The predictability, certainty and timing of the tax credits is the primary focus of underwriting a LIHTC project. After a project has been approved by the state housing finance agencies, Lihtec will engage third party consultants to provide a detailed examination of the project, market, management and finance factors. With the general contractor in particular, they will most likely want payment and performance bonds and/or a construction completion letter of credit. They want to make sure they have the expertise and experience to ensure they will complete the project on time and within budget. With all other development team members, they will look to see if they have experience with tax credit deals to ensure that the tax credit regulations are adhered to and to minimize any noncompliance issues.
Despite these efforts, unforeseen issues may arise that could impact the deliverability of the credits. To mitigate this, various structures are built into the partnership agreements including reserves, developer and general partner guaranties, and equity payment holdbacks. These risks may seem more significant for limited partnerships, as the investors do not have day-to-day control. The risks of an investment in LIHTCs can be divided into four main categories:
Development Risks-The most significant risks for real estate in general are primarily in the construction and lease-up periods for a property, and this is no different for a tax credit property. Not only is on-time completion essential but also the developer must construct the property as specified and within budget. Further, the lease-up period is more important in a LIHTC project because tax credits do not become available until a qualified resident occupies a unit. Delays in the early years of an investment can impact projected yields from being met because benefits are pushed further out into the future.
- Due diligence on the developer, including development experience, construction skills, financial strength, and track record. The developer’s net worth and liquidity must be commensurate with the size of the investment and its obligations that it guarantees.
- Completion guarantees are provided by the developer to cover construction costs as will as the time frame under which construction must be completed. These guarantees may require a form of collateral such as performance bonds, letters of credit and/or reserves.
- Equity and capital holdbacks are used to provide incentives to the developer to complete the project. Once certain hurdles as outlined in the partnership agreement are cleared, capital is released to the developer. Capital holdbacks are based on performance criteria such as completion, permanent loan closing, determination of tax credits, and reaching target debt service coverage ratios.
- Although infrequently used, the investment partnership can replace or step in the shoes of a developer that fails to manage the project appropriately. Third party development companies are able to work on contract basis if the asset manager determines that a removal is necessary.
Tax Credit Risks-The principal risk of LIHTC investing is the loss of the tax credit itself and its “recapture” by the IRS-which means that the investor would forfeit all future credits and all or a portion of the previously claimed credits, plus interest, and might also have to pay a penalty. Owners of LIHTC properties must meet specific requirements during the planning, construction, and operation of the property to claim the credits. Failure to meet many of these requirements will not have adverse impact on the tax-credit status if the problems are remedied quickly.. For example, a LIHTC property could lose its tax credits through failure to maintain the necessary minimum number of low-income units or failure to maintain its low-income status for the full 15-year compliance period. It should be noted that LIHTC projects have historically had a strong compliance history.
- Protection against tax credit maintenance risk is addressed primarily through credit adjuster provisions. Credit adjusters are used when there is a shortfall of actual credits as compared to projections and are the responsibility of the developer. The adjuster provisions require that the developer provide funds to the partnership that compensate the investor for the loss of credits. Payments may also be made to adjust for the timing of the credits.
- The designated asset manager monitors compliance under its asset management responsibilities. In some instances the removal of the property management company may be warranted, or even the general partner in more extreme situations. In the case that tax credits are recaptured, reserves that may be structured into the partnership may be distributed to compensate investors.
Operational Risks-Experienced and proven management is essential to the successful day to day operation of an apartment community and the ongoing viability of the investment. Management must ensure that rents are collected on time, expenses are kept in check, and deferred maintenance issues are addressed. However, LIHTC projects have a less than 1% foreclosure rate, the lowest foreclosure rate of all commercial real estate assets.
- The general partner, who is most often an affiliate of the developer, agrees to fund operating deficits until breakeven is achieved at a property. In addition, at least 15% of the partnership’s capital is retained until breakeven is achieved. Breakeven is reached when a property’s revenues have exceeded expenses for six consecutive months. The general partner is obligated to advance funds to cover operating deficits for a period after breakeven in many cases as well.
- The partnership is capitalized with reserves, covering deferred maintenance (replacement reserves), tax and insurance expenses, and operating reserves used to fund debt service in the event the property’s net operating income become inadequate.