Five Steps for Historic Tax Credit Developers to Better Anticipate Difficulties, Overcome Obstacles

Published by Michael Novogradac on Thursday, September 1, 2022
Journal Cover Thumb September 2022

The National Park Service (NPS) certifies the rehabilitation of roughly 1,000 historic properties a year. Receipt of this certification by a property owner is generally the final step in confirming a renovation qualifies for federal historic tax credits (HTCs). Along the way, developers of historic properties face many challenges. To better anticipate future challenges and overcome obstacles, there are five steps every developer should take. While these steps are directed toward developers of HTC properties, with slight modifications they are equally applicable to developers of properties using other federal and state community development tax incentives.

Here are the five steps every HTC developer should take:

1. Question the Assumptions Used in Your Forecast

A financial forecast is central to raising equity from a tax credit investor. A forecast is used by a developer and their potential tax credit equity investor to help assess the feasibility of a proposed renovation and establish mutual expectations. But a forecast is, by definition, a mere point estimate of the future. The one certainty about a forecast is it will never be 100% accurate.

In developing assumptions for a financial forecast, a developer, particularly a new developer, may be inclined to be a tad optimistic. With sufficiently optimistic assumptions, most proposed developments appear to be financially feasible. Such optimism can extend to many areas, such as total project costs, costs eligible for HTCs, the speed at which construction will occur, rental rates, and much more.

Overly optimistic forecasts can and often do lead to notable difficulties later during the course of development. Such difficulties may not reveal themselves until far down the road, such as when an equity installment is scheduled to be made.

Conversely, an overly pessimistic forecast can lead to a proposed development never appearing financially feasible, and therefore the renovation won’t move forward. It can also result in less equity being raised from investors, as tax credit equity isn’t maximized.

In short, a realistic forecast is the goal. And the key to a realistic forecast is to be constantly questioning your assumptions. With every question, every challenge, the forecast becomes more realistic, more robust. Realistic forecasts build in some cushion, acknowledging that all variables cannot be clearly identified and adequately estimated. Many developers reach out to get a second (or third) set of experienced eyes to review their forecast and further identify and challenge their underlying assumptions. Having a forecast reviewed by an experienced HTC advisor can help spot overly optimistic or pessimistic assumptions, or other flaws in a forecast.

2. If You Are Counting on State HTCs, Learn the Details

More than 35 states have a state HTC that can be paired with the federal HTC to help make the renovation of an historic structure more financially feasible. But state HTCs do not completely mirror the federal credit, there are always differences. Developers must identify the differences and plan accordingly. Developers working in multiple states must be aware that each state HTC is different. Some differences are dramatic, others more subtle.

One example (of many) is Missouri, which has a vibrant HTC incentive. In Missouri, any contractor or service provider performing HTC work must be licensed in the state for the costs paid to the contractor to be included as qualified rehabilitation expenditures (QREs). Another Missouri-specific nuance is that costs are eligible only if they are paid by the development entity, even if subsequently reimbursed.

Those details are specific to Missouri, but other states have other nuances, so fully understanding the requirements of your state HTC can help avoid later difficulties. A reminder that the monetization of state HTCs may also have federal income tax consequences, so developers should take time to understand tax mitigation strategies and the cost and tax risks associated with such strategies.

Taking time to master the details of your state credit will help you maximize the dollars raised from using the state HTC and mitigate problems that can arise from making incorrect assumptions. Consult with an expert to master the details of your state HTC.

3. Get a Third-Party Review of Estimated QREs

The amount of equity a developer can raise from federal and state, if applicable, HTCs is a direct function of the total, actual QREs. A property’s total HTCs equals a percentage (20% for federal HTCs, varying percentages for state HTCs) of a property’s QREs, so developers should closely review their costs and have a professional conduct a further detailed review of the estimates.

An HTC-funded rehabilitation includes many expenditures that are not QREs. Examples of non-QREs include costs attributable to increasing the volume of a structure (enlargement costs); costs incurred to demolish noncontributing outbuildings (demolition costs); sitework; utility work outside the building footprint; and personal property such as equipment, furniture, appliances and window treatments. Other items that aren’t QREs include components of an electrical system that are not permanently installed; legal and accounting fees not in connection with construction-related matters or financing; interest costs allocable to the financing of the acquisition of the building; land improvements or the construction of outbuildings; and interest and other carrying costs (insurance property taxes, utilities, etc.) incurred after the construction period has ended or allocable to portions of the building placed in service before completion of the entire building.

Many of these and other items are often incorrectly included in QREs–leading to a financial pinch when they are later identified and disallowed. The financial pinch comes in the form of reduced HTC equity contributions from the equity investor.

The more accurate the initial estimate of QREs, the less likely a developer will face an HTC shortfall upon completion of the development.

4. Negotiate a Detailed Term Sheet with Your Tax Credit Investor

Developers usually begin the process of monetizing HTCs by obtaining equity term sheets from prospective investors. This is how a developer documents the legal and business structure that will be used to draft the tax credit partnership operating agreement and related documents. It is very important for a developer to pay close attention to the details, particularly those that address timing and credit amount differences.

Every developer knows it is important to obtain a high per-credit equity price, but developers should also consider other issues. Term sheets should (and generally do) include the major economic and noneconomic terms for each proposal, including such things as preferred returns, the investor put price, asset management fees, responsibility for third-party transaction costs and more. A term sheet also will specify the transaction structure–whether the development will use a single-tier or lease-passthrough structure.

Here are three key financial details to pay particularly close attention to when negotiating the term sheet:

Credit adjusters. Typically, the operating agreement obligates the investor to contribute a fixed dollar amount of equity to the project based on the forecasted tax credits. Actual QREs will always differ from the point estimate included in the financial forecast. If the actual expenditures are higher, a developer wants the equity investor to contribute a greater amount of equity. If actual expenditures are lower, the equity investor wants to contribute less equity. This is where credit adjusters come in. Agreements include “credit adjuster” provisions that increase or decrease the amount of equity the investor is obligated to contribute based on the difference between the forecasted credit amount and the actual credit amount. Typically, both the upward and downward adjusters are capped at a percentage deviation from the forecasted amount. Downward adjusters are almost universally capped at 25%, but upward adjusters can vary and typically range between 5% and 20%.

HTC projects often, particularly in the current inflationary environment, incur cost overruns of 10% or more, so the cap on upward adjustments can come into play–making that a key part of the negotiations. In some cases, it may be prudent to forego conservatism in estimating QREs to avoid exceeding the upward adjuster cap. In such cases, the developer may wish to adjust the contingency as an offset.

Tax equivalency payments. Tax equivalency payments, sometimes referred to as special tax distributions, are a provision included in most HTC operating agreements. They obligate the partnership to make a special cash distribution to the investor when the investor is allocated taxable income. In addition to taxable income allocated to the investor on its Form K-1, many (but not all) lease pass-through agreements include income the investor is obligated to report on its tax return by Internal Revenue Code (IRC) Section 50(d) in the tax equivalency computation.

A knowledgeable HTC tax advisor can recommend strategies that allocate more deductions to the investor to mitigate the need to make tax equivalency payments, but it is first important to evaluate the developer partners’ tax situation. For instance, an individual developer in a high tax bracket may be better served paying the investor a tax equivalency payment at the corporate tax rate rather than allocating the investor more deductions that have a greater present value to the developer in a higher tax bracket. A knowledgeable, experienced forecasting professional can provide guidance in this area.

Cash flow waterfall agreement: The safe harbor provided in Revenue Procedure 2014-12 helps ensure that an investor will be respected as a partner in an HTC partnership and thus be eligible to be allocated the expected tax credits. Virtually all federal credit investors require a safe-harbor-compliant structure and that the tax opinion cover this risk. A central element of the safe harbor requires the investor have “a bona fide equity investment with a reasonably anticipated value commensurate with the investor’s overall percentage interest in the partnership, separate from any federal, state, and local tax deductions, allowances, credits, and other tax attributes.” Rev. Proc. 2014-12 further stipulates that “…an investor’s partnership interest is a bona fide equity investment only if that reasonably anticipated value is contingent upon the partnership’s net income, gain, and loss, and is not substantially fixed in amount.” In practice this means the investor must enter the partnership with the expectation of receiving more than a de minimis share of the partnership’s cash flow and at least a portion of that cash flow must be variable with the project’s performance (i.e., in addition to any preferred return). There are a variety of ways an investor and developer can share cash flow while remaining compliant with the safe harbor. Developers should negotiate and understand how cash flow will be shared among members of the partnership and where there is flexibility.

Focusing on the details in the term sheet allows the partnership to function as intended. The key is in the details, so get professional experts to help you negotiate the correct terms and ensure that the term sheet reflects your desires.

5. Regularly Update Your Forecast, Course Correct as Needed

As noted early, a forecast is a point estimate, and actual results will differ. Developers should regularly update their forecasts for actual results and updated prospective assumptions. Updating a forecast will help identify how a project’s sources and uses of financing are changing and identify issues on the horizon, thus providing some lead time to potentially mitigate coming issues.

How often to update a forecast can be as much art as science. But a guiding principle is to update a forecast anytime a material change in underlying assumptions has occurred. Don’t assume that you know the consequences of the change. By updating the forecast, unseen issues may be identified.

Updates should be made during the development period to monitor actual activity compared to the forecast and certainly should be done when the cost certification is complete. Subsequent updates should be considered when the project has stabilized for a year and when a refinancing transaction is considered.

Simply put, keep updating your forecasts and adjusting.

The need to update a forecast becomes obvious when monitoring progress toward reaching key benchmarks that must be met to receive the next installment of investor equity. When an HTC development fails to meet a funding benchmark, there can be a domino effect of a bridge loans being outstanding longer than budgeted, resulting in increased project costs. In this era of supply-chain and labor-availability issues, the likelihood of missing benchmark dates on a development is increased, even for the developer with realistic forecasts.

Developers should focus on progress in the months leading up to the deadlines, which can be accomplished by updating forecasts. Early awareness gives a developer time for alternate plans.

Updating estimates can also identify when the upward adjuster cap may be exceeded, allowing a timely discussion with the investor advising them of this fact. In many cases, the investor will be willing to contribute additional equity for some (or all) of the excess.

Regularly updating forecast and estimates for QREs can help developers more easily meet equity-timing benchmarks and allow time for adjustments to the property’s financing. Plan by establishing times for those updates and having professionals perform them.

Conclusion

As with nearly all property development, details matter and savvy HTC developers recognize the importance of paying close attention to better anticipate future challenges and overcome difficulties.

It’s highly advisable to retain experts–including Novogradac professionals–to guide you through the planning, structuring, closing and ongoing management of an HTC project.