What are the Key Economic Terms to be Aware of in HTC Term Sheets?
Published by John Dejovine on Friday, September 8, 2023
Q When evaluating historic tax credit (HTC) term sheets, there are various economic terms for developers to understand–and they’re not always intuitive.
A Thomas Boccia’s article in the August 2022 Journal of Tax Credits, “What HTC Developers Need to Know about Evaluating and Negotiating Term Sheets” does an excellent job of explaining how to solicit, evaluate and negotiate term sheets. This article will provide developers with additional background on some of the key financial terms commonly found in term sheets and the financial impact of these terms. It is highly encouraged to have your HTC accountant and attorney be involved in the term sheet and to review these term sheets as there are many nuances that can have significant financial and legal impacts to developers.
The federal HTC pricing is the price the HTC investor will pay for each dollar of federal HTC they are allocated. For example if an investor is allocated $6,250,000 in credits and the pricing is $.80 per credit, they would contribute $5 million of HTC equity to the HTC partnership.
The range of federal HTC pricing can vary widely based on a several different factors. One is typically the size of the project, as an investor gets the benefit of a larger credit for a similar amount of work and cost for the investor. Other factors are the economic strength and experience of the developer as well as the economic risk related to the specific project. Pricing tends to be the focus for HTC and while it is certainly important, there are a host of other factors that we encourage developers not to overlook. For instance, some investors prefer to have lower pricing but also require a lower preferred return and put payment.
Preferred Return and Put Payment
One economic term that can have a big impact on the ongoing cash flows of HTC projects is the preferred return or priority. Most HTC term sheets will require an annual preferred return of 1% to 2.5% of the HTC equity contributed to the project paid annually. So, if an HTC investor is contributing $5 million to the project in HTC equity and had a 2% preferred return, the HTC investor would be entitled to $100,000 in annual preferred distributions during the period they are a partner in the HTC partnership. The preferred return is paid out of cash flow and accrues if cash flow is unavailable. Any accrued amount that is not able to be paid during the compliance period would typically be paid as part of the put payment to the HTC investor.
The put payment is a payment the HTC investor requires that is paid after the HTC compliance period expires. The HTC investor has a put option with the developer to cause the developer to purchase the HTC investor’s interest in the HTC partnership. The most common put price is 5% of the equity the HTC investor contributed. So from our previous example of a $5 million HTC equity contribution, the put payment would be $250,000 plus any outstanding preferred returns, legal fees and any other payments owed to the HTC investor.
Tax Equivalency Payments
Tax equivalency payments are payments required by an HTC investor based on the amount of taxable income allocated to the investor multiplied by the federal and state tax rate applicable to the HTC investor. Generally, federal HTC investors are C-Corporations which pay a 21% federal tax rate plus any state tax rate the investor may owe. Like the preferred return, tax equivalency payments are generally paid of out of cash flow and accrue if cash is not available. Like the preferred return, any unpaid tax equivalency payment will be due with the put at exit. One nuance to the tax equivalency payment is if the calculation for taxable income includes Internal Revenue Code Section 50(d) income, which is income related to the federal HTCs, allocated to any recipient of the federal HTC in a lease pass-through structure equal to the amount of the credit spread over the amount of shortest depreciable life of the property that produced the HTC. From our previous example, of $5 million of federal credits related to residential property which is depreciated over 27.5 years would yield annual Section 50(d) income of $181,818 allocated to the investor and at a 21% tax rate would increase the annual tax equivalency payment by $38,181. Not all investors require Section 50(d) income to be included in the calculation of the tax equivalency payments, making it an important nuance to be aware. Also of note, tax equivalency payments can be reduced by allocations of depreciation and other losses allocated to an investor, so there is an opportunity for developers to reduce any amounts owed for tax equivalency payments.
Another economic term is the timing of when an investor will make their capital contributions to the HTC partnership. Revenue Procedure 2014-12, which provides a safe harbor for investors following certain requirements, one of which to have contributed at least 20% of their equity to an HTC project before the placed-in-service date. Based on this safe harbor, HTC investors will typically contribute 25% of their equity at the financial close to provide some cushion if the HTCs from the project are greater than what was originally projected. Subsequent installments are contributed to HTC projects based on a wide list of benchmarks set out at the financial closing which include placed-in-service date, lien waivers from all contractors, NPS Part III submission, final cost certification and stabilization among many others. These requirements dictate when equity is available from an HTC investor to pay down any bridge loans that were used to finance construction. An additional note is that HTC bridge lenders will not typically allow developers to borrow against any installments related to stabilization, which could require developers to have more equity available at financial close.
Conclusion: There’s More to Know
The economic terms above are the key factors for developers to know. However, there are a host of other terms that can have a significant economic impact to developers–including structure, cash-on-cash return, upward adjusters, timing adjusters and reserve requirements. With so many different terms to be aware of and so many nuances to those terms, it is imperative to have your accountant engaged early to help review term sheets and help developers make informed decisions on their HTC investors.