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Understanding and valuing Low Income Housing Tax Credit (LIHTC) properties is complex due to the unusual, severe restrictions imposed upon them and the limited number of these properties. In order for LIHTC property owners to receive tax credits, they must agree to follow the restrictions in a land use restriction agreement (LURA) promulgated by the state and federal governments; the restrictions vary from LURA to LURA. The LURA includes recorded deed restrictions that negatively affect the market value of an LIHTC apartment complex. Tax credit property valuations must address those restrictions that reduce market value compared to conventional properties. [PUBLICATION ABSTRACT]

Valuation of Low Income Housing Tax Credit (LIHTC) apartments for property taxes is complex due to the unusual restrictions imposed upon them by federal and state governments. Accounting for such restrictions presents special difficulties because of the limited number of these properties and the severity of the restrictions, including a lack of residual value, restricted rental rates, and a compliance period of up to 30 years. Such factors reduce the market value of LIHTC properties when compared to conventional properties and, therefore, need to be addressed in LIHTC property valuations.

This article focuses on valuation of the real estate and does not address the value of the tax credits, which are considered personal property and are not assessed property taxes in Texas (and some other states). Also addressed is the valuation of stabilized LIHTC properties for property tax purposes when the owner essentially loses the reversion proceeds due to the state's right to select a nonprofit purchaser after rent restrictions end. This study does not deal with valuation before stabilization or after rent restrictions terminate, nor does it address the effect of leverage since the value for property tax purposes is based upon the unleveraged fee simple value in many states (including Texas). This article cites the Texas Property Tax Code; property tax laws for LIHTC apartments are similar in some other states. Conclusions are based on Texas property tax law and will vary if laws are different in other states.

What is an LIHTC Apartment Property?

Under the Tax Reform Act of 1986, the federal government established the LIHTC program, now under Section 42 of the Internal Revenue Code of 1986, in order to create affordable rental housing by using private capital.

In Texas, the Texas Department of Housing and Community Affairs (TDHCA) allocates tax credits to apartment developers as an incentive to provide low-cost housing. These tax credits can be used to reduce effective development costs since the tax credits are typically sold or syndicated to large corporations. In order to receive these incentives, developers must charge rents below the market rate and agree to abide by various construction and rental restrictions. To be eligible for LIHTC status, a property must be either new construction or a substantial rehabilitation (minimum of $6,000 per unit) of an existing complex; the amount of tax credits depends on the type of additional financing sources, location, development costs, and number of low-income housing units available. For example, while the total development cost of an LIHTC property may be $10 million, the net development cost after selling tax credits is more typically $5 million, or half the total cost.

Governmental regulations require that a minimum percentage of rental units be set aside as low-income housing. Rent values will then depend on a level correlated to the median income. To qualify, one of the following two minimum conditions must be met:

* At least 20% of the units are rent restricted and inhabited by renters whose income is a maximum of 50% of the area median gross income.

* At least 40% of the units are rent restricted and inhabited by renters whose income is a maximum of 60% of the area median gross income.

Tax credits can be claimed on the portion of units matching one of the above conditions; this could be up to 100% of the units if all the units meet the criteria. The owner can claim tax credits for all eligible units based on the cost of the property, minus the cost of the land, for new construction or on the amount of rehabilitation for renovations.

Land Use Restriction Agreement (LURA)

In order for LIHTC property owners to receive tax credits in Texas, they must agree to follow the restrictions promulgated by the state of Texas and the federal government in the land use restriction agreement (LURA). By executing the LURA, LIHTC property owners accept rent rate restrictions, a 15- to 30-year compliance period, limited proceeds upon sale, and government monitoring of the property.

In an LIHTC application that is authorized by the low-income, rental housing tax credit rules, the property owners must represent to the TDHCA that they will lease a portion of the units to individuals or families with an income that is 60% or less than that of the area median gross income (AMGI). A portion of units is often allocated for those at 50% or less of AMGI. Property owners must represent in the application that they will impose additional rent and occupancy restrictions, as required. The LURA also states that the property owner is subject to the regulatory powers of the TDHCA. Ultimately, for allocation of tax credits to exist on an LIHTC property, the TDHCA mandates that the property owner "execute, deliver, and record" the LURA in real property records of the county in which the property is located in order to create covenants with the land; this allows the TDHCA to enforce the restrictions described in the LURA. Moreover, the covenants made by the property owner with the TDHCA are binding upon all subsequent owners of the property.

Example of Typical LURA

An examination of a typical LURA shows the effects of LURA provisions. For example, one LIHTC property in Houston, Texas, contains approximately 200 units and has been allocated tax credits based on a commitment that a minimum of 85.91% of its units to occupancy by individuals or families with incomes 60% or less of AMGI. For this property, 172 units out of the 200 (200 × 85.91% = 171.8) must be occupied by low-income residents. The property owner's failure to lease 172 units to qualifying residents could cause the reduction or recapture of the property's tax credits, with significant cost to the developer/owner. Further, the LURA provides that at least 40 of the 172 units must be rented to families earning 50% or less of AMGI. In addition to the initial income/rent restrictions, 6% to 10% of the units (at least 12 in this case) must be allocated to persons with physical or mental disabilities.

Nonrental LURA Restrictions

The property owner must pay annual fees to the TDHCA based on the number of low-income units in the property. For properties with commitment notices issued in 1998 or later, the fee is $25 per unit; for example, the Houston model property mentioned previously is assessed an annual fee of $4,300 (172 × $25 = $4,300). This model property also incurs a supportive services restriction in which the owner must make available to the residents a local, tax-exempt organization providing supportive services, such as educational and job-training services or an on-site day care center. These supportive services are only required during the compliance period, which for the model property is 15 consecutive taxable years. The extended use period is an additional 10 consecutive taxable years. The combined compliance period and extended use period result in a total of 25 consecutive years during which the property owner cannot sell the property. In contrast, most real estate limited partnerships have a life of 5 to 10 years, according to discussions with real estate syndicators.

Relevant Texas Law

Under the Texas Property Tax Code, all real and tangible personal property, including LIHTC apartment properties, is appraised at market value as of January 1 of a year unless otherwise noted. For LIHTC apartments, however, a substantial difference exists between the cost of development and market value due to the LURA restrictions (primarily lower rent, lack of reversion benefits, and illiquidity).

Section 1.04(7) of the Texas Property Tax Code defines market value as the price at which a property would transfer for cash or its equivalent under prevailing market conditions if

(A) exposed for sale in the open market with a reasonable lime for the seller to find a purchaser;

(B) both the seller and the purchaser know of all the uses and purposes to which the property is adapted and for which it is capable of being used and of the enforce able restrictions on its use; and

(C) both the seller and purchaser seek to maximize their gains and neither is in a position to take advantage of the exigencies of the other.

Part (B) of Section 1.04(7) is important to LIHTC apartments because of the enforceable restrictions on the use of the property. Section 23.01 of the code states these restrictions must be taken into consideration because "each property shall be appraised based upon the individual characteristics that affect the property's market value." The LIHTC restrictions limit the residual value and rental rates, and prohibit converting the property to any other use for up to 30 years.

Section 23.21 (Property Used to Provide Affordable Housing) specifically addresses rental restrictions:

(a) In appraising real property that is rented or leased to a low-income individual or family meeting income-eligibility standards established by the owner of the property under regulations or restrictions limiting to a percentage of the individual's or the family's income the amount that they may be required to pay for the rental or lease of the property, the chief appraiser shall take into account the extent to which that use and limitation reduce the value of the property.

(b) In appraising real property that is rented or leased to a low-income individual or family meeting income-eligibility standards established by a governmental entity or under a governmental contract for affordable housing limiting the amount that they may be required to pay for the rental or lease of the property, the chief appraiser shall take into account the extent to which that use and limitation reduce the market value of the property.

The difference between parts (a) and (b) is whether the property owner or the government sets the regulations on the property. In either case, the appraiser must consider how the LIHTC restrictions affect market value of the property.

Valuation Issues with LIHTC Properties

Many valuation issues arise when appraising the market value of an LIHTC property. First, LIHTC property owners experience a loss of residual value due to the right of the government to determine who can purchase the property. Ssecond, there are negative value factors linked to rental rates, including restrictions on rate amounts and increases, and limits on resident income. Finally, liquidity is an issue due to the compliance period of up to 30 years for LIHTC properties. Each of these issues is reviewed next.

Direct Capitalization versus Discounted Cash Flow Analysis

Anecdotal evidence suggests that investors in affordable housing in Texas typically use direct capitalization instead of discounted cash flow analysis to value apartments. Further, appraisal district staff and appraisal review hoard (board of equalization) members also typically use direct capitalization to value affordable apartments. Guarino1 reasonably proposes using a discounted cash flow analysis to value LIHTC properties and tax credits. In contrast, the analysis here uses direct capitalization since it is consistent with methodology used by investors and tax assessors and does not include a value for tax credits, which as previously noted are not considered real property under the Texas Property Tax Code. This study also reviews the impact of illiquidity on valuation of LIHTC properties, which was not addressed in Guarino's work.

Loss of Residual Value

Valuation of an LIHTC apartment complex must take into account the limited resale potential of the property due to the government's right to designate a purchaser. When an LIHTC property owner sells the property at the end of the 15- to 30-year compliance period covered by restrictions, the government has the option of designating a nonprofit as purchaser, usually for the sum of the mortgage and federal taxes owed. (This varies from LURA to LURA, but is prevalent in recent LURAs in Texas and other states.) For owners and investors, resale proceeds are one of the primary benefits of investing in apartments. Because the government-orchestrated sale is likely to be at a value lower than the market value, there is a disincentive to invest that, in turn, affects the value of the property.

Appreciation of a conventional apartment complex and an LIHTC apartment can be compared to show differing rates of return based on resale value. By looking at the investment return from a conventional apartment and an LIHTC apartment that initially had the same income characteristics, it is possible to determine the appropriate adjustment to the capitalization rate if reversion proceeds are not received. For this income model, the conventional apartment used would probably be 25-30 years old. The reason for comparing a newer LIHTC apartment with an older conventional apartment (versus contrasting a new LIHTC with a new conventional apartment) is that they are more similar with regard to value, net operating income per square foot, rental rate, and resident profile. Table 1 shows a comparison of conventional and LIHTC apartment complexes held for 10 years. In this example, the apartment complexes exhibit the following characteristics:

* 200 units with a total of 150,000 net rentable square feet

* Initial rent of $520/month for each unit

* Other income initially $20,000 with a 5.78% annual growth rate

* Gross potential rental income growth rate of 5.78% per year2 for the conventional apartment complex and 5.54% per year for the LIHTC apartment complex, based on the 1995-2005 compound annual growth rate for median annual household income in Texas

* Initial expenses at 57.4% of effective gross income for the conventional apartment, including other income ($5,294/unit), and initial expenses at 58.1% of effective gross income for the LIHTC apartments, including other income ($3,393/unit). This is the same gross level of expenses for the conventional apartments plus $100/unit per year in additional expenses3

* Expense growth rate of 2.45%4

* Total vacancy for the conventional apartment of 9.4%, which includes 7.9% physical vacancy and 1.5% economic vacancy, and for the LIHTC apartment complex, 7.9% total vacancy, which is 1.5% less than conventional5

* A hypothetical initial cost or value of $5 million for both the existing conventional property and the net cost of the LIHTC property, which is used to calculate the difference in the capitalization rate necessary to induce an investor to purchase a LITHC property6

The difference between the yield rate for the conventional apartment and the low-income apartment is in the resale value of the complex; this is due to the government's option to designate a purchaser of the LIHTC property. Resale value of the conventional apartment is $7,264,971, calculated by using the net operating income of year 10 capitalized at 10.25%. Using this number, the internal rate of return (IRR) is 14.0%.

According to LIHTC lenders, property taxes in Texas and many other states are based on the fee simple value. An analysis based on the fee simple value on an unleveraged basis is appropriate, assuming no leverage and assuming the yield rate is equal to the unleveraged IRR. The financial leverage available to the LIHTC investor may be higher or lower than the leverage available to a conventional apartment investor.

The resale value for the LIHTC property is $4,490,900, based upon an initial mortgage of $4 million (80% of initial value for a conventional property) plus federal taxes. Federal taxes recaptured are $490,909, assuming annual depreciation of $327,273 (based on a $9 million depreciable basis and a 27.5-year straight-line depreciation) and a 15% capital gains rate. The depreciable basis is substantially higher than the initial loan amount since the proceeds from selling the tax credits are a significant source of capital for building the property. The 15% capital gains rate is the federal tax rate currently used to tax the gain on real estate held longer than one year. Therefore, the option price of $4,490,900 is the mortgage plus the taxes recaptured. The IRR for the LIHTC property with similar income and operating expenses for the covered period is 10.9%, a rate 22.1% lower than the 14% IRR of the conventional property (a 510 basis point reduction) as a result of the restricted resale value of the property.

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This shows the need for an increase in the LIHTC capitalization rate of 34.99% ((12.46% / 9.23%) -100%) due to the decreased residual value associated with the property. Further, it could be argued that the yield rate should be higher for the LIHTC property, given the limits on rental rate growth, government supervision, income restrictions for residents, and exposure to possible tax credit recapture. Using a yield rate of 16% to 17% would indicate a capitalization rate between 14.46% and 15.46%.

Conversely, it can be argued that a smaller adjustment is appropriate since the owners can elect not to sell the property. While they do not have the option of selling the property to harvest reversion proceeds, they may elect to keep the property to obtain its net cash flow. LIHTC investors report they will typically force the sale of the property at the end of the compliance period to resolve and complete the partnership's business.

The capitalization rate differential is dependent on the remaining term of the LURA. The shorter the term of the LURA, the higher the differential; the longer the term of the LLIRA, the lower the differential.

While the resultant capitalization rates are not precisely consistent with the initial values ($5 million in each case), the primary objective of the preceding analysis is to demonstrate the higher "going-in" capitalization rate necessary to induce an investor to purchase an LIHTC property which has limited terminal reversion proceeds.

While a discounted cash flow analysis is used to determine the appropriate adjustment in the capitalization rate, a direct capitalization analysis is used to calculate market value since appraisal district staff and appraisal review board members are more accustomed to this valuation technique. Alternatively, a discounted cash flow analysis could be applied, but this method of valuation is used infrequently in determining property tax assessments in Texas.

Rental Rate Restrictions

Another issue affecting LIHTC property values is the requirement that residents not pay more than 30% of income for rent.7 This causes rental rates per unit to be lower than those of comparable, conventional properties built about the same time, particularly in urban and suburban areas. The rental rate differential will typically be lower in rural areas, since there is characteristically limited, newly built conventional multifamily housing in rural areas. The conventional properties typically have a higher level of finish and more amenities than the LIHTC properties. Discussions with LIHTC and conventional apartment developers active in Texas indicate that the cost difference is approximately $3 to $7 per square foot of net rentable area. However, while the conventional properties are superior in amenities and finish, the net differential caused by the LURA restrictions results in a rental rate that is much lower than would be indicated by the difference in quality. Table 2 shows a comparison of five pairs of similar apartment properties in Harris County, one conventional and one LIHTC per pair; this illustrates the substantial rental rate reduction for LIHTC properties. The average rent per square foot for the conventional apartment is $0.906, while average rent per square foot for the LIHTC property is $0.728-19.6% lower.

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Rental rates for LIHTC properties in Table 2 bracket the $0.693 per square foot used for Table 1 to document the higher capitalization rate necessary for an LIHTC property. For the purposes of the illustration, a rent level similar to the LIHTC rents was selected and the rent level for the conventional properties had to equal the rent level for the LIHTC properties.

Rental rates for LIHTC properties are linked to and limited by the area median household income and therefore cannot exceed the median household income growth rate. According to the most current Texas data, the compound growth rate in Texas was 3.54% for the period from 1993 to 2003. During this time, owners had to abide by this 3.54% rate instead of a potentially higher increase of market rents. The rate of increase for Texas median household income was below the rate increase for apartment rents in Harris County during this specific period, causing LIHTC rental rates to increase less briskly than rental rates for conventional apartment complexes. Further, while the increase of rental rates is limited, there is no limit to the increase in an owner's potential expenses. Expenses increasing at or above the rate of inflation for LIHTC properties may cause net operating income to decrease if inflation exceeds the median income growth rate. This is a serious restriction since a conventional apartment owner is permitted to adjust rental rates without regard to household income when market conditions dictate the opportunity.

While there is great demand for rent-restricted apartments, the potential owner must balance this positive against the aforementioned risks.

Illiquidity

Assuming all other factors are equal, an illiquid investment is inferior to and worth less than a liquid investment. An illiquid investment does not allow the owner to sell the investment in advance of a declining market. It limits the investor's ability to seek higher return investment options and to adjust asset allocation. Further, the owner cannot sell for personal reasons, such as a transition to a less management-intensive investment, or perhaps to meet other financial obligations.

For a potential owner or investor, illiquidity is a very serious issue and one that may limit those interested in an LIHTC property. Webb8 investigated the effect of marketability on market value and analyzed the problem that an owner of an illiquid investment faces. Webb has suggested a range of 20% to 50% decreases when evaluating illiquid real estate investments.

Hopson and Sheehy9 have reviewed multiple court decisions and determined that marketability discounts in a range of 10% to 50% are necessary to reflect the difference in liquidity.

Transaction costs will cause an investor to demand a discount on the price of the asset equal to the cost of converting the asset to cash. Similarly, investors demand a discount if they are unable to sell the asset for a period of time (e.g., compliance and extended use period). Bajaj et al.10 discuss three main approaches in estimating marketability discounts:

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* The initial public offering (IPO) approach, which compares the price of an asset during a relatively nonmarketable period to a period of increased marketability. Studies of the IPO approach suggest that average private transactions take place at a discount of 45% relative to the price of the same share in the IPO aftermarket.

* The restricted stock approach, which attempts to quantify the marketability discount through shares issued in unregistered private placements. Average discounts on unregistered shares range from 20% to 35%.

* The acquisition approach, which estimates the marketability discount by comparing acquisition prices for public and private companies. The conclusion was a 20.4% discount for private firm transactions relative to an acquisition made by a public counterpart.

Westerfield11, in his article on marketability discounts, reviews several court decisions that indicate that a 25% to 40% discount is appropriate.

Table 3 summarizes the marketability discount rates proposed by the literature examining illiquid investments.

This discussion of discounts for illiquidity or lack of marketability is not a comprehensive review of the topic. For a subject case, there would need to be a careful study of the particular issues, a review published articles, and a review current judicial decisions to determine the appropriate discount. The marketability discount used in an example may be higher or lower than is appropriate, depending on the circumstances. Here, the income analysis for a 200-unit LIHTC property in Harris County uses a 25% discount for this 15- to 25-year holding time.

Effect of Reducing Real Estate Taxes

Reducing the real estate tax assessment will cause lower real estate taxes and higher net operating income. This could lead to higher net operating income than in a conventional apartment complex and higher net operating income than shown in the illustrations in Tables 1 and 4. An iterative process of adjusting the property taxes to a level based upon the prior iteration's market value can lead to a property tax expense estimate consistent with the market value conclusion.

Proposed Valuation Model

Table 4 illustrates a proposed model for valuing an LIHTC property. Gross potential income, vacancy, operating expenses, replacement reserves, and net operating income are the same as used for the LIHTC apartment in Table 1.

Based on a 9.25% capitalization rate, the market value of the property if not encumbered by an LIHTC LURA would be $5,298,245. Based on a 12.46% capitalization rate, which adjusts for the lack of reversion value, the market value would be $3,924,783. This value does not reflect an adjustment for illiquidity (lack of marketability).

The appropriate discount for illiquidity should reflect the remaining term of the LURA and the quality of the income stream; the literature suggests a discount in the range of 20% to 50%. A discount of 25%, near the bottom of the range, has been selected for this illustration. Applying a 25% discount to $3,924,783 indicates a market value as restricted of $2,943,587; this value is 44.4% less than the market value without restrictions ($5,298,245). While this is a meaningful discount, it is reasonable considering the limited reversion proceeds and illiquidity.

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Conclusion

The impact of an LIHTC LURA on market value is substantial. The typical LIHTC LURA limits rental rates, restricts eligible residents, limits appreciation potential, denies the owner the option of selling the property during the compliance period, and exposes the owner to risk due to the limits on rental rate increases. These restrictions vary from LURA to LURA, but are recorded deed restrictions that negatively affect the market value of an LIHTC apartment complex. Thus, in valuing an LIHTC property, these factors must be taken into account and the value adjusted accordingly.