UNDERWRITING RENTAL HOUSING REAL ESTATE FOR                                             TAX EXEMPT INVESTING. SOME KEY BUSINESS CONCEPTS USE (INCOME) RESTRICTED PROPERTY: An apartment building whose owner must rent a certain percent of the units to households below the area median income . Depending upon the public policy that sets the restrictions, and depending upon the local market, income restrictions can be relatively unimportant, or they can impose serious, long term economic conditions on a property. All buildings financed with municipal bonds must rent at least a portion of their apartments to households that earn below-median incomes. Whether or not restrictions on tenant income actually result in a reduction on a development’s income, should be a key issue in lender underwriting of any property which has such restrictions. OWNER RESTRICTED PROPERTY:  Under provision of the federal tax code as it governs tax exempt financing, any rental housing development which is currently owned by a  non-for-profit entity can be sold only to another non-for-profit entity, in order to maintain the tax exemption. . Such a requirement restricts the marketability of a property, and it can affect the ability to foreclose on an owner-restricted property. CAP(ITALIZATION)  RATE:   A rate of return used to derive the capital value of an income stream. The formula for Value is: Annual Income divided by the Capitalization  Rate.  Cap rates during the 2001-2002 low in the interest rate cycle have been in the 8.5%-10% range.  Hence, a development with a net operating income of $950,000 and a 9.5% cap rate is worth ten million dollars. FAVORABLE FINANCING:  Debt which adds value to a property due to the longer term on the loan,  below market interest cost (compared to conventional rates), or both.  Although the amortization of conventional loans for apartment properties is usually thirty years, the loan term seldom extends beyond ten years.. PROPERTY TAX ABATEMENTS:  State or local property tax provisions which allow favorable tax status to apartment developments owned by non for profit entities. In many jurisdictions. state property tax abatements are substituted by an arrangement with local tax officials which is called a payment in lieu of taxes, or PILOT. APPRAISAL :  A written explanation of a  property’s value, which takes into account such concepts as property type, location and condition, net operating income, both trailing and in previous years, and the appropriate cap rate. Since the use of a market-based cap rate usually does not include such issues as tenant income and ownership  restrictions, nor it is expected to reflect the presence of favorable financing and tax abatements, some appraisals rendered specifically when tax exempt financing is involved, will include a value based on:: “favorable financing.” Most appraisals however, do not. NET OPERATING INCOME:  Income from property after operating expenses have been deducted, but before deducting taxes and financing expenses. TRAILING 12:  The net operating income of a property within the last twelve months for which operating information is available. COVERAGE RATIO:   The number of times the debt service cost for a financing is ‘covered’ by the net operating income produced by the facility. PROPERTY NEEDS ASSESSMENT:  A written analysis of a property’s current physical condition, which includes an estimate of the current and future  capital finance needs of a specific  property.  This study is sometimes called an engineer’s report. RESERVE FOR REPLACEMENTS:  The requirements established at the time of financing that sets up the amount of funds needed for the routine and extraordinary maintenance and repair of a rental development.  Usually the requirement is calculated as a set dollar amount for each year, on an annual basis (Per Unit Per Year, or PUPY.)The standard used for properties financed in the municipal market has been $250. LOAN TO VALUE RATIO (LTVR) :  The portion of the amount borrowed compared to the cost or value of the property being financed. This ratio is a standard, and key,  underwriting benchmark for conventional lenders of rental housing real estate.  Hence $9 million loan on a development appraised at $10, creates a loan to value of 90%, which is a standard conventional industry lending benchmark. LOAN TO VALUE FOR TAX EXEMPT MARKET LOANS:  Due to the significance of other lending considerations, such as tenant income restrictions, property ownership restrictions, the presence of favorable financing, and the availability of local tax abatements, reliance upon the loan to value ratio is less determinative. Instead debt service coverage ratios have become more important.  In addition, the “value” component in a loan to value ration depends upon the use of an ‘arms length’ cap rate which is based upon conventional financing terms, which do not factor in tenant use and ownership restrictions. OWNER EQUITY AT THE TIME OF REFINANCING: the amount of accumulated net revenues held in a bond trust estate on behalf of an owner, which can be used to help effectuate the optional refinancing of a property. Such owner equity can in part, can serve as an offset to the relatively low loan to value ratio that exists at the time of the initial financing of a property purchased by a non-for-profit owner. PJ Fugiel © 3/26/02