IV. What Are Key Risks and Regulatory Issues Associated With LIHTCs?
Banks active in the LIHTC business initially review these investments as commercial real estate transactions. Once a bank is satisfied with its normal due diligence of the transaction, it needs to be comfortable with this transaction as a long-term investment.
While investing in LIHTCs has benefits, there are risks that need to be identified and understood. Careful planning, selection of good partners, and diligent oversight can help banks mitigate risks.
Banks have responsibilities as investors in these projects. LIHTC projects and syndicated funds often have minimum investment thresholds that can present barriers for some banks. Pledged funds must be available when needed. In some cases, additional unscheduled capital calls may be required to address problems with certain properties.
Investors need to be aware of the processes for project selection and ongoing operating oversight. The LIHTC program is intended to meet public goals. Bank investors can face reputational risk when those public goals are poorly or unsuccessfully met.
The potential loss of the tax credit and recapture by the IRS represent significant risks to bank investors. Tax credits are available to investors when projects provide affordable housing to qualifying low-income tenants. The projects must be built within specified periods, operated with financial and operational discipline, and according to regulatory requirements over the 15-year compliance period. Because the tax credits are available over extended periods, bank investors must be able to project taxable income and losses over the term of the investment.
Tax credits are recaptured if a project does not lease its minimum set-aside of low-income rental units to income-qualified tenants at affordable rents during the 15-year compliance period. The amount of the recapture is based on the prior LIHTCs claimed by the bank investor and the time elapsed since the tax credits were first claimed. 48 Once the 15-year compliance period is over, the IRS cannot recapture the tax credits and the bank investors often exit the LIHTC partnership.49
Banks have several choices when making LIHTC investments, including multi-investor funds, specialized funds, private-label funds, and direct investments.50 The choice of investment method depends on numerous factors, including the amount of the investment, the bank’s internal capacity, and the costs of risk mitigation. LIHTC investment funds involve syndicators that specialize in managing the process of acquiring and overseeing LIHTC projects. Syndicators can offer specialized expertise in understanding affordable housing markets, working with nonprofit and for-profit developers and addressing any problems that arise. Multi-investor and specialized funds can spread risk across multiple investors and projects.
Assessing a Bank Investor’s Needs and Capacities
Banks considering investing in LIHTCs must assess their internal needs and capacities. This assessment starts with a careful review of projected tax needs. To realize the financial benefit of the tax credits, the bank investor needs to have a sufficient federal tax liability for at least 10 to 12 years. LIHTC program regulations allow some flexibility if an investor’s tax needs are not uniform. LIHTCs can be carried forward or back, with limitations,51 although this can affect the investor’s rate of return. While there is no organized secondary market for LIHTC investments, an investor may transfer a partnership interest to another investor, assuming an investor can be found. Some multi- investor funds offer mechanisms for one investor’s shares in a fund to be sold to other investors in the fund.
Banks also should review their needs with respect to CRA consideration. 52
Banks considering investments in LIHTCs should take into account their internal capacities. Direct investors should thoroughly understand the LIHTC program, real estate development, and the market for affordable housing in their areas. Investors in LIHTC funds should have sufficient capacity to choose a syndicator, oversee their investments, and understand the basic requirements of the LIHTC program.
Required Investment Management Capacities
Managing risk in LIHTC investments requires expertise and capacity in selecting projects and partners, negotiating agreements, overseeing project development and operations, and ensuring compliance. For banks that are direct investors, these duties often are handled internally. In LIHTC funds, syndicators assist bank investors with these duties.
The general partner of the LIHTC partnership plays a key role in the investment decision. The investor is entering into a 15-year partnership with the general partner, and it is important that the general partner has the capacity and expertise to develop and manage LIHTC properties throughout the life of the investment. The general partner should have a demonstrated track record of successfully developing and managing affordable housing. The general partner should also have the financial capacity to address problems as they arise and depth of expertise to weather staff turnover. Nonprofit general partners, which seldom have significant internal financial resources, may demonstrate an ability to draw on public or philanthropic resources, if needed.53 The general partner must put together strong development teams and should demonstrate the capacity to comply with any regulatory requirements that could affect the flow of tax credits to investors.
LIHTC projects can require special underwriting considerations for loans or investments.54 Affordable rent restrictions and tenant income thresholds affect the size of available markets for the units; the cash flow available to cover expenses, fund reserves, and service debt; and the “as is” appraised value of the properties at completion. In higher-cost areas, public entities may be important partners by contributing soft debt to the financing packages to address market uncertainties, or by pledging tenant income subsidies that allow the projects to reach broader markets of tenants. Direct investors should investigate the likelihood that the LIHTCs will flow in the amounts projected and will not be recaptured during the 15-year compliance period.55
Syndicators play a key role in LIHTC funds. Investors should perform document reviews of the syndicators and assess their track records. Investors often gather information on the syndicators’ management teams, organizational structures, and key capacities. Audited and current unaudited financial statements should be reviewed. Bank investors should understand the syndicators’ ability to find and underwrite quality deals in the bank investor’s AA, oversight of projects during construction and lease-up, asset management capabilities (including the ability to address problem properties), and the ability to comply with rule and reporting requirements. Investors should understand the syndicators’ process of communicating property performance with investors.56
Coming out of the financial crisis, there has been a greater interest in understanding the sustainability of syndicators. At issue is whether the syndicator has sufficient resources to continue to operate and manage an existing portfolio of LIHTC properties if the syndicator no longer has new projects (and one-time fees) coming into the fund. Several syndicators reported preparing annual sustainability strategies to address these concerns.57
Syndicators often include the underwriting guidelines used for the acquisition of investments in the fund offering documents. These guidelines may include minimum rates of return, debt coverage ratios, and reserves. In some cases, syndicators may be required to inform investors of deviations from these guidelines.
Direct investors—or syndicators, in the case of LIHTC funds—are responsible for negotiating rights and responsibilities in the partnership agreement with the general partner. These agreements specify developer guarantees, fee schedules, and reserve requirements. Developers and general partners provide investors with completion, operating, and tax delivery guarantees to mitigate the risk associated with investing in LIHTCs.
An unconditional guarantee of construction completion is the most important factor because an unfinished project cannot produce tax credits. Investors and construction lenders contract with an independent construction inspector to monitor progress and ensure completion in accordance with LIHTC program requirements. Reporting requirements can help mitigate risks, especially reports on any actions or circumstances that affect the value of the asset or the flow of credits to the investors. Investors should be informed of and approve any changes in the development plan or the financing of the project. Investors should be promptly informed of any compliance issues.
Investors should engage legal counsel to review the fund partnership agreement. In addition to the representations and warranties, investors should carefully review the acquisition underwriting guidelines, the reporting requirements, and the controls that the syndicator has over the general partner. The syndicator should be required to approve any actions that can affect the flow of credits to the investor or that affect financing of the property. In addition, the syndicator should be able to change the general partner or the property manager if there is sufficient cause to warrant the action. Investors may also want to consider the protocols on the use of fund-level reserves, including limits on the reserves that syndicators can devote to individual projects.
Most large investors and syndicators maintain extensive asset management and compliance departments. They are particularly diligent during the construction and lease- up period, when the project is most at risk. Investors receive at least quarterly reports on the performance of the projects and review performance metrics such as occupancy levels, debt coverage ratios, cash flows, and compliance levels. Asset management teams perform regular site visits to review the physical properties and the project sponsor’s compliance documentation. Portfolio investors and syndicators maintain a watch list of problem properties and institute workout strategies for those that are not performing to industry standards.58
Public Welfare Investments
National banks: Under the OCC’s public welfare investment (PWI) authority, national banks may make investments in federal LIHTCs and other community and economic development entities and projects that are designed primarily to promote the public welfare, as specified in 12 USC 24(Eleventh) and federal regulation 12 CFR 24.
Regulation 12 CFR 24 specifies that a national bank or national bank subsidiary may invest directly or indirectly if the investment primarily benefits low- and moderate- income (LMI) individuals, LMI areas, or other areas targeted by a governmental entity for redevelopment, or if the investment would receive consideration as a “qualified investment” under 12 CFR 25.23 of the CRA. Because LIHTC investments generally meet these criteria, they are considered eligible investments pursuant to PWI regulations.
The regulation prohibits a bank’s aggregate PWIs and outstanding commitments, including the proposed investment, from exceeding 15 percent of its capital and surplus. A bank needs written OCC permission, however, if its aggregate investments exceed 5 percent of capital and surplus. Furthermore, a bank’s LIHTC and other PWIs under 12 CFR 24 may not expose the bank to unlimited liability. 59
The regulation requires banks to notify the OCC either through an after-the-fact notification or prior approval request process. The bank completes the CD-1–National Bank Community Development (Part 24) Investments60 form to provide information about its PWI investment and submits this information to the OCC’s Community Affairs Department.61
Federal savings associations (FSA): FSAs may make investments in LIHTCs under PWI authorities separate but similar to those of banks.62
Under current generally accepted accounting principles, a bank that invests in a qualified affordable housing project (LIHTC project or syndicated LIHTC funds) through a limited partnership investment may account for such investments using one of three primary methods of accounting. The options are: (1) the cost method when significant influence is not present, (2) the equity method when there is significant influence; or (3) the effective yield method when certain conditions are met.63 In addition, the Financial Accounting Standards Board’s (FASB) Emerging Issues Task Force (EITF) reached a final consensus related to LIHTC investments on November 14, 2013. The EITF’s decision allows an institution to make an accounting policy election to apply a proportional amortization method when certain conditions are met. Guidance was issued in January 2014.64 The effective yield method will be allowed only for investments previously accounted for using the effective yield method.
The equity method is currently the most predominant method used for qualified affordable housing projects.65
Effective Yield Method
The effective yield method has been preferable for some investors. The effective yield is the internal rate of return on the investment, based on the cost of the investment and the guaranteed tax credits allocated to the investor. Under the effective yield method, the investor recognizes tax credits as they are allocated and amortizes the initial costs of the investment to provide a constant effective yield over the period that tax credits are allocated to investors. The tax credits are recorded as a reduction of income tax expense, and the amount invested to purchase the credits is recorded as amortization expense.
Because both the expense and benefit of the credits are recognized “below the line,” the risk of distorting operating performance metrics (such as “earnings before interest, taxes, depreciation, and amortization”) are reduced.
To qualify for the use of the effective yield method, however, an investor must currently meet all of the following conditions under FASB ASC 323-740-25-1:
- The availability (but not necessary the realization) of the tax credits allocable to the investor is guaranteed by a creditworthy entity through a letter of credit, a tax indemnity agreement, or another similar agreement.
- The investor’s projected yield based solely on the cash flows from the guaranteed tax credit is positive.
- The investor is a limited partner in the qualified affordable housing project (the LIHTC project or syndicated LIHTC fund) for both legal and tax purposes and the investor’s liability is limited to its capital investment.
Proportional Amortization Method
The EITF’s recent decision allows a bank with LIHTC investments to make an accounting policy election to apply a proportional amortization method when certain conditions are met. An entity must meet all of the following conditions to elect the proportional amortization method:
- It is probable that the tax credits allocable to the investor will be available.
- The investor does not have the ability to exercise significant influence over the operating and financial policies of the limited liability entity, and substantially all of the projected benefits are from tax credits and other tax benefits.
- The investor’s projected yield, based solely on the cash flows from the tax credits and other tax benefits, is positive.
- The investor is a limited liability investor in the limited liability entity for both legal and tax purposes, and the investor’s liability is limited to its capital investment.
The new accounting guidance should be applied retrospectively to all periods presented when adopted. A reporting entity that uses the effective yield method to account for its investments in qualified affordable housing projects before the date of adoption may continue to apply the effective yield method for those preexisting investments. The new accounting guidance is effective for public business entities for annual periods and interim reporting periods within those annual periods, beginning after December 15, 2014. For all entities other than public business entities, the amendments are effective for annual periods beginning after December 15, 2014, and interim periods within annual reporting periods beginning after December 15, 2015. Early adoption is permitted.66
Capital Treatment for LIHTC Investments
National banks and FSAs are subject to minimum risk-based capital requirements calculated under either the general risk-based capital rules or the advanced approaches rules. Under the general risk-based capital rules for national banks, LIHTC investments are risk-weighted at 100 percent. For national banks and FSAs subject to the advance approaches (Basel II rules), investments in LIHTC partnerships are treated as “equity exposures.” Community development67 “equity exposures” are assigned a 100 percent risk weight.
Under Basel III rules, as long as investments in LIHTCs are considered equity exposures and they meet the definition of community development equity exposures, they receive 100 percent weight.68
48 See 26 IRC 42(j)(1-3), which provides detailed information about the calculation of recaptured tax credits plus interest for the 15-year period of compliance. See 26 IRC 42(j)(6)(A) for a description of conditions pursuant to which liability may be discharged through the posting of a bond.
49 While there are not consequences for the original investor after the 15-year compliance period, the owner of the property is subject to legal action by the HCA in the event of noncompliance.
50 Smith, David A., Vehicles, Drivers, and Road Maps, National Affordable Housing Management Association News, January/February 2011, www.recapadvisors.com/wp-content/uploads/2013/11/NAHMA_News_Smith_vehicles_and_ drivers_Feb_2011_1102.pdf.
51 See 26 IRC 42(j)(4)(A) for information on allowing LIHTC benefits to be carried back one year and carried forward 20 years.
52 For a variety of resources designed to help banks understand CRA requirements, see www.occ.gov/topics/compliance- bsa/cra/index-cra.html.
53 Werwath, Peter, Financial Underwriting of Low-Income Housing Tax Credit Projects, Enterprise Community Partners, 2007, www.enterprisecommunity.com/resources/ResourceDetails?ID=19410.doc.
54 Various underwriting guidelines are available publicly. For example, see Affordable Housing Investor Council’s AHIC Underwriting Guidelines, www.ahic.org/tools-resources/.
55 Werwath, Peter, Financial Underwriting of Low-Income Housing Tax Credit Projects, Enterprise Community Partners, 2007, www.practitionerresources.org/showdoc.html?id=19636&topic=Housing%20Development%20 Process&doctype=Spreadsheet.
56 Increasingly, syndicators are posting property information securely online, so investors have instant access to up-to-date information.
57 If a syndicator is unable to perform its duties, the investors have the ability to replace the syndicator with another third party. This process involves the time and transaction costs of finding and underwriting an appropriate third party and executing the required legal documents.
58 The Affordable Housing Investors Council has published criteria in an effort to establish generally accepted performance standards for the LIHTC industry. Standards have been established for debt coverage ratio, vacancy levels, delinquency rates, and more than 20 other categories. See www.ahic.org/tools-resources/.
59 12 CFR 24.4(b).
61 Each national bank making a PWI under 12 CFR 24 is required to maintain in its files information adequate to demonstrate that its investments meet the public welfare beneficiary standards and investment limit requirements.
62 FSAs are permitted to make PWIs, although FSAs are subject to different investment standards and limits than national banks, 12 CFR 160.36 and 12 CFR 559; see Office of Thrift Supervision, Community Development Investment Authority: A Guide to the Federal Laws and Regulations Governing Community Development Activities of Savings Associations, December 1998, www.occ.gov/topics/community-affairs/resource-directories/public-welfare-investments/federal-savings- association-investment-authorities.html.
63 See the call report instructions under Equity Method of Accounting and Subsidiaries section for a more detailed discussion of these accounting methods.
64 See FASB’s Accounting Standards Update 2014-01.
65 Per ASC 970-323, “Real Estate Investments–Equity Method and Joint Ventures,” the equity method of accounting for investments in general partnerships is generally appropriate for accounting by limited partners for their investments in limited partnerships. A limited partner’s interest may be so minor that the limited partner may have virtually no influence over partnership operating and financial policies. Such a limited partner is, in substance, in the same position with respect to the investment as an investor that owns a minor common stock interest in a corporation, and, accordingly, accounting for the investment using the cost method may be appropriate.
66 See FASB’s EITF, Proposed Accounting Standards Update–Investments–Equity Method and Joint Ventures (Topic 323), and Accounting for Investments in Qualified Affordable Housing Projects, April 17, 2013.
67 A community development equity exposure is defined as an equity exposure that qualifies as a community development investment under 12 USC 24(Eleventh), excluding investments in a small business investment company. The risk-based treatment under the advanced approaches rules is found at 12 CFR 3, appendix C, 52(b)(3).
68 12 CFR 3.52(b)(3)(i); Regulatory Capital Rules: Regulatory Capital, Implementation of Basel III, Capital Adequacy, Transition Provisions, Prompt Corrective Action, Standardized Approach for Risk-weighted Assets, Market Discipline and Disclosure Requirements, Advanced Approaches Risk-Based Capital Rule, and Market Risk Capital Rule , Fed. Reg., vol. 78, no. 198, October 11, 2013.
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