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Eight Tips for HTC Developers to Increase Investor Equity
Developers looking to complete successful historic rehabilitation of properties funded with historic tax credit (HTC) equity face many challenges, not the least of which is lining up sufficient sources of funding to make the project financially feasible.
Financial feasibility includes maximizing HTC equity, a task that isn’t as simple as trying to receive the highest price per credit dollar. There are many factors in HTC transactions that affect the amount of investor equity that can be raised, including when the equity is needed, qualifying costs, development timeline, investment structure, tenant type and property location. In addition to traditional permanent loan debt, the financing needs of historic properties often necessitate other nontraditional sources, with their own unique requirements and timelines.
In the following paragraphs, we discuss steps that developers can take to better increase the net amount of HTC equity and other non-traditional financing sources.
Maximize Present Value of Tax Credits
1. Maximize QREs
The amount of qualified rehabilitation expenditures (QREs) determine the amount of federal HTCs a property can generate. Simple math: 20% of QREs equals HTCs. Developers should closely review development costs to maximize QREs. An experienced tax accountant or attorney can help ensure that developer fees and other expenditures are structured and calculated in a manner to generate maximum QREs, while remaining compliant with IRS regulations. It is important to claim the maximum amount of QREs and there are many nuances in the calculation. For example, previous additions to a building may qualify as QREs. Ensure that every eligible rehabilitation expenditure is counted as a QRE. Review to ensure certain ineligible costs, such as enlargement costs, are not included. To assess financial feasibility, an accurate assessment of eligible costs is critical.
2. Accelerate Timing
Investors generally begin claiming HTCs (over five
years) when the property is placed in service. Typically, this means that the earlier a property is placed in service, the greater the value of the HTCs to an investor–think time value of money. Assess and estimate expected placed-in-service dates and closely monitor the construction timeline to stay on track. Time literally can mean money. (Caveat, general rule: The HTC investor must be in the investment partnership when the property is placed in service to be allocated credits, so don’t delay in finding and admitting an investor.)
3. Qualify Under Transition Rule
Even better than placing a property in service as early as possible is this: A one-year credit. Tax reform legislation at the end of 2017 changed how the federal HTC was claimed, switching from a one-year credit taken the year the property is placed in service to a five-year, ratable credit–but the legislation provided a transition rule for properties to qualify under the former rules. Developers should see if they’re eligible under the transition rule by considering whether these two conditions exist: the property was owned or leased by the current taxpayer before the tax reform legislation changes went into effect and the project qualifies as a phased rehabilitation. Assuming the property satisfies those conditions and is otherwise eligible, developers potentially have until 2023 to claim 20% of the QREs as a single-year credit. Work with your tax professional to see if your project currently qualifies under the transition rule and then ensure you continue to qualify.
4. Evaluate Other Tax Incentives
Historic renovations usually need additional financing beyond federal HTCs and traditional permanent debt, so developers should consider other tax incentives to fill that gap. Start with state HTCs: Nearly 40 states have a state-level HTC, which allows a property owner to generate additional financing sources from state credits. States have varied regulations concerning their HTCs, including such issues as whether the credits are certificated or allocated, competitive or noncompetitive and whether there are bonus credit percentages for affordable housing or developments in opportunity zones (OZs). Consider getting assistance to evaluate and maximize the benefit from the state HTC.
There are also other state and federal tax incentives that can help fill HTC financing gaps. Affordable housing properties may be eligible for federal and/or state low-income housing tax credits, and federal and state new markets tax credits are often combined with the HTC in properties with major community impact in low-income communities. Both require additional planning and coordination. Adding renewable energy tax credits (RETCs) to the capital stack isn’t easy–the National Park Service values historic integrity, even if there is a green energy element–but more developers are finding ways to pair RETCs with HTCs. Developers should also check whether their property is in an OZ, which will make it more attractive to some HTC investors, as well as be an opportunity to receive a pure equity investment from a qualified opportunity fund.
Optimize Investment Structure
5. Evaluate Partnership Structure
HTC investors often adjust equity pricing based on partnership structure. For instance, there may be more equity for properties that use a lease-passthrough structure instead of a single-tier structure, so developers are well-advised to consider that possibility. However, it’s not a simple matter: Other financing sources in an HTC transaction may require or benefit from a simple partnership structure. Other elements of the transaction can also impact the equity investment: the cash flow from the business, a delay in timing of capital investment and other issues. Before finalizing an agreement, consider examining different scenarios with a tax professional to see the positives and negatives to help you make an informed decision. There is no one-size-fits-all structure, so examine your entity structure holistically.
Address Real Estate Fundamentals
6. Assess Asset Type and Location
Take time to understand how investors will assess your development’s underlying real estate fundamentals. HTC equity investors focus on the development and operating risk of their property investments, so real estate underwriting is crucial–at a minimum to ensure that the property will survive five years to cover the tax credit period. HTC equity is greatly influenced by asset type and location, because those are key factors in the investor’s perceived risk level. Among HTC asset types, housing is generally considered the least risky investment and draws the greatest interest. Next are commercial properties (including offices) and finally hospitality–particularly in the wake of the COVID-19 pandemic. Location matters–a hotel in a major metro area is more likely to attract investor interest than the same property in a rural area or smaller metro area. Developers generally already have a specific property, so the location isn’t going to change, but the use of the property could affect interest from investors. That means it is worthwhile to consider the effect on raising HTC equity when evaluating various uses of the property. Consider mitigating some of the perceived risk with an early market study to show how the property meets needs in its community.
7. Secure Strong Tenants
HTC investors–particularly those in the commercial subset–are interested in the strength of the potential tenants: The stronger your tenant, the more attractive the investment. A rental property preleased, for instance, to a single, financially strong tenant will merit higher equity prices. A building being renovated with minimal preleasing will generally draw less interest from equity investors, although positive market studies can help offset this. In other words, an office property with a long-term lease with a credit-worthy tenant will be more attractive to investors than a multiunit retail property without lessees. This isn’t to say that commercial investors should avoid retail or nonprofits or businesses without a historically strong balance sheet as tenants, but that it’s important to understand that leasing status and credit worthiness of potential tenants can affect equity investment.
8. Have Strong Guarantors
Properties with strong tenants and strong guarantees will be more attractive to investors. HTC investors examine the financial strength of the entity into which they’re investing, so ensuring that the guarantor is as strong as possible can increase HTC equity and interest. Think of this from an investor’s perspective: Many things can go wrong during the period of the transaction–the economy can turn; a major tenant can move out–so having a strong guarantor makes the investment more appealing.
Recap: Be Informed, Negotiate
Knowing factors that increase investor interest in their historic property puts developers in a stronger position. This means takings steps to maximize QREs for a property, including reviewing how the property will be used, examining the partnership or investment structure, examining other tax incentives that can be twinned in a transaction and structuring the development with the developer in mind, then negotiating with investors.
Potential investors often have wiggle room, so don’t be afraid to offer researched options to your investor. Also, it’s almost always better to evaluate proposals from multiple investors. Having a professional evaluate your offers can help you make a wiser decision.
Finally, it’s important to keep in mind that while equity price-per-credit is important, other factors can often outweigh a small difference in price-per-credit. In comparing and evaluating investor term sheets, developers and their advisers should also consider equity pay-in benchmarks, investor priority returns, tax equivalency terms, reserve requirements, credit adjuster provisions, exit options and other factors.
Historic preservation is important. Considering all the ways to make it work financially is worthwhile. The best investments involve developers considering multiple factors to find what works best for them and the investor.
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