Thesis Driven dives deep into emerging themes and real estate operating models by featuring operators executing on each theme. This week’s letter is a guest post from Jake Chai, Managing Partner at Mana Tree Properties, a New York-based developer. It dives deep into historic tax credits as a path for redeveloping historic structures.
Rehabilitating older buildings is often more complicated and costly than building new ones. Bringing older assets into compliance with present-day building codes and tenant standards presents a number of challenges, especially when it is critical to preserve the historical identity of the building. But as higher interest rates and increased construction costs have made conventional development challenging, more GPs are looking to the redevelopment of historic buildings with a powerful and under-appreciated tool: historic tax credits.
From a financial perspective, historic tax credits can completely upend typical real estate development math. Because the credits can cover a significant percentage of the cost of a project, they reduce the amount of equity that developers need to put into a development, making it easier to finance a project and—ultimately—making it more profitable.
Before-and-after of The Lace Mill in Kingston NY, a 55-unit affordable housing development for artists built by AHC.
The historic tax credit is a federal tax credit designed to encourage developers to preserve historic buildings and adapt them for new uses. The credit is available to developers who rehabilitate historic buildings and—depending on the state—can cover 20% to 40% of a project’s total development cost.
This letter will dig into the specifics of the Historic Tax Credit program, including how a developer goes about getting HTCs and applying them to his or her project. We'll also cover project-level math and how these credits can make a development project's economics work through a few illustrative examples.
The economic benefits of Historic Tax Credits are numerous. For one, they help to revitalize communities by bringing historic buildings back to life, bringing new residents and businesses. In addition, the preservation of historic buildings can help to protect a community's cultural heritage which can be a draw for tourists and other visitors.
Understanding the history and evolution of the HTC program requires starting in 1966:
The HTC has its roots in the National Historic Preservation Act of 1966, which created the National Register of Historic Places, which helped coordinate and support public and private efforts to identify, evaluate and protect historic and archeological resources. A decade later, in 1976, the federal government began providing tax incentives for historic building renovations in the form of accelerated depreciation. Congress introduced a HTC in 1979, with anyone who rehabilitated a building 20 years or older receiving a 10 percent credit based on qualified expenditures.
The Federal credit currently stands at 20% of applicable project costs. Since the program’s inception in 1976, the National Parks System ("NPS") has certified the rehabilitation of more than 47,000 historic properties throughout the United States, with the HTC leveraging over $199.1 billion in private investment in historic rehabilitation and generating over three million jobs. In 2021 alone, 1,063 completed projects generated $7.2 billion in rehabilitation work, creating approximately 135,000 jobs.
Source: National Park Service. https://www.nps.gov/subjects/taxincentives/upload/report-2021-economic-impact.pdf
Notably, Federal HTCs are made available through a non-competitive, open application process; any project that meets the program requirements can claim the credit. In contrast, other credits, particularly at the State level, are issued in a limited amount in any given year, creating a competitive process that adds uncertainty to a developer’s ability to claim them.
The HTC program supports projects across the spectrum of development size and are dispersed in both large and small population centers. Almost half (47%) of all projects in FY 2021 were under $1 million, and 18% were under $250,000. PolicyMap determined that 30% of all certified rehabilitation projects in FY 2021 were located in communities with under 50,000 in population and 19% in communities with under 25,000 in population.
HTC projects by the size of city they’re in. Source: https://www.nps.gov/subjects/taxincentives/upload/report-2021-economic-impact.pdf
Getting Historic Tax Credits
Using historic tax credits is not without its challenges. For one, the process of obtaining the credits can be time-consuming and complex. Developers must go through a rigorous application process which includes obtaining site recognition and design approvals from both state and federal agencies.
In order for a developer to obtain the credits, he or she must progress through a three-part approval process with the National Parks Service ("NPS"):
Evaluation of Significance
Description of Rehabilitation
Request for Certification of Completed Work.
To gain a Part 1 approval a building must be a certified historic structure, buildings individually listed on theNational Register of Historic Places or listed as a contributing building in a National Register or state or local historic district certified by the Secretary of the Interior. The National Park Service determines if a building is a certified historic structure by approving Part 1 of the application.
Submitting a Part 2 application, Description of Rehabilitation, typically requires the support of a historian and an architect. A developer needs to produce rehabilitation plans along with sufficient historical documentation to make the case proving that their plan adheres to the original historic detail of the building. This often involves a lot of research to find old drawings or photos of the building while it is in its original state of construction. The NPS will review the application and confirm if the plan is in fact in alignment with the historical reference.
Part 3 of the application occurs after the construction of the project is complete and has secured its Certificate of Occupancy. An inspector from the NPS will visit the site and review the building ensuring that it was constructed according to the Description of Rehabilitation. If they sign off, the credits will be released.
When pursuing an HTC project it’s important to assemble a specialized team that has experience working with credits. A developer will need all the typical components of a classic development team but will want to be sure the professionals are well-versed in the nuances of HTCs.
Some key members of the team include:
Tax Credit Agent
Tax Credit Bridge Lender (can also be the main construction lender if they offer that program)
In general, costs directly related to the repair and improvement of the structural and architectural features of the historic building will qualify. In addition to hard costs, some soft costs qualify, including construction period interest and taxes, architect and engineering fees, construction management costs, and developer fees.
However, certain development expenses do not typically qualify as "rehabilitation expenditures." Site acquisition costs as well as any work done to expand the structure or build new structures on the site are unlikely to qualify, as is work done on ancillary facilities such as parking lots or sidewalks.
In addition, historic tax credits do come with some strings attached. Most notably, selling more than one-third of ownership in a property during the five-year compliance period following the time a property is put into service would trigger the recapture of credits received.
Structuring Historic Tax Credit Deals
A key decision to consider when structuring a tax credit deal is whether to utilize the credits internally or sell them to a specialized tax credit investor. Each path has its own pros and cons, although the size of the project is often a key factor in determining which path is chosen. In general, larger projects with over $5 million in credits are sold to a specialized investor, whereas smaller projects with fewer credits tend to avoid an external sale given the structuring challenges and costs of completing the transaction.
Typically, credits are purchased by a larger company with a very large annual tax bill. Many acquirers have teams dedicated to structuring and acquiring tax credits of various forms at a discount to the value of the credits in order to offset the acquiring company’s tax liability. The pool of buyers also skews heavily towards financial institutions like big banks and insurance companies. For example, US Bank’s annual net income in 2021 was $8B. US Bank has a meaningful incentive to reduce its tax liability; therefore, US Bank has a team that purchases tax credits at a discount that it can utilize to offset its tax liability.
As an example, let’s consider a real estate development project that generates $10 million in credits to be sold to a large institution:
Our example project has $28 million in total project costs excluding site acquisition, of which approximately 90%--a typical percentage–are Qualified Reimbursable Expenses (QREs). Between the 20% state credit and 20% federal credit, this conveniently yields approximately $10 million in total tax credits.
Tax credit investors will purchase tax credits at a discount to the face value of the credit. State credits will sell for a deeper discount since they can only be used to offset state income which is more restrictive to an investor. The market for tax credits is dynamic and the price you can sell them for fluctuates based on supply and demand. While the discounts outlined here are typical, they’re not fixed and must be negotiated with the investor. In years when companies are more profitable and the future economic outlook is positive, demand for tax credits increases, and a developer can solicit multiple offers and negotiate better terms.
In the example above, the large institution pays ~$8 million to receive ~$10m in tax credits. So they generate $2 million in net savings ($10m - $8m = $2m) on an $8m investment. A developer typically loses about one-third of the value of the HTCs between the discount offered to the institution and associated structuring and financing costs. The deal is typically papered prior to the start of construction. The developer receives approximately $6.5m of "free" capital he or she can utilize to finance a project, minimizing the amount of contributed equity and increasing the ROE.
Typically, a HTC buyer releases the purchase funds in stages with the largest portion provided once the building is placed in service (receives a CO) and meets other investor-imposed requirements. A Part 3 approval from the respective State Historic Preservation Office and National Park Service is the final hurdle.
Given the delay in funding, a developer typically arranges a tax credit bridge loan in order to utilize the value of the credits up-front to finance construction rather than waiting until a project is completed. A lender—typically either the tax credit investor themselves (many big banks buy credits) or the bank issuing the construction debt on the project—will provide financing for the credits. This loan is repaid once the building is put into service and the tax credits are earned by the tax credit investor as a result of their equity investment in the project.
While retaining the credits directly as the developer is far simpler and more efficient, it requires a developer to have a meaningful tax liability that they need to offset. In addition, there is a limit on the amount of credits a developer can utilize in a given tax year unless they are a Qualified Real Estate Professional. If an individual qualifies as a Real Estate Professional then there is no limit to the credits they can claim in a year so long as the income tax liability is derived from real estate related activity or passive income. New York State has recognized that smaller projects require additional tax credit support and in 2022 increased the State HTC from 20% to 30% for projects with less than $2.5m of QREs.
Example Deal: The Foundry, Newburgh, NY
I co-founded a real estate development platform, Mana Tree Properties, in 2019 alongside my partners Eric Edelman and Michael Engels. We’ve been focused on HTC adaptive reuse and value-add multifamily projects. To date, all of our projects are in the state of New York within the Hudson Valley. The following is an overview of The Foundry, an HTC deal that Mana Tree is developing along with our partners, AHC and Andrew Schrivjer of Attic Labs.
Aerial view of the Foundry in Newburgh, NY
The Foundry is located in Newburgh, NY, a small city approximately 1.5 hours north of New York City by train or car (see the NY Times feature on Newburgh). The city caught my attention in 2018 due to its vibrant community and numerous historic buildings, several of which were designed by renowned greats like Andrew Jackson Downing, Frederik Olmstead, and Stanford White. However, many of Newburgh’s historic structures were and still are in disrepair, which presents an opportunity for restoration and adaptive reuse. While Newburgh has strong potential for using historic tax credits, most buildings in the market are too small to justify a tax credit sale. There are, however, a few outliers large enough to warrant selling credits to HTC investors—one of which is the Foundry.
The Foundry is a gorgeous 160,000 square-foot former factory complex, where early ice machines and cold storage refrigeration technology were developed and manufactured. The complex was built out in stages from starting in the 1880s, into the early 1900s. The last industrial owner sold the complex in 1985, and the project cycled through several developers’ unsuccessful attempts to complete a residential conversion prior to our group acquiring the remaining portions in a bankruptcy auction in August 2020. We are on track to complete the remaining 59 residential units in September of 2023.
The Foundry offered one big starting advantage to the project: the prior developer had already obtained their Part 1 and Part 2 approvals from the National Park Service, which provided greater certainty on what the NPS would require to restore the building from a historic perspective. In some cases, the NPS requires the use of specific materials or the restoration of certain building accents. Going into the project with clarity from the Parks Service removed significant risk.
Oversized windows, high ceilings, and arched entranceways at The Foundry, Newburgh, NY
Navigating the layout of the building’s penthouse floor in relation to the existing roof structure and truss heights was a challenge. The previous developer had already poured a concrete slab flooring and didn’t leave optimal clearing height for the trusses, so our team had to figure out a cost-effective creative solution. These unforeseen expenses are unfortunately common when rehabbing existing buildings, and they often add up to drive the cost of a rehab higher than that of a new, ground-up development.
Top floor and roof support truss system, The Foundry, Newburgh, NY
As mentioned earlier, building a strong team is key for executing an HTC deal. Our partners AHC and Attic Labs have both completed HTC projects in the past and were invaluable through the process. AHC in particular has a long track record of completing similar projects which made the process of securing financing and an HTC investor much easier. We also received support from experienced tax credit and development specialist, Andy Golubistky and his consulting company APRE.
Replacing the roof at The Foundry, Newburgh, NY
Through utilizing HTC’s we are able to develop this project while contributing significantly less of the total project costs as equity than if this was financed as a conventional project. The remainder of the project costs are financed through tax credits and conventional bank financing. This results in a much higher ROE and MOC than if we had used a conventional capital structure. The impact of the tax credits is significant as this deal would not pencil as a conventional development.
The project is currently well into construction and is set to deliver in late Summer or early Fall 2023. Our team’s next HTC development will be just across the street from the Foundry in Newburgh. We’re redeveloping the Shaw Building, a 25,000 square foot former Shaw Family hardware store built in the 1800s, into a mixed-use residential, F&B, and flex office space.
The Shaw Building, Newburgh, NY
HTC’s are often a necessary component of the capital stack to unlock the financial viability of a historic rehabilitation project. In a market such as Newburgh, the hard costs to build a simple ground-up type III construction project can range from $125 to $175 per square foot. By contrast, rehabilitating a historic building can cost between $200 to $300 or more per square foot. Without HTCs, many historic rehab projects wouldn’t make economic sense. This is particularly true of historic projects outside of expensive rental markets.
HTC’s can be paired with other credits and incentive programs which can further create value for developers. Programs like Low-Income Housing Tax Credits ("LIHTC"), Brownfield Tax Credits, and New Market Tax Credits should be assessed along with obtaining a Payment in Lieu of Taxes ("PILOT") or Tax Incremental Financing ("TIF") from local governments.
The challenges of scaling HTC development have prevented large, institutional investors from participating significantly in HTC deals to date. One, each historic deal is unique and must be underwritten and evaluated individually. Two, as mentioned earlier, many HTC deals are small and don’t offer the opportunity to deploy large checks into individual assets. Finally, the number of historic properties is relatively fixed. While new properties may be added to the National Historic Register, any new property must meet the National Register Criteria for Evaluation. This involves examining the property’s age, significance, and integrity.
Age and Integrity: Is the property old enough to be considered historic (generally at least 50 years old) and does it still look much the way it did in the past?
Significance: Is the property associated with events, activities, or developments that were important in the past? With the lives of people who were important in the past? With significant architectural history, landscape history, or engineering achievements? Does it have the potential to yield information through archeological investigation about our past?
Currently, there are about 95,000 buildings listed on the National Register of Historic Places. We know that around 47,000 have already been developed using HTCs, which leaves around 48,000 left to develop. It’s worth mentioning that the most accessible and viable projects get developed earliest so it can be difficult to find great new opportunities. This presents both a challenge and opportunity for smaller more specialized developers and investors to earn outsized returns given the lack of competition with cheaper institutional capital.
As a real estate developer, one of the biggest challenges is finding a way to breathe new life into historic properties. These buildings may have once been magnificent, but time and neglect have left them dilapidated and unoccupied. Fortunately, there is a solution that can help developers and communities alike: the historic tax credit.
— Jake Chai
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