Strategic Capital Planning to Ensure Long-Term Sustainability. Ohio Housing Conference November 7, 2017

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1 Strategic Capital Planning to Ensure Long-Term Sustainability Ohio Housing Conference November 7, 2017

2 Elaine Magil Assistant Director TCAM (617) David Jackson Senior Associate On-Site Insight (617) Tony DiBlasi Chief of Asset Management Ohio Capital Corporation for Housing (614) x157

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4 PROBLEM: Our Replacement Reserve accounts are woefully inadequate to meet our long-term needs and are routinely misused!

5 But if carefully managed and planned, Replacement Reserves may enable a thoughtful owner to be well-positioned for a successful (albeit modest) recapitalization event post Y15

6 Our Goal Today To explore how we think about and use our replacement reserve accounts / why it is so important Highlight best practices from the most sophisticated owners Provide examples of strong capital planning models To be more strategic with our reserve accounts!

7 Do we believe that a standard $300/unit annual reserve deposit will really meet our long-range capital needs?

8 Typical $300/unit RR Deposit IF NEVER DRAWN UPON

9 Is $8K /unit enough to revitalize a unit? Is it enough? Water heater ~$500 Furnace ~$1,000 Air Conditioner ~$1,000 Appliances ~$1,000 Roof ~$2,500 Paint ~$1,000 Flooring ~$1,000 Cabinetry ~$3,000 Total is roughly ~$11,000

10 Example #1 Example below is new construction, single family lease purchase LIHTC project Withdrawals between years 5-10 have reduced reserves by 50% Roofs and other mechanicals need to be replaced in a few more years! What s the plan?

11 Example #2 Example below is new construction, family townhouse LIHTC project Routine withdrawals after year 3 have suppressed reserve balances Roofs and other mechanicals need to be replaced in a few more years! What s the plan?

12 If you don t have a formal strategy YOU MAY NOT REALIZE that you are at risk of exhausting your replacement reserve account prematurely! Reserve accounts are very limited and critical resources are you preserving them for their intended use? Failing to PLAN is planning to FAIL! -- Benjamin Franklin

13 Q: Are we really thinking about the long-range perspective? As an owner, your thinking about and planning for the future? How far can your property survive into its 30-year extended use period? Are you acting like an owner with a long-term obligation? Ask yourself What does my organization DO?

14 Strong owners know what s really worth spending time on BUDGETS Establish portfolio-wide goals, then translate them into project budgets Look at historical, comparable, and market data when projecting for the coming year Balance input from central office and site management Getting budgeting wrong will undermine a lot of other processes CAPITAL PLANNING If you were a manufacturer, your properties would be your factory take care of your physical plant! Replacement reserve deposits are almost never sufficient Balance input from central office and site management Get experts when needed Managing bids is time consuming 14

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16 Owner Practices (TCA Article) Actually track data on usable lives [e.g. LDG] Need to translate PCNA findings effectively into a meaningful plan Who reads the PCNA? Do Executives have the time, expertise, or process to synthesize the findings? What is the role of AM in this? How are current needs balanced against a future recapitalization (e.g. deciding what to save for future basis)? Knowledgeable asset managers can do this translating of PCNA from informative to actionable document look at findings, speak to maintenance staff, ID specific projects to propose Central locus for Capital Needs decisions: a Physical Plant department [Vesta] Not for routine site maintenance; these staff collect PCNAs centrally for use in annual budgeting Created this group when portfolio was < 4,000 units to provide a portfolio- and organizationallevel (rather than property-level) approach to physical condition Cost rolled into corporate overhead, recognizing that for site managers, overseeing daily operations often crowds out the ability to focus on CapEx Deciding what to do in-house and what to contract out External vendors: more specialized, more flexible capacity BUT expensive and must may require a long/costly procurement process Internal staffing: increases payroll cost regardless of utilization AND logistics of broad geographies can lead to high travel costs and down time, or even a need for local teams Compromise? Cultivate a relationship with a go to GC firm

17 From Article (cont d) Stabilized properties with sufficient R4R balances are unfortunately rare overly optimistic underwriting combination of rising costs, a desire for cash flow, and under-appreciation of wear-and-tear Ensure that annual R4R deposits escalate provision Often 3%, could be CPI Just to match inflation, let alone the greater needs over time Esp. past ~Y8, where the time before recapitalization is shorter, remember that $300 set aside in 2002 won t yield the same $300 worth of work in 2017 Internal analysis of R4R needs: even if the lender requires $350 [PUPY] but we see it ll need $400, we ll just put that extra $50 into a separate account that we hold. [Vesta]

18 From Article (cont d) Asset managers consider which CapEx projects to put forward, with eye on how to pay for it, not trying to scrutinize PCNA Think about when / what to hold off items to roll into basis for LIHTC recapitalization Remember: $1 of CapEx (or OpEx) is $1 from the project, $1 in basis is subsidized by the Investor Some projects can be done well via annual CapEx spending, but some large or costly projects need the resources of a new transaction Owners thinking strategically about reserve balances at the LP s exit may want to spend reserve $ on improvements rather than have them be distributed at Y15 only to be funded again at re-syndication In general: need to connect the person planning a recapitalization with good info about the physical asset, to make responsible decisions about what to defer Asset managers look at what an anticipated capital event is likely to entail, and essentially re-underwrite the deal to estimate what funds (with what restrictions) are likely to be available then I m careful not to get into a situation where we re relying on a resyndication to actually keep up the property. [Chris Dischinger, LDG]

19 From Article (cont d) Given the spread between interest rates 15 years ago and now, a refinance-andhold plan often makes sense Only works if the property is in good shape! Energy & Sustainability Manager looks for local or federal sustainability incentives, including free labor or materials, purchase rebates, and tax exemptions [VOA] A lesson we learned over time was to do things right the first time, use quality materials, and it pays off. [Vesta] Analyze the payoff for investing in things like more expensive Hardie-plank (likely to eventually need repainting) as opposed to cheaper but shorter-lived vinyl siding Such analyses are time-consuming but can be worth the effort, especially if a longterm hold is expected

20 Asset Management & Aging Assets As with so much in AM, while there may be general agreement about how things should work, high-performing organizations distinguish themselves by what they actually do Many state HFAs rely on 4% LIHTC and the market to take care of properties aging out no extra resources available for capital needs of older properties How owner/developers deal with aging assets (e.g. Year 15) varies widely: Large and seasoned owners generally well-equipped Smaller organizations with few assets relying on outside experts and learning as they go Transition to next stage generally gone well but much of it due to favorable capital market environment conditions and demand for MF investments

21 On Recapitalizing Owners: Maximize resources from existing portfolio where you can Dearth of soft financing and rising levels of hard debt mean less ability to pull money out at refi/re-syndication All housing stakeholders: Establish the right org structure, policies and tools to proactively address aging assets Public agencies: In the face of real constraints, agencies can help convene key stakeholders Important to act while you can recent low inflation has led to a false sense of security about operating expenses

22 Industry Observations Large regional non-profit developer/owner: building out information as well as processes to be super-smart about CapEx Serious capital budgeting, including budgeting how much is going to be drawn from reserves Track all expenses and reserve draws monthly so there are no scrambles at year end Populate database with extensive information on building systems types, makes, ages so they can really know what s happening with the capital plant Control utility expenses, including through careful decisions about when to invest in systems upgrades Often see owners in perpetual catch up mode: don t prioritize CapEx from the outset and quickly get into downward spirals of deferred maintenance, which then hurts occupancy & marketability For LP s, this cuts both ways Not maintaining the property can drive down value and the amount for which the LP will settle as a buy out On the other hand, LPs will be looking to get a piece of whatever is left in the reserves By now, most LPs are fairly savvy about these manipulations so owners are probably better off playing it straight and not trying to game the LP

23 Owner Preservation Options at Year 15 Get control of the property usually by purchasing the investor s interest And then: Continue to own and operate the property Refinance the property to fund purchase of investor interest and capital improvements Sell the property into a preservation fund Sell the property into a new tax credit syndication Many transactions combine several of these elements

24 Year 15 and Long-Range Capital Planning Transactional AM (including Year 15 dispositions) is a very different skillset than ongoing, regular AM Start planning early for exit as early as Year 8 may be wise Understand your relative power in each deal GPs typically drive the timeline, and may have strong rights Don t just strategize to get the investor out think about what you are going to do with the property once it s yours!

25 Stories from GP-side Asset Manager Projects under-rehabbed so they were behind from Day 1, and needed more CapEx throughout Reserve drained by Y5 Ended up pushed into trying to pull out money at refi, just to complete the rehab This also sucked up a lot of Asset Manager time, distracting from regular oversight elsewhere Idea: use handoff from Development to AM to do a check-up on the project s overall health Post-rehab PCNA supposed to be done but skipped Story of property manager bringing water in bottles b/c money for expenses had been spent on CapEx Watch out for deals that only look good on paper: critical that AM has some visibility in the underwriting / structuring

26 Stories from GP-side Asset Manager When to spend reserves vs. expense: As property ages, stronger pressure to use reserves because income is increasingly restrained On properties with lots due to soft lenders, incentive to expense since the money won t stay with GP anyway Careful! Cities, states, and HUD vary greatly in how much they prescribe what s expense-able. There can be consequences for bad behavior on this. Strictly following most recent PCNA is usually a safe bet Budgets: are you budgeting draws > balance?! In the event of an emergency, there s never any good solution.

27 Reserve Balance is a Risk Factor

28 Critical Elements of a Capital Needs Assessment (CNA)

29 Critical elements of a Capital Needs Assessment (CNA) Evaluates the physical condition of a property Identifies current conditions Anticipates future conditions Determines costs (capital) needed to address conditions Repair, upgrade, replacement, etc. Timing of action In what year? Why / rationale for action

30 Replacement Reserve Account A set-aside account to fund the capital needs of the development Reserve account balance and annual funding should sufficiently keep pace with capital costs Suggested starting balance: $1,500 to $2,500 per unit Suggested annual contribution: $600 to $900 per unit

31 Madison Village Case Study #1

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41 Verne Barry Place Case Study #2

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51 Top 7 Indicators That Owner is Being Strategic in Use of Reserves

52 Top 7 Indicators That Owner is Being Strategic in Use of Reserves 1. Owner maintains a 20 year capital needs schedule that is regularly updated and in doing so, has a very clear understanding of the physical needs (and can quantify in dollars) the long-term cash needs to appropriately maintain the asset 2. Owner is mindful of the long-term capital needs $$$ (above) and knows exactly how much is being deposited on a monthly / annual basis to the reserve accounts (and KNOWS if the long-term cash needs can be satisfied with the future reserve balance or can quantify the shortfall)

53 Top 7 Indicators That Owner is Being Strategic in Use of Reserves (cont d) 3. If anticipated deposits are inadequate to meet the future anticipated need, Owner is disciplined enough to escrow more than required to meet the future need (or has a clear strategy to cover the gap) 4. In developing a project originally and during the operational phase, Owner is very selective and thoughtful with the selection of the building and unit components to ensure longevity and reduce the need for unnecessary replacement

54 Top 7 Indicators That Owner is Being Strategic in Use of Reserves (cont d) 5. Owner has (and adheres to) a clear policy related to when items are capitalized (and places items in service and depreciates its value accordingly on the books) 6. Owner establishes clear expectations with its managing agent as it relates to the use of reserves and does NOT permit reserves to be used as a crutch to mask weak management 7. Owner is mindful of reserves relative to the Y15 disposition process, and understands and is planning for the LP exit (YEARS before Y15)

55 Open Discussion / Q&A Elaine Magil Assistant Director TCAM emagil@tcamre.com (617) David Jackson Senior Associate On-Site Insight djackson@on-site-insight.com (617) Tony DiBlasi Chief of Asset Management Ohio Capital Corporation for Housing tdiblasi@occh.org (614) x157