost of capital is increasing.

For the past several months, there have been pressures to sell long-term debt (e.g,. the 10-year U.S. Treasury).  The 15/30-year mortgage rates are tied to the 10-year Treasury because most homeowners either (i) tend to pay off their mortgage loans as result of selling, or (ii) refinance their mortgages within 10-years.  In the past several weeks, the yield on the 10-year Treasury has risen quickly because investors are trading out of long-term debt.

U.S. Treasuries have been under significant pressure after the U.S. election.  The market is pricing in stronger economy growth, higher inflation and that the Federal Reserve will raise short-term interest rates at a faster pace.  The catalyst behind economic expansion is greater spending, lower taxes and curb on regulations sought by Donald Trump.  Another reason behind the selloff is that contemplated economic expansion requires greater fiscal spending thereby more bonds will likely be issued putting pressure on debt market because of the increase in supply.

With that selloff, the yield price on the 10-year Treasury has increased, which has increased 15/30-year mortgage rates.  With loan costs becoming more expensive, buyers will, at some point, expect a corresponding decrease in selling prices. Sellers are generally slow to react to changing rates because they want to maximize the most from the the sale of their homes.  If, and as, rates continue to climb, there will be pressure on sellers to adjust their home prices downward, which is hard, because most sellers have been locked out from selling their homes and have seen other homes recently sell at record highs.

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Billions Available for Desired Commercial Projects

Billions Available for Desired Commercial Projects

In 2016, the CDFI (Community Development Financial Institutions) Fund held $7 billion in NMTC (New Markets Tax Credits). More than $75 billion in total capital investment through public-private partnerships has been made since the program started.

The ABC’s of NMTCs

The NMTC program encourages a private investor, typically a financial institution, to invest in operating businesses (generally in the form of a loan) known as QALICBs (Qualified Active Low Income Community Businesses) that are located in a distressed census tracts. For making this investment, the investor receives a 39% tax credit (i.e. 39 cents for each dollar invested) on its total investment, which the investor receives over a 7-year period. Because the investor receives the 39% tax credit (i.e. year 1: 5%; year 2: 5%; year 3: 5%; year 4: 6%; year 5: 6%; year 6: 6%; year 7: 6% = 39%) over  seven (7) years it is typically committed to the project for a seven (7) year period. The tax credits are used by the investor to offset its tax liability, dollar-for-dollar. Even though the tax credits are received by the investor over a seven (7) year period, it must make its entire investment in the first year, which is made available to the project. The benefit to the commercial project is that a portion of the investment (i.e. debt) made to the project is forgiven (i.e. deemed free equity).

The equity investment made by the investor is passed through a third-party entity, called a sub-CDE (which is affiliated with the Community Development Entity (CDE)). The CDE holds the tax credits sought by the investor. There are numerous CDEs that are affiliated with financial institutions. The CDE receives the tax credits from the CDFI Fund, which is administered by the US Department of the Treasury. The capital investment that the CDE receives from an investor passes through the sub-CDE, and the money is made available to the project (QALICB). Because of the tax credits, which the investor receives for making the capital investment, the money received from the investor is passed to the project as an investment with favorable terms (e.g. interest-only payments for seven (7) years, part of the debt is forgiven at the end of the seven (7) year period). The amount of the free capital (i.e. equity) investment, the below-market interest rate, and the amount of the debt forgiven are based on a desired yield by the investor. At end of the seventh year, there is an exit strategy for the investor; typically, the investor has no interest in the project after it exists.

Desired Projects

Non-exhaustive examples of projects that have been financed with NMTC proceeds include: revitalization of downtown areas with renovations or construction of office buildings, commercial and retail buildings, shopping centers, mixed-use projects, for-sale housing, workforce housing, hotels, performing arts centers, theaters, charter schools, hospitals, assisted-living facilities, college campuses, high-tech and biotech facilities , homeless shelters, transitional housing, facilities to assist educating the homeless, and assistance with home ownership.

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Working With an Open Listing

Working With an Open Listing

An open listing agreement is a non-exclusive, agency engagement that awards the procuring broker/agent. Open listings are more commonly used in commercial transactions, but sometimes they do find their way into residential deals (note: an open listing is not allowed within the MLS). Generally, open listings are pushed by experienced sellers with the idea that no single broker/agent should control a listing. Open listings tend to be disfavored by brokers/agents because they are not exclusive (i.e. multiple brokers/agents have the opportunity to participate in the sale or the seller can find the buyer themselves and not pay any broker/agent). With that in mind, it is very important that a broker/agent is aware as to how to work with an open listing.

If a broker/agent finds a prospect, it is important that prior to disclosing the name of the prospect, the broker/agent should ask the seller to disclose, in writing, all potential buyers that have been disclosed to the seller. By having the seller disclose all potential buyers, the broker/agent avoids a situation in which he or she discloses the buyer, but finds out that the same buyer is already known to the seller. This important strategy should be discussed with the seller upfront, so the seller appreciates the concern.

Because of the nature of open listings, brokers/agents should take their time to review and negotiate certain terms. For example, the seller should not be allowed to advertise the property for less than the amount the broker/agent is advertising the property for; and, for that matter, if the seller advertises the property, it should be for an amount that includes the broker/agent’s maximum commission amount, so there is not an advantage to a buyer to work directly with the seller. Further, the buyer should not be allowed to place signage on the property or place advertising in the same sources that the broker/agent uses to advertise. The broker/agent should agree to favorable terms in the open listing agreement or some other engagement agreement. Even though the use of an open listing may be required, a broker/agent should not be discouraged for working the listing, provided that basic safeguards are negotiated.

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It’s More Than the Property, It’s the Amenities for Some…

It’s More Than the Property, It’s the Amenities for Some…

Location, location, location is the real estate mantra, which means that a property’s value is determined by its location. This applies to both residential and commercial properties. With that said, amenities are becoming increasingly more important to today’s buyers, whether for personal or business reasons. There are buyers who will share which amenities must be easily accessible to a subject property. For such buyers, the location of the amenities is the starting point for making a decision as to where to buy, even before considering the nature of the neighborhoods.

For those buyers, more than anything else, it’s important to narrow down properties that are well situated to the desired amenities. Greater weight may be place on how far a property is situated from certain amenities. When working with today’s buyers, it is becoming increasingly important to have them identify which amenities they consider important and what is the maximum distance (or time) to a property from those amenities. Once that is known, it is much easier to show properties. Some buyers are so focused on living next to certain amenities that they can look beyond some of the shortcomings of a property.

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