Under most circumstances, commercial real estate development projects are financed via some combination of equity and debt. Lenders and investors will evaluate the merits of the project to determine whether or not it meets their respective criteria. Lenders’ criteria may include metrics such as Loan-to-Value (“LTV”) and Debt Service Coverage (“DSC”) while equity investors are typically more focused on the project’s Risk-Adjusted Return by evaluating the likelihood of achieving a targeted Equity Multiple or Internal Rate of Return (“IRR”).
Often, a prospective development or redevelopment will never come to fruition because the lenders and/or equity investors could not get comfortable that the project would meet their criteria. This can be for many reasons, but typically it boils down to two factors: 1) the project cost is too high and 2) the projected income is too low.
However, sometimes in certain markets development is simply cost-prohibitive because prevailing rental rates in those markets do not justify construction costs. This can result in a shortage of goods and services or housing in that market. New development could breathe life back into neighborhoods or submarkets and ideally spur a new cycle of additional development and economic growth.
This is when New Market Tax Credits (“NMTC”) may come in to play. The NMTC Program was created in 2000 by the Community Renewal Tax Relief Act of 2000. The purpose of the program is to use federal tax incentives to attract private capital into investments in businesses and real estate in urban and rural low-income communities. Eligible communities typically must have a 20% or higher poverty rate or a median income that does not exceed 80% of the statewide median income. Approximately 40% of US communities qualify.
Here is how the program works: The Community Development Financial Institutions Fund (“CDFI Fund”) awards allocation authority to qualified Community Development Entities (“CDEs”) through a competitive process. A CDE will raise capital via Qualified Equity Investment(s) (“QEI”) up to the amount of its authorized allocation and then deploy that capital via flexible or non-traditional financial products that meet community needs. These financial products are known as Qualified Low-Income Community Investments (“QLICI”). Investors who make QEIs will receive a federal tax credit equal to 39% of the QEI, paid out over six years.
In an unleveraged structure, NMTC investor(s) will invest directly via a QEI into the CDE. For every $1 of QEI, the investors will receive $0.39 in federal tax credits, paid out over six years. Additionally, the CDE will typically earn an interest rate and/or equity participation on their QLICI.
In a leveraged structure, the NMTC investor(s) will not invest directly in the CDE. Instead, they will invest in a leveraged fund, and that fund will make the QEI into the CDE. For example, the NMTC investors make a $2.5MM equity investment into the fund alongside a $7.5MM loan from a Leverage Lender. The fund will make a $10MM QEI into the CDE, and the NMTC equity investors will receive the 39% tax credit on the entire $10MM QEI. Now, instead of the NMTC investors earning $0.39 for every $1 invested, they will now earn $0.39 for every $0.25 invested. Under this structure, the CDE will fund the project via an ‘A’ note and a ‘B’ note. The ‘A’ note will match the loan amount and the terms of the leverage loan while the ‘B’ note mirrors the tax credit equity net of fees and effectively becomes a subsidy to the project.
As you can see, New Market Tax Credits can be a very powerful financing tool. However, NMTCs do come with some caveats. First and foremost, all QLICIs will be subject to a “but for” test. Essentially, the project must not have been feasible but for the NMTC in order to receive the QLICI. Second, all projects that utilize NMTCs will have a minimum hold period of seven years. QLICIs are continuously monitored to ensure that the QEIs are compliant with NMTC regulations during the entire seven-year compliance period. If they are not compliant, all previously issued NMTCs are subject to recapture. Finally, NMTC transactions tend to come with substantial transactional fees. CDE fees, legal fees, consulting fees, lender fees, etc. can pile up quickly and erode part of the economic benefit gained from the NMTC.
At Metropolitan Capital Advisors (“MCA”), we advise our clients on evaluating the benefits and tradeoffs of utilizing NMTCs and help them to make informed decisions. If you are working on a transaction that may qualify for New Market Tax Credits, contact one of our team members or email Brandon Wilhite at firstname.lastname@example.org.