Understanding Nuances of LIHTC Investments:

tax credit

The Low-Income Housing Tax Credit (LIHTC) is a federal tax credit created through the Tax Reform Act of 1986, and administered by the IRS, to encourage private equity investment in affordable and public housing by commercial real estate stakeholders.

Tax incentives are provided in exchange for capital for development and/or financing costs directly used to create and preserve affordable housing, including new construction, acquisition, or rehabilitation of existing properties. These tax credits are proportionally set aside for each state based on population and are distributed to the state’s designated tax credit allocating agency. These state agencies then distribute the tax credits based on the state’s affordable housing needs and federal and state-specific program requirements. This is known as the Qualified Allocation Plan (QAP) process. The Federal Housing Finance Agency also recently increased the lending caps for Fannie Mae and Freddie Mac, which have been putting more capital into LIHTCs since 2018, to $100 billion per agency for five quarters. The FHFA will also require that 37.5 percent of agency lending be “mission-driven, affordable-housing” loans. Earlier this year, The Department of Housing and Urban Development (HUD) announced the start of a LIHTC Pilot Program, including an expedited review process for loan approvals for new construction or rehab tax credit projects.

LIHTC investments are in hot demand for 2019, with yields averaging a 4.75 percent rate of return, and interest doesn’t appear to be waning. These investments remain a very attractive option for portfolio diversification and to take advantage of continued opportunities in the multifamily sector in the foreseeable future. However, before moving forward, make sure to pay attention to these LIHTC challenges that I encounter with our clients.

Understanding your financing strategy early is critical

LIHTC deals typically involve several lending agencies and/or sources of funding, all of whom have different reporting standards and requirements. Currently, key funds for LIHTC investments come from the HUD’s HOME Investment Partnership Program, Community Development Block Grant, Affordable Housing Program, and the National Housing Trust, among others. There are two types of equity tax credits for LIHTC investments: 4 percent and 9 percent tax credits, awarded through state-specific QAPs. Hard debt is funded through a conventional mortgage, while soft debt comes from a government agency source. Today’s average LIHTC deal is approximately 45 percent equity, consisting of roughly 24 percent hard debt and 21 percent soft debt.

Underwriting structuring and due diligence risk management for Fannie Mae, Freddie Mac, or HUD financing vary greatly, as with government money comes a host of requirements. Additionally, housing authorities and/or the state agencies issuing the tax credits may have their own due diligence requirements that may or may not align with the due diligence requirements of any given lender. This can present a tricky timing challenge. In some cases, the application for tax credits may require the applicant to order due diligence items long before they know what loan type they will pursue.

If an additional lender or equity investor comes on board later in the deal, they may require a totally different set of reporting standards, especially Property Condition Assessments to determine the condition of existing assets and expected short- and long-term costs of the current improvements. Furthermore, depending on whether your investment model involves buy-build-sell or buy-build-hold-manage, this might inform your risk management strategy differently.

Therefore, understanding your source(s) of funding, their requirements, and your risk tolerance as early in the process as possible will help your consultant to carry out the most efficient and complete due diligence plan to execute your transaction and optimize long-term investment potential.

Engaging with the right consultant can make or break a deal

Because there are so many stakeholders and sources in the capital stack structure of a LIHTC deal, we have noticed a general trend towards more due diligence and risk management oversight to ensure that federal and state regulations are met, and proper use of funds is planned. Required services may include environmental compliance, a review of structural/building code standards and conformance, accessibility standards review, and green/energy efficiency compliance for multifamily housing.

Unfortunately, these LIHTC deals can vary a lot state by state. This can come in the form of specific due diligence requirements, what type of consultant is qualified to assess projects, and how compliance requirements are reported. Some states require a certified architect or engineer to do all Capital Needs Assessments for HUD financing. In other states, accessibility compliance is required above and beyond typical debt reporting standards. Some states differ in their documentation requirements, and how reports are delivered (with some even requiring their own template format).

Some QAPs call out additional requirements, such as energy efficiency and environmental sustainability requirements. For example, California, Oregon, Virginia, New York, New York, Georgia and Maryland, among other states, have unique energy audit requirements for rehabs and may have green certification requirements (such as LEED, ENERGY STAR or Enterprise Green Communities) for ground up/new construction projects.

Finally, application deadlines differ from state to state, and if you must start the process again in the following year, it may require additional paperwork or assessments.

Managing these intricacies can hinge on choosing a knowledgeable, experienced consultant who can help you navigate correct reporting standards, who understands state-specific requirements and meeting hard deadlines, and who can guide you through the meticulous underwriting and due diligence assessment process. A good consultant should be able to evaluate a potential property’s environmental, physical and accessibility needs and help you decide whether the deal is worth your bottom line. Finally, your consultant should be able to provide ongoing support with projects that are already at various stages in the 15-30-year LIHTC cycle. Your multi-disciplinary team should ideally possess technical skills, staff resources and portfolio experience to navigate the requirements of a LIHTC deal.

Blighted neighborhoods and environmental considerations

The EPA recently announced it’s targeting 149 communities nationwide to receive $64.6 million in funding for Brownfield Assessments and clean-up, the vast majority of which are targeted for Opportunity Zone investments. Especially when paired with LIHTC funding, value-add investments like Opportunity Zones, brownfields funds, or rehabilitation projects, can provide a great long-term rate of return. Qualifying for brownfields funds requires a careful process, and missing an environmental issue during your due diligence period could cause you to fail to take advantage.

Buildings or sites located in blighted neighborhoods can provide an excellent profit margin as an affordable housing investment. Unfortunately, they may also pose contamination liabilities based on usage history or building hazards that should be addressed and factored into development cost. An older building, for example, may have asbestos-containing materials, while an industrial site may have an underground storage tank or groundwater contamination issues that must be addressed. A remedial cost estimate can help investors understand the full scope of environmental risk and plan for remediation based on the construction budget and risk tolerance.

When structured correctly, LIHTC deals are a reliably profitable investment opportunity. However, at this late stage of the post-recession real estate cycle, when many of the 15-year tax credit deals from the previous recession are starting to mature and development opportunities may begin cooling off, many investors will give renewed interest to LIHTC programs. Understanding the complexities, strict underwriting requirements and navigating risk management are the keys to a successful investment.

Joseph P. Derhake, PE, is the CEO of Partner Engineering and Science, Inc., an environmental, energy and engineering consulting firm serving real estate investors, lenders, and corporations throughout North America and Western Europe.

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