White Paper LIHTC Apartments Mortgage Risk Why They Do Not Default By George Vine, CFA
Introduction People generally know that LIHTC mortgages (first mortgages on low income housing tax creditfinanced apartment projects) perform well. I don t think they realize how well, but that is a paper for another day. The purpose of this paper is to illustrate one of the possible reasons for this outperformance the incentives facing a tax credit investor in a LIHTC project. Tax Credit Partnership Structure First we need to review the basics of a low income housing project s typical partnership structure. We commonly talk of the project developer selling tax credits to investors. What the developer is selling is actually limited partnership interests in the partnership that owns the low income housing project. Tax credits, like other benefits of owning real estate such as depreciation and cash flow, flow through the operating partnership to the individual partners. Institutional investors who want the tax credits do not want the risks of real estate ownership so they take their ownership interests in the form of limited partnership interests. The partnerships are structured to pass through to the tax credit investor the great majority of the tax credits. Because the tax credits are allocated proportionately to ownership interests, tax credit investors by necessity own the majority of the project, typically 99% or more. Because the tax credit Investor i) has put up essentially all of the equity money, ii) has the risk of not receiving credits it has paid for, (iii) has the risk of tax credit re-capture (see below), and iv) owns the majority of the project, it dictates the terms of the partnership agreement. In particular, it dictates the provisions that specify the powers and limitations of the general partners and the provisions that allow for the removal of the general partners. Typically, tax credit investor partner approval is required for any sale or refinancing of the project, any admission of new partners, a change of management agents, the filing of bankruptcy and other major partnership actions. The investor partner can remove any general partner with as little as 30 days notice for defaults of the partnership agreement (which usually calls out a default in the mortgage loan as a partnership default). While the general partners manage the partnership s day to day activities, the investor partner effectively controls the partnership. A typical organizational structure of a tax credit project is shown below: LIHTC Partnership Structure Operating Partnership LIHTC Project Admininstrative General Partner Developer 0.9% Managing General Partner Non-Profit 0.1% Investment Limited Partner Tax Credit Investor 99.0% Tax Credit Investor Incentives The tax credit Investor claims its tax credits against taxable income in approximately equal amounts over each of 10 years. However, part of the bargain is that the investor must promise that the project will comply with the tax credit regulations (including rent restrictions) for 15 years (the compliance period ). To enforce the investors promise, if the project falls out of compliance the IRS recaptures from the tax credit investors the excess of the tax credits that have been taken over what would have
been taken, had the tax credit period been 15 years. The rent restrictions are enforced through a recorded regulatory agreement which is subordinate (except for the 3 year de-control provision) to the mortgage. In a foreclosure the regulatory agreement is extinguished and the lender has the option to convert the property to a market rate project, i.e. to raise the rents to their market levels (unless other unsubordinated regulatory agreements have been recorded). Such action would take the project out of compliance causing the tax credit recapture. Thus after a foreclosure (during the compliance period) the tax credit investor would not only lose the property but also the benefit of the remaining tax credits, for which the investor has already paid. Additionally the investor would have to pay back up to 1/3 of the tax credits already taken on the project (plus interest and penalties). Since the value of the tax credits is typically two to three times the mortgage loan balance, a tax credit investor has a strong incentive to support a troubled project to avoid a foreclosure. Indeed, in the case of the project presented on the last page of this paper, for the first 12 years the tax credit investor would be better off economically to pay off the mortgage loan balance at a total loss, than to take the consequences of a foreclosure. Underwriting Implications To explore the underwriting implications of the tax credit partnership structure over the compliance period we prepared 15 year projections (attached) based on a typical simple LIHTC project. The assumptions contained in the boxes at the top of the sheet, along with the project s first year Effective Gross Income and Operating Expenses, generate all of the subsequent numbers. Moving down the spreadsheet, the first year s Debt Service Coverage is 1.15, as per typical lender s credit policy. The Debt Service Coverage ratio slowly improves over the 15 years, a function of the assumed 2.5% income growth and 3.5% expense growth and the property s operating expense ratio. The property value calculated by dividing the first year s NOI by the assumed cap rate results in a 75% LTV ratio. The LTV ratio also slowly improves again as a result of the income and expense assumptions, and a fixed annual debt service. The next line, Tax Credit Value, calculates the value of the remaining tax credits by multiplying them by the original Tax Credit Price. The remaining tax credits have value for the mortgage lender since it can keep the property in compliance with the regulatory agreement through a foreclosure, and re-sell the remaining tax credits to another tax credit investor. This of course would be more difficult than the run of the mill REO disposition, but the lender would have the choice of keeping the property in compliance or converting it to market rents, whichever would result in the greatest recovery and/or gain. The next 3 lines calculate the remaining Loan Balance based on the assumed amortization (here 30 years), along with the Loan-To-Value ratios excluding the value of the Tax Credits and including their value. The real estate only LTV ratio gradually improves as the property value slowly increases and as the loan is slowly paid down. The LTV ratio including remaining Tax Credit Value begins very low and gradually increases as the tax credits are consumed. It is interesting to note that this LTV ratio reaches a maximum of 57% in year 10, precisely when the potential tax credit recapture is at a maximum, at 1.6 times the loan balance. The next 4 lines show the remaining tax credits as they are consumed each year, and the potential recapture of credits that an investor would face if the project were to fall out of compliance. A Costs of Abandon is calculated which measures the potential cost to the tax credit investor of a mortgage foreclosure in each year. This is calculated by adding the value of the remaining tax credits to the recapture amount, which is what the investor stands to lose if the project is foreclosed and converted to a market rate project. As the spreadsheet shows, this cost exceeds the loan balance through year 3 P a g e
12, and is less than 40% of the loan balance at the beginning of year 15. At year 16 and beyond the cost is zero (although there are other likely costs of a foreclosure). Conclusion The spreadsheet shows the strong economic incentive for a tax credit investor to support a problem project during the first 14 years of the project s life. During the first 12 years, the tax credit investor stands to lose more than the entire loan balance from a foreclosure implying that the tax credit investor s self-interest would be better served by paying the loan off rather than allowing the property to be foreclosed. Of course, the investor could support the project to year 16 without paying off the loan and then abandon it, if that were cheaper. Reliance on support from a tax credit investor pre-supposes that the investor has the financial capacity to pursue its self interest, so the assumption of the tax credit investor s continuing financial capacity over the 15 year period is a crucial one for this analysis. Theory and Practice I have been involved with a LIHTC mortgage lender client for over 15 years. During that time it has approved over $800,000,000 of LIHTC mortgages without a single realized credit loss. Another of my clients was a major tax credit investor. I helped the investor restructure 9 tax credit partnerships with a single developer. Most of these projects did not underwrite to their actual or proposed permanent financing. The developer was replaced as general partner in all 9 partnerships, at first by an affiliate of the tax credit investor, and gradually over time by other developer clients of the investor. I saw the investor write an 7 figure check with 2 days notice to pay off in full a difficult construction lender. I saw how the investor was prepared to do what it takes to repair construction defects, cover operating deficits and pay for legal costs, accounting costs and property management, both historically and for up to 15 years into the future (I did the projections and many of these partnerships would not cash flow even after 15 years). I am not aware of any occasion where the option of abandoning a property was even mentioned. For me this experience strongly supports the reliance by a LIHTC apartment lender on a tax credit investor acting in its self interest, even though the investor is under no legal obligation to the lender to do so. About Vine Associates LLC Our clients are the providers of capital for community development (primarily affordable housing), including commercial banks, LIHTC investors, CDFIs and other investors. We partner with our clients to craft effective custom-tailored solutions to their community development asset acquisition and management needs. Learn More Visit our website at www.vineassociates.com To discuss how Vine Associates LLC can help with your community development challenge, contact George Vine via email gvine@vineassociates.com or telephone (818 541-1701). Copyright 2012 Vine Associates LLC. All rights reserved (but feel free to copy it, think about it, provide us with feedback, and pass it on to others). 4 P a g e
15 Year Projections of a LIHTC Project ASSUMPTIONS Proposed Loan Terms Tax Credits Amount $ 2,651,135 Income Inflation 2.50% Total Tax Credits 10,720,000 Interest Rate 5.75% Expense Inflation 3.50% Tax Credit Price $0.95 Amortization (years) 30 Capitalization Rate 6.00% Monthly Payment $ 15,471 Year that Loan Balance exceeds "cost of abandon" RESULTS Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Year 11 Year 12 Year 13 Year 14 Year 15 Effective Gross Income 533,759 547,103 560,781 574,800 589,170 603,899 618,997 634,472 650,334 666,592 683,257 700,338 717,847 735,793 754,187 Operating Expenses (320,255) (331,464) (343,065) (355,072) (367,500) (380,362) (393,675) (407,454) (421,715) (436,475) (451,751) (467,563) (483,927) (500,865) (518,395) Net Operating Income (NOI) 213,504 215,639 217,715 219,728 221,670 223,537 225,322 227,018 228,619 230,117 231,505 232,775 233,919 234,928 235,792 Debt Service 185,656 185,656 185,656 185,656 185,656 185,656 185,656 185,656 185,656 185,656 185,656 185,656 185,656 185,656 185,656 Debt Service Coverage 1.15 1.16 1.17 1.18 1.19 1.20 1.21 1.22 1.23 1.24 1.25 1.25 1.26 1.27 1.27 Property Value 6.00% Cap Rate 3,558,400 3,593,984 3,628,590 3,662,127 3,694,501 3,725,614 3,755,361 3,783,632 3,810,314 3,835,286 3,858,422 3,879,591 3,898,654 3,915,465 3,929,875 End of Year Tax Credit Value 95 Cents per $ 9,165,600 8,147,200 7,128,800 6,110,400 5,092,000 4,073,600 3,055,200 2,036,800 1,018,400 - - - - - - Loan Balance 2,651,135 2,617,030 2,580,912 2,542,661 2,502,152 2,459,251 2,413,817 2,365,701 2,314,744 2,260,779 2,203,627 2,143,102 2,079,003 2,011,119 1,939,228 1,863,092 Loan to Value (LTV) Ratio 75% 74% 72% 70% 68% 67% 65% 63% 61% 59% 57% 56% 54% 52% 50% 47% LTV (Including Tax Credit Value) 21% 22% 24% 26% 28% 31% 35% 40% 47% 57% 56% 54% 52% 50% 47% Remaining Tax Credits 9,648,000 8,576,000 7,504,000 6,432,000 5,360,000 4,288,000 3,216,000 2,144,000 1,072,000 - - - - - - Potential Tax Credit Recapture 357,333 714,667 1,072,000 1,429,333 1,786,667 2,144,000 2,501,333 2,858,667 3,216,000 3,573,333 2,858,667 2,144,000 1,429,333 714,667 - Cost of Abandon (recapture + loss of credits) 9,522,933 8,861,867 8,200,800 7,539,733 6,878,667 6,217,600 5,556,533 4,895,467 4,234,400 3,573,333 2,858,667 2,144,000 1,429,333 714,667 - Cost of a Foreclosure Divided by Loan Balance 3.64 3.43 3.23 3.01 2.80 2.58 2.35 2.11 1.87 1.62 1.33 1.03 0.71 0.37-5 P a g e