To my understanding, tax credit investors buy tax credits at a reduction of face value in exchange for contributing to equity in the deal. However every ownership structure I've seen has this investor being some type of limited partner with 99% ownership so that they can get 99% of the tax credits.
My question is, this seems like kind of a raw deal for the developer. The investor is getting tax credits, and 99% of cash flow for 5 years until the developer can be buy out them out? I know the developer gets a developer fee/asset management fee, but how large of a % of free cash flow can that reasonably be? Am I missing something?
That sounds like a very specific deal structure and not one I'm familiar with.
As far as tax credits go we've only outright sold them, never for equity in a deal.
You've confused two concepts. The tax credits belong to the developer as of right. When an investor buys them, they aren't "contributing equity to the deal." They are buying the tax credits. That equity belongs to the developer. The developer then contributes that equity to the deal. The 99% ownership comes because they buy the tax credits, not the other way around.
Moreover, minor point, credits aren't always bought at face value. Prior to tax reform in 2017, LIHTC in the NYC market were trading for close to $1.30 on the dollar.
Developer fee is paid out above the line. Which is why the 99% ownership is a meaningless term, because affordable deals are levered up as highly as possible. There is rarely meaningful cash flow post-developer fee.
The fee depends on the state. In New York, it's 10% of acquisition costs and 15% of construction costs. For easy math, call it 12.5% blended. On a $50mm TDC development, that means the developer's fee is $6.25mm. And since the developer sold tax credits, it's highly likely that have little to no equity in the deal. Assuming (and this is obviously a big if in terms of risk adjusted returns) said developer can build and deliver the asset without triggering a completion guarantee or whatever, that means they're making that money with literally no equity risk. That's a damn fine deal. You aren't making luxury condo returns c. 2016, of course, but you also don't have the risk of luxury condo returns c. 2020.
All of that makes sense. Assuming an investor does acquire tax credits at less than face value, these types of deals seem great for the investor, they're getting a return on their initial investment when they enter the deal, cash flow (although small) for 5 years, and then 5% of ownership in perpetuity after an ownership flip. Where is the risk for the investor aside from credit recapture form falling out of compliance or something?
There isn't any, aside from those you mention. You have typical risks on construction, and then tax credit recapture risk, but there really aren't market risks unless market rents are somehow close to tax credit rents (think a poor area of a wealthy county, for example).
That is why affordable development is attractive. You have a great return, technically an infinite one because you have no equity in, and you mitigate a lot of the biggest risks that market rate developers face (lease-up/sell-out). The flip side is you severely curtail your upside.
The yields are pretty low on credit investments...consummate with the risk.
As somebody who worked as a syndicator, this is wrong. The developer is not contributing the tax credit equity to the deal. Take a look at the capital contributions exhibit in your LPA and at your capital account balance on your k-1. The LP is making a capital contribution in exchange for a ~99% stake in the partnership. This structure is necessary because the LP is primarily motivated by the credits. Tax credits must follow the allocation of depreciation.
The credits "belong" to the developer in the sense they get the go ahead from the allocating agency, but the credits are generated when the partnership incurs eligible basis expenses. The right to the 9% credit is reserved to the partnership ahead of time whereas with a 4% deal they are automatically earned when the deal is financed with TEBs.
Sure. But think about it from the perspective of a developer. I have $100mm of uses. I have $80mm of sources between my bonds, and whatever subsidies I am receiving. In a traditional deal that 20% is equity. However, I'm not putting a dime into the project. From my perspective, the tax credits I've sold are the equivalent of equity. It's unimportant from a theoretical standpoint that I earn the credits when I incur eligible basis or place a building in service. Those credits are coming my way regardless (obviously with the caveat of completion or recapture risk, but that exists anyway). If you want to think about it as if I'm selling a futures contract for the credits, that's fine, but the point is that someone is paying me dollars for tax credits.
At the end of the day the specifics of it are irrelevant to the OPs question. As a developer I am selling the tax credits and the associated depreciation to my tax credit investor. I don't have to do that, in which case I have to put real equity in the deal. We can get as into the weeds as you'd like on this issue, but at the end of the day, someone is paying me for those credits, and that means that one of my sources is their payment and not my dollars. Which, in the scheme of things, effectively means that someone is giving me equity for the tax credits which I am proceeding to put into the deal. I suppose I should have included the fact that the buyer gets the advantage of the depreciation as well (and, nowadays, the CRA credit), but it didn't seem pertinent to the question the OP was asking.
dev fee is massive for these guys
I know that the original post is a bit dated but I wanted to add some clarity for anyone that may come across it later. I've worked in the HTC industry for a number of years in various roles and have been responsible for structuring and financing these transactions. The conversation above drifted into LIHTCs, which while they are similar in some ways to HTCs, are very different in others.
In 95% of deals, developers of historic tax credit projects bring in a third party to serve as the HTC equity investor. The HTC investor does in fact contribute their own equity into the project for a piece of the deal. There are two predominant structures used.
The single tier (similar to the LIHTC discussion above) has the investor coming in as a 99% LP into the fee owner of the property. That interest flips down to 5% after the 5 year compliance period ends and the HTC investor has a put option to facilitate their exit at that point. The developer is still able to sweep cash out via various fees and other mechanisms, so they do maintain some upside in the transaction despite having only 1% of the deal for the first 5 years after the project has been completed.
The other structure is a master lease/pass-through. A master tenant entity (owned 99% by the HTC investor), master leases the property and is recognized as the tax owner, allowing them to receive 99% of the tax credits. This structure allows the developer to keep the depreciation benefits and sweep some cash flow out at the fee owner leve, but there is generally not as much flexibility in this regard as there is under the single tier structure. This is the more common of the two structures.
On balance, HTCs are a good deal for developers as they are a relatively cheap source of equity that allows them to piece together a stack that includes less of their own cash equity than would otherwise normally be required.
Thanks for the detailed breakdown. Hopefully OP sees this.
I have only done one deal that was exclusively HTC and about 8 deals that were HTC and LIHTC. Those all used the single tier structure. I have worked on one transaction that utilized the master lease structure but it was paired up with NMTCs.
I remember reading about the master lease structure and thinking it could be a huge benefit to LIHTC transactions since the master lease structure preserves the LIHTC basis you would normally have to subtract due to the HTC equity. I was told that it is more difficult to get a tax opinion and that the legal fees were significant higher. Can you speak to either of these points?
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