The Low-Income Housing Tax Credit (LIHTC) program, established under the Tax Reform Act of 1986, is one of the most significant tools for encouraging affordable housing development in the US. It allows investors to reduce their federal tax liability in exchange for financing or purchasing affordable housing properties.
For real estate investors, especially those seeking long-term investments with consistent returns and tax advantages, investing in existing buildings under the LIHTC program is an attractive strategy.
Understanding LIHTC
The LIHTC program provides tax credits to property owners who invest in the development, acquisition, or rehabilitation of affordable housing. The credits are available over 10 years, with an obligation to comply with rent restrictions for 15-30 years. The credits are based on the building’s percentage of low-income housing units.
There are two types of credits available:
1. The 9% Credit: This is available for new construction and substantial rehabilitation projects, without any other federal subsidies.
2. The 4% Credit: This is used in projects that involve other federal subsidies, such as tax-exempt bonds or existing affordable housing that needs substantial rehabilitation.
Initially, many LIHTC properties are developed by partnerships between a funding partner, who is frequently a financial institution, and a developing partner, who builds the property.
Once the building is complete, the funding partner receives tax credits over a 10-year period, with a compliance period of 15 years. Once the first 15 years have been realized, there is a second 15-year period governed by “extended use agreements” wherein the housing must remain affordable or go through a relief process to remove them into the market rate.
Typically, existing properties under the LIHTC program do not trade hands until after the 15-year compliance period.
Why Invest in Existing Buildings Under the LIHTC Program?
1.Tax Benefits
The investors who may purchase LIHTC properties after the initial compliance period may elect to seek additional tax credits under the program for rehabilitation of capital improvements. These credits are used to help maintain the building as affordable housing for a longer time frame. These credits work as a dollar-for-dollar offset against income.
2.Long-Term Cash Flow
Investing in existing buildings under the LIHTC program offers the potential for steady, long-term cash flow. Because the properties are typically stabilized and already operational, investors can begin receiving rental income immediately after acquiring the property. Since rent prices are regulated and affordable housing properties typically have a high occupancy rate due to the high demand, these properties often generate consistent income.
A chart from the interim LIHTC Portfolio Performance Update, presented by the Affordable Housing Investors Council, is shown below. This chart shows that physical occupancy has remained over 97% for most of the past decade, with economic occupancy sitting 100 basis points lower.
3.Stable Investment with Lower Risk
Affordable housing is generally less susceptible to economic downturns than market-rate housing because the demand for affordable rental units remains high during recessions. This makes existing properties under the LIHTC program a relatively low-risk investment in the real estate sector.
Because the rents are determined by the median incomes in the area, the property’s income is very predictable. Default rates for loans on LIHTC properties are the lowest in the industry and, as a result, are a more stable credit risk to lenders – increasing your chances of approval in this challenging market.
4.Community and Social Impact
LIHTC properties provide much-needed affordable housing to underserved populations, including low-income families, seniors, and individuals with disabilities. Investors in these properties are contributing to solving a significant social issue, while potentially benefitting from community goodwill, positive public relations, and incentives from local governments.
Ways to Invest in LIHTC Properties
1.Direct Acquisition
Real estate investors can directly purchase existing buildings under the LIHTC program outright from the current owners. These properties have already been placed into service and have tenants in place who qualify under the affordable housing guidelines. The investor then takes over the management and operation of the property, including adhering to the rent restrictions and income qualifications for tenants.
Acquiring an existing LIHTC property can provide a quicker return on investment compared to new developments since the property is already stabilized. However, investors must ensure that the property complies with the LIHTC program’s regulations, or seek to be released under an extended use agreement.
Typically a property will be placed up for a recapitalization event, i.e. a sale, 15 years after a new development is placed into service. During this time, the original equity investors who received the initial tax benefits will exit.
2.Private Equity Funds Specializing in LIHTC
Another way to invest in existing properties within the program is through private equity funds that focus on affordable housing. These funds pool capital from multiple investors to acquire LIHTC properties.
Investing through a fund provides diversification across multiple properties and markets, reducing the risk for individual investors. It also offers a more hands-off approach, as the fund managers handle the asset management and regulations compliance.
3.Tax-Exempt Debt Funds
Section 142 of the IRC code allows for tax-exempt bonds to be invested into specific, community-enhancing projects. Existing properties under the LIHTC program are one such project.
Having returns that are tax-exempt at the federal level and may also be tax-exempt at the state level can offer a significant increase in returns that is not often seen on the debt side of the equation.
What to Consider
1.Compliance with LIHTC Program Regulations
Investing in LIHTC properties requires a clear understanding of the compliance requirements. The property must maintain its affordability status for a minimum of 30 years or it must seek relief from the state housing authority to come to market rate. This includes adhering to income limits for tenants, rent rate restrictions, and proper maintenance. Investors should work with experienced property managers who understand the program’s regulations to ensure compliance.
2.Limited Market for Resale
Selling a property under the LIHTC program can be more challenging than selling market-rate real estate. The restrictions on rent and tenant income levels can limit the pool of potential buyers, and the property may only be attractive to other LIHTC investors. Additionally, some properties may have restrictions on the transfer of ownership, depending on the initial financing structure.
3.Potential for Lower Initial Returns
Compared to market-rate properties, LIHTC investments may have lower cash-on-cash returns initially, due to the rent restrictions of the program. However, due to their stable income streams, these properties can provide dependable, long-term cash flow. Investors should carefully evaluate the financial performance of the property they’re considering, including looking at operating expenses and potential rent increases, to ensure that it meets their short-term and long-term investment goals.
Safeguarding against substantial increases in costs for the property is an essential component of maintaining a positive cash flow for existing properties in the LIHTC program. Consider the maintenance history of the property, major improvements that could become necessary in the near future, and risk remediation that has or should be done.
Conclusion
Investing in existing buildings within the LIHTC program offers a unique opportunity for real estate investors to combine financial returns with social impact. The tax benefits, steady cash flow, and lower risk associated with affordable housing make these properties an attractive option for investors seeking stable, long-term investments.
Why not invest and do good within your community at the same time?
We help the investors we work with to expand their investments in niche ways while making an impact. Capstone believes in connecting values with vision, and we support investors in doing the same.
Contact us today for a strategy call to plan your next move.
Sources
https://ahic.org/images/downloads/cr_2023_performance_report_for_ahic_members.pdf
https://www.novoco.com/resource-centers/affordable-housing-tax-credits/about-lihtc
https://www.housingfinance.com/finance/no-tax-credits-now-what_o
Skip to content