02

                                                             “The Loan to Value is How High?”
                                     Underwriting Multifamily Assets in a 501(c)(3) Non-profit Framework

                Introduction

     Underwriting the municipal bond financing of real estate assets in general, and multifamily rental assets in particular, has long troubled the lending and investing communities. Differing forms of public subsidies, beyond the interest rate benefit afforded by tax exempt financing, carry their own benefits and drawbacks. Such subsidies as low income housing tax credits and non-profit ad valorem tax abatements for example, often cause lenders to have to ask more questions than is usual. As a matter of fact, these differing ‘subsidies’ can result in unexpected loan to value levels and debt service coverage ratios, depending on how the underlying project is capitalized.

            Loan to Value-What does it mean?

    In a municipal bond framework, higher loan to value ratios (the amount of project debt divided by the underlying asset value) lose some of their significance when compared to a conventional financing scenario. Generally, underlying project loan to value ratios are important considerations when determining whether or not a lender can get out of financing at the loan balloon maturity date. The lower the loan to value, the easier it is to set a shorter note date (7-10 years,) and the easier it is to obtain sufficient proceeds at a sale to pay off the existing financing.

     However, in the tax exempt market, most debt is very long term (30 years) and there are fewer incentives for borrowers to prepay their debt prior to maturity. Consequently, the only time the loan to value ratio comes into consideration is in a default scenario, when one needs to realize a certain proceeds level from a sale of the project.

           Public Subsidies-When upfront equity does not necessarily help and the asset’s illiquid status could be a good thing.

     The primary forms of tax exempt financing for multifamily assets in the past decade have been new or rehabbed properties financed through the low income housing tax credit, as well as existing properties financed with non-AMT bonds that include 501(c)3 non-profit ownership. While tax credits may provide upfront equity (usually 30% of total project cost,) the cash return on equity is usually not the main economic goal, and the equity investors do not have real estate expertise. Most importantly, the use of tax credit equity limits the amount of rent that can be charged for a particular unit. Consequently restrictions on how much rent can be paid (a use restricted property) will directly affect the economic viability of a tax credit property.

      In contrast, a non-for-profit financing, which may have more overall debt, is not as severely rent restricted. In addition, in a variety of local jurisdictions, a project may be eligible to receive property tax abatements to some level (75% in Florida, 100% in some locales in Texas.) Since it is true that the bonds and the tax abatements come about solely by virtue of the non-profit ownership, the property being financed is an ownership restricted property. So with this kind of financing, the illiquidity of the asset is offset by improved operating margins.

      Below is a hypothetical comparison of the LTVR and debt service coverage margins for a 300 unit, all two-bedroom apartment project in San Antonio.

As illustrated above, an initial equity infusion does not give an investor a better loan. Even without any tax relief, the loan to value level is slightly lower and coverage is better under the non-profit scenario. This is true even though the non-profit financing provides $12,000 more in debt per unit. Finally, even though the foreclosure of a non-profit property brings the inevitable whole loan creditor risk, foreclosure in tax credit deals can raise re-issuance and re-syndication risks that are virtually untested in the municipal market.

   What does it all mean: do we just throw up our hands?

   Well no, you don’t throw up your hands. All this means is that at the end of the day, cash flow is king! Investors need to look more deeply into the underlying economics of a project and the specific market in which it is located. While high income and expensive markets may benefit from tax credit ‘affordability’ deals, less expensive markets (where there is a lot of population growth,) may benefit from non-profit ‘preservation’ deals.

   In the case of San Antonio, which was the second fastest growing MSA last year, a deal which raises much more debt per unit, may in fact be a better deal. The bottom line is that while important, the LTVR is not as integral a component to real estate underwriting in the municipal market as it is in the shorter term conventional market. And even if the cap rate for the non-profit scenario was higher, and the LTVR was higher, the non-profit still provides 54% more net operating income than does the more severely use restricted tax credit deal. Consequently, in at least lower-income, fast growth markets, debt service coverage is the more important measure of anticipated property performance.

Peter Fugiel ©May, 2002