Our Perspective 12/ 16/ 2019

Will James responds to Multi-Housing News questions on adaptive reuse

What are the best financing sources for adaptive reuse projects and why?
Non-recourse lenders (debt funds, mortgage REITS, etc.) tend to be more interested adaptive reuse given the complicated nature of these transactions.

Have these capital sources changed in the past few years? How?
Yes. In the past few years, many debt funds have entered the market, but a select few non-bank/non-life company balance sheet lenders have also entered the picture.

What makes an adaptive reuse project ‘easier’ to finance (more attractive to lenders/investors)?
There is nothing easy about adaptive reuse. Many times it includes unknown construction risks that are uncovered only after construction starts. Adaptive reuse frequently involves high profile buildings left dormant, so from this perspective lenders may gravitate to having interest but the risks are higher.

What are the particularities of financing an adaptive reuse project (versus a regular multifamily construction project)? Is it more difficult or easier to finance the conversion of a historic building? Why (not)?
Most adaptive reuse entails historic tax credits (HTC) which provide a grant, so to speak, from the federal and state tax authorities. Many times the local property tax authority will also provide a property tax abatement. How the HTC and property tax abatements interface with the value of the property are essential to a developer’s success. The property tax abatement really doesn’t provide much at the construction phase (unless there is a HUD loan involved), but usually proves valuable for the refinancing/permanent loan phase of the project.

How did interest rate volatility impact the adaptive reuse financing segment?
Adaptive reuse felt the impact of interest rate volatility no different than conventional market rate multifamily/apartments.

What are the challenges of financing adaptive reuse projects? How can these be overcome?
In most deals developer experience is key. But in some rare cases the project can be so profitable that an inexperienced adaptive reuse developer can assemble the right team to execute a complicated HTC adaptive reuse project.

Are any tax incentives for adaptive reuse projects (historical preservation, decontaminating brownfields, etc.) available in any of the markets you are active in/operate in? Tell us more about this.
Brownfields are autominous, site specific and not tied to HTC programs. A site qualifies based on known historical uses. Some ground-up construction projects will have a brownfield program. Federal historic tax credits are available in any project registered on the national historic registry and the federal program generally speaking drives the respective state program as well.

Some states are more lucrative than others where mill credits and empty building credits are applicable if a project qualifies. Others are so sporadic in their programs that it’s difficult for developers to rely on the state to routinely pass the same rules and regulations year-after-year. This means that some projects simply do not happen.

One state in particular currently does not have a 2022 program. The adjacent state’s program, however, is bankable. It’s always there, and that state’s programs are 2-2.5x times more lucrative providing developer’s ample protection to convert otherwise dormant buildings. There is a lot risk in these deals, and in all cases these programs are essential to redeveloping a building that has been dormant for decades.

Give the developer economic incentive to take the risk so the immediately surrounding area will transition increasing property, sales, hotel and other taxes. The upfront HTC investment will generate many other tax revenues for the area. Anything is better than letting an 80-year old building sit dormant.

Tell us about a recent adaptive reuse financing deal that is illustrative of current trends in this segment.
The competitive lender landscape today has made financing HTC transactions more predictable. Understanding the end value and where these historic tax credit programs provide the assistance for the developer to take the risk is key.

What are your expectations on adaptive reuse financing for multifamily in 2020?
In regards to Macro level factors, yes, more adaptive reuse projects are now viable today given where rents are in this current cycle. Class A rents topped out at $1.50 to $1.75 per square foot in the last cycle that ended in 2008, but today rents are nearly double making these projects more viable.

The other factor is the state the asset is located. Some state governments are not focused on their HTC program. One state will give you a 20-year tax abatement, but another will want full taxes phased in over a 10 year period. One state did make the program more lucrative in 2016, but it was substantially underfunded that year and subsequent years. The demand for these credits far outweighs the supply. Some politicians view these programs as windfalls for the developer. A state’s pipeline of HTC projects is the proof needed to gauge a program’s importance in the community.