Tax Credits Display Increased Risk But Value Can Still Be Found, Investors Say
By Caitlin Jones & A. J. Johnson
7 min read
Tax Credit Advisor June, 2006: Despite a worrisome trend towards increased risk and reduced yield, investment in housing tax credit equity still makes sense if the underlying property has strong fundamentals and adequate protections are in place, a group of investors concluded. The investors spoke in March at a panel held during the National Housing & Rehabilitation Association’s annual meeting in Miami Beach, Fla.
“Risk is rebounding in a negative direction at exactly the same time that yields [on housing tax credit corporate funds] are lower than ever,” warned David Kunhardt, senior vice president at AEGON USA Realty Advisors Inc., the panel’s moderator.
But Kunhardt said that investors can navigate this difficult environment if they carefully analyze tax credit investments before adding them to their portfolios. In particular, they must make sure that operating expenses are carefully scrutinized, and that debt service and replacement-reserve coverage levels are adequate. The AEGON executive was joined by three other portfolio managers: Susan Leahy of Bank of America, Robert Maulden of John Hancock Realty Advisors, and Lawrence Mandel of General Electric Capital Real Estate.
A Representative Portfolio
Leahy reviewed her bank’s housing tax-credit equity portfolio, noting that it typifies the current stresses on these investments. She said that about 20 percent of Bank of America’s $5 billion in these holdings are on its watch list, with about three-quarters of that amount flagged because revenues from the underlying properties are below breakeven. Many of the tax-credit properties, she said, have recently become burdened by sharply higher property taxes and utility costs.
As for the remaining 25 percent of the watch-list, she said, construction and lease-up postponements have delayed delivery of tax credits. In at least one case, she added, a tax-credit property was not able to convert from construction to permanent financing because revenues were not sufficient to meet debt-service coverage ratios.
She noted that this percentage of underperforming tax credit properties is “in line” with a recent study from Ernst & Young. According to a report that E&Y released late last year, about a third of tax-credit properties in any given year are underperforming in one of three areas: debt service coverage, cash flow, and occupancy rates.
Risk-Management Recommendations
Based on her bank’s recent experience, Leahy urged other investors to carefully assess the adequacy of the demand for tax-credit properties, beginning with a detailed review of the projects’ market studies. She also said that full funding of debt service replacement reserves is crucial. When conversion to permanent financing is a problem, a workout plan should be put together as quickly as possible.
As for the problem of delayed construction and lease-up, Leahy said that investors should make sure that developers are being realistic in setting their timelines, with due allowance made for seasonal variations in weather and the schedules of renters. She gave two examples of mistakes in this area: the scheduling of construction during the winter in the Northeast, and rent-up periods initiated at the beginning or end of a school year.
Other panel members offered recommendations to prevent tax-credit properties from becoming underperformers.
John Hancock’s Maulden said that it is helpful to work with experienced developers, who are most apt to provide investors with an accurate fix on operating expenses. But investors should not rely only on developers’ projections, he added: they should also make an independent analysis, including reviewing their own portfolios to see how comparable existing investments have performed.
“Overwhelmingly, the most important thing to underwriters is the operating expense budget, and that is not being done well,” said Kunhardt. “Debt service coverage of 1.15 times, or 1.2, doesn’t matter if you’re off by $200 to $300 [a month] per unit on your expense budget minimums,” he said.
Kunhardt also urged investors to insist on higher capital replacement reserves than are currently the industry norm. Specifically, he suggested adoption of best practices guidelines established in 2003 by the National Council of State Housing Agencies. NCSHA has set annual minimum replacement reserves of $250 per unit for new construction projects for seniors, and $300 per unit for rehabilitations and new construction projects for families.
Although some investors delay making equity contributions to a tax-credit project during the construction period in an effort to increase investment yield, Kunhardt characterized this approach as short-sighted. He recommended early pay-ins to help the property owner avoid higher borrowing costs that can burden the project down the line.
“We put as much of our equity as possible into construction to keep down the exposure of the project to adjustable-rate construction loans, because every dollar the developer spends then is friction to the project,” he said. “Those who believe that delay gives you a better yield are just flat-out wrong.”
Investors can also help by stepping up to the plate and providing permanent financing, said Kunhardt. Insurers, which tend to have a long-term investment horizon, may be in a better position to do this than many banks, he noted. In addition, investors should be willing to take ownership of a project if all else fails, he said.
Identifying Investment Opportunities, Pitfalls
The panelists said that in the current environment, several kinds of tax-credit developments have performed well, including acquisition/rehab, mixed-income, and urban-infill projects.
Maulden said that acquisition-rehab properties are often good performers because “there is less construction risk, and generally less lease-up risk, because many times properties are full, and you are not adding new units to the market.” When evaluating such projects, he said, it is important to obtain a property-condition assessment and schedule of replacement reserve requirements.
“The big issue for us is must making sure there is enough money in the replacement reserves to get it through the 15-year period,” he added.
Kunhardt said that mixed-income properties, when “developed in strong market areas,” can do very well. “As long as we have a partner with skin in the game and the fundamentals of the market are there, we’re interested,” he said.
Maulden agreed that mixed-income properties often perform well, but he also noted that they can pose problems, particularly in secondary rental markets outside large urban areas, where rents are sometimes soft.
General Electric’s Mandel said that he has found value in urban-infill projects that are “well structured and have strong community support, with subsidies from the city and state, and reasonable demographics.” Citing the same underlying fundamentals, he said that he also likes many projects developed by local housing authority.
The investors said they were interested in development projects that will be funded by new tax credits in Louisiana, Alabama, and Mississippi provided by the Gulf Opportunity Zone legislation recently passed by Congress. Mandel said that one of the possible attractions of these projects is that a higher percentage of their development costs could be covered by tax credit equity than is normally the case.
On the other hand, he said, there are still many uncertainties, including increased insurance costs, and the need for supporting infrastructure such as rebuilt roads, schools, and levies.
The investors agreed that some types of tax-credit properties should generally be avoided. An example of this, said Kunhardt, is assisted living projects. He said that these properties are difficult to rent, have a high turnover, and are very expensive to operate. The only way they can work, he said, is when Medicaid waivers can provide an additional subsidy.
In concluding, Kunhardt said that investors are apt to become more demanding in their assessment of housing tax-credits as these holdings become a larger portion of their overall portfolios.
“The fine points we have talked about are more important for institutions that are growing their tax credits,” he said. “When we were merely at five, six, or seven hundred million dollars in a portfolio of $120 billion, these things were de minimus – but now that we are approaching the 5 percent range they have become material, and the question becomes should we continue with them.”
