What Development Teams Can Learn From Asset Managers, Part 2: Legal and Financial Structure
How do decisions affordable housing development teams make, before a project is up and running, impact long-term property operations and resident quality of life? Three affordable housing asset management pros shared their perspectives in an HDC-hosted panel discussion at the Housing Oregon Industry Support Conference in September. We’re recapping their insights in this three-part series. Start at the beginning and learn more about the panelists, Natalie Thornton, Brian Shelton-Kelley, and Holly Vander Schaaf, here.
In today’s installment, we’ll look at how to design a property’s financial and legal structure to prevent future operating challenges. Natalie, Brian, and Holly offered these top four recommendations:
Build an accurate operating proforma. We can’t stress this enough: the accuracy of the operating proformas you prepare during a project’s development phase will have a direct impact on the project’s long-term financial performance. If a property’s financial structure isn’t built atop realistic operating cost assumptions, the property will struggle. That said, we recognize that competitive funding requirements don’t always encourage developers to show operating expense budgets that are based on actual expenses at comparable projects (e.g., projects that are comparable in size and population served). So, how can we work together to balance the immediate goal of getting the project funded with the long-term goal of putting the project on solid operational footing?
Some suggestions:
Talk to us, the owner’s asset management team, early and often. When you start plugging numbers into your operating proformas, ask for our input and feedback. If sources and uses don’t line up, or if the numbers we propose fall outside funder-imposed parameters, let’s work together to find the best solutions for closing the gaps.
When looking at comparable projects for purposes of estimating operating costs, be aware that aggregate data can be deceptive. Every project is different, and line-item costs vary widely from project to project. Let us help you tease out context in the data story.
Don’t forget to ensure, specifically, that operating expense items inflate realistically. (Hint: 3% annual increases in water expenses are not realistic.)
Partner with us to push back against funder-imposed budgetary constraints that set up properties to fail.
Deepen the cash-flow waterfall. Some background for lay readers, first: When a property is developed using low-income-housing tax credit (LIHTC) equity as a source, the sponsor and tax-credit investor create an operating agreement or a limited partnership agreement (LPA). This agreement governs everything about how the partnership functions—including, usually, a stipulation that the investor owns a 99.99% stake in the property.
A standard part of the LPA is the cash-flow waterfall. The “waterfall” is a visual metaphor: imagine a series of cascading pools of water, then replace the water with cash. When the project generates cash flow, the cash runs to the topmost pool, and it only flows to the next pool after the first is filled. The pools are arranged in a specific order: LP fee, deferred developer fee, sponsor debt, and so on.
For the majority of LIHTC projects, at the end of each year when the limited partnership is in effect, any cash left at the bottom of the waterfall (99.99% of it, that is) goes to the tax-credit investor. If the waterfall is set up so that all the pools fill and leave cash at the bottom most years, that’s called having a “shallow” waterfall. In our industry, a shallow waterfall—where significant cash payments flow to investors—is a problem to avoid.
Our advice on structuring the waterfall:
Understand that a shallow waterfall can be disadvantageous to the investor as well as to the sponsor. Investors don’t necessarily want to receive taxable cash at the end of the year.
Remember that the waterfall is negotiable. If the investor offers terms you don’t like, you can push back.
Bring asset management in early to advise on how to structure the waterfall to ensure both the sponsor and the property will benefit from good property performance. Having a chance to review the waterfall will give asset management a head-start on understanding the deal for purposes of ongoing financial management, as well.
Do a sensitivity analysis on the waterfall as part of the structuring process. Include a scenario in which the property overperforms for years in a row.
Make sure all parties to the deal—equity investor, term lender, and public funders—share the same assumptions about how the waterfall is structured.
Mix sources wisely and document the deal. Many times, the only way to get a project funded is to layer multiple sources—e.g., HOME, OAHTCs (Oregon Affordable Housing Tax Credits), federal or local project-based vouchers, etc. These layered sources trigger different, sometimes conflicting operating requirements. You can minimize the negative impacts on asset and property management by consulting with us when you negotiate the deal.
Ask our advice on actions you could take to make the operating compliance burden easier. For instance, some subsidy programs work well with other funding layers, but some don’t. Check with us to stay informed about the latest compliance updates.
When the deal is done, immediately pass on your knowledge of funder agreements to us. Whether you call it a “deal book,” a “compliance chart,” or something else, create a tool to document and communicate funder requirements before the information is filed away (or forgotten).
As with funder-imposed operating cost restrictions, work with us to push back against a funding system that sets burdensome operating requirements—and to communicate what it is that we, affordable housing providers, really need to build and operate affordable housing. Over time, our voices will have an impact.
Consider selling the commercial space—and choose the right occupants. Will you be including ground-floor commercial space in your development? Carefully weigh options related to ownership structure and tenant selection; and consider relative risks.
If the intent is to lease, not sell, the commercial space, model a scenario that shows a 100% vacancy rate. An owner that leases to for-profit tenants should be prepared for lengthy vacancies to occur, especially during the first 10 years of operation. Tenants may go out of business or decide to leave.
Don’t assume it will be possible for the project to lease commercial space to nonprofit service providers. Other than a federally qualified health center, possibly, few nonprofit service providers can afford to pay Class B rent.
Still not ready to make that ground-floor space a commercial condo? Then consider one last piece of advice about leasing: Be wary of the risks involved in okaying major tenant improvements. (No one wants to spend $19 per square foot to rent a 3,000-square-foot space that has toddler-sized toilets—because it used to be a Head Start.)
Whether the decision is to lease or sell, be sure to assess how a prospective occupant’s business operation will impact residents’ quality of life. A new restaurant or coffee roaster might be great for the neighborhood—but not so great for residents if their living spaces fill with unpleasant sounds or odors emanating from ground-floor commercial neighbors.
Coming next
Check back soon for part three of this series, which addresses the right and wrong reasons to install a water submetering system.
Liz Winchester is a Senior Asset Management Project Manager at HDC. See her full bio here.