New Markets Industry Chugs Along Despite Fewer Investors and Leveraged Loan Sources
By Caitlin Jones
10 min read
Tax Credit Advisor, November 2009: No matter how you look at it – from the perspective of a developer, investor, lender, community development entity, or other participant – the federal new markets tax credit (NMTC) program is grappling with significant challenges. Not as severe as in the low-income housing tax credit industry, but serious tests nonetheless.
On the eve of the announcement of $5 billion in additional, seventh-round new markets allocation awards, fewer new NMTC deals are getting closed and successful transactions are harder and taking longer to do. This is the result of fewer active investors, reduced credit pricing, less leveraged loan funds, tighter underwriting, and the general economic downturn. Ironically, this comes as the program is awash in available tax credits for new deals, estimated by one source at about $11 billion by the end of October.
Another hurdle is that the program will expire on 12/31/09 unless Congress enacts an extension before then. The Obama Administration has proposed a one-year extension and $3.5 billion for a 2010 funding round. Identical bills pending in Congress (H.R. 2628, S. 1583) would continue the NMTC through 2013 or 2014, provide $5 billion in annual funding, and exempt the new markets credit from the federal alternative minimum tax.
Established in 2000, the NMTC is a tax incentive that helps finance real estate projects, businesses, and other qualified activities in low-income communities. Organizations certified as community development entities (CDEs) compete for allocations of NMTC authority in annual funding rounds held by the Community Development Financial Institutions (CDFI) Fund. CDEs that win allocations awards issue the tax credits to investors (Qualified Equity Investments, or QEIs) in exchange for cash that is deployed into eligible projects and businesses called Qualified Active Low Income Community Businesses (QALICBs). Investors claim the tax credits over seven years. The program is governed by regulations issued both by the CDFI Fund and Internal Revenue Service.
Through May 2009, the CDFI Fund had made 396 total awards of NMTC allocations totaling $21 billion in six regular and one supplementary funding rounds. Through FY 2007, CDEs had invested $8.9 billion in NMTC proceeds into 1,981 businesses and real estate projects supporting $30 billion in total project costs. As of September 2009, $14.1 billion in QEIs had been finalized.
Jarred by Market Conditions
In interviews, industry participants said the NMTC program is undergoing challenges and changes wrought by the broader economic downturn and the financial sector crisis.
“The new markets tax credit marketplace has not been immune to the basic liquidity concerns of the marketplace,” says James Howard, Jr., of Dudley Ventures/TransCapital, which manages captive NMTC investment funds that have institutional investors, and develops NMTC projects in a joint venture with an investment bank.
“There are less investors than there were two years ago,” says Joe Wesolowski, of Enterprise Community Investment, Inc., which operates a CDE that has obtained $610 million in NMTC allocation awards,
of which $515 million had been invested as of year-end 2008.
The NMTC industry, like the larger housing credit industry, is heavily reliant on financial institutions – mainly major national banks – as the predominant equity investors. But there are fewer of these active major investors, and some have reduced their investment, as the result of banking consolidation and reduced profits and tax shelter need at some banks.
Said to be the major active investors today are national institutions US Bank, through its affiliate US Bancorp Community Development Corporation, along with Bank of America, JPMorgan Chase, and Wells Fargo. Regional bank investors include PNC and SunTrust.
The biggest investor by volume is US Bank. Marc Hirshman, of US Bank Community Development Corporation, said US Bank before 2009 probably accounted for between 30% and 40% of total annual NMTC equity investment. He noted US Bank’s share is probably even larger this year. “Our volume has increased and there are fewer active investors in this market,” says Hirshman, noting US Bank made over $1.5 billion in QEIs in 2008, has worked with more than 90 CDE allocatees, and has closed more than 300 NMTC projects to date, with another 15 to 20 projects currently in the closing pipeline.
Hirshman said US Bank has invested nationwide in all types of NMTC projects. “We’ve done everything, the whole gamut,” he notes. A recent example is a solar energy deal involving affordable rental housing in California.
Hirshman, and Claudia Robinson, of Bank of America, said their banks are both active this year investing in new NMTC deals. Each bank also has its own CDE that can provide new markets allocation authority to projects in which the bank often is the investor, and sometimes also the leveraged lender. The banks’ CDEs provide their allocations alone to projects or in combination with one or more additional NMTC allocations from other CDEs.
The reduced number of active investors has been accompanied by a decrease in pricing paid for the new markets credit and a corresponding increase in projected yields to investors. CDFI Fund Director Donna Gambrell said pricing has fallen from a peak of about 75 to 78 cents per dollar of tax credit to about 65 cents today. Several sources, though, said they still see some deals fetching higher prices.
Robinson said current NMTC investment yield levels are comparable today to those in the LIHTC program, in the low and mid teens. In a new report that focuses on the LIHTC, Ernst & Young LLP says projected rates of return appear to fall in a wide range from 12% to 20%.
As with the LIHTC, the federal Community Reinvestment Act (CRA) influences banks regarding the location of NMTC projects in which they invest.
Leveraged Loans, Gap Sources
The most serious challenge today, participants concurred, is finding leveraged loan funds for new NMTC transactions.
After the tax credit itself, leveraged loans have been the lifeblood of the financing packages for most NMTC transactions. Loan dollars funneled through an upper-tier investment fund in a leveraged structure produce more tax credits for the investor than a non-leveraged structure, as well as a healthy return for the lender.
“Third-party CDEs are having a real difficult time finding leveraged lenders,” says Robinson.
The financial market and economic difficulties have reduced the number of traditional past sources of leveraged loans, particularly specialized third-party lenders. National banks continue to be a source of leveraged loans, though they may tend to direct this resource to deals in which they are provide the NMTC allocation and/or the equity, or for deals that involve their regular stable of third-party CDEs. Several sources said more regional banks are stepping up today as leveraged lenders and equity investors.
But even if a sponsor succeeds in securing a leveraged loan, it usually is smaller than it would have been in the past. “Everybody is very concerned about risk in underwriting,” says Washington, DC attorney Jerry Breed, a partner in the law firm of Bryan Cave LLP. Sources said underwriting criteria by both debt and equity providers are now tighter and more conservative, including lower loan-to-value ratios.
The combination of lower pricing for the new markets credit, which generates fewer equity dollars, together with fewer leveraged loan sources and more conservative underwriting is hitting sponsors of proposed new NMTC deals with larger funding gaps that they are scrambling to try to fill in a variety of ways. And the kinds of alternative funds and subsidies that they are tapping, together with influences from the economic downturn, are prompting changes in the types of NMTC projects getting closed.
Participants said they’re seeing more nonprofit-sponsored and community facility-type projects, such as museums, health clinics, and theaters, and fewer major commercial real estate projects than in the past such as hotels, shopping centers, and other retail.
Breed said some nonprofit organizations, for instance, are using charitable donations they’ve raised to make a leveraged loan to their project. Some sponsors, if they can, are putting their own equity into deals.
Ira Weinstein, of Reznick Group, indicated that the alternative funding sources are of two types. One is where an affiliate of the QALICB is using funds it has somehow amassed to loan to the project – self-leverage. He said the second is a “government-centric” approach, in which sponsors are looking for dollars from federal, state, or local governmental loan or grant programs; other federal or state tax credits, which can generate extra equity; and other soft sources that can be leveraged and enhanced with new markets credit.
Several sources said they’re seeing more use of the Section 108 loan program of the U.S. Department of Urban Development (HUD), for instance. Sources also said they’re seeing more sponsors exploring the possible use of various HUD FHA mortgage insurance loan programs, tax-exempt and taxable bond financing, and some of the new tools and dollars available under the American Recovery and Reinvestment Act (e.g. Build America Bonds, school construction bonds, extra public housing capital funds).
“You need to turn over every rock to find what you need to accommodate the capitalization of these QEIs,” says Weinstein. Echoes Wesolowski, “You have to think of all the things that could be available to you.”
Other current trends in affordable housing and community development are also spilling over into the NMTC program. Wesolowski, for instance, said Enterprise’s latest NMTC allocation, of $95 million, has a “green stamp on it.” Enterprise is looking to deploy this into deals with green or sustainable purposes or characteristics, such as a project that involves the cleanup of a brownfield, or an historic redevelopment that makes use of green building practices.
Howard also sees a shift in this direction. “There seem to be a number of folks actively looking at the renewable space,” he says. “I think those deals are going to start to get done.”
“Twinning” of the NMTC with federal historic tax credits has been common, and some expect greater pairing of new markets and federal energy credits.
Another occurrence is that the liquidity problem in the general capital markets is prompting some developers to look at the new markets credit for the first time, as a possible resource to make their current project pencil out. “We’re seeing a lot of the historic people trying to fill their gap by bringing in the new markets credit,” says Hirshman. Likewise, Weinstein said some conventional developers are eying the NMTC as a possible way to help fund their commercial real estate projects.
The economic downturn has also had another impact on the program. Several sources reported that more and more existing NMTC projects are struggling financially, some to the point of tipping into bankruptcy. Lower rents and operating income than originally projected, because of the soured economy, is to blame for much of this.
Extension, AMT Fix
Arguably the industry’s most immediate focus, though, is on Congress. Participants want Congress to extend the program beyond 2009, and to exempt the NMTC from the alternative minimum tax (AMT) to put it on parity with the federal housing and historic tax credits, which already enjoy this treatment.
Industry participants generally said the looming sunset isn’t affecting their current activities and future plans so far. But they asserted that an extension of the program, preferably multi-year, together with an exemption from AMT, is essential to attract new investors to the program and broaden the investor base.
“The year-to-year reauthorization that we’ve been going through the last couple of years is no way to incent new investors to dig into this program,” says Jonathan Goldstein of Sunwheel Energy Partners, an energy company affiliated with urban redeveloper McCormack Baron Salazar.
Hirshman says an AMT “fix” for the NMTC is key. “That’s pivotal to the ongoing viability of the program itself.”
