The Stack, and the Question Beneath It

The overlap

A particular kind of real estate deal has become markedly easier to finance: the rehabilitation of an older, often historic, income-producing building in a census tract that qualifies as a low-income community, in a municipality willing to use tax increment financing.

That is a narrow description, and the narrowness is the point. When a project sits at the intersection of several incentive programs, it can draw on more than one of them at once. Practitioners call this credit stacking. The programs most often involved in this particular stack are these.

Three currents, one direction

Three separate policy currents happen to be pointing the same way at once.

The first is that the New Markets Tax Credit became permanent. For most of its life the program lived on short extensions, which meant sponsors and Community Development Entities planned in one and two-year horizons and a project that slipped a cycle could lose its allocation entirely. Permanence changes the planning horizon rather than the credit itself, and the recent double allocation round was the largest in the program's history.

The second is that the federal historic credit has been stable. It survived the last major round of tax legislation in its five-year ratable form, and stability in a program this administratively demanding is worth a great deal, because the certification process takes long enough that mid-project rule changes are genuinely destructive.

The third is municipal. A great many older commercial buildings emptied out and stayed empty, and municipalities holding vacant, non-performing, often architecturally significant property have become more willing to put tax increment financing behind projects that would return those buildings to use.

None of this was coordinated. The programs were written at different times for different reasons. They simply overlap, and a building that happens to sit in the overlap is worth considerably more to develop than the same building a mile away.

Financeable is not the same as viable

Here is the failure mode, and it is worth stating plainly because it is common and it is expensive.

A stack of incentives can make a project financeable without making it viable. Those are different things. Financeable means the capital stack closes. Viable means the completed building produces enough net operating income to service its debt, cover its reserves, and reward its equity once the incentives have run their course.

Incentives are front-loaded and finite. The federal historic credit is consumed over five years. The New Markets credit runs seven. TIF has a district term. Operations are permanent. If a project only works because of the credits, then the credits are not improving a good project, they are disguising a bad one, and the disguise has an expiry date.

The questions we would want answered before the incentives are modeled at all:

• Does this project produce an acceptable unleveraged return with every credit and every TIF dollar set to zero? If the answer is no, the incentives are carrying the deal rather than improving it.
• Is there real demand for the completed asset at the assumed rents, evidenced by something other than the sponsor's own projection? Rehabilitated square footage in a low-income census tract is qualifying by definition and leasable only if somebody actually wants it.
• Who bears the cost overrun? Historic rehabilitation of an old building is the category most prone to discovering expensive surprises inside walls, and the certification standards constrain how you are permitted to solve them.
• What does the compliance period actually require, and who is monitoring it? These programs carry recapture exposure if conditions fail during the period. Recapture arrives precisely when a project is already struggling, which is the worst possible timing.
• What happens in year eight? When every incentive has run off and the building is simply a building competing on its merits, does it still work?

For the investor

Most individuals encounter this stack as investors rather than as developers, which changes which questions matter.

1. 01Establish whether you can actually use the credit. This is the first question, not a detail. Credits are subject to passive activity and at-risk limitations, and a credit you cannot use in the year it arises is worth substantially less than its face amount, sometimes much less. The answer turns on your own facts, not on the deal's.
2. 02Understand the compliance period before you fund, not after. Seven years is a long time to hold an illiquid position with recapture attached, and the exposure sits with the investor, not with the sponsor who arranged it.
3. 03Separate the credit analysis from the real estate analysis, and do the real estate one first. If the underlying project would not attract your capital on its own merits, a credit should not change that conclusion. It should change how much you earn from a project you already wanted.
4. 04Get the sponsor's downside case, and if there isn't one, treat that as the answer. Every developer has a base case. The ones worth investing with can also tell you what happens if lease-up runs a year late and the rehabilitation costs 15% more than budget.
5. 05Have your own CPA confirm the treatment for your circumstances before you commit. Not the sponsor's advisor, and not ours. Yours.

Used properly this is a genuinely favorable environment, and the overlap of a permanent New Markets program, a stable historic credit, and willing municipalities does not come along often. The opportunity is real. So is the failure mode, and they tend to arrive wearing the same suit.