General Overview of Financing Sources
Soft loans are a source of funding for affordable housing projects. There are a number of federal, state and local government programs which provide such funding for affordable housing. The common characteristics of soft loan financing provided by these governmental programs generally include low interest rates, provisions for subordination to primary financing, provisions for due on sale or refinancing, and loans which are payable, if at all, out of net cash flow (sometimes referred to as "residual receipts," "net operating income," etc.).
Soft loan sources include, but are not limited to, community redevelopment agencies, city housing departments, city and county housing authorities, the Federal Home Loan Bank System (Affordable Housing Program ) and issuers of tax exempt multi-family housing revenue bonds.
Another source of funding is tax credit investor equity. This type of funding, for these projects, is typically raised through the sale of limited partnership interests in the borrowing entity which ownership interest entitles the limited partner to the low income housing credit ("LIHC"). The LIHC is a federal tax credit available each year for ten years to an owner of a newly constructed, acquired or substantially rehabilitated "qualified low income housing project."
There is also conventional financing. A portion of the construction financing for affordable housing projects is typically provided by banks or other financial institutions.
Although the construction lender and other conventional lenders are committed to making affordable housing loans to comply with Community Reinvestment Act ("CRA") requirements, these loans are subject to and must meet the lender's general loan underwriting criteria and due diligence to satisfy regulatory requirements and auditing review standards. Aside from the usual due diligence and underwriting requirements of conventional developer loans, the following factors are relevant:
- Track Record
- Financial Strength
- Appraisal Issues
- Tax Credit Investor Pay-In
- Property Tax Exemption
Because non-profit developers tend to lack a track record, lenders often view non-profit and for-profit developers differently. Non-profits are perceived as committed to ensure long term affordability of projects, but may lack financial depth or a track record.
For-profit developers are sometimes viewed as motivated by short term considerations, but bring considerable construction, development and financial expertise. Lenders also review the track records of the local agencies that provide soft loans, in supporting troubled projects and in performing as a co-lender.
The lack of financial resources and credit support of the non-profit developer, make these loans seen similarly to nonrecourse "project finance" type loans where the only source of repayment is the project and the contracts relating thereto.
The construction loan amount is based on an appraisal of the project cash flow (based on restricted rents) instead of its replacement cost and a valuation of the tax credits applicable to the project. A loan based on appraised value of the real property only would result in a much smaller construction loan and greater need for other "soft loan" funding. The construction lender will value the tax credits and increase the loan amount provided it has adequate assurance of repayment at maturity. The appraisal should indicate that restricted rents are significantly less than market rents for similar units.
Tax Credit Investor Pay-In
Depending on the "track record" and financial strength of the developer, the tax credit investor and the structure and conditions for pay-in of the tax credit investor equity, the lender may consider tax credit equity as a factor in its final determination of the construction loan amount.
Because of the limited financial resources of the borrower, the lender should review, assess and require an assignment of all potential sources of repayment as additional collateral.
Property Tax Exemption
Affordable housing owned by a partnership, the managing general partner of which is a non-profit corporation, will qualify for a property tax exemption under current California law. California Revenue and Tax Code §214(g ).
The residual receipts concept is the most common financing method used to facilitate a low or moderate income housing development. The borrower is required to repay the loan currently only if rents are sufficient to pay all operating expenses, including management fees, and debt service on a first mortgage. If developer equity has been provided the soft lender may share the "residual receipts" with the developer on a pro rata or other negotiated basis.
The loan terms can include restrictive covenants and regulatory agreements in connection with these loans. The soft loan lender will require that affordability covenants or restrictions be recorded against the project for a minimum of 15 years and typically 55 years restricting the type of tenants and rents and income of tenants in the project. Conventional construction lenders will require subordination of affordability restrictions to enhance flexibility following a foreclosure sale. See discussion on subordination below.
Construction Lender Issues
A construction lender will often require a subordination agreement. In order for the construction lender to make more loan funds available and to insure maximum resale flexibility following a foreclosure sale or a deed-in-lieu of foreclosure, the construction lender usually requires subordination of all affordability and eligibility restrictions.
The California Health and Safety Code (CHSC) §33334.3(f) provides that when redevelopment housing funds are used for new construction or substantial rehabilitation, the affordability restrictions apply for the longest feasible time, but not less than the statutory period, which is 15 years for rental units and 10 years for owner occupied units. CHSC §33334.14 permits the local agency to subordinate these restrictions, if the agency has certain specified cure and/or negotiation rights as set forth in the statute.
A subordination agreement executed by the construction lender and all other lending agencies providing financing or recording affordability restrictions on the project, will be required by the construction lender. The subordination agreement will customarily include:
- The agreement that the construction lender's deed of trust is and will remain superior to all junior liens, including affordability restrictions. The relative priority of the various liens and affordability restrictions will be specified.
- An agreement regarding the relative priorities of the debts held by all the lenders. If partial payments will be permitted on subordinate debt before payment in full of the first priority debt, then the terms and conditions should be specified.
- Specific cure and/or negotiation rights with the relevant agency as required by CHSC §33334.14, including, but not limited to, the requirement that the construction lender provide written notice of default to the agency and a specified period from receipt in which to cure, agree to negotiate for such period regarding the default, allow agency the right to purchase the project from the fee owner, and if the agency takes title and cures the default, refrain from accelerating the loan by reason of the transfer of title to the agency.
- An estoppel provision from the agency, fee owner and other lenders that the various loan documents are in full force and effect and there are no defaults thereunder.
When more than one construction or take-out lender is involved, the lenders must work out among themselves the relative priority of their debts and liens and the order in which they are to disburse funds. Where a construction lender and an agency or multiple agencies are involved as construction lenders, the construction lender usually requires that it hold all other funds, or that all other funds be disbursed first to ensure that all funds necessary to complete the project will be available and that the construction lender has control of the remaining sources and application of funds.
Various other issues and procedures remain to be resolved, and are usually set forth in an intercreditor construction agreement between the agency and construction lender. If the tax credit investor is contributing capital during the construction period it may also request to be a party to this agreement. The intercreditor construction agreement will usually include provisions which address the following issues:
- the priority of disbursements among the lenders, which may be on a pro rata basis or require full disbursement by one lender (exclusive of any retention) before funding by the next lender;
- the timing of draw requests;
- the amount of any retention;
- the form of draw requests;
- the relevant inspection period for the disbursing lender and reviewing lenders;
- a mechanism to resolve disputes regarding approval/disapproval of all or a portion of a draw request;
- a procedure for exchange of information among the inspectors for each lender, including waivers by each lender of any reliance on the other lenders' inspector;
- conditions for disbursement of the retention; and
- provisions for direct disbursement of "hard" and "soft" costs.
The construction lender will have received an assignment of the construction contract and architect's contract as partial security for repayment of its construction loan. The construction lender will typically consent to the further assignment of such contracts to the other lenders on a subordinated basis, subject to the conventional lender's prior rights upon any default.
In some cases, the construction lender does not wish to hold and disburse other lenders' fund. In such instance, the parties might disburse separately or utilize a "Fund Control" or independent loan disbursement company to process the draw requests, insure satisfaction of disbursement conditions, receipt of applicable lien waivers and disbursement of all costs. The method for disbursement of the respective loan funds will typically include:
- A requirement that, as a condition to initial disbursement by the construction lender, all other lenders certify that the proceeds of their loans have been fully disbursed (other than the allowable retention)
- Mutual inspection rights and procedures for joint approval of change orders in excess of specified amounts
- An acknowledgment by all construction lenders of the amount of their respective loan obligations and any special conditions to disbursement
- Restrictions on the modification or amendment of any lender's loan documents without the prior consent of all other lenders
Tax Credit Investor - Ownership Structure
The most common ownership vehicle for a low-income housing project is a limited partnership in which the developer (which may include a for-profit and/or a non-profit) is the general partner and the investor is a limited partner. A partnership structure allows the flow-through of the tax benefits to the investor. There has been recent interest in using Limited Liability Companies ("LLCs") which are treated like partnerships for tax purposes. However, LLCs do not work in California if a non profit is involved and a property tax exemption will be sought.
- Investor Structure: Investor structure can vary significantly.
- Single Investor: Certain corporations have established direct LIHC investment programs. These corporate investors may invest directly in the project partnership or may invest through a special purpose subsidiary to provide additional liability protection.
- Corporate Fund: A number of corporate funds have been established to acquire LIHC. These funds range in size from $10M to 100+M, with most funds in the $50M range.
- Partnership structure: Usually corporate fund is structured as limited partnership with "Sponsor"/ "Syndicator" as general partner and corporate investors as limited partners.
- Sponsor identity: Some sponsors, or their affiliates, are very strong financial entities. Other sponsors are financially limited.
- Number of investors: Most corporate funds usually have between five and ten corporate investors.
Must funds are established to make multiple investments. Usually the LIHC projects are not specifically designated. The fund documents may establish parameters for investment that sponsors must meet. In certain cases investors must consent to each project investment.
Corporate funds differ significantly in the pay-in structure utilized. The pay-in structure is heavily influenced by the impact of the pay-in on the corporate investor - Internal Rate of Return (IRR).
- Corporate investor makes full cash capital contribution to corporate fund at inception (not common).
- Corporate investor gives marketable promissory note for full capital contribution at inception. Corporate fund "sells" the notes.
- Corporate investor is subject to capital call. Can be structured as periodic capital call (i.e. quarterly) or specified notice (i.e. 10 days' notice).
Lender Issues - Structure of Owner/Investor
In the case of a single investor, a lender can analyze the credit risk of that investor. In the case of a corporate fund, a lender must analyze the status of the fund (does it have all of the investors committed), the structure of the investors' capital contributions (notes, cash, capital call), the liability and credit of the sponsor/general partner and the credit of each investor to the fund.
The timing, structure of, and conditions to the investor's obligation to contribute capital to the project partnership will affect the construction lender's collateral package and its underwriting of the construction loan. Usually, the investors make their investment in several installments, with each installment subject to the satisfaction of certain conditions precedent.
The threshold issue is whether the investor will put in substantial capital during construction. If substantial investor capital is contributed during construction, the construction risk is decreased and arguably the investor will be more likely to step in to cure borrower defaults to avoid losing its equity in the project and tax benefits.
Generally, an investor will make a portion of its capital contribution at the completion of the construction of the Project. An investor may also require a Form 8609 and/or permanent loan closing, although these are sometimes required at a later installment.
Generally, an investor will make another capital contribution installment based on the project achieving some type of lease-up, occupancy, and/or NOI requirements. A Form 8609 and permanent loan closing may also be required at this installment.
If little or no investor capital is contributed during construction, the construction lender must make a closer evaluation of the track record and financial strength of the investor and the terms of the investor's commitment, capital notes or funding agreement to evaluate the risks.
In addition to a deed of trust, UCC-1 financing statement, assignment of leases and rents, assignment of construction contracts, security agreement, and other typical lender collateral documents, conventional construction lenders may require collateral which may include the following:
- An assignment of the commitment of the limited partner to make its capital contributions, which includes an assignment of all of the borrower's and general partner's right to the investor's written commitment, right to receive payments, security interests, security agreement, promissory notes and all other instruments given by the investor/limited partner pursuant to the commitment.
- An assignment by the borrower (owner) and general partner of all their rights, as permitted by law, to the federal low income housing tax credits reserved for or allocated to the project.
- An assignment of the general partner's and limited partner's, partnership interest in the borrower.
In connection with the due diligence on this collateral, construction lender and its counsel should carefully review the tax credit allocation, the limited partner's commitment and the conditions to the limited partner's payments under the commitment, and the provisions of the tax credit limited partnership agreement with respect to capital adjuster clauses, management and developer fees, and the scope of the general and limited partner's authority and liability.
Assignment of Rights to Tax Credits
The right to claim the LIHC belongs to the owner of the specific project that has been allocated the LIHC. Therefore, it is not possible to separate the LIHC from the ownership of the project. Generally, an Assignment of Rights to Tax Credits is an assignment of the proceeds from the syndication of the LIHC to investors. It was initially developed for use in situations in which the investor had not yet joined the project partnership or made any of its capital contribution.
Security Agreement and Assignment of Partnership Interests
As noted above, the right to claim the LIHC belongs to the owner of the project that has been allocated the LIHC. Further, the LIHC is a wasting asset since it is used up over time. Taking as assignment of both the general partner interest and the limited partnership interest in the borrower project partnership provides a lender with the ability to take title to the ownership of the project and the tax benefits, including the LIHC without going through a foreclosure on the property. The assignment also gives the lender more flexibility in dealing with a default that may have been caused by only one of the partners.
Assignment of Capital Notes, Funding Agreement or Commitments
The ability of a construction lender to take an assignment of the capital notes or other funding commitments will depend on the identity of the investor and the structure of its investment. It is simplest to get an assignment of the capital notes of a direct corporate investor, although some corporate investors have a "policy" that they will not give such an assignment. It the case of a fund, it may be possible to get an assignment of the capital note from the fund to the project partnership. It is generally not possible to get an assignment of the capital notes from the investors to the corporate fund, since these often are pledged or sold. The value of these assignments depends in part on the conditions to the funding of the capital notes.
UCC-1 Financing Statement
In order to perfect the lender's security interest in the partnership interest, California requires the filing of a UCC-1 financing statement. Other states may require possession of the partner's partnership certificate or written notice to the general partner of the lender's security interest in the partnership interest.
Special Covenants re Tax Credit Compliance
In order to ensure compliance with tax credit filing and reporting requirements, the security agreement and loan agreement should contain specific covenants by the borrower and/or partners regarding compliance with all state and federal tax credit and regulatory requirements.
If tax credit investor equity is paid in during the course of the construction, the tax credit investor may require that it is a party to the intercreditor agreement between the construction lender and soft loan lender.
For those investors who are not required to pay in capital until completion of construction or lease-up, the construction lender should obtain an estoppel certificate or written certification from the investor of the enforceability of the commitment and any other relevant facts or issues.
Permanent Lender - Permanent Commitment
The borrower will provide construction lender with written permanent loan commitment to pay all or a portion of the construction loan at maturity. A portion of the construction loan may also be repaid from tax credit investor equity which is paid in after completion of construction.
Agreement Regarding Permanent Financing
To the extent possible, the conventional construction lender wants all conditions precedent to the funding of any permanent loan to be confirmed in a tri-party or other agreement regarding permanent financing. The conventional construction lender will carefully review the permanent loan commitment given to the borrower and require an agreement between the lender, permanent lender and borrower which specifically limits and sets forth the conditions to funding of the permanent loan. This agreement may include the following provisions:
- A provision obligating the permanent lender to fund upon compliance with the permanent commitment, which should include an extension period for construction and other delays.
- An acknowledgment of the form of American Land Title Association (ALTA) Loan Policy and endorsements required (and exceptions permitted) to preclude additional requests by the permanent lender.
- A clear and precise definition of "Completion Date" or the other triggering date for satisfaction of the funding conditions.
- A provision requiring the permanent lender to give the construction lender written notice and a specified period to cure any borrower defaults under the permanent commitment.
- Specific representations by the permanent lender, including an acknowledgment of its review and approval of all plans and specifications, contracts, partnership agreements, tenant leases, rent and affordability restrictions and all other loan documents and project lenders.
Funding and Pay Off Issues
To the extent state or local agencies are providing permanent financing, the funding of the permanent loan and pay off of the construction loan may be delayed due to lack of staffing or resources in the governmental agency. The borrower should be encouraged to make all required submissions to any permanent lender as early as possible to insure funding of the permanent loan on or prior to the maturity date of the construction loan.