A historical and stable niche lending opportunity is found lending into historic rehabilitation projects. There are 10s of 1,000s of historic buildings across the United States. Many of them need a face lift or adaptive rehabilitation. Many of these historic structures are in key areas of town and carry a strong sentimental value for their communities. Lending for the rehabilitation and maintenance of these buildings can check several important boxes for community banks, often including community revitalization, positive press, high profile developments, community reinvestment act credit, catalytic investments, and more.
Federal historic tax credits provide a critical supplement for rehabilitating historic structures. They also provide for interesting niche lending opportunities. The Internal Revenue Code provides for an income tax credit of 20% of the rehabilitation costs of qualified historic structure. The tax credit may be used to offset federal income taxes. The federal historic tax credit may be taken over five years and unused portions may be carried forward for up to 20 years. The tax credit benefit may be transferred in a way by making an allocation of partnership income and credits to a third-party in return for an equity capital investment in the rehabilitation. This incentive was created to encourage the revitalization and reuse of historic structures that are often torn down to make way for less expensive development of newer improvements. Since its introduction, the federal historic tax credit has been used to aid the rehabilitation of over 40,000 structures in the United States.
Texas offers an additional powerful incentive for the redevelopment of historic structures. Texas historic tax credits of up to 25% of the rehabilitation costs of a qualified historic structure may be used to offset the cost of rehabilitating a historic structure. The credit may be used against franchise tax liability or insurance premiums tax liability. The credit is a useful tool for bringing cash equity into a redevelopment because the Texas historic tax credit may be freely transferred in return for cash. The Texas credit has been highly effective at encouraging the rehabilitation of historic structures in the State of Texas and may be used in conjunction with the federal credit. Over $2 billion in project costs have been supported by the Texas historic tax credits.
A number of other states also have state level historic tax credit programs or other redevelopment incentive programs that may be used alone or in conjunction with the federal historic tax credit.
Both state and federal programs are frequently used to bring sources of cash equity into the rehabilitation and redevelopment of historic structures. That is, tax credit investors or purchasers are introduced to bring cash in return for the use of the credits generated by the rehabilitation. The capital injection can be used to pay rehabilitation expenses and does not need to be repaid like a loan.
The advantage and opportunity for traditional construction and permanent lenders is that a project with a 5-15% equity contribution by its owner can turn into a project with a 50-60% equity contribution. Up to 45% of the project costs of the redevelopment can be covered without introducing debt or other expensive sources of funding. Overall, using the historic tax credits reduces the debt service and stabilizes the project’s prospects for success. The credits can be used for many types of properties, including office, retail, industrial, special purpose, and, dare I say it in 2020, hospitality. For state only historic tax credit projects, this opportunity comes with little added complexity and can be treated much like another construction loan.
For construction and senior lenders lending into federal historic tax credit projects, the barrier to entry lies in complexity. Understanding the ins and outs of allocating federal income tax credits to a third party takes effort. The IRS code imposes restrictions on owners of buildings rehabilitated with federal historic tax credits for five years following completion of the project. This means that loan workout and foreclosure scenarios must be carefully planned in advance and may require more creativity than typical construction loans. Nevertheless, large and small institutions have been lending into historic tax credit projects for over 40 years and have developed adequate strategies for managing historic rehabilitation projects.
For a construction banker willing to learn a new construction niche, making a bridge loan in support of a historic tax credit project carries a risk profile that is similar to construction lending and carries substantial benefits. Most of the cash generated by historic tax credits project becomes available upon completion of the project. For projects where the tax credits are is necessary to pay for the construction costs, a bridge lender may advance funds in anticipation of receiving tax credit dollars at the end of the project. The bridge loan may be secured by a lien on the tax credit proceeds and interests which control the proceeds. The proceeds from the transfer of tax credits would then be used to repay the loan at the completion of the project. The tax credit bridge loan does not require a lien on the real estate.
Advantages of tax credit bridge lending are a) this is a niche banking opportunity for which there are few competitors; b) the bridge lender does not need to compete with a senior lender for its security interest; c) repayment of the bridge loan is not dependent on the income from the project; d) once the construction is complete, the loan is repaid without any risk for the failure of permanent financing; and e) moderate cost overruns actually make repayment easier. The risks of bridge lending resemble construction lending. Risks to consider include construction completion, casualty risk for the structure, and non-payment of construction period interest. These risks and others can be adequately mitigated through insurance, interest reserves, underwriting, and other traditional risk management strategies. For an alert construction lender, historic tax credit bridge lending is an opportunity worth looking at.
As noted above, historic tax credit incentives have been used to finance the construction of over 40,000 buildings over more than 40 years throughout the United States. Most of these projects have had the support of bank financing, yet relatively few banks are involved in this area of lending. The longstanding success of these programs and limited competition make this a great niche banking opportunity.
