Financing of Mixed-Income Multifamily Residential Developments
By Caitlin Jones & A. J. Johnson
10 min read
Developers of tax-exempt, bond-financed, mixed-income residential rental developments typically receive significant benefits and face many challenges.
These benefits include a mortgage with a lower interest rate and longer term, potential incentives from local government, access to federal low-income housing tax credits, and strong cash flow that boosts the property’s value. Challenges include finding a jurisdiction suitable for mixed-income development, obtaining other needed funds or subsidies, and constructing and operating the development in compliance with a multitude of requirements.
Mixed-income bond-financed multifamily projects are common in New York City and some other major U.S. cities, such as Los Angeles, Boston, San Francisco, Atlanta, and Washington, DC. These projects are generally found in major cities with higher market rents where the local jurisdiction offers significant incentives to encourage mixed-income development. These incentives include property tax abatement, zoning density bonuses, waived or reduced mortgage recording or other fees, or other benefits.
Mixed-Income Project
A mixed-income project, as described in this article, is a privately owned multifamily rental housing development financed by tax-exempt private activity bonds issued by a state or local housing finance agency. Interest on the bonds is exempt from federal income tax, and a developer must obtain an allocation of tax-exempt bond authority for the project from the state’s annual bond volume cap. There are, of course, other types of mixed-income housing projects which are not financed this way.
Mortgages funded by tax-exempt bond proceeds often have terms of 30 years or more and can save a developer significant interest costs compared to a conventional mortgage. These interest savings have been as much as 200 basis points, but are more modest today.
To qualify for tax-exempt bond financing, a project must have either: (a) at least 20% of its units occupied by households earning, at initial occupancy, no more than 50% of the area median income (AMI), adjusted for family size; or (b) at least 40% of its units occupied by households at or below 60% of AMI.
The remaining 80% (or 60%) of the project’s units are rented at market rent levels. Mixed-income projects are often referred to as “80/20″ projects due to the typical proportion of market-rate to low-income units. Developers of mixed-income projects usually try to limit the percentage of total units that are low-income to as close as possible to 20%. This maximizes the project’s cash flow, which is the primary motivation for developing a mixed-income project. Greater cash flow, from the market-rate units, in turn, increases the property’s real estate value and potential future residual benefits.
Mixed-income bond-financed projects consist of one or more buildings or structures with at least five rental housing units, together with any functionally related and subordinate facilities (e.g., heating/ cooling equipment, parking space, manager’s unit). Functionally related and subordinate facilities may only be financed with tax-exempt bond proceeds to the extent restricted to tenant use. In a mixed-income project with multiple buildings, the buildings must be contiguously situated, similarly designed, and have the same owner and be financed pursuant to a common plan. While the low-income units must be constructed similarly to the market-rate units, they do not need to have identical amenities, subject to certain limitations.
Most bond issuers also require that the low-income units generally be in proportion (as it relates to unit sizes – 0, 1, 2, or 3 bedrooms) to the market-rate units, and that the low-income units be distributed throughout the project. Most issuers do not permit the low-income units to be physically segregated in one section of the building or project, but generally do not require these units to be in the most attractive parts of the building (i.e. the highest floors or best views).
Housing Tax Credits
The use of tax-exempt bonds can enable a developer to qualify for low-income housing tax credits (LIHTCs), which can be sold to syndicators or corporate investors to raise substantial additional equity to help finance the project or be used by the developer to reduce federal income tax obligations.
In a mixed-income project, only the eligible project costs (e.g., acquisition, new construction, substantial rehabilitation) attributable to the low-income units qualify for housing credits. The housing credit amount is determined by multiplying the amount of the project’s “qualified basis” by the applicable credit percentage. The qualified basis is determined by multiplying the amount of the project’s “eligible basis” by the percentage of the project that is low-income use. The latter percentage is the lower of the: (i) number of low-income units as a percentage of the project’s total residential rental units; or (ii) the aggregate rentable floor space for the low-income units as a percentage of the project’s total rentable floor space. Consequently, in a mixed-income project, if the average size of the low-income units is less than that of the market-rate units, the amount of housing credits will not be maximized.
The 30% present value housing credit (“4%” credit) is the applicable credit percentage utilized for eligible costs in a mixed-income project financed by tax-exempt bond proceeds, rather than the 70% present value (“9%”) credit available for new construction or substantial rehabilitation expenditures funded by other sources. The applicable percentage for the 4% credit floats and is adjusted monthly; the actual rate was 3.40% in September 2008. The credit rate used for a project is normally the applicable percentage in effect in the month the project is placed in service. However, a developer may elect to use the applicable credit percentage in effect for the month in which the bonds are issued.
If more than 50% of the costs of a project are financed by tax-exempt bonds, a developer can receive 4% housing credits without having to obtain a separate tax credit allocation from the state housing credit agency. If the bond-financed costs are less than this threshold, a developer normally needs to obtain a tax credit allocation. [Note: Our firm has developed a proprietary structure that enables a developer to qualify for housing credits without a separate tax credit allocation where less than 50% of costs are bond-financed.]
As an alternative to the use of tax-exempt financing and the 4% housing credit, a developer of a mixed-income project could instead utilize conventional financing for the project and seek an allocation of 9% tax credits for the low-income units. However, the competition for 9% tax credit allocations is stiff in most states. Furthermore, if only 20% of the project’s units will be low income, the additional equity generated by the 9% vs. 4% tax credit will normally be offset by the higher interest costs and smaller size of a conventional mortgage. In addition, the project may be ineligible for the special incentives that some local jurisdictions offer to encourage development of mixed-income residential rental projects. These incentives include reduced property taxes, waivers of mortgage recording or similar fees, zoning density bonuses, and other benefits.
Mixed-income projects can provide significant benefits to a community, most notably the promotion of economic integration. By providing incentives, local jurisdictions can facilitate the development of projects that have residents of different incomes, including lower-income tenants who gain from living in a quality apartment in what is often a prime location.
Syndicating Tax Credits
Syndication of LIHTCs for mixed-income projects can be challenging. Developers who cannot use the housing credits themselves [projects placed in service prior to 2008 have been subject to federal alternative minimum tax (AMT) requirements for corporations and individuals] or otherwise need upfront cash, generally do not want to transfer the rights to cash flow, residuals, and depreciation on these mostly market-rate projects as part of a tax credit syndication.
In addition, third party investors in housing credits generally do not like what they perceive to be the added risk created by market-rate units without an extra benefit. In addition, public corporations typically do not want any extra tax losses generated by the market-rate units since they reduce earnings.
As a result, developers have often been unable to utilize the LIHTCs at all in mixed-income projects. Recently, though, structures have been developed to enable developers to syndicate LIHTCs while keeping the tax losses and economics for the market-rate units. In an environment in which housing credit pricing has deteriorated and lenders are requiring more equity, the ability to syndicate these credits is much more important.
The new Housing and Economic Recovery Act of 2008 also makes changes to the LIHTC program that may positively impact his area. As noted above, housing credits may, as a result of the Act, be used to offset federal income tax liability under the AMT for both corporate and individual taxpayers (e.g., investors, developers) with respect to projects placed in service after 2007.
Challenges, Feasibility
Mixed-income projects are generally financially feasible only in areas where market-rate rents are high enough to help subsidize the low-income rents, or (in rare instances) where market-rate rents are not materially higher than low-income rents. Mixed-income projects usually also require substantial supplemental assistance for viability, such as tax abatements and/or zoning bonuses.
In addition to special local incentives, developers may also be able to tap other federal, state, or local grant, loan, and subsidy programs to obtain the extra assistance needed to make a mixed-income project viable. Possibilities include the federal HOME Investment Partnerships program, Federal Home Loan Bank financing programs, and other soft loan and reduced interest rate programs.
Developing mixed-income projects creates many challenges. The cost of amenities necessary to attract the market-rate tenants is often an issue. Also, as previously noted, issuers generally require the affordable units to be dispersed throughout a bond-financed project. Competent management is necessary to assure that the existence of low-income units does not reduce the attractiveness of the development for market-rate tenants. Dealing with diverse tenant populations with various needs and expectations also requires special management skills. And, compliance with the complex bond and tax credit certification rules is always a challenge.
Compliance with the bond/tax credit regulatory agreements that each project owner must enter creates other restrictions and challenges. The regulatory agreement imposes requirements concerning the rental, occupancy, use, and operation of all the units in the project to ensure compliance with the federal tax code and with other policy concerns of the bond issuer. In some cases, the regulatory agreement may have transfer restrictions that impose consent requirements and the payment of a fee to transfer the project or ownership of it. This regulatory scheme is typical and generally not an issue for owners of 100% affordable projects. However, 80/20 projects are mostly market-rate properties with greater equity requirements and an expectation of significant cash flow and residual value. Among the requirements that must be met are certification and financial reporting requirements, and continuous compliance procedures for usually at least 15 years. If housing credits are received for the project, the regulatory agreement is extended for another 15 years.
Conclusion
There are many interesting challenges facing developers of mixed-income housing. The ability to utilize tax-exempt bond financing and more efficiently harvest the benefits of LIHTCs often creates interesting solutions. With some new developments in the law and innovative structures which have been developed, these projects can achieve success in many markets.
Kenneth Lore is a partner in the law firm of Bingham McCutchen LLP in its Washington, DC office, and is Co-Chair of Bingham McCutchen’s Real Estate Practice Group. He is also a member of the Editorial Advisory Board of the Tax Credit Advisor. He may be contacted at 202-373-6281, [email protected]. *William Meltzer, Counsel at Bingham McCutchen LLP, assisted in the preparation of this article.
