The Federal Government: America’s Most Liquid Lender
While the United States economy has recently hinted at signs of recovery, credit availability remains largely inaccessible for new real estate projects. The bearishness of credit providers seems couched in fears of future market turmoil tied to rising defaults as long term commercial real estate debt comes due. Until these fears manifest themselves in market corrections or markets return to stability, traditional financing for commercial development projects may remain largely unavailable. However, there are still alternative sources of low interest financing available which can provide start-up and operational capital even in this period of credit scarcity. In this edition, we present two articles that discuss alternative financing programs as a means to capitalize on underutilized real estate in a company’s portfolio or to develop new opportunities and business models in qualifying areas or for qualifying businesses.
While the programs discussed in this edition are not available for some of the traditional business models for development and utilization of portfolio properties, for many companies, they can be a fresh and creative approach to capitalize on underutilized properties, enter new markets, or revitalize commercial real estate even in this environment of credit scarcity. It is important to note that, even if these programs do not appear to present an opportunity for your company, they can be valuable tools when looking at disposal options relating to underutilized real estate by sharpening the focus of your company in seeking potential buyers. In particular, many potential buyers of commercial real estate are unaware of these programs and may be sitting on the sidelines because they are deterred from executing on their business model due to the perception that credit is unavailable. Where a company can locate a potential buyer and create value in property by offering suggestions for alternative acquisition financing, this little bit of education for the buyer could increase the sale price and get the deal to closing – benefitting both the buyer and the seller.
As has been done in the past Snell & Wilmer will provide you with timely updates on legal developments as they appear. In this edition, we are including a Legal Alert with respect to important changes in IRS Code Section 162(m) which will be of interest to many of you.
Brian Burke and Jim Mulligan
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Tax Credit Financing: An Alternative to Consider
In this stagnant credit market environment, many real estate developers and other companies are struggling to manage their real estate assets. However, there are options to obtain attractive financing for certain projects through tax credit financing. Tax credit financing involves the use of proceeds from equity investors to construct and operate projects where the investors seek an internal rate of return on their investment solely from the tax benefits obtained from their investment. In a typical situation, a tax credit investor will receive income tax credits and income tax deductions from their investment. An income tax credit is a dollar for dollar reduction of a taxpayer’s income tax liability. Income tax deductions reduce a taxpayer’s federal income tax liability by 35 cents for every $1 of deduction (assuming a 35% effective tax rate).
Two federal income tax programs which have been highly successful in providing tax credit financing are the New Markets Tax Credit (NMTC) program and the Low-Income Housing Tax Credit (LIHTC) program. Each of these programs typically involves the participation of an institutional investor as the tax credit investor. This article provides a basic overview of these two programs.
The New Markets Tax Credit (NMTC) Program
The NMTC program was created in 2000 to encourage investments in businesses located in low-income communities where traditional financing is often difficult to obtain. The NMTC program is facilitated by the Community Development Financial Institutions (CDFI) Fund. Each year, the CDFI Fund allocates tax credits to entities called community development entities (CDEs) formed for the purpose of applying for and, upon receiving an allocation, seeking equity investors to provide cash investments in exchange for NMTCs and then using such investments to provide financing to certain types of businesses (including certain real estate transactions) located in certain qualifying areas. In structuring transactions, a CDE will seek both equity from tax credit investors and commercial financing through the use of an investment fund. As illustrated below, the CDE will use the proceeds of the equity from tax credit investors and commercial financing to make two loans to the real estate developer at an interest rate that is effectively below what that developer would receive in the traditional commercial finance markets. Note that, although it is possible for the CDE to make an equity investment to the real estate developer, the proceeds from the CDE to the developer almost always involves a loan. The following is a hypothetical transaction.
Assume for this hypothetical transaction, the CDFI Fund, a federal agency, has granted an allocation of tax credits to a CDE and that CDE has been approached by a borrower (i.e., the real estate developer) with a $10 million project in a qualifying location. If the CDE approves the project, the CDE will bring a tax credit equity investor into the transaction through the issuance of an equity interest in an investment fund in exchange for cash contributions. The equity investor in the investment fund will thereafter be allocated tax credits. In most cases, the transaction will include leverage, which requires the investment fund to obtain a commercial loan. The equity from the tax credit investor and the debt from the commercial loan will be used as an equity contribution to the CDE, in this case totaling $10 million. Typically, the CDE will then make two loans to the borrower (the developer): the first loan will bear similar terms to the commercial financing obtained by the investment fund; the second loan will have a principal balance in an amount that is approximately equal to the tax credit investor’s equity investment. This second loan typically bears a 0.5% to 1% interest rate and is designed to eventually be forgiven (although it not required that it be forgiven). The combination of the two loans produces an effective interest rate that is designed to be less than the interest rate that the developer would be able to obtain in the commercial finance market. For illustration, see the flowchart below:
The proceeds of the equity and commercial financing are ultimately invested by the CDE in certain types of businesses located in certain qualifying areas. Generally, the business needs to be located in a low-income area. There are alternatives to this location requirement; however, being located in a low-income area is the easiest requirement to satisfy. A low-income area is determined based upon census information related to poverty rates for a particular area or the median family income for such an area.
In addition to the location requirement, the real estate developer/borrower must be engaged in the active conduct of a qualified business, which includes most commercial enterprises and rental activities other than certain disqualified businesses and residential rental property (although a mixed-used project can still qualify if it obtains more than 20% of its gross income from commercial rent). The disqualified businesses generally are golf courses, country clubs, massage or tanning parlors, hot tub facilities, racetracks, gambling facilities, or stores where the sale of alcohol for consumption off premises is the principal business; businesses holding intangibles for sale or license; farming operations; and the rental of real property for any of the foregoing. A further requirement for the rental of real property is that the proceeds from the CDE generally be used to create substantial improvements on the property.
The Low-Income Housing Tax Credit Program
The low-income housing tax credit (LIHTC) program was enacted in 1986 as an indirect subsidy to finance low-income housing. This credit is specially designed to provide equity financing to developers of newly constructed and renovated residential rental buildings. Under this program, developers apply, in a highly competitive application process, for an allocation of LIHTCs from their state housing agency (e.g. Arizona Department of Housing, Colorado Housing and Finance Authority, California Department of Housing and Community Development, etc.).
In order for a project to qualify for LIHTCs, either at least 20% of the available rental units must be rented to households with incomes not exceeding 50% of the area median income; or at least 40% of the available rental units must be rented to households with incomes not exceeding 60% of the area median income. Further, rents charged to the tenants must be below market rates and the project must remain restricted to below market rents for a period of between 30 to 40 years (depending on the state in which the project is located). There are numerous other requirements with which the developer will need to comply for a 15 year period after the project is placed in service.
In its basic structure, the project is owned by a limited partnership where the developer or its affiliate owns a 0.01% interest as general partner and the tax credit investor owns a 99.99% interest as limited partner in exchange for its equity contribution. The tax credit investor will receive 99.99% of the tax credits over a ten year period and 99.99% of the depreciation deductions. These tax benefits typically constitute the tax credit investor's entire return on investment since the net cash flow from the rental project is usually insignificant. Construction financing is almost always still necessary. The tax credit investor must maintain its interest in the limited partnership for at least 15 years or face potential recapture of the income tax credits. Generally, the structure is designed for the developer to generate its returns from both selling the land to the limited partnership and receiving a development fee that is typically equal to approximately 10% to 15% (depending on the state in which the project is located) of the costs of the project. The following is a hypothetical transaction.
Assume for this hypothetical transaction, real estate developer purchased raw land for $1 million in 1995 and it is now worth $2 million. The real estate developer is contemplating constructing a residential rental project on the raw land for $10 million which includes a $2 million acquisition price for the raw land. The real estate developer will form a limited partnership and apply to its state housing agency for an allocation of LIHTCs. Once it receives an allocation, the real estate developer will enter into an agreement with a tax credit investor. The tax credit investor will contribute $5 million to the limited partnership in exchange for a 99.99% interest in the limited partnership. A commercial bank will provide $5 million of construction financing and thereafter permanent financing to the limited partnership as well. The real estate developer will sell the raw land to the limited partnership for $2 million for a $1 million profit. A developer fee will be paid to the real estate developer as well although a portion of fee will be deferred. For illustration, see the flowchart below:
Market Trends; Regulation
Under the typical structures, tax credit investors invest equity in the CDE’s investment fund or the LIHTC limited partnership, as applicable, based upon a certain price per income tax credit. This price per credit has decreased over the last couple of years as a result of the financial crisis. This is the result of a loss of appetite among traditional tax credit investors for income tax credit investments. This loss of appetite did not necessarily result from any perceived changes in risk of the tax credit investments; rather many traditional tax credit investors no longer need the tax credits because of the significant net operating losses that they incurred and are carrying forward. However, as the economy slowly recovers, experts predict that more tax credit investors will be coming back into the market. Further, lobbying efforts are continuing with Congress to enact legislation that will hopefully bring more tax credit investors to the table in short term. Having more tax credit investors participating in the tax credit equity market should increase the price of the credits thereby creating more financing opportunities for real estate developers.
In summary, these two tax programs are promising alternatives to equity financing that could be beneficial to certain real estate developers.
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HUD/ FHA Financing for Multifamily Housing
and Health Care Facilities
In the current economic climate, HUD/ FHA insured mortgage programs have become an increasingly attractive financing tool. FHA has a number of multifamily, long term care and hospital loan programs that help finance the construction of new projects, as well as the purchase or refinance of existing projects. FHA Mortgage Insurance Programs provide long term, non-recourse financing. The programs can be used for “market” rate or “affordable” projects, and can often be combined with tax incentives and economic development programs. FHA is completely self financing, generating its income through fees and mortgage insurance premiums, and FHA insured mortgages have the added benefit of being eligible for financing with Government National Mortgage Association (GNMA) Mortgage Backed Securities.
The Federal Housing Administration (FHA) was created by Congress in 1934 (multifamily insurance began in 1937) as a tool to provide housing finance during the Great Depression. FHA became part of the Department of Housing and Urban Development in 1965, and is today the largest mortgage insurer in the world. Since its inception, FHA has insured over 47,000 multifamily projects, over 4,000 long-term care facilities, and nearly 400 hospitals.
FHA programs can be particularly appealing during economic disruptions and slowdowns when private sources of capital dry up. The demand for FHA and other government insured financing programs has increased dramatically during the past year due to economic uncertainty and the paucity of private sector credit and equity. It should be noted, however, that FHA relies on the ability of government staff to respond to increased demand and continue the timely processing of applications and it is therefore important for lenders and developers interested in FHA multifamily programs to begin the application and approval process sooner rather than later.
To clarify a common misconception, FHA does not lend money directly, but rather insures the mortgage loans provided by private lenders, protecting lenders against the losses that can occur when borrowers default on their mortgages. In order to protect FHA from excessive risk, the loans that FHA insures must adhere to certain underwriting and other requirements. Lenders who wish to participate in FHA’s multifamily insurance programs must first apply to become FHA-approved multifamily mortgagees. Once approved, FHA has “fast track” processing systems which allow lenders to prepare FHA forms and conduct preliminary underwriting independent of HUD in order to expedite the insurance approval process. This eliminates the need for the lengthier site appraisal and market analysis and approval process.
The HUD/ FHA process is best illustrated using the example of a market rate multifamily development. This type of development will typically be processed under a “fast track” processing system. The process begins at the pre-application stage where the lender provides HUD with a market analysis, including comparables, an environmental report, preliminary sketches, a description of the proposed multifamily development, and other documents. HUD then reviews the materials and either rejects the application or invites the Lender to submit an application for a firm commitment. There is no fee associated with the pre-application review.
HUD’s issuance of a firm commitment consists of a thorough review of the components of the project financing and development including a site visit. The lender conducts a complete underwriting of the loan guarantee application. This review will include items such as an architectural review, a management analysis, a mortgage credit analysis, and a review of the appraisal. HUD has 45 calendar days (for new construction and substantial rehabilitation projects) to review the firm commitment application materials and either reject the application or issue a signed commitment. During this stage HUD charges fees in connection with firm commitment application review which include a fee of $3 per thousand dollars of the mortgage amount for the firm commitment application review and inspection fee that is typically $5 per thousand dollars of the mortgage amount. The mortgage insurance premium varies, but is based on a percentage of the mortgage amount. The initial premium is due at initial endorsement/loan closing.
Once a firm commitment has been signed by HUD, the lender may begin preparing the closing documents and working with the local HUD office to schedule a closing. Below is a brief overview of each of the major FHA mortgage insurance programs.
New Construction or Substantial Rehabilitation of Nursing Homes, Intermediate Care Facilities, Board and Care Homes, and Assisted Living Facilities; Purchase or Refinance of Existing Facilities
Provides financing for what are typically termed “long-term care” facilities, where patients generally require skilled nursing care, or care by licensed or trained personnel. The maximum amount of the loan for new construction and substantial rehabilitation is 90 percent (95 percent for nonprofit sponsors) of the appraised value including major movable equipment. Under the purchase and refinance program, the maximum loan is 85 percent (90 percent for nonprofit sponsors) of the appraised value and also includes major movable equipment. There can be no equity take out under the refinance program. The mortgage term under the new construction and substantial rehabilitation program is up to 40 years, while the mortgage term for existing properties is up to 35 years.
New Construction or Renovation of Acute Care Hospitals
Public, proprietary and non-profit acute care hospitals regulated by a state are eligible under this program, as are Critical Access Hospitals (25 beds or less) that have received designation from the state and the Department of Health and Human Services, and large Urban Teaching Hospitals. The maximum loan-to-value is 90%; the maximum loan term is 25 years; and the loan is non-recourse. A Certificate of Need (CON) must be issued or pending in those states with the CON process. Design/build construction is allowed up to $30 million per project.
Hospital Mortgage Refinancing
On July 1, 2009 FHA announced that it is implementing its existing statutory authority to refinance debt for hospitals. Previously, FHA had only insured financing for the new construction, renovation or rehabilitation of hospitals. This recent decision was made due to the lack of access to capital for hospitals seeking to meet obligations on existing debt, and hospitals must show that as a result of the credit crisis they have experienced, or will soon experience, an increase in their interest rate of at least one percent (1%) since January 1, 2008. The maximum mortgage amount is limited to existing indebtedness plus reasonable fees.
Market Rate New Construction or Substantial
Rehabilitation of Multifamily Rental Housing
This program provides mortgage insurance on loans made by private lenders to finance the development or substantial rehabilitation of multifamily rental housing. The 221(d)(4) program is for profit motivated developers, and insures mortgages for up to 90% of the development’s replacement costs. The Section 221(d)(3) is available for non-profit developers, and insures mortgages for up to 100% of the replacement cost. The loan term under both versions is 40 years and covers the construction and permanent financing. The substantial rehabilitation aspect of the program includes projects where the cost of repairs exceeds the greater of $6,500 per unit or 15% of the estimated replacement cost after all repairs and improvements. Properties with improvements costing less than the above thresholds are eligible for an alternative program -- the 223(f) purchase/refinance program.
Purchase or Refinance of Existing Multifamily Rental Housing
Provides mortgage insurance for loans to purchase or refinance existing multifamily properties. In order to qualify, construction or substantial rehabilitation of the property must have been completed at least three years prior to the insurance application date. The maximum mortgage term is typically 35 years, and the mortgage limit is up to 85% of the appraised value.
New Construction or Substantial Redevelopment
in Urban Renewal Areas
Insures multifamily development and rehabilitation in urban renewal areas and allows for a significant commercial component in the development. Commercial space may cover up to 20% of the gross project area, and commercial income may be up to 30% of the project gross income. The maximum insurable mortgage for a new development may be up to 90% of the replacement cost, and is up to 90% of the sum of the estimated cost of rehabilitation and “as is” value of the property for a substantial rehabilitation. The loan term may be up to 40 years.
In today’s economy it is critical that investors move quickly to take advantage of opportunities. HUD/ FHA mortgage insurance can provide an immediate opportunity for lenders to put funds to work in the real estate development arena.
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Legal Alert: Performance-Based Compensation Arrangements
Public Companies May Need to Amend “Performance-Based Compensation” Arrangements to Address 162(m) IRS Guidance By Year End.
Section 162(m) of the Internal Revenue Code exempts from the $1 million cap amounts paid to a public company’s CEO and certain other executive officers that qualify as “performance-based compensation.” On February 21, 2008, the IRS officially reversed a long standing position and released Revenue Ruling 2008-13 which held that compensation will not qualify for the Section 162(m) exception if it is paid at target levels upon an executive’s termination of employment without cause or for good reason (regardless of whether the performance target is met). Revenue Ruling 2008-13 provided significant transition relief; however, the IRS will begin enforcing its new position for performance periods beginning after January 1, 2009. As a result, agreements and incentive plans that pay performance based awards upon termination of employment without cause or for good reason (regardless of performance) and that have performance periods beginning after January 1, 2009 must be brought into compliance with Revenue Ruling 2008-13 by December 31, 2009.
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