The State of the Low Income Housing Tax Credit Market National and Local Perspectives An Arizona Housing Alliance Training Session May 26, 2010 Wayne H. Hykan, hykanw@ballardspahr.com Ellen O Brien Kauffmann, kauffmanne@ballardspahr.com Mark J. Maichel, maichelm@ballardspahr.com
How the Credit Crisis Even Clobbered Affordable Rental Housing A loss of tax capacity by investors in the market especially Fannie Mae and Freddie Mac Investors prefer shorter holding periods that are provided by LIHTC investments LIHTC investors generally face risk for 15-year compliance period Increased risk aversion, especially real estate risk Useful sources on the state of the affordable housing industry - The Disruption of the Low-Income Housing Tax Credit Program: Causes, Consequences, Responses, and Proposed Correctives, Harvard Joint Center for Housing Studies, December 2009 - Low-Income Housing Tax Credit Investment Survey, Ernst & Young, October 2009 2
American Recovery and Reinvestment Act of 2009 Provides Some Assistance Tax Credit Assistance Program - $2.25 billion of subsidy to fill funding gaps - Arizona has committed approximately $27 million - Program is only available for projects awarded tax credits during 2007 through 2009 - This was a stopgap program only 1602 or Tax Credit Exchange Program - Program does not involve large tax expenditure to Treasury - Only applies to 2009 unless extended - Shrinks the total amount of tax credits to be sold in 2009 - Any grant funds must be used to make subawards by January 1, 2011 3
Apr-10 May-10 Section 42(b) Tax Credit Applicable Percentages and Interest Rates 10.00% 9.00% 8.00% 7.00% 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% 4 Jan-07 Feb-07 Mar-07 Apr-07 May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07 Nov-07 Dec-07 Jan-08 Feb-08 Mar-08 Apr-08 May-08 Jun-08 Jul-08 Aug-08 Sep-08 Oct-08 Nov-08 Dec-08 Jan-09 Feb-09 Mar-09 Apr-09 May-09 Jun-09 Jul-09 Aug-09 Sep-09 Oct-09 Nov-09 Dec-09 Jan-10 Feb-10 Mar-10 30% PV Applicable Percentage US Treasury Securities 10 Year CM 70% PV Applicable Percentage 10 Year Treas Rate
The Banks as Leading Buyers of Tax Credits Community Investment Act requirements Disruption of markets allows much higher yields than before the credit crisis Complementary products (e.g. construction loans) Big banks already have the expertise in underwriting real estate in general, and tax credits in particular Low interest rate environment provides predictable profits tax capacity 5
Deals That Are Getting Done 9% deals vs. 4% deals 100% low income vs. mixed use Real estate markets Well-capitalized developers/strong track record Underwriting standards conservative Certain acquisition/rehab (e.g. - 8 property) 6
Tax Credit Financing of Public Housing Increased volume cap makes facilitates acquisition and renovation of public housing by public-private partnerships Tax credit structure allows leveraging of governmental resources (e.g. capital fund financing program money) HUD support for mixed finance transactions Deals often structured with little or no must pay debt Example in March 2010, New York City Housing Agency finances the modernization of over 14,000 units using tax credits HUD Transforming Rental Assistance initiative 7
Deals That Are Getting Done LIHTC and Energy Credit Projects Energy credits are investment tax credits like historic tax credits (HTCs) with many similar rules. Investors have routinely worked on projects that combine HTCs and LIHTCs, and are comfortable with transactions that combine energy credits and LIHTCs. Higher IRRs to investors because energy credits are claimed immediately in the year the property is placed in service. Credit pricing has been slightly higher in such projects If ARRA Section 1603 grants in lieu of energy credits are utilized, the energy property must be placed in service in 2010 or construction of the property must commence in 2010 and must be completed by the tax credit expiration date of the particular energy property. 8
Pricing Yields 11-11.5% Geography E and Y report participating syndicators reported prices from 58-82 Areas showing increased interest and pricing include Minnesota, Virginia, Maryland and Arizona. 9
Passed and Pending Legislation Extension of Exchange Funds Codification of Economic Substance Extending carryback for 5 years - Bingaman bill - Pascrell bill Modification of Passive Loss Rules for certain taxpayers Accelerated Credit Delivery Making the LIHTC a refundable credit 10
Passed and Pending Legislation/IRS Guidance IRS Notice 2010-18, 2010-14 I.R.B. 525, issued on March 17, 2010, clarified: (1) ARRA Section 1602 tax credit exchange sub-awards are exempt from federal income taxation and, therefore, are excluded from the gross income of sub-award recipients, and (2) The sub-awards do not reduce either the eligible basis of a building for purposes of IRC Section 42(d)(5)(A) or the depreciable basis of the building. 11
Passed and Pending Legislation Codification of Economic Substance Doctrine: The judicial doctrine of economic substance was codified at IRC Section 7701(o) in the Health Care and Education Reconciliation Act of 2010. Economic substance codification is designed to clarify the doctrine by providing courts with a uniform definition of economic substance, but not alter the flexibility of courts in other respects. When the economic substance doctrine applies to a transaction, the transaction will have economic substance only if the taxpayer establishes (i) the transaction changes in a meaningful way, apart from federal income tax consequences, the taxpayer s economic position, and (ii) the taxpayer has a substantial non-tax purpose for entering into the transaction (a conjunctive analysis). 12
Passed and Pending Legislation With respect to the first prong (change in economic position), a taxpayer can rely on factors other than profit potential to demonstrate that the transaction results in a meaningful change to the taxpayer s economic position. However, where a taxpayer relies on profit potential, the present value of the reasonably expected pre-tax profit has to be substantial in relation to the present value of the expected net tax benefits to be received by the taxpayer. The statute does not require or establish a minimum return that will satisfy the profit potential test. In evaluating the taxpayer s non-federal income tax purpose for entering into the transaction, any state or local income tax effect which is related to the federal income tax effect is disregarded. In addition, the achieving of a financial accounting benefit is also not taken into account if the origin of the accounting benefit is a reduction in federal income tax. 13
Passed and Pending Legislation The legislative history of the codification of the economic substance doctrine provides that if the realization of the tax benefits of a transaction is consistent with the Congressional purpose or plan that the tax benefits were designed by Congress to effectuate, it is not intended that such benefits be disallowed. In this regard, the legislative history states: Thus, for example, it is not intended that a tax credit (e.g., section 42 (low-income housing credit), section 45 (production tax credit), section 45D (new markets tax credit), section 47 (rehabilitation credit), section 48 (energy credit), etc.) be disallowed in a transaction pursuant to which, in form and substance, a taxpayer makes the type of investment or undertakes the type of activity that the credit was intended to encourage. 14
Preservation Current portfolio of multi-family projects - 1.6 million - Federally assisted or insured by HUD (e.g. - 8, 236) - 2.1 million LIHTC units since 1987 Public policy for acquisition/rehab deals Key priority for state agencies is the acquisition/rehab of existing properties using tax credits - 40 state housing agencies have a priority or set aside for preservation projects Preservation Strategies - Tax exempt financing and 4% credits - Recycling credits - Year 15 exit strategies 15
Preservation Affordable Housing Preservation Bill 16
APRIL 2010 ARIZONA LIHTC OUTLOOK ARIZONA HOUSING ALIANCE & BALLARD SPAHR WEBINAR 1.Community Reinvestment Act Initiative 2.Who s in the market and what s the appetite 3.Pricing 4.What kind of projects are getting done
Community Reinvestment Act CRA SUMMARY-CRA Investor SUMMARY-CRA Investor CRA is a United States federal law designed to encourage commercial banks and savings associations to meet the needs of borrowers in all segments of their communities, including low- and moderate-income neighborhoods. Congress passed the Act in 1977 to reduce discriminatory credit practices against low-income neighborhoods, a practice known as redlining. The Act requires the appropriate federal financial supervisory agencies to encourage regulated financial institutions to meet the credit needs of the local communities in which they are chartered, consistent with safe and sound operation. To enforce the statute, federal regulatory agencies examine banking institutions for CRA compliance, and take this information into consideration when approving applications for new bank branches or for mergers or acquisitions. The law, emphasizes that an institution's CRA activities should be undertaken in a safe and sound manner, and does not require institutions to make high-risk loans that may bring losses to the institution. Lending TEST Matrix Investment TEST Matrix Service TEST Matrix Lending activity Investment & Grant Activities Lending Activity Assessment area concentration Responsiveness to credit & community Accessibility to delivery systems Geographic distribution of loans development needs Changes in branch location Borrowers Profile Community development initiatives Reasonableness of business hours Responsiveness to credit needs of Community development services economically disadvantaged, small business & low income Community development lending Product innovation Ratings: Outstanding, High Satisfactory, Satisfactory, Needs to Improve & Substantial Non- Compliance.
Who s in the Market & what s the appetite CRA DRIVEN CRA DRIVEN Arizona was obviously one of the worst hit states in the economic downturn. With lots of available land and plenty of new demand resulting from population growth, housing development hit all time record highs. This was a major backbone to the economic development of the state. Many of the large banks and smaller community banks provided credit products that facilitated this growth. As the markets started to fail the liquidity of those banks fell into risk and in many cases resulted in non-performance and then followed into foreclosure. Today many of the large banks like US Bank, JPMorgan Chase, Wells Fargo are active in the state; but are very sensitive to new lending and investment opportunities. Some community banks like Johnson Bank, Alliance Bank/Bank of Nevada & National Bank of Arizona are starting to emerge with some gathering interest into the affordable housing lending and investment space. ECONOMIC DRIVEN ECONOMIC DRIVEN A positive aspect to the erosion in LIHTC credit price has been the fundamental increase in yield which has caused more interest in the credit as the markets continue to change. **Regardless of the type of lender or investor there is still a very large emphasis placed on the sponsor, the development team, deal location and proposed target populations.
Price LIHTC Price LIHTC Price In Arizona the LIHTC price growth was pretty closely tied to the demand and CRA activities taken place in many of the Arizona markets. Prior to the current economic conditions pricing reached $.95 cents or higher. Today, we are seeing more risk based pricing tied to the sponsor, the location and the populations served. Where the average price may be.67 cents in a large MSA you could see that reduced to.63 or lower depending on the rural location or on the complexity of the structure and intended populations. The syndication firms placing the credits are further challenged by a more strategic management of their lines of credit and the timing of the actual upper-tier pay in schedule. Some upper-tier investors have also placed caps on what can be paid at the lower-tier and even have required the use of particular material suppliers at the transaction level. DEBT DEBT Construction debt remains a challenge as similar sensitivity to the sponsor, location and project characteristics are tightly reviewed. Some concerns are starting to grow as most of the construction debt is floating LIBOR based pricing. LIBOR is currently low, but for how long? Additionally, construction debt can be tied to LIHTC investment. Permanent debt remains the most challenging in Arizona. Rates can range from 6.75% to 9.75% and higher. The higher rate has placed a large amount of pressure on larger gap investment from softer sources of funds.
What type of projects are getting done 9% DEALS 9% DEALS Arizona s competitive round has been a system devised of set-asides and scoring. Specific populations or project types have been targeted such as; Historic, Acquisition/Rehab, Special Needs, Rural location and the federally mandated Non-Profit set-aside. Projects that do not fall into these categories land in a general pool and all categories are scored and ranked. Arizona has a focus to get LIHTC distributed into the Rural communities. It has become extremely challenging to do so as investors are focused on CRA and locations with the highest demand. Limited soft sources of funds has increased the difficulty of filling the gap from the loss of permanent debt sizing and reduced credit price. CURRENT 2010 ROUND INITIAL SUMMARY CURRENT 2010 ROUND INITIAL SUMMARY This year there were 31 applications submitted. (1) Set-Asides = 2 Veteran, 6 Rural, 3 Tribal, 8 Non-Profit; (2) 12 projects are not in a Set-Aside; (3) 10 in total are located in Rural areas; (4) 9 appear to have a rehabilitation activity; (5) Average units per project 78; (6) Average project cost/unit $166,805; (7) Average annual credit request $1,163,473; (8) Average gap financing request is $1,600,000; (9) Estimated average developer fee $1,400,000; and (10) 17 Senior tenant and 14 Family tenant projects.
What type of projects are getting done 4% DEALS 4% DEALS Not many TEB deals have been executed in the last few years due to various local and national market conditions. The TEB system in Arizona allocated through a lottery system. A proposed project seeks approval from an issuer. Once approved the proposed project enters the lottery on either January 1 or July 1. If Volume Cap is available or becomes available after those dates, then its an over the counter submission. There are hard allocation fees that must be paid upon a reservation of TEBs and the project must close within a required period of time. The lottery and closing requirements coupled with the at risk capital make it considerably difficult to get all the moving parts to come together. An experienced underwriter, feasibility and legal team should be assembled before beginning this process.
Q&A Please submit your questions now. Or, contact our presenters: Wayne H. Hykan, hykanw@ballardspahr.com Ellen O Brien Kauffmann, kauffmanne@ballardspahr.com Mark J. Maichel, maichelm@ballardspahr.com Quinn Gormley, qgormley@ashlarenterprises.com 23