Tax Exempt Bond Financing and Mortgages

Note: This post is technical in nature and not necessarily intended for the accounting faint of heart.

In today's finance world, developers of affordable housing often leverage LIHTC projects with other forms of public financing. (For more information on LIHTC's see previous posting "What the Heck is LIHTC? (Lie-Tech)".)

One form of financing that is commonly used it the tax exempt bond. Tax exempt bonds are issued by government agencies as a means of underwriting affordable housing. There is normally a series of bonds issued to cover both the construction and permanent loan phases of a project (approximately 30 years on average). The construction loan phase is paid at or near "conversion" to permanent financing with equity contributions from the LIHTC investor and the permanent bonds are paid off in phases over the life of the debt service. Interest rates will vary for each of the bonds depending on the length of the bond terms.

Being involved in a bond financed project comes with additional costs, including but not limited to annual Trustee fees, regular arbitrage calculations, state agency monitoring fees and remarketing fees. Not all issues have the same fees, but it is important to understand that interest and principal are not the only period costs incurred in the case of bond financing.

Despite the underlying debt being composed of bond financing, it is becoming more typical to structure the debt service on the Project in the same manner as an amortizable mortgage to cover all of the interest, principal and related fees. It is at this point that the accounting can get tricky.

When a servicer is used for the purposes of collecting the "mortgage payment", the Project will often get a monthly mortgage statement which covers debt service and monthly additions to the required reserves. Sometimes this statement will break out all the fees and reserve payments in addition to the interest and principal and sometimes it won't (believe me, I have seen everything!); but either way, that mortgage payment is not recorded in the same manner as other mortgages.

For a very basic example, here is what’s happening:

1. The Project pays the mortgage and escrow payments to the Servicer.
2. The Servicer transmits payments to the Trustee under some schedule they have and you don’t. Sometimes they keep a portion for their fee (called “interest”) and sometimes they don’t.
3. The Trustee puts the payments in reserve accounts typically labeled as follows: Replacement Reserve, Debt Service Reserve, and Operating Reserve.
4. The Trustee pays interest earnings on the Reserve accounts and sends statements to the Project.
5. On January July 1st, the Trustee makes interest and bond pay downs as required on the face of the bond coupon.
6. Throughout the year, the Trustee either makes payments or sends invoices to the Projects for payments on fees.

If you were following this narrative above, you might consider the fact that the Project has paid its mortgage, but it has ended up in bank accounts on the Project’s books (the Trustee accounts). And because bond pay downs are typically made around January 1; at a December year-end, a number of accountants would show large cash balances held by the Trustee (confirmed) and a large accrued interest and bond payable (due to the bondholders the next day).

If you are already lost on the accounting technology, turn back now!

Now consider this: the Project has paid its mortgage payments on time. There should be at most one month of accrued interest for January's payment in accordance with the mortgage agreement (if the servicer keeps a portion of the interest, none if they don’t). However, the bondholders are still owed their interest, so there would be up to 6 months of accrued interest according to the bond documents.

Both these statements are true, but you have a conflict if you try to account for both since you can’t have both one month and six month’s of accrued interest. That would be weird. So, here is how I have handled this situation in the past (with auditor blessing):

Assuming the servicer is not being paid out of the mortgage payment, the accrued interest is zero. The bond principal (debt) should be reduced to reflect the payment that the Trustee will make the next day. Interest expense should equal the amount paid to the bondholders on July 1st and January 1st (of the next year). The offset for this entry would be a contra-account to the Trustee balances for the amounts due to bondholders. The entries would look like this:

Monthly Mortgage payments:
Debit Trustee Accounts
Credit Cash

Debit Interest Expense
Debit Bond Payable
Credit "Due to Bondholders" (Contra to Trustee Accounts) in accordance with the bond pay down schedule (yes, you need this schedule)

January 1 and July 1 Bond Payments:
Debit "Due to Bondholders"
Credit Trustee Accounts

Monthly Trustee Statement:
Debit Trustee Accounts
Credit Interest income

Debit Any fees (Note: Fees should be analyzed for prepaid accruals as needed)
Credit Trustee Accounts

At year-end, there should be no accrued interest, the balance on the bonds payable should be reduced by the next day's payment, and the Trustee accounts should be shown net of the payment of principal and interest due January 1. This reflects that the required payments have been made by the Project, and there is no other period expense to the project requiring operating cash. This also reflects that the money paid, while still in the Project's name at the Trustee, is not under the Project’s control and is therefore reduced by the TRUSTEE'S obligation to the Bondholders.

I would like to say that the preceding example covers all situations, but alas, each one is slightly different, so you will need to use your noggin. My general advice would be – make sure you get activity statements regularly from both the Servicer and the Trustee. Once you have those, you should FOLLOW THE CASH.

Before submitting financial statements for audit, step back and do a reasonableness test – does interest expense make sense based on the underlying debt obligation and the mortgage payment? If no, go back to the statements and trace it through again until it does make sense.

Next time: Why you should sweep cash from the management company and how you should record it.

What the Heck is LIHTC? (Lie-Tech)

Low Income Housing Tax Credits (LIHTC's) are a tax program used commonly over the past 15 years for affordable housing developments. Pronounced most recently Lie-tech, these so-called tax credit deals are responsible for pushing affordable housing out of the old Section 8 stigma and into a world where you don't always know that you are walking into affordable housing. With notable exceptions, the construction is generally better, the management is more high-class, and the apartments are nicer than what we had previously seen in affordable housing.

Tax credits are generally allocated by various State agencies on behalf of the federal government and can be obtained through a rigorous application process. While there are several very good developers involved in LIHTC housing, the trend has been for not-for-profit corporations to act as developer and owner of these projects. A benefit of having a not-for-profit involved (typically called a CDC or Community Development Corporation) is that they often provide some type of resident services programs that contribute to the stability of the rental population, which in turn keeps these properties more pleasant, livable and healthy. When you are involved with your residents, you can identify and respond more quickly to problems as they arise, before the whole community is affected. Problems can be of both a social and/or livability nature.

The LIHTC is a tax credit that never shows up in GAAP financial data. Rather, it is taken as a dollar for dollar reduction in tax on tax returns. The credit is issued for 15 years with related compliance requirements, but generally received on the return for 10 years.

As a tax exempt entity, CDC's have no use for a tax credit and so they sell their allocation to banks and other consortiums to raise additional financing to complete development of affordable housing projects. In exchange for purchasing the credit, the investors typically retain 99% ownership in the project on a limited basis during the compliance period. Because of the government's involvement and the now typical leveraging of the credit with other types of tax-exempt and federal financing, LIHTC projects should never be undertaken without the assistance of competent professionals versed in these matters.

My Dream Job is a Nightmare

NOTE: Every so often, I write about a different topic than accounting/affordable housing. This is one of those times. I personally believe thinking about other things is relevant to a well rounded business approach and I hope you enjoy my thoughts. However, I feel compelled to disclaim that most of my blogs are of a more business oriented nature. For whatever that is worth.

On my personal page, I follow http://www.dumbemployed.com/, a sometimes funny site that allows people to post snapshots of their day in the format, "At work today, I... (insert funny story) ...I'm dumbemployed."

On March 22, 2010, someone posted the following, "At work today, I did beta testing for a video game. Sounds fun, right? Well, why don't you try running into a wall 50 times in a row? My dream job is a nightmare. I'm dumbemployed." This made me smile and I started thinking of all the times I have heard from the kids that their dream job is to test video games.

I have the same problem in my office all the time. I hear employees expound on what they want to do, and I look at them and think, no you don't. You really don't. The same thing happens with clients.

When faced with this situation, I try to listen to the desire and work with that desire in any way I can, but the reality sometimes crushes the person when it happens. Dreams can cost money and dream jobs can still be, well, work.

The old saying "be careful what you wish for, as you will surely get it" comes to mind. I remember the day I took the words "seeks challenging position" off my resume. I didn't need to seek any challenge, it always seems to land right in my lap. But I do embrace the challenges now, and when I start to imagine that my current dream job (owner of a CPA firm) is a nightmare, I remember the lessons I have learned:

1. Identify the problem and then either finish it first, pay someone else to do it, or get rid of the job. That's it. 3 choices.
2. You chose to be where you're sitting. I know that sometimes it feels like you are wandering down some pre-ordained path; but in reality, you make choices every day to be right where you are. You could change.
3. Living really is about the path. If you have "arrived", start looking for the new path (the next dream) or you will stagnate.

Okay, you have the three lessons I apply when faced with the prospect that My Dream Job is a Nightmare. To continue in the cheesy quote tradition - I never said it would be easy, just that it would be worth it.

Managing Your Affordable Housing Portfolio (A Brief Introduction)

Real estate development has slowed over the past years and the focus for developers and owners of Affordable Housing has turned to managing the assets that they do have. Frankly, the cost of managing projects was never contemplated as a Company cost and was never underwritten when the deal was put together. In the past, the Managing Member or General Partner just provided administrative support and the Company paid for its audit.

In the current environment of accounting regulation, it is clear that the management company financial information, while useful for determining cash flow, is not sufficient for producing GAAP financial information on a quarterly/annual basis. Additionally, there are important development milestones that are met during the course of the compliance periods which need to be monitored for both the Investor and the Manager and the Manager is charged with monitoring the management company and on-going operations.

When these duties are performed by qualified individuals, an additional cost to the Company is incurred, and then the negotiating begins. Who pays the costs to manage these properties? Is it really the Manager's job to fund this from their "Partnership Administration Fees", a cash-flow fee that they may never actually generate? Or do we need to budget in these costs the same as we budget in the organization's audit?

In light of the fact that many non-profit Community Development Corporations are scrambling to fund operations with no development fees, and many Investors are reluctant to take back the management and ownership of the Projects, it is becoming more commonplace to bill this work directly to the project. Fortunately, occupancy for most projects has been stable in the down economy and cash flow can cover these expenses. However, as mentioned above, these were not underwritten costs and cash flow for these costs may not be sustainable.

Further education, discussion and decisions are going to have to be made on how a Project is expected to pay for the costs of Asset Management by the Company during the compliance period and going forward.