by Steven Polivy and Rogelio Carrasquillo
Affordable housing project developers look for alternative financing sources to bridge the gap between available funding and total project development costs.
As developers become more familiar with the EB-5 program, we expect to see an increased use of EB-5 capital in combination with federal tax credit programs such as low income housing tax credits ("LIHTC"). For a large number of affordable housing projects, the capital generated from the sale of tax credits does not provide the necessary capital for the full construction and development of the project. EB-5 funding is an excellent source of gap financing to assist these projects incorporating the use of tax credits within their capital stack, but which are in need of additional capital or financing to become financially viable. According to the U.S. Department of Housing and Urban Development, the LIHTC program has produced and financed over two and a half million affordable apartments for low-income households and seniors since it was created. One of the things that make EB-5 and LIHTC work so well together is that like the EB-5 program, the LIHTC program is a job creator. According to the National Home Builders Association, the LIHTC program has helped generate approximately 95,000 jobs per year. Due to the large number of jobs generated by LIHTC projects and the fact that only a portion of the capital stack is necessary to complete the necessary funds, LIHTC projects incorporating EB-5 would also be extremely attractive to foreign investors looking for EB-5 projects.
Low-Income Housing Tax Credits: A General Overview
LIHTCs are a federal subsidy used to finance the development costs of low income housing. It was enacted as part of the Tax Reform Act of 1986 and became effective on January 1, 1987. The LIHTC allows a taxpayer, typically the partners of the partnership that owns the project, to subsidize either 30 percent or 70 percent of eligible costs for the development of low-income units in a rental housing project. There are two “pools” of credits: the 9 percent credit (which subsidizes approximately 70 percent of eligible project costs) and the 4 percent credit (which subsidizes approximately 30 percent of eligible project costs). The 4 percent credit refers to the credit percentage which is available for existing housing or for federally subsidized new construction or rehabilitation, while the 9 percent credit refers to the credit percentage available for new construction or rehabilitations, subject to the satisfaction of certain thresholds. The annual amount of 9 percent credits available to each state is based on population. Due to the limited availability of these credits there is a high degree of competition and states create their own allocation processes. The 4 percent credit is part of a state's annual private activity volume cap allocation and may be less competitive, depending on the available and competing needs in a particular state for private activity bond allocations for projects like airport improvements, ports and terminal projects, pollution control projects, as well as other small-issue industrial projects.
The low-income tax credit works by allowing the credit claimed by the taxpayer pro rata over a period of 10 years to be used in connection with both new construction and renovation of residential rental units. Taxpayers claiming the LIHTC may use the tax credit to offset their regular tax liability, subject to certain limitations. Often, the LIHTC are sold to a financial institution through a tax credit syndication since LIHTCs are subject to alternative minimum taxes and are most advantageous if owned by financial institutions or corporate owners.
To avoid tax credit recapture and the repayment of any tax savings, LIHTC taxpayers must comply with all applicable compliance rules and retain an ownership interest for at least a 15-year period. As a result, an investor in the project will typically retain its participation in the project for at least the compliance period. In addition, most state allocating agencies require an additional restriction on rents for a specified period beyond the initial 15-year compliance period, typically evidenced in an additional 15-year extended use agreement.
“Sale” or Syndication of the LIHTC: Source of Equity
As mentioned above, the LIHTC provides an additional source of equity for the construction of rental low-income housing projects for families and seniors. Once a developer is allocated tax credits by a state allocating agency, such developer “sells” the tax credits to an investor or syndicator by entering into a limited partnership or limited liability company with such investor or syndicator. The investor’s or syndicator’s participation in the newly formed entity is typically 99.99 percent of the profits, losses, depreciation and tax credits, as a limited partner or member of the entity, and the developer typically serves as the general partner or managing member of the entity, holding the remaining 0.01percent of the newly formed entity. The capital raised by such sale or syndication reduces the amount of equity that a developer would have to obtain from loans or the issuance of debt to cover the costs of the project. Additional benefits to an investor acquiring the LIHTC include allocating the depreciation of the buildings owned by the entity, which is tax deductible, based on the investor’s equity participation in the entity.
EB-5 as Part of the Capital Stack
Although EB-5 can be used in several ways within the capital stack, it is most common for projects to utilize EB-5 investment either in a first mortgage position or as preferred equity or subordinated debt. EB-5 financing does not typically utilize traditional institutional lender underwriting criteria, and therefore EB-5 financing can be deployed as first mortgage debt for projects which might not have reached the leasing requirements or other criteria typically required by an institutional lender. Given the respective current costs of institutional first lien financing for projects where such financing is available, mezzanine debt is a far lower cost alternative to traditional mezzanine lenders and can be used to replace higher cost equity either in the form of subordinated secured debt or preferred equity.
For large scale construction projects where the construction timeline extends beyond 24 months, the job creation generated by the construction of the project may support EB-5 participation in the range of 20-35 percent of the capital stack, with a term of at least five years with no amortization and interest rates in the range of 6 percent. This approach also has the benefit of maximizing job coverage security, as a project will generate the same number of jobs no matter how it is financed, but limiting EB-5 financing to 20-35 percent of the capital stack leverages the job creation generated by the remainder of the capital stack for the benefit of the EB-5 investors, since the balance of the investors are not dependent on the job creation for their financing. Limiting the size of the EB-5 raise will also enable greater flexibility in raising the capital by making the project more attractive to foreign investors.
On a transaction combining EB-5 financing and LIHTC, the EB-5 financing portion is generally removed from the capital stack by funds generated from a refinancing transaction five to seven years after the closing of the EB-5 financing. At such time, the project would be completed and in operation, therefore reducing the lending risk for the refinancing institution, which should provide a more attractive interest rate.
Other Tax Credits
In addition to LIHTC, projects incorporating other tax credit programs into their capital stack, such as new markets tax credits ("NMTC") or historic tax credits ("HTC"), can also benefit from incorporating EB-5 financing as a portion of their source of funds. As described above with respect to LIHTC projects, EB-5 financing can also become source of gap financing for projects taking advantage of these other tax programs.
Public Use of EB-5
States and municipalities have realized that EB-5 can be an important source of funding for high priority projects, including the development of affordable housing projects. Just in the last year, Michigan, Miami, and Puerto Rico have moved forward in establishing their own public regional centers, showcasing a growing trend in publicly owned and operated centers. A publicly owned regional center can be a great tool to complement existing public and private financing sources for private and public uses.
For example, the Commonwealth of Puerto Rico Regional Center Corporation – the third state-owned and operated EB-5 regional center in the United States--was recently approved by USCIS to serve the Commonwealth of Puerto Rico. The regional center will focus on infrastructure and public-private partnership projects and it plans is to provide EB-5 funding to high priority projects, including affordable housing projects being allocated LIHTCs. Given the diminishing availability grants and subsidies for the development of affordable housing projects at the federal and state levels, combining EB-5 funding with LIHTC equity would provide the much needed gap financing required in the market.
Incorporating EB-5 financing to LIHTC projects for the development of low-income housing rental projects facilitates the construction and development of these projects, while providing an incentive for private developers to make affordable rental housing available. At a time when financing options for construction projects remain limited, the use of EB-5 funding for these real estate development projects already taking advantage of tax credit programs could be the difference in making a project viable. Also, as more states and municipalities see the advantages of EB-5 to complement their traditional funding efforts, we expect to see an increase in the number of public entities taking advantage of this alternative financing source by creating their own publicly owned regional center or partnering with existing centers to provide EB-5 financing. In so doing, they are leveraging the investment dollars of foreign investors into important projects for our municipalities and creating jobs.