Blogs| LIHTC Financing: The Complexities & Investment Structures
Written by
Soumya Jain
Published
Aug 12, 2024
Topics
LIHTC
Up till the first half of the 20th century, for nearly 200 years, the US Government avoided involvement in housing and left the reigns in the private sector’s hands. During the New Deal era and World War II, however, the government began developing housing to address safety concerns. Over time, the focus of public housing shifted towards affordability, laying the groundwork for policy changes. One such change was the Tax Reform Act of 1986, which produced one of the most important sources of affordable housing funding in the US: the Low-Income Housing Tax Credits (LIHTC) Program.
Established to encourage private investment, the LIHTC program offers a dollar-for-dollar reduction in federal tax liability to developers for creating and rehabilitating affordable rental housing.
In an ideal scenario, this program is the perfect incentive for developers and investors to give back to the community. The actuality differs. The equity generated from the standalone tax credit is rarely sufficient to close the gap between the development costs and affordable rents for low-income households.
Hence, developers smartly rely on “capital stacking” where multiple sources of funding are “stacked” to make a deal financially profitable. By bringing private capital to the table in addition to the credits, developers can take on less debt, which in turn translates into lower rents.
The stacking process and deal financing are overwhelming in terms of the number of documents that need to be maintained in addition to regular bookkeeping. Here’s where Fusion makes everything simple: we help you put your LIHTC portfolio on autopilot.
The LIHTC program subsidizes the acquisition, construction, and rehabilitation of affordable rental housing. It’s administered by the US Internal Revenue Service (IRS), which allocates tax credits to state housing finance agencies based on state population. State agencies then allocate these credits competitively through their Qualified Allocation Plans (QAPs) that define investment priorities.
Essentially, LIHTC operates by providing tax credits to developers, who then sell these credits to investors to raise equity for their projects. The investors’ capital enables developers to potentially remain debt-free, which in turn helps them keep rents subsidised for low-income households.
There are two types of LIHTC Credits:
*Most development expenses (excluding land acquisition and certain financing costs) are considered eligible costs.
The amount of tax credits allocated to a project is based on the project’s eligible costs multiplied by the applicable credit rate (4% or 9%) over a 10-year period.
At its most basic level, LIHTC development works as follows:
State Housing Agencies have Qualified Allocation Plans (QAPs), which outline the criteria for awarding federal tax credits. From location factors – such as proximity to public transportation, schools, etc. – to capital stack plans, every state has different QAP criteria. A developer (profit or non-profit) must carefully select sites that align with these criteria to maximize their chances of securing tax credits. For example, in Salt Lake City, points are awarded for sites near redevelopment zones and transit lines, among other factors.
After the site is secured, the developer creates the plan for an affordable housing development. This plan includes a proposed capital stack, in which the developer demonstrates how they plan to finance both construction and long-term operations. The capital stack takes into account the equity anticipated through the LIHTC program and the amount of debt the project can afford.
Once a plan is in place, developers apply to the state agency for credits. Each state monitors the LIHTC program through their QAP, which sets forth the regulations and criteria on the basis of which a developer’s application will be judged.
Securing funding for a LIHTC project involves complex negotiations, the coordination of various funding sources, and multiple steps, of which the Credit Application is the first. During the initial phases, developers typically secure a construction loan covering 75-80% of the project cost. Additional funding comes from equity financing, which is covered in Step 5.
Developers build a capital stack based on various funding sources, including federal, state, and local programs. Effectively extracting the most out of public and private resources is crucial for the project’s financial stability. Once they have a capital plan, developers market their deals to various investors who bid on purchasing the tax credits with equity, which is in turn used to fund the transaction. Developers often follow one of two methods to onboard investors:
The natural next step is the construction phase which resembles any other real estate development project, except for one unique aspect: the phased receipt of tax credit equity. Credit is disbursed at key milestones such as construction completion, occupancy stabilization, and final project audit.
Despite this phased approach, the process of managing cash flow and compliance requirements is complicated. Fusion is a specialised LIHTC Management software designed by Asset Managers to make the overwhelming LIHTC complexities simpler and easier to manage.
LIHTC-financed housing must guarantee at least 30 years of affordability for a share of units, to households with average incomes at or below 60% of the metropolitan median income. After 30 years, the developer, syndicator, and investor entities can realise capital gains after the sale in their previously-decided shareholding patterns. Else, they can choose to rent at higher prices.
Developers could easily choose private real-estate projects, but they prefer LIHTC because:
Investors are the entities that park their capital in an asset to gain maximum returns on their investments. LIHTC offers them three major benefits:
Syndicators act as intermediaries between developers and investors. They pool several properties into one LIHTC equity fund and market that fund to investors. What they do:
What makes LIHTC different from a market-rate real estate deal?
While market-rate developers are generally compensated through rental income or from the sale of their developments, LIHTC developers often seek multiple sources of funding to offset building costs and keep rentals subsidised for low-income households, after which they qualify for the LIHTC Tax Credits.
But which sources of funding, how many, and when? These decisions are contingent on several factors:
With so many moving pieces, there is no one “ideal” capital stack. However, there are several sources of funding that most developers should consider:
Federal Programs such as HOME and CDBG have traditionally been part of a LIHTC capital stack. A growing number of states now provide their own state tax credit to augment the federal.
LIHTC projects allow developers to charge a fee to develop and operate the property, and states can set a threshold for this (many states set a maximum threshold of 15% of development costs at the median). Developers often defer a portion or all of this fee to cover a portion or all of a funding gap.
This deferred fee then becomes one of the sources in the capital stack, to be paid back to the developer from future capital contributions, cash flow (rents), or refinancing proceeds after a project is set for occupancy.
QAPs can dictate the developer’s contribution to the capital stack and set criteria or preferences for developments based on federal or state investment goals.
States use three mechanisms to decide whether the application qualifies for tax credits, and if yes, which type of tax credit. These 3 mechanisms are:
States’ QAPs use several evaluation criteria for LIHTC applications:
Many QAPs include preferences for developments that leverage other government funds. This stipulation helps align LIHTC Credits with the priorities of other funding sources and gives developers a further incentive to leverage more public funds.
For example, in 2001, 46 states gave preference to applications that secured matching funds (such as grants) from public sources other than LIHTC, with 14 giving preference to developments that received USDA 515 Rural Housing Service Grants.
Some QAPs cite a preference for applications where the developer commits some of their own equity to the project.
For example, some states award points if owner equity exceeds 10% of total development costs, or if the developer commits a percentage of allowable developer fees to project development.
QAPs often incentivize developers to build more housing in higher opportunity areas, near transit, or to use sustainable building techniques to reduce the project’s environmental impact. In addition, states sometimes create additional funding streams to support LIHTC incentives.
For example, California has developed special funding streams to incentivise the production of permanent supportive housing, which in turn can influence the pipeline of development projects.
LIHTC projects may also have additional financing sources, such as debt, other public subsidies, and private grants.
LIHTC management can be more hectic than most real-estate projects because the multiple sources of funding and stringent compliance requirements add additional layers of complexity. Developers, Syndicators, and Investors must all be adept at project management and financial structuring to successfully manage the books, development phases, projections, reports, and compliances.
Here’s where Fusion is a game-changer – being a LIHTC Management software developed by Asset Managers for Asset Managers, it makes day-to-day management efficient and simple. With interactive interfaces for automated data ingestion, financial reporting, compliance, and more, Fusion makes LIHTC management easy and enjoyable.
From what we’ve learned so far, we can definitively conclude that LIHTC is not an investment made for the short-term. Hence, the question we need to ask is if the long-term benefits offset the short-term challenges and complexities.
The answer? Yes. The long-term benefits of LIHTC projects are substantial and often make these challenges worth the effort.
Let’s put it into context with a case study.
TownSquare Housing is a 50-year-old, 100-unit affordable multifamily housing complex in Hudson, Ohio. The property has a 70% occupancy rate owing to the disrepair state of several units. Fusion LLC decides to take on this project and redevelop the complex to meet modern standards while maintaining rental affordability. They look into several Affordable Housing Programs and find LIHTC to be the most suitable long-term opportunity with a clean performance record.
Since major renovation is required and the project costs are massive, they apply for the 9% Credit. Their project is approved by Ohio’s State Housing Agency.
Eligible Costs: The development cost for the TownSquare Housing project is estimated at $20 million (excluding land acquisition and some financing costs, because those are not considered eligible costs). Per the LIHTC guidelines, $18 million of this amount qualifies as eligible costs.
Tax Credit:
Annual Tax Credits = Eligible Costs * Credit Rate
Annual Tax Credits = $18,000,000 * 9% = $1,620,000
Since the tax credits are allocated over 10 years:
Total Tax Credits = $1,620,000 * 10 = $16,200,000
Fusion LLC prepares a capital stack including equity financing, and reaches out to investors and syndicators to sell these tax credits. The current market price for LIHTC is approximately $1.05 per tax credit dollar. They find an investor directly and create a partnership with them.
Equity Raised:
Equity Raised = $16,200,000 * $1.05 = $17,010,000
By securing $17 million in equity for the TownSquare Housing project, Fusion LLC significantly reduces the amount of debt they’ll have to secure.
Less debt = Low rents = Affordable housing = LIHTC compliances met and credits received
Hence, this rotation of money makes the project financially viable, and the projected occupancy rate upon redevelopment is 95%. The construction can commence.
Similar to TownSquare Housing are many developments in need of refurbishment.
Similar to Fusion LLC are many developers who can utilise LIHTC to address the affordable housing shortage in cities across the country.
LIHTC is not a short-term investment. It’s a long-term contribution to a community’s future, and it’s a great one at that.
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