A Guide for Creating and Preserving Affordable Artist Spaces
Pro Formas and Pre-Development Costs
From the very beginning you need to be preparing a financial model or "pro forma" of the project. There should always be an understanding of the project's finances from the earliest phases to the latest phases. These costs will include the cost of acquisition, construction, design, engineering and other soft costs, and the costs of borrowing money. The pro forma is a flexible working document that will change as different inputs and outputs occur during the process of development, and it is imperative that someone on your team understands how this works.
Depending on size and complexity, soft costs can be a significant portion of your pro forma. Examples of soft costs are:
- Architectural and engineering services
- Site survey
- Environmental analysis
- Code analysis
- Legal services
- Loan fees
- Marketing materials
- Project coordinator
You will certainly incur costs before construction financing is in place. In most artist projects, the developer or group of artists has to put up the money to cover these "pre-development costs". You should have a formal agreement that any money you put in will cover certain costs in a phased way. Once again, someone who has gone through a real estate project is an invaluable person to have on your team.
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Sources of Financing
When you are obtaining financing, you are, in effect, buying money. As with anything else you buy, you should shop around for the best deal. Your development consultant or attorney should be familiar with various banks and the products they offer. Every building project has a mixture of money you put into it (equity) and money borrowed form a bank (debt).
The decision to purchase a building comes down to two issues:
- Whether the artists/group has enough money (equity) for the initial down payment;
- Whether the artists/group can convince potential lenders that it will have sufficient cash each month to pay mortgage (debt service) and the operating costs.
Down payment (equity): Lenders require that the borrower have some of its own money (equity) in the project. That money is your down payment. If you can make a large down payment, you will need to borrow less, and therefore your monthly payment will be less. Since the mortgage would be lower, the total amount paid in interest would be lower. Reducing interest costs may be a disadvantage, however, if you are looking to maximize your income tax deductions.
Mortgage (Debt) Financing: A mortgage refers to the money that you borrow to pay for the purchase and renovation costs of a building. Most lenders base their maximum loan on 80 percent of the appraised value of the acquisition and construction costs of the building.
Financing involves a two-stage process that consists of:
- Construction Financing (interim)
- Permanent Financing
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Acquisition and construction financing are usually paired together with the same bank. While acquisition and construction financing comes first, it is not as critical as permanent financing because construction lenders, notably commercial banks, need to be assured that, at the end of the construction period funds will be available to pay off the construction loan. Such assurance that these funds will be paid comes in the form of a permanent (or "takeout") commitment by the permanent lender. This form of financing limits the construction lender's risks to those risks involved in the construction process.
In the case of condominium financing, the transition from construction to permanent financing is achieved through a series of transactions as individual studios or units in the condominium are purchased by unit owners with their own mortgages.
Construction loan risks: While a construction loan is less risky with a takeout commitment in place, there are certainly risks involved, including:
- Labor problems
- Insolvency of the contractor
- Supplier problems
- Poor planning and management
Because of these risks, construction loans have the following features:
- Short terms
- Higher interest rates
- Staged disbursements – the loans are given in stages to match the phasing of construction, you pay interest only on those funds released.
- Partial financing – loans represent a percentage of lender's estimated value of the property (typically 80 percent)
- Permanent financing commitment required
- Personal guarantees from the borrowers
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Permanent Financing (medium or long term)
A lender must feel secure that the market value of the property will remain high during the term of the loan and that the individual (in the case of a condominium) or the group (in the case of a co-operative) can afford the monthly carrying costs. It's important to ensure that there will be adequate cash flow. The monthly carrying costs not only cover the debt service (principle and interest on the loan), but also include the operating and maintenance costs.
Traditionally, the lender will make a judgment about your ability to repay the loan based upon certain ratios of income to housing expenses. One common formula is that one should not pay more than 28 percent of gross income for housing and not more than 36 percent of gross income for all debt. Lenders are more liberal with their income ratio on formulas for projects financed as co-ops and/or by making a case that artist studios are places of business in addition to being available as living space.
If utilizing a condominium approach, the construction lenders may require that each of the potential buyers (or group members) obtain an individual form of preliminary permanent financing commitment.
Seller Financing: Several artist-initiated projects have used seller financing (often referred to as a "purchase-money mortgage") to fill a gap between the artists' equity and the loan from a conventional lender. This type of financing is secured by a second or subordinated mortgage. For example, if the total development cost of a project is $1 million and a bank is willing to lend $800,000, but your group only can come up with $100,000 in cash (equity), one way of filling the gap and making the deal work is to ask the seller for a $100,000 purchase-money mortgage. This, in effect, reduces your need for up front cash, although it increases your overall debt.
Financing Co-ops: In co-ops, all of the artists/members will be screened before the lender commits itself to make a blanket loan. One aspect of a co-op is that the presence of several financially strong members can help a lender accept other members with lower incomes and/or fewer assets. The typical lender for a co-op is a commercial bank or insurance company. The length of the commitment is usually five years, although some lenders may go as long as 15 years. You can negotiate for a long–term amortization or payback period, for example, 25-30 years, even though the term of the actual loan may be much shorter. These short-term loans are not unusual for commercial real estate projects, but it is preferable to obtain a long term commitment and hopefully a fixed-rate mortgage. Your objective should be to reduce uncertainty about the long-term costs of the project.
It may be useful to discuss these issues with a few different lenders early in the process so that before incurring major expenses the group can make an informed and realistic judgment about their ability to qualify for financing.
Loan Presentations: Whether you are applying for a conventional loan or a small pre-development loan/grant, the presentation of your business plan is crucial to the outcome. The business plan is a sample of your work and an extension of your competence. You and your project will be judged on the merits of your plan. It must be a first-class, professional presentation. While there is no standard format, several elements should be included:
- Summary of project and loan request
- Developer/development team information
- Project analysis, including:
- Description of the property
- Floor plans
- Engineer's reports
- Description of the intended market for the units in the project
- Income and expense statements
- Financial analysis for the development (a "pro forma")
- Timetable – a detailed schedule for the development of the project
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Tax Credits: Federal and State
The government provides tax credits for creation of affordable housing and historic tax credits for the restoration of certified historic structures. A "new market" tax credit is also available to mixed use and commercial projects in economically targeted areas. These credits, singly and in combination, can provide much of the equity needed for a project.
Tax credit projects are best left to experienced developers. Matching the credits to investors who can use them, meeting the detailed requirements of the programs, and servicing the information demands of the investors and the IRS, are all beyond the scope of most people. However, teaming with a for-profit developer, or a not-for-profit Community Development Corporation (CDC), can bring expertise and project management. Therefore, it is always wise to consider the potential for tax credits, especially if the project is large, is rental, is in an historic district, or a New Markets census tract.
LOW-INCOME HOUSING & NEW MARKET TAX CREDIT
In every state, the Low-Income Housing Tax Credit (LIHTC) is allocated according to guidelines set forth by each state's Qualified Allocation Plan or QAP. Massachusetts is very conservative in allowing its LIHTC's to support affordable housing explicitly built for artists. As a result, developers of artist space typically forego the LIHTC.
New Markets Credits are designed to bring commercial investment into lower income areas. Generally, the credit is available for investments in mixed-use projects where more than 20 percent of the gross rental income is from non-residential rentals. New Markets credits are complex to administer, due to the fact that special entities known as Community Development Entities (CDE) must be formed in the ownership structure to use them. A logical sequence to determine if these credits might apply to a non-residential arts project starts by asking the economic development director of your municipality if your project is located within a qualified census tract that meets the median income standard. When properly managed, this program can bring useful funds, but it is complex and requires significant third party expertise.
HISTORIC TAX CREDITS
The Federal Government provides a 20 percent tax credit to developers of certified historic renovations. The federal government also provides a 10 percent tax credit to support non-historic renovations of non-residential buildings over 50 years old. Historic credits are not difficult to understand, but there are numerous crucial details that must be correctly addressed. Federal historic credits are not suitable for condominium or co-op (owner-occupied) projects. They are only good sources for income producing properties/rental projects, which may later be sold to occupants no sooner than five years after they are completed.
The Massachusetts historic credits may be granted for amounts ranging from one percent to 20 percent of the qualified rehabilitation costs. The total for Massachusetts credits was recently raised to $50 million per year. It has regulations similar to the federal credit, although state credits do not require that the credit investor be within the partnership, which makes them applicable to condos and co-ops.
THE 10% REHABILITATION TAX CREDIT
The 10 percent tax credit is a good fit for non-historic, non-residential work-space renovation projects. It does not involve historic approvals. Think of it as a sort of "green" credit. The federal government is subsidizing you to keep an old building standing, to avoid sending it — and its embedded energy — into the land-fill. This tax credit is available for the rehabilitation of non-historic buildings placed in service before 1936.
Project owners can take a credit off their federal income tax bill in the amount of 10 percent of most construction and "soft" development costs. Like all things tax-related, the details are important, so one needs to proceed with an open mind when looking over this source of funds, and — it goes without saying — you need to contact an accountant as soon as it looks like you might be able to use the credits.
What is good about this 10 percent credit?
- You don't need to submit your plans for historic review.
- You don't need to get your building on any historic register.
- There is almost no bureaucracy involved.
- You can make major modifications to the building as long as they meet code. It does not add to the construction or design cost at all.
- There is almost no paperwork to do to claim the credit.
- In small amounts this credit can be used by ordinary people, not just corporations.
What is daunting about this credit?
- In large projects the credit gets too big for use on personal tax returns, so you would need to bring in investors which creates legal and accounting expenses up front, and to some extent annually if they are partners.
- You need to commit to keeping the project afloat for at least five years or else pay back part of the credit if you used it all up front.
- You need to have a CPA accountant, not just a tax preparer, if you are going to use this credit, especially in the first year. CPAs generally charge more for services than tax preparers..
Historic credits may be used in combination with other forms of credits, especially when the same tax paying entity is using them together. Often they are packaged with Low Income Housing Tax credits, but examples of artist projects located in Massachusetts are rare. The historic credits may also be used in conjunction with New Markets credits to help fund mixed-use arts projects.
Larger projects fare better with tax credits since the documentation costs are similar no matter the size of the project. The legal and accounting overhead is significant. While complex, creditis can be quite helpful in galvanizing a major initiative in an older urban area.
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