by Joel Cohn
Often, the goal of satisfying the economic objectives of each party in a historic tax credits deal competes with the various requirements of the tax law. Fortunately, with creativity and a little compromise, these challenges can be overcome.
Third Party Capital: This is determined based upon the amount of credits generated by the rehabilitation. The market for historic tax credits is far from fluid, so the price of credits can vary widely from deal to deal. Further, investors are sensitive to the type of property and its location. For example, investors are more apt to bid on properties that are perceived to have less risk. Therefore, a multifamily project may receive more offers, and command a higher price, than a hotel project.
Time of the Capital Investment: Generally, portions of total capital are advanced based on the occurrence of specific events: construction start, construction completion, receipt of final approvals from the National Park Service, and stabilization. Accelerated investments are worth more to the REIT than a deferred arrangement.
Sharing of the Annual Cash Flow: Tax law gives rise to an interesting dilemma: cash must be allocated in the same percentage as the credits—and the credit allocation to the investor is maximized to attract the most capital, yet its desirable to minimize the cash shared with the investor. One structure to deal with this issue is the sandwich lease structure. Though admittedly the lease structure adds a level of complexity, it may be the most effective way to limit the extent to which the REIT must share economics with the investment partner. Essentially, this arrangement puts the REIT in control by having the REIT master lease the property and limiting the lease payments from the master tenant to the owning entity, and its partners. Excess cash remains in the master tenant.
Exit Strategy: By far the most sensitive issue lies at the end of the deal—developing an exit strategy for the third-party. From the REITs perspective, an ideal arrangement would be a nominal buyout. Unfortunately, investors count on these funds to support their return on investment. Worse yet, the invisible thumb of the tax law tips the scales in favor of the third party, increasing the buyout price. The law requires the third party to participate the same as any investor in a real estate transaction, which generally means that as the property appreciates, the buyout price increases also. Fortunately, many investors are willing to compromise by disposing of their interest with a put option at a discount. The price of the buyout often weighs much more heavily in the determination of the cost of the capital than any other negotiated item.
Joel Cohn is a principal in the Baltimore office of Reznick Fedder & Silverman
