Financing historic rehabilitation projects is complex. Tax credit equity is paid in installments with only about 1/3 of the equity being available pre-development. Moreover, tax credit equity providers require balance sheet strength or developer guarantees, and banks will ensure that there is adequate sponsor equity in the deal (10% or more), the ability of the developer to cover the trailing equity deficit, and a deferred developer fee. Banks have tightened their lending requirements, making it more difficult to secure a commercial loan for redevelopment. Tax credits can be leveraged (or used to secure bridge financing) to fund or pre-development costs and/or the trailing equity deficit. Furthermore, soft costs, such as acquisition (or leasing) costs, carrying costs, interest and other financing costs, as well as architectural, engineering, accounting, legal, and so forth will need to be incurred prior to securing tax credits. The developer will need to have the capital or access to capital in order to meet these costs, which can amount to as much as 10% of the project budget.
Assume a project has the following costs: The cost of the building is $1.5 million, the project rehabilitation budget is $12 million, of which $10 million are tax credit eligible - known as qualified remediation expenses or QRE’s. The tax credits that the QRE’s would generate would be $2 million. Additionally, some states, such as Massachusetts allow state tax credits, which would amount to $1 million. The developer and tax credit equity investor would form a partnership to which the tax credit equity investor would make a capital contribution of $2.35 million based upon current market conditions. Based upon the above assumptions, total project costs would be $14.5 million, including a $1 million reserve or contingency for overages. Construction funding would probably amount to a maximum of 75% of the total project costs, or $10,875,000. Of the tax credit equity only around $500,000 would be funded pre-construction, leaving a trailing equity deficit of $3.125 million. The developer fee of around 12% or $1.2 million would be deferred and claimed only at around $300,000 per year. Once all the tax credit equity is paid in, the developer will have contributed only $1.275 million or 8.8%, and the developer fee will essentially reimburse all of the equity requirement, leaving the developer owning the project at around year 5 with no equity down. However, the developer will need to initially cover the $3.125 million, or secure an equity investor or bridge financing to cover that gap. This requires substantial financial resources, solid corporate and/or personal guarantees, which place balance assets at risk, and use of innovative bridge and/or construction financing to pull off such a project.
Accordingly, tax credit projects can be profitable when structured correctly, and they are very rewarding, since you may be saving and restoring a historical building, providing affordable housing, or creating renewable energy. However, these deals can be pressure-filled, jarring, and require a strong stomach, skill and expertise in this niche area.