Negotiating the Best Position for the PJ
Due to project viability considerations, HOME funds will most often be provided in the form of a soft loan. This term refers to a loan that has one of the following repayment structures:
- No required payments from operations
- Required payments that are limited to a percentage of available excess cash
- Payments that do not begin until late in the life of the project.
When structuring a soft loan, PJs need to consider the interest rate, loan term, repayment requirements, lien position, and sale /refinancing requirements. The LIHTC project sponsor may have certain needs and preferences about how the PJ structures these terms, because of the impact of these terms on the investors’ taxes (and their resulting impact on the price of the credits). These terms should be discussed and negotiated before the PJ finalizes its loan structure. This is because loans increase the amount of eligible basis in the project. IRS regulations require that loans are likely to be repaid; and therefore the HOME loan will need to be structured in a way that demonstrates it is likely to be repaid.
Factors Affecting the Strength of the PJ’s Negotiating Position
The PJ may be in either a strong or weak position to negotiate favorable loan terms, depending on a number of factors including:
- The timing of the LIHTC application. If the owner has already negotiated a cash flow waterfall with other parties to the transaction, it is more difficult to accommodate the PJ’s requirements.
- The size of the PJ’s investment. If the HOME funds are a relatively large source of funds to the project, the PJ is in a stronger position to negotiate favorable terms.
- The level of expertise on the PJ’s team. If the PJ’s underwriter, attorney, and other advisors are experienced in LIHTC deals, and are aware of the factors that impact a HOME-LIHTC project’s success, then there is an increased likelihood that the PJ can negotiate favorable terms.
LIHTC owners typically prefer HOME loans that have as long a term as possible. One reason is that it may be important for income tax purposes to demonstrate a reasonable expectation that the loan will be repaid from cash flow and sale proceeds. All else equal, extending the term of the HOME loan increases the likelihood that it will be repaid. It is a good practice for PJs to develop policies for the maximum loan term that the LIHTC owner finds acceptable.
Typically, PJs are more interested in ensuring the long-term affordability of the project than maximizing repayment of HOME funded loans. Consequently, when lending HOME funds to projects, PJs often offer loans at the lowest rate of interest and the longest term that are acceptable to both the PJ and the LIHTC owner.
Other HOME loans are intended to provide future program income to the PJ. These loans are intended to be repaid, at least in part. For these loans, the PJ needs to consider:
- Interest rate. A relatively high interest rate generates more program income for the PJ. However, a relatively low rate minimizes the risk that the property will have too much debt, and maximizes the likelihood that the project will be able to repay the loan in full. The LIHTC owner’s income tax concerns affect this decision as well.
- Level of required payment. A best practice is to require the project to repay a percentage of available (surplus) cash. HUD’s Office of Multifamily Housing provides a good definition of surplus cash: cash that is not needed to meet operational requirements on a particular day (such as December 31). If the PJ requires a relatively low percentage of the surplus cash to be repaid (such as one-third), the owner may have more incentive to maximize cash flow. If the PJ requires a high percentage of surplus cash be repaid (such as three-fourths), it may minimize the owner’s incentive to operate the property efficiently and in so doing reduce the amount of surplus cash.
- Deferral. It is a best practice for PJs to begin required payments after the project has stabilized for a few years. This practice limits the burden on cash flow in the early years of the project.
- Priority position. LIHTC owners are likely to ask the PJ to subordinate payments on the soft HOME loan to a variety of non-operational payments. This means that these non- operational payments would be made before calculating available surplus cash, a percentage of which will be paid to the PJ. Project sponsors may refer to this process as deciding the position that the HOME loan will have in the cash flow waterfall.
In HOME-LIHTC projects, negotiations regarding priority are likely to arise in at least these areas:
- Asset management / monitoring fees to the LIHTC investor. Investors commonly ask for an annual fee to be paid by the project, from excess cash, to cover the investor’s cost for monitoring compliance.
- Deferred developer fee. If a portion of the developer fee cannot be paid from Sources of Funds, that portion of the fee is called a deferred developer fee and is paid from future cash flow, refinancing proceeds, and sale proceeds. In order to include a deferred developer fee within LIHTC basis, the project sponsor must be able to demonstrate a reasonable expectation that the deferred fee will be repaid, with interest, during the 15-year LIHTC compliance period. Obviously, if the deferred developer fee has a high position in the cash flow waterfall, the likelihood of repayment is greater than if it has a lower position in the waterfall. Sophisticated PJs will project how much of the deferred developer fee is likely to be repaid based on the long-term operating pro forma, and will negotiate a cash-flow sharing arrangement that balances the developer’s interest in collecting the deferred fee, with the PJ’s interest in repayment of its loan.
- LIHTC adjusters. LIHTC investors typically negotiate guarantees from the LIHTC owner that the owner/manager will not rent to ineligible tenants, set rents above LIHTC maximums, commit fair housing violations, or take other actions that could cause the investor to lose LIHTCs. LIHTC owners often ask a PJ to subordinate HOME loans to these as “LIHTC adjusters.”
It is a good practice for the PJ to have clear requirements, stated in its Request for Proposals (RFP) or Notice of Funding Availability (NOFA), regarding repayment provisions, and for these requirements to strike a reasonable balance between meeting the PJ’s needs and providing the LIHTC owner with sufficient flexibility to achieve a successful project. Otherwise, the owner can (and likely will) claim that it was not aware of the PJ’s requirements, that the owner has already negotiated the cash flow waterfall, and that it is simply not possible to accommodate the PJ’s requirements.
Lien Position and Payment Priority
If there are multiple soft loans, there will be negotiations concerning lien position and payment priority. The lien position determines which soft lender will be paid first in the event of foreclosure. The payment priority identifies which soft lender will be paid first from available cash. Most typically, soft lenders demand lien position and payment priority according to loan amount. That is, the largest soft loan is most likely to demand and receive second lien position and second payment priority, after the first mortgage. PJs need to be aware of lien position because of the requirement to repay HOME funds in the event of loss of the affordable units during the minimum affordability period.
Sale / Refinancing Requirements
In structuring their HOME loans, many PJs require the HOME loan to be due on sale. Many LIHTC owners, however, want to be able to sell the property, and to refinance the first mortgage, without triggering repayment requirements for the HOME loan.
The PJ, however, will not want to grant these types of concessions routinely. It should consider the following issues regarding assumption of the HOME loan by a subsequent purchaser:
- Acceptability of the purchaser. The PJ wants to ensure that the purchaser is qualified to own/manage the property in compliance with remaining HOME requirements. One approach is to require that the purchaser meet any requirements that were contained in the PJ’s NOFA or RFP and to require the purchaser to submit its qualifications to the PJ, and be subject to PJ approval.
- Affordability. At a minimum, the PJ must require, as a condition of assumption, the continuation of the existing affordability requirements. The PJ may opt to impose longer and/or deeper affordability restrictions on the purchaser.
- Paydown. The PJ may want to require that a portion of the loan be repaid, in a lump sum, as a condition of assumption. This is especially true if the sale involves equity pay-out to the seller and/or a new developer fee to the purchaser. This enables the PJ to capture some of the net proceeds from the sale and not allow all of it to go to the owner. At a minimum, the PJ may require the loan to be brought current to the date of the sale. For example, consider the case where a PJ provides a loan of $100,000 with the understanding that it would be repaid over 20 years, with principal payments of $5,000 if there is surplus cash flow. If there is no cash flow, the payment is deferred. In year 10 the property is sold. The PJ has been repaid $25,000 through year 10 and has deferred $25,000. A sale occurs and generates net proceeds of $100,000. The PJ may say that the first $25,000 must be paid to bring the HOME note current, and the remaining balance will be paid from future cash flows of the project. The original use agreement stays in force.
- Lien position and payment priority. The PJ typically would not want to allow assumption if the result is that the HOME loan would have a lower lien position and/or a lower position in the cash flow waterfall.
Because assumption decisions typically require case by case judgment, it is difficult to state these sorts of requirements in advance, so it is a best practice for HOME loans to be due on sale, allowing the PJ to later negotiate transaction-specific terms.
Similar issues arise with respect to refinancing. LIHTC project owners often ask for the right to refinance the first mortgage without requiring any payment on the HOME loan. PJs typically are reluctant to agree to such a request in advance. However, if the proposed first mortgage term is shorter than the term of the proposed HOME loan, the PJ and owner should discuss what happens when the first mortgage either has to be refinanced or is paid off.
Issues that may come up regarding a potential future refinancing include:
- First mortgage loan amount. Typically the PJ does not want the new first mortgage amount to be higher than the amount being refinanced, but the LIHTC owner will want the opposite result.
- First mortgage loan payment. Similarly, the PJ generally does not want the new first mortgage payment to increase because it decreases the amount of cash flow available for repayments on the HOME loan, and the LIHTC owner is likely to have an opposite motivation.
- Equity pay-out. Typically, the PJ wants a portion of any net refinancing proceeds to be paid toward the HOME loan. The LIHTC project sponsor wants any such payment to be as small as possible.
- Affordability. The PJ may want a commitment to longer and/or deeper affordability as a condition of refinancing, especially if there will be an equity pay-out.
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