LENDING TO DEVELOPERS OF LOW INCOME HOUSING TAX CREDIT PROJECTS - PUBLIC AGENCY ISSUES

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1 Spring Meeting May 13-15, 1998 By: Natalie L. Gubb, Partner, Gubb & Barshay LLP LENDING TO DEVELOPERS OF LOW INCOME HOUSING TAX CREDIT PROJECTS - PUBLIC AGENCY ISSUES The Low Income Housing Tax Credit -A Brief Overview Section 42 of the Internal Revenue Code provides for both a 9% and a 4% tax credit computed on the basis of the improvements (and not the land) comprising the project. The basis is equal to the hard and soft costs of developing the improvements. The 9% credit is available for new construction and rehabilitation, and applicants must apply to the California Tax Credit Allocation Committee in competition with other projects. The 4% credits is available for acquisitions and projects financed at least 50% with private activity bonds. The credit (equal to the credit percentage multiplied by the basis of the improvements multiplied by the percentage of the units that are "low income") is available each year for ten years. The compliance period (during which a portion of the credit can be "recaptured") is 15 years. Although the credits are referred to as 9% and 4%, in actuality the credit percentages are established monthly by the Department of the Treasury and varies with interest rates. The current rates are 8.35% and 3.58%, respectively. Generally, a project's credit percentage is established in the month it is placed in service (ready for occupancy). In California, in order to compete for the 9% credit, developers must agree to 55 years of affordability; whereas for 4% credits the affordability period is generally 30 years. The required affordability criteria for 9% credits ranges from an average of 40% to 46% of median income. Income limits for 4% bond-financed projects are higher; usually the bonds restrict 20% of the units for households with incomes of 50% or below of median income and the credits restrict the balance of the units to households with incomes of 60% or below of median income.. In order to qualify for an allocation of 9% credits, developers must compete in a lottery system managed by the California Tax Credit Allocation Committee ("TCAC"). The demand for 9% credits is so keen, that currently only 1 in 5 applicants receives an allocation. Because of the fierce competition for 9% credits, in the last couple of years demand for 4 % credits has increased so that now it is extremely competitive to receive an award of private activity bond authority.the California Debt Limit Allocation Committee had received enough applications by February of this year to use up the entire 1998 private activity bond limit available for multi-family housing. The demand for credits by investors has also intensified in the last few years, increasing the amount they are willing to pay. The typical investor pay-in has increased from 45 cents typical ownership structure for a tax credit project is a limited partnership in which the project sponsor, or its affiliate, is the general partner, and the investor is the 99.9 % limited partner. Investors are usually large corporations or funds comprised of corporations. Because tax credit projects qualify for property tax exemption under Section 214(g) of the California Revenue & Taxation guide if the "managing general partner" is a tax-exempt

2 organization, many nonprofits organizations have sprung up whose primary purpose is to serve as managing general partner for for-profit developers. For 9% projects, the rents are so low that they generate very little cash flow, and sometimes cannot service any permanent debt. Four percent deals, however, have higher rents and the bond financing often requires a debt service coverage ratio of 1.15 to 1, or greater, thereby forcing a project to generate cash flow. Cash flow, often referred to as residual receipts, is the source of funds available for debt service on public agency loans. Loans from cities and redevelopment agencies are considered "soft" financing with no obligatory payments during the term except to the extent of residual receipts. Permanent lenders, i.e. banks, do not allow additional junior required debt service, unless it is limited to residual receipts. The structure and terms of cities' financial participation in low income housing tax credit projects is driven by many third party considerations, which often include general tax considerations in addition to the specific requirements of Section 42, investor requirements, Article 34 of the Constitution, senior lender concerns, as well as the developer's particular business issues. The following discussion describes how those competing interests affect the nature of city financing of these projects. 1. Tax and Section 42 issues. Local financing is important not only for project financial feasibility but also to affect the amount of tax credits for which a project qualifies. In order for the project costs financed with local funds to be included in "tax credit basis ", the city financing must be in the form of a loan, due and payable in all events. The typical loan structure is a long-term loan, bearing no interest, or a low rate of simple interest, typically 3%. Grants generally cannot be included in tax credit basis. Payment may be deferred for the term of the loan, or annual payments may be required from all or a portion of residual receipts. The actual payment terms may vary depending on how many different soft loans the project will have. The typical rules of priority of public agency soft lenders, in order of highest to lowest, is State, county, locality.the loan is secured by deed of trust and often a regulatory requiring a specified level of affordability for the term of the loan. The source of local financing can have serious implications for tax credits projects. Localities generally have a limited source of funds that can be used to subsidize affordable housing: Community Development Block Grant funds, HOME funds, housing mitigation funds, tax increment, and the proceeds of tax allocation bonds. Generally, housing mitigation funds and tax increment funds are the easiest to use with tax credit projects because they are local funds and have few restrictions other than required affordability which pose no problems for these projects. More problematic are CDBG funds only because of federal restrictions on the costs these funds can be used to finance. Because they are considered "federal subsidy" under Section 42, HOME funds are more difficult and require careful for structuring for use in tax credit projects. HOME funds, if they are used for other than land, can cause projects in certain federally designated

3 difficult to develop or low income areas who are otherwise eligible for additional credits, to lose those extra credits. In fact, depending on the location and costs of the particular project, it may be more advantageous to structure the HOME financing, if for other than land acquisition, as a grant (and thus not eligible for tax credits) than to lose the additional credits for which the project qualifies. For projects that are not in the designated areas, there may still be other concerns how best to structure the use of the HOME funds. The use of tax allocation bond ("TAB ") proceeds is restricted by the Internal Revenue Code. These funds cannot be loaned, but only granted to developers. Because grants cannot be included in tax credit basis, TAB funds are not a very attractive source of financing for tax credit projects unless the project costs far exceed the basis on which they can receive credits. Because of the myriad of tax implications of local financing sources and structure, it is very important that the developer's tax counsel is consulted before the local financing is consummated. As a condition of applying for tax credits, TCAC requires that all soft financing is committed to the project at the time of application. The good aspect of this requirement is that developers cannot receive an allocation of tax credits for projects that are not financially feasible without local financing and then go back to the localities and strong arm them to give them financing because they are one of the few lucky developers with a tax credit allocation. The difficult aspect of this requirement is that localities must commit funds to projects which may have to compete for several years, if ever, before they receive an allocation of credits. 2. Bank Requirements. "Banks and other institutional lenders, both construction and permanent, and regardless of the amount of their loan relative to the local financing, require that their deed of trust be in first position, senior to all other encumbrances. In addition, banks always require local agencies to subordinate their affordability restrictions. Banks are usually amenable to providing local agencies notice and cure rights in the event of a developer default in consideration for the locality's subordination. More problematic than local regulatory agreements controlling tenant incomes and rents is the statutory restriction imposed under density bonus law. Section of the Government Code requires continued affordability for a specified time period if the project receives a density bonus. Banks want all affordability restrictions including density bonus restrictions to be subordinated, but since they are statutorily mandated, density bonus restrictions cannot be subordinated. There has been no ready solution to this problem and each situation has had to be addressed individually. Construction lenders often will not disburse their funds until all local funds have been disbursed.

4 Permanent lenders also require that the term of the soft loans not mature before their loans which are usually for 30 years. Because most public agency loans close at or before the start of construction, public agency loans should have a term of at least 35 years. Another permanent-lender requirement is that their loans be the only loans with mandatory debt service; all other loans must limit debt service to residual receipts so that the developer cannot default under the junior indebtedness for nonpayment. 3. Article 34 of the Constitution. Article 34 of the California Constitution requires voter approval before a low rent housing project is developed, constructed, or acquired by any state public body. The California Supreme Court has ruled that even when the project is privately owner, if the public entity is sufficiently involved, Article 34 will be triggered under a co-developer concept. California Housing! Finance Agency v. Elliot, 17 Cal.3rd 575 (1976). However, under Health and Safety Code Section , a public body that acts as a conventional lender and carries out routine government functions will not be subject to Article 34. Furthermore, Health and Safety Code Section exempts from Article 34 the rehabilitation of a previously existing low income housing project, as well as a privately- owned project that receives no tax exemption except under Section 214(!) or (g) of the Revenue and Taxation Code, provided that not more than 49% of the units may be occupied by low income persons. Most attorneys take the position that this exemption applies as long as the government body does not restrict as low income more than 49% of the units--the fact that the owner may voluntarily restrict 100% of the units so as to qualify for low income housing credits will not invalidate the exemption. Finally, Article 34 has a fairly short statute of limitations that limits its impact on government bodies. Health and Safety Code Section prohibits challenges once 60 days have elapsed after the final approval of housing assistance. 4. Investor Requirements The investor-limited partner's contribution, in the form of equity, is oftentimes the largest single amount of money in the project. Because the investor's funds are not secured, the investor is most concerned that the project not be subject to foreclosure in which the investor would lose its investment. Accordingly, the typical investor has a number of requirements regarding the financing, including the right to receive any notice of default and the right to cure such default, even if such cure requires the removal of the existing general partner. In the case of a troubled project, corporate investors have been known to cure monetary defaults by advancing or contributing the funds necessary for the project's solvency. Because an investor will lose all future credits and suffer recapture of a portion of previously received credits, if all or a portion of a project is damaged or destroyed, investors often require that lenders allow the borrower to use insurance or condemnation proceeds to repair or rebuild the project.

5 Investors frequently require the partnerships to pay them an annual asset management fee in the range of $3000- $7,500 which must be treated as an annual operating expense by public agency lenders when defining and computing residual receipts. In addition, investors often have minimum reserve requirements which must also be treated as an operating cost for purposes of determining residual receipts. 5. Developer s Business Concerns. Developers' concerns regarding the business terms of local financing tend to center around the timing of the availability of the local funds, the computation of residual receipts, and providing that the loan is nonrecourse Local funds are often needed to fund predevelopment costs and land acquisition, which oftentimes can occur many months before the start of construction. In most cases, local agencies commit, but do not advance funds, until the developer has received an allocation of tax credits or private activity authority, as applicable. Because a nonprofit developer does not expect to receive ongoing distributions of cash flow, the only annual amount that the general partner can expect to receive to defray its costs for managing the partnership is a partnership management fee. This fee, which may range from $15,000 to $25,000 annually, is only payable in the event the partnership has sufficient cash flow. In order for the partnership to pay this fee to the general partner, the fee must be treated as an operating expense for purposes of computing residual receipts. For profit developers may wish to receive more annual distributions that just an annual partnership management fee and may negotiate with a locality to require that only a portion of annual residual receipts be required for debt service on the soft loan. As a business issue, and oftentimes a tax issue (particularly for 4% projects), borrowers will require that the loan specify that it is nonrecourse. In that case, the lender can only look to the security, i.e. the property, for repayment in the event of default. In many cases, investors, too require that the debt be nonrecourse. In almost all cases, permanent bank lenders structure their loans as nonrecourse as do public agencies.