How do LIHTC developers make money?

In the process of discussing a VP level position with an affordable developer (mostly 4% LIHTC deals).

My background is primarily market rate value add multifamily and commercial. I was curious if they comp structure for affordable groups is similar or less than what it would be for a pure play equity shop investing in value add deals?

Also, given that these LIHTC deals are held for longer periods, would I be off base assuming that I could ask for some form of "carried interest"? Or would that be pointless given the structure of a LIHTC deal? My understanding is the main source of upside for affordable groups is through the developer fees and other assorted fees?

Thanks

 

I'm not sure if this is totally correct, but since nobody responded I will chime in.

My understanding is that LIHTC 4% shops that are doing well are typically making their money on the fee side. Developer fees, OH fees during construction/renovation, etc.

Now, how those fees are structured is something I am not all too familiar with.

Also, I read somewhere that the developer, despite only owning .001% of the deal, is able to participate in the cash flow of the property? Is that right? They technical have no skin in the game, but are able to rake fees and a portion of the distributable cash flow? Anyone?

 

The developer pretty much always takes the majority of the cash flow. In a 100% affordable development however, there isnt much.

 

I am currently an intern for a vertically integrated developer that specializes in tax credit deals and a lot of what I've been working on has had to deal with actually understanding this, so I'll explain how at least this company structures it.

They have a development, construction, and property management company. They take a fee for construction, a developer's fee, and then a management fee once the property is occupied.

In addition to the developer's fee, the developer also makes profit from the sale of the tax credits.

 

Thanks for the feedback.

With respect to the different fee streams, is there a standard that you typically assume will be charged for each fee?

I was under the impression that the actual sale/syndication of credits was handled by an intermediary, not the same entity as the developer. Is that not the case?

Also, when it comes to the operation of the property after occupancy, who gets the net cash flow? Is it the LP or does the developer get a piece?

Thanks!!

 

Picklemonkey answered the first question. The operating agreement for the partnership would describe where the net cash flow goes, but the shop I'm with sets it up like this:

They create a limited partnership as the official owner of the property. The LP is then comprised of an LLC that they also create with 0.01% equity as the General Partner, and then a temporary limited partner with 99.99% equity until the LIHT credits are sold. Their development company is the sole member of the General Partner. An intermediary, then sells the LIHTC for the developer to an investor who then takes the Limited Partnership equity.

After the property is occupied, all money goes to the LP. Most partnership agreements will stipulate that the developer will receive payments for their developer fee that was deferred. Then, because they are the owners of the management company, the LP would pay them a management fee as well.

There are other circumstances where the GP can receive greater than 0.01% of net cash flow, but it can vary from partnership to partnership.

 

not always but often. it really depends on how much soft debt (other public funding sources, grants, loans) you can get, and construction costs and land basis. if you didn't get the land for free or if you are developing in a high construction cost area, usually you will have to defer. the deferred fee is backed into after you take all your sources and uses and figure out if you have a shortfall or not. any "residual receipts" or basically cash flow after debt service goes to pay off this deferred fee.

3-month operating reserves are required at the close of the permanent loan but it's typically a buffer for slow absorption or a short spike in turnover and not for extended (and projected) annual shortfalls. you can set up a reserve but it just seems like a bad deal. why would cash flow suddenly turn negative? capex? typically a replacement reserve should take care of this as in any other deal. rents don't typically drop out like in market rate (hold harmless policy). shortfalls would have to be made up by the developer, in which case there's really no reason to do the deal. but maybe i'm missing something...

 

Yes, that is how you underwrite a LIHTC deal expenses grow faster than income on a 15yr cash flow.

The theory is that at the end of the compliance period you re syndicate the property for another 15 years and get another allocation of 4% Credits

 

Another general question, coming from a developer's POV, are deals generally sold via the same channels as your typical market-rate apartment deals? i.e. do the same gang of brokers that sell market rate apartments also sell deals that would be pursued by LIHTC developers? I have recalled seeing income restricted deals being brokered, with the "opportunity to re-syndicate".

Do LIHTC groups generally chase market rate apartment properties that can be converted to income restricted? Or are the economics tougher to make work?

Also, during a typical acquisitions, are deals taken down with a LOC or some other facility? It would seem that the process of tying up a potential deal, and then needing to submit an application, wait for the results, etc etc, would take a heck of a lot longer than the standard 30 day DD period allotted for standard apartment transactions. How do LIHTC deals generally look from a purchase timing perspective?

 
egold70:

Do LIHTC groups generally chase market rate apartment properties that can be converted to income restricted? Or are the economics tougher to make work?

If this ever happened I would love to read a case study on it. I could not imagine it working though.

Commercial Real Estate Developer
 

This happens more than you would think. Commonwealth Development in Wisconsin, American Community Developers in Michigan, and Millennium Housing in Kentucky and Ohio use this strategy. When they acquire the market rate building they let it cash flow while they apply for and get approved for a tax credit allocation. Once that is approved they completely renovate the building and move everyone out. They then release the building to their approved allotment of affordable vs. market rate units.

It probably goes without saying, but these aren't "nice" Class A or even Class B market rate properties.

A few of the larger LIHTC syndicators like PNC, Enterprise, and NHT have programs where they are trying to do this on a larger scale. It's to early to tell if big players can really make this a successful longer term strategy.

 

You typically put an option on the property contingent upon an allocation of credits. In Ohio the 4% credits are non competitive. For instance we did a market rate to LIHTC conversion and we had a hold period until the award of credits.

Resyndication is the getting another allocation of 4% credits for an existing LIHTC restricted property. Those properties are at the end of their compliance period an you would be technically preserving housing affordability (the way the HFA looks at it)

Some acquisitions teams buy distressed market rate deals and convert because the NOI of the property does not allow the current owner to keep up with repairs ect.. I did a 466 unit property in Cincinnati like this.

 

Curious as well. It would seem that the actual purchase of the property would be done traditionally and then "syndicated" afterwards, similar to traditional syndicators using a line of credit to close the acquisition and then spending subsequent months syndicating the equity out.

Is LIHTC the same way?

How many times per year do states typically accept these applications, or are they submitted on a rolling basis?

 

This is a great thread, but I had a more nuanced question. I've been doing a lot of research lately on LIHTC and noticed that often once a property hits year 10 or 15 and intends to be sold the sale will be structured as a purchase of the GP instead of the real estate. Can anyone explain why this is? Does the transfer of the real estate trigger something?

 

Ah... I've got this figured out. It has to do with syndications and resyndications. A change in ownership changes the placed in service date which could lock out a property for 10 years before it is eligible to receive new tax credits. So, if the buyer is purchasing the property with the intention of trying to do an acq/rehab, they need to acquire the entity instead of the real estate to prevent the 10 year lock out.

 

Hey DetRustCohle. I work in LIHTC asset management for a large institutional investor. I usually see the opposite transaction take place, where the GP exercises a ROFR or $100 PO etc. Once the LP takes its benefits (credits, depreciation, and losses) it doesn't want the deal any more. If there is no value in the deal we'll essentially give it to the GP, maybe make them pay our transfer taxes and legal fees. If there isn't a ton of debt on the deal and there is actually value, that's just a bonus for us. Sometimes the GP will get an offer and we'll sell our LP interest, assign it over or maybe structure it differently depending on the exit taxes. Capital account issues become very important at this point but I digress. The point I'm trying to make is we don't want the property because we aren't in the operating business. A vertically integrated shop that has their own developer affiliate may operate differently.

 

Not to hijack this thread, but ALL of this is going to change in the coming year. I currently work (analyst level) for a large syndicator in the LIHTC (low income housing tax credits) world and we have been bleeding investors since the election. The prospect of a lower corporate tax rate and the volatility of interest rates (blowing up underwriting because of rising perm rates) has investors running scared. My company also has a guy in DC that is actively working with the Ways and Means committee to determine the future of this program. He has told us that the LIHTC program will be changing completely. All of the "tax credit law" will be torn up and they will be starting over. Personally, I am looking to get into CRE and I'm advising others to avoid the LIHTC world until things calm down. It might take two years for the market to adjust. I definitely will not be receiving a bonus or a salary increase this year.

You eat what you kill.
 

I took my own advice and got of of LIHTC 6/7 months ago. Let's just say the syndicator I used to work for has lost 75% of its analyst class since the election and the company is not hiring anyone to replace us. From what I've been told, deals are still getting done, but volume is down. The industry will never "die" because it is political suicide to discontinue affordable housing, but the volume may decrease over time. The need for syndicators is decreasing as well. Institutional clients are doing everything in house and don't need the broker/syndicator as much as they used to.

You eat what you kill.
 

The tax abatement can be valuable for a potential acquirer. Then the issue becomes "valuing" this stream of CF's...One questions I have never found a logical answer to is "WHAT DISCOUNT RATE DO YOU APPLY TO THESE ABATED CASH FLOWS?" Not the CF's of the asset, but the value of the money that is being saved due to the tax abatement structure...

But specifically, the business model's profits have been explained (fees, government breaks and tax abatement structures, etc.). You are correct in that at a specific year during the asset's life cycle, due to the rent restrictions, etc, CFs often become negative...

 

Does a developer make cash flow in perpetuity? What happens when investor wants to get out in Yr 15? If the property is run well it seems there should still be annual funds coming in after servicing debt and operating costs?

 

So basically the only way developer makes money in a tax credit transaction is via development fee. And if there are any distributions those are paid yearly over the 10 year hold period. What happens after that? There is no other money coming to the developer? Does the investor just leave and the developer is left with a property in perpetuity which as you mention doesn't throw off much cash flow if any? Basically you hope you have enough to cover your debt service and operating expenses and that's it? Can the property ever be sold? Why would anyone ever buy one of these deals? Isn't there a long affordability period?

 

I have a ton of questions. A lot of these LIHTC deals have a tremendous amount of soft debt with large balloon payments due as they approach year 30 (30 year compliance period). I am seeing deals where the LP essentially gives their ownership to the GP. So now the GP has all of the liability associated with this soft debt. The properties have such little NOI and many times DSCRs that barely cover the first mortgage. The soft debts are usually state funded, cash flow deferred loans... I have no idea how a developer would get themselves out of this situation...for a rehab you are basically left with resyndicating and getting a 4% tax credit or going to market rate...either way the soft debts have to be paid...

Essentially the developer is making a fair amount of money through developer fees, management fees and cash flow distributions...but now the soft debt is coming due with large principle balances and accrued interest. Ownership had little interest in paying down the soft debt through surplus cash and paid themselves large management fees...

Is anyone else seeing this?

 
lihtcquestions:
Essentially the developer is making a fair amount of money through developer fees, management fees and cash flow distributions...but now the soft debt is coming due with large principle balances and accrued interest.

You aren't looking at it from the right perspective. As you note, that soft debt is coming from public or quasi-public entities. In other words, institutions that don't have a mandate to make a profit, but to serve a public good. Those balloon payments? They're not supposed to be paid back. It's just the municipality ensuring that those properties remain affordable. Imagine if this was happening 25 years ago in Williamsburg, in Brooklyn. If you didn't have that balloon debt, the owner of the property would 100% be taking them out of an affordable regime and going to market. With the balloon debt in place, it makes it impossible to do that except in the most extreme circumstances.

TL;DR - the soft debt is meant to be restructured and rolled over in order to ensure permanent affordability, it's not as much an obligation to repay as a guarantee by the state that the buildings/units stay affordable after the 30 year affordability period.

 

Thank you! I appreciate the feedback...the state financing sources are saying that the balloon payments have to be paid in full or they are willing to negotiate extensions if we re syndicate. If they "forgive" any principle or accrued interest it will be taxed as phantom income.

In this particular situation, would the developer be forced to re syndicate to remain affordable and keep the soft debt rolling? In that case, you would be put in the 4% pool - our state rep is stating that they save the 9% deals for ground up development.

 
Best Response

Section 42 LIHTC projects often are not cash flow positive as they have to be loaded up with "soft" loans. The return to the investors is driven by the receipt of the tax credits. The government does not pay your rent for you on Section 42 properties. You just have to meet certain household income criteria. The LP investors are really only interested in the tax credit stream from these properties, any cash flow that is generated often goes towards the soft loan payments. GP's generally make their money through the development fee and property management fees.

Section 8 properties usually are cash flow positive. As a tenant you will never have to pay more than 30% of your income towards rent. Whatever the remainder is gets paid by the government. These properties can be incredibly lucrative as they are usually pretty low cost with guaranteed cash flow. You can also reapply for another allocation of 4% tax credits every 15 years to address any capex at the property. Again the LP investors are just interested in the stream of tax credits. GP's get a better deal here as they can collect the cash flow and their split from any capital event despite the fact they often put almost nothing into the deal.

In general firms often specialize in LIHTC/Sec 8 deals deals. Those deals often have their own set of headaches you have to deal with. They underwrite much differently than a Class A multifamily project. I would be surprised if many shops looked at a high volume of Class A and LIHTC deals. Some shops, like Miller Valentine, and Millennium Housing look at market rate/naturally affordable deals and LIHTC deals, with the plan to convert them all to LIHTC deals.

 

Interesting, thank you. I'm coming at this from the tax side of the fence, so my understanding of the investment side is severely limited. Whenever I see tax credits or different contingencies in the code that seem to open a small window of opportunity, I like to gain a little insight.

From what you're saying, it sounds like section 42 properties offer more value to a firm that has a management arm offering maintenance? Would this be equivalent to acquiring or developing the property, then charging an HOA due per unit that goes toward the revenue stream of a subsidiary or separate BU?

Can you go into more detail about the soft loan component? Is this a situation where the financing has higher yield requirements that can't be covered through gross margin + interest? Or is the GP subsidizing mortgage rates?

I am very unfamiliar with the RE space so I'm probably looking through a kaleidoscope when I'm trying to find the margin, but my understanding would be: -LP invests in GP, requires X hurdle -GP raises and invests 100% capital or levers raised/invested funds -GP has a building arm that charges a fee on construction, also manages properties for HOA dues -Project is CF negative during construction - the "investment period" -Returns come from margin on selling units or rental income

Obviously a very rudimentary description of the investment horizon...

I figured people purchasing units would be going through a mortgage lender, so for-sale units would be able to recover costs relatively quickly (buyer gets mortgage, bank pays cash), with Fannie Mae or whoever collecting that stream of income from the buyer.

I am clearly missing a huge piece of the puzzle here.

 

@picklemonkey is spot on with the explanation--a couple things to also think about are the types of tenants that utilize Section 8 vouchers, or Housing Choice vouchers as they are now called. Typically ELI or extremely low income are 30% AMI or less, with very low income being 50% or less and low income being 60% or less. Section 8 properties (think mostly 30% or below/folks who used to be homeless) are typically cash flow positive and will actually have a higher cashflow after debt service than your typical LIHTC deal (50%-60% or below) because hard debt is simply not an option to finance properties catering to the lowest of incomes. They simply don't generate enough cashflow to cover debt service. NOI on a standard LIHTC deal will be higher than 100% Section 8. An important consideration is that your average LIHTC deal targets folks making less than median income (think teachers, blue collar workers, etc.) whereas Section 8 is usually reserved for the lowest of the low incomes/ex-homeless. In many circumstances, Section 8 properties will have onsite social services (think case workers, drug and alcohol treatment, etc.) whether they are mobile or permanently staffed there. Security can be a big issue as well, and thus 100% section 8 communities (or permanent supportive housing as others call it) are very cost intensive and require significant operational subsidies/grants in addition to the rental vouchers than the tenants or project itself has an allocation for.

 

When it comes to market rate developments and affordable housing, you're generally talking about units set aside as affordable (not actually LIHTC units) within the larger building/community. In expensive areas like mine, new luxury developments are great for the upper-middle class and lower class. The middle class, as always, is f*cked by liberal Democrat social engineering.

Array
 

I'm late to this discussion but I work in LIHTC Asset Management and wanted to clarify something that I didn't see in the responses. I've worked in market rate portfolio management previously and the reality is LIHTC is a very different animal from typical partnerships in the market rate space.

The biggest difference is that investors aren't looking for 'yield' in the traditional sense. They are simply trying to mitigate tax losses. Because of the niche nature of this business most GP's are specialists and don't make their money hitting hurdles but rather through a developer/operating fee/share of cashflow/conversion to market at exit/new regulatory partnership at exit. In fact due to eligible basis adjusters and the nature of the yield calculation, it can be beneficial to the GP and LP for the GP to incur cost overruns of a $1mm. Additionally, higher net cash flow from operations can soften the yield from benefits, which include tax credits but also depreciation.

In conclusion, LIHTC investment has little to do with real estate investment and more to do with tax law.

 

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