Mixing 4% and 9% LIHTCs

10 min read

Projects fill holes in budget by using both credits

The end of 2016 brought both good news and bad news for affordable housing developer the Pacific Companies.

First the good news: Bow Street Apartments, its plan to build 98 affordable apartments in Elk Grove, CA, won a reservation of hard-to-get federal Low Income Housing Tax Credits (LIHTCS).

The bad news is that the month before, prices for LIHTCs had dropped sharply.

“A big, $2 million gap opened in the construction budget for our deal,” says Caleb Roope, founder and CEO of the Pacific Companies, based in Boise, ID.

Fortunately, developers, like TPC, have found a solution. Many affordable housing projects across the country are now struggling to fill deep holes in their construction budgets, often created by falling tax credit prices. There are several examples of developers over the years that have solved budget problems by bringing both kinds of federal LIHTCs to their projects – competitive nine percent LIHTCs and the four percent LIHTCs that come with tax-exempt bond financing.

These deals are very complicated – and might not work for every project. However, this structure has helped, and officials in states, like Virginia and California, now encourage developers to mix LIHTCs in this way.

Celadon at Ninth and Broadway mixes LIHTCs in the same building
In the aftermath of the Global Financial Crisis, BRIDGE Housing used four percent and nine percent LIHTCs to finance different parts of its 17-story apartment tower in San Diego, CA.

Like the Pacific Companies’ Bow Street plan, BRIDGE’s plan to finance Celadon at Ninth & Broadway had also suffered a heavy blow to its construction budget.

The innovative project would bring micro-apartments to the valuable site. It includes 250 affordable apartments, with 143 averaging 335 square feet in size, in addition to more conventional studios and one-bedroom apartments.

The nonprofit developer won the site in 2009 in a city competition to find a new use for a downtown parking lot where a scheme to build luxury condominiums had failed.

BRIDGE planned to pay the high cost of high-rise construction with tax-exempt bond financing and equity from four percent LIHTCs, in addition to $21.7 million in soft financing from the California redevelopment agencies through the City of San Diego, in one of the last deals made before those redevelopment agencies closed.

That financing plan worked when BRIDGE wrote it – but by the time BRIDGE controlled the site, the financial crisis was in full swing. Prices for LIHTCs collapsed. That opened a deep hole in the project’s budget.

BRIDGE could not fill the gap by simply switching to nine percent LIHTCs, which provide more subsidy dollars per apartment. Most states resist reserving too much of their competitive nine percent LIHTCs on one development. In California, developers cannot attempt to finance more than 150 units of affordable housing with a single reservation of nine percent LIHTCs.

Instead, BRIDGE used both four percent and nine percent LIHTCs to build the $74.6 million tower, which is split into two separate ownership entities, or condominiums.

For the most part, the apartments are divided up neatly by floor. The 129 apartments on floors two through seven are in the nine percent LIHTC part of the building. The other 121 apartments on floors eight through 17 are in the four percent LIHTC part of the building.

Separating the areas outside the apartments – both physically and legally into the two separate ownership entities – was the most difficult part of the deal.

That’s because only certain construction costs can be used to generate LIHTCs. Any part of the Celadon used by both the four percent LIHTC and the nine percent LIHTC parts of the building cannot be counted by either as “eligible basis” for generating LIHTCs.

That meant the shared lobby space on the first floor didn’t generate any tax credits. Neither did the management offices on the first floor.

The elevators could generate tax credits, however. They are neatly divided between the two separate projects, since they serve different floors of the building.

The two parts of the tower also need to be separated so that even if one of the sides is seized in a foreclosure, both sides can still operate – even though the plan is for BRIDGE to manage both sides of the building. The legal agreements for the building explicitly lay out how each condominium contributes to the cost of operating the building and the rights each owner and manager would have to use any shared spaces.

The two ownership structures also doubled the complexity of the construction process.

“I had two general contractor contracts… two sets of audits…two construction draws every month,” says Aruna Doddapaneni, director of development for BRIDGE Housing. “The biggest challenge was getting everyone to work together.”

It helped with the financing that a single investor, U.S. Bancorp Community Development Corporation, provided both debt and equity to both sides of the project. “I can’t imagine having two separate investors,” says Doddapaneni.

The tower opened in April 2015 and was fully leased by December.

“Nobody ever would have thought we could do a nine percent and four percent project, but look – we made it work,” says Doddapaneni.

Higher interest rates stress residences at Government Center
These complicated deals have also worked on the other side of the country.

In 2013, Stratford Capital Group Development (SCG), based in Vienna, VA, and its partner Jefferson Development, had gone a long way towards starting construction on 270 affordable apartments at Residences at Government Center in Fairfax, VA.

Local officials had already granted all the zoning approvals the project would need, in addition to providing the prime, nine-acre site. Low-interest, tax-exempt bond financing and the equity from four percent LIHTCs would cover most of the development cost.

“Historically low, long-term bond interest rates allowed us to pursue the transaction,” says Stephen Wilson, president and principal for SCG.

But those low-interest rates couldn’t last forever. In late spring 2013, Federal Reserve chief Ben Bernanke said but a few words on the outlook for interest rates. The bond markets responded immediately, and long-term interest rates rose nearly 100 basis points.

Suddenly, the tax-exempt bond loan for the development was much smaller – because the community would not be able to support the monthly payments on a larger loan at the new, higher interest rates.

“Our deal quickly became unfeasible,” says Wilson. “We had to figure out a different way to get this done.”

Like at the Celadon, simply financing the entire 270-unit development with nine percent LIHTCs would not work. Virginia state officials were unlikely to reserve so many nine percent LIHTCs to a single property, even though the state rules would technically allow it.

“It would have taken the whole new construction pool for Northern Virginia,” says Wilson. “I wasn’t willing to go for the whole nine percent pool and risk failing and having to wait another year.”

Instead SCG came up with a plan to mix nine percent and four percent LIHTCs. It divided the $59.5 million development into two parts, one $34.8 million segment with 150 apartments financed with nine percent LIHTCs and a second $24.6 million segment with 120 apartments paid for with tax-exempt bond financing and four percent LIHTCs.

State officials rewarded the developers for using this complicated structure with extra points in the tough competition for nine percent LIHTCs. “The state’s qualified allocation plan had substantial points for submitting under this structure,” says Wilson.

Both parts of the development took out mortgages through the Federal Housing Administration’s 221(d)(4) program.

“The most challenging part of the transaction was the lender – they need to be sure their collateral was secure,” says Wilson. “They wanted to be sure they could foreclose on either part of the property if necessary, and could operate, re-market and sell either piece.”

Once again, that meant cleanly separating the two parts of the development. SCG hired an independent management group to operate both parts of the community. “They would be able to manage for two different owners, if necessary,” says Wilson.

SCG also separated its ground lease on the site into two pieces. “It gave everyone more comfort that it is two separate deals,” says Wilson.

Low LIHTC prices threaten Bow Street Apartments
At Bow Street, the Pacific Companies faced another deep gap in its construction budget. But unlike at the Celadon or Government Center, the project already had the benefit of nine percent LIHTCs and the rich stream of subsidy provided by those tax credits.

However, the developer could still benefit by mixing four percent LIHTCs into the deal. That’s because the original financing plan for Bow Street would not have used all of the construction costs that could have counted as “eligible basis” to generate LIHTCs. California, like many states, rewards applications to develop affordable housing projects that use fewer tax credits per apartment and mix in funding from other sources, like local soft financing sources.

At Bow Street, the developers had applied for and won a reservation of nine percent LIHTCs equal to $15 million in tax credits. But the total development cost of $30 million for Bow Street included costs that could have generated a lot more tax credits.

“We had $9.9 million in excess basis on our project,” says Roope. “In California, the LIHTC program scoring effectively requires projects to have excess basis…it favors you if you ask for fewer tax credits.”

When tax credit prices fell at the end of 2016, the Pacific Companies tapped that unused eligible basis to bring a fresh infusion of tax-exempt bond financing and four percent LIHTCs to its plan for Bow Street.

Once again, mixing different kinds of LIHTCs required the Pacific Companies to split Bow Street into two separate ownership entities: one with 50 affordable apartments financed with nine percent LIHTCs and a second with 48 apartments financed with four percent LIHTCs.

Splitting up the property was relatively simple this time, because the planned community includes several different garden apartment buildings. “We kept entire buildings on the nine percent or four percent sides,” says Roope.

The apartments at Bow Street will be priced to be affordable to residents with incomes ranging from 30 percent to 60 percent of the area median income.

The Pacific Companies concentrated the apartments where it planned to charge the lowest rents in the buildings financed with nine percent LIHTCs. That’s because that part of the project does not have to use its rental income to support a substantial mortgage.

In contrast, the part of the project financed with four percent LIHTCs will have to make payments on a $1.8 million, permanent, tax-exempt mortgage provided by Citi Community Capital. Because the apartment rents in that part of the community are higher, it can support a larger loan, adding about $200,000 to the financing.

The four percent LIHTC side of the project also received most of the soft financing provided by the city of Elk Grove.

“I made the numbers work,” says Roope. The Pacific Companies plans to begin construction at Bow Street in June.