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Gap Financing

Although a significant portion of a LIHTC project's costs can be raised as equity from syndication, additional subsidies may still be needed. HOME funds may be used to help close part or all of the funding "gap" that remains for a LIHTC-funded project after the sale of tax credits and mortgage financing have been determined.

Providing HOME funds to a LIHTC project triggers the HOME layering analysis requirement at 24 CFR 92.250. The layering analysis requires that HOME funds, combined with other government assistance, not exceed what is needed to provide affordable housing. Therefore, it is the responsibility of HOME participating jurisdictions (PJs) to calculate the extent of gap financing needed while considering other public subsidies involved in the project. In such cases, it is recommended that PJs coordinate with the LIHTC administering agency to obtain a complete understanding of the financing involved. The state LIHTC allocating agency is required to make a similar determination (that the project does not use more LIHTCs than necessary). The PJ may want to obtain a copy of this analysis for use in its layering analysis.

SIMPLIFIED EXAMPLE: CALCULATING THE FINANCING GAP FOR A 100 PERCENT LIHTC PROPERTY (UNDER THE 9% CREDIT PROGRAM)

Calculate LIHTC Equity
See example. Assume LIHTC equity of $767,500 for this example.

Calculate First Mortgage Amount

Gross Potential Income =
Less: Rent Loss (7%)
Effective Gross Income =
Less: Operating Expenses
Net Operating Income =
$120,000
(8,400)
111,600
(75,000)
36,600

DSCR = 1.15 : 1

Annual amount available for 1st mortgage repayment ($36,600/1.15) = $31,826

Based on the annual amount available for debt service, the loan maximum is $239,615 (based on a 7%, 30-year self-amortizing loan).

Calculate Financing Gap

Total Development Costs =
Less: First Mortgage =
Less Equity from Sale
of LIHTCs =
Financing Gap =
$1,510,000
(239,615)

(767,500)
$502,885
 






Calculating Gap Financing

To calculate the amount of HOME subsidies needed involves the following steps:

Step 1: Calculate the amount of equity that can be raised through the sale of tax credits, as demonstrated in this module's Topic 2: Calculating Housing Tax Credits.

Step 2: Calculate the maximum market rate mortgage the project can support:

  • Calculate Gross Potential Income, which is the amount of annual rent the project will generate at full occupancy, given the rent restrictions of both the HOME and LIHTC Programs, and given the limitations imposed by local market conditions. It is important to note that many affordable rental housing developments are located in neighborhoods in which the local market rents are lower than the maximum LIHTC and/or HOME rents.
     
  • Adjust Gross Potential Income to account for vacancy and collection losses, typically at 5 to10 percent depending on local market conditions, and on the relationship between the rents to be charged and comparable market rents. Gross Potential Income, minus vacancy / collection loss, equals Effective Gross Income.
     
  • Estimate the annual operating expenses of the project. Typical underwriting practice is to use the higher of the developer's proposed operating expenses and the expenses of comparable projects (that have reached stabilized occupancy and are well managed). Industry norms may also be a useful source of data on operating expenses. For additional information, visit the following agencies' websites: Institute of Real Estate Management, National Apartment Association, and the Urban Land Institute.
     
  • Determine the Replacement Reserve deposit that, in combination with the maintenance budget, will fully fund the estimated long term capital needs of the project

    Note that the property's maintenance budget typically will provide for replacement of short-lived, inexpensive components such as plumbing parts, light bulbs, mini-blinds, interior paint, and door locks. Longer-lived and more expensive items (such as roofs, exterior paint, appliances, carpet, floor tile, windows, and siding) are typically funded from a Replacement Reserve and/or from a combination of Replacement Reserve funds and cash flow. Leading developers and lenders require a property-specific capital needs assessment that estimates the property's likely annual capital needs, by component, for an extended period. All components not covered in the property's maintenance budget will be analyzed in the capital needs assessment. Leading developers and asset managers recommend a capital needs assessment term of at least 20 years, to ensure that the assessment will encompass at least one replacement of most major building systems. Based on the results of the capital needs assessment, the owner, lenders, and regulatory agencies can determine an appropriate Replacement Reserve funding strategy.
     
  • Calculate Net Operating Income (Effective Gross Income, minus operating expenses, minus Replacement Reserve deposit).
     
  • Mortgage debt service is paid from Net Operating Income (NOI). The ratio of available NOI to debt service is expressed as the Debt Service Coverage Ratio (DSCR), which is established by lenders.

    Note that mortgage debt service includes principal, interest, and any credit enhancement costs such as FHA mortgage insurance premiums. Typical multifamily mortgage loans have equal monthly payments toward principal and interest ("level payment" loans).

    Also note that the Debt Service Coverage Ratio (DSCR) is the relationship between NOI and debt service. DSCR is usually expressed either as a ratio (for example, 1.15 : 1) or as a percentage (for example, 115%). Debt Coverage Ratio (DCR) means the same thing as Debt Service Coverage Ratio (DSCR). Typical multifamily loan programs require a minimum DSCR between 1.10 and 1.50.
     
  • Calculate the maximum mortgage loan amount based on the lender's interest rate, the loan term, and the amount available for debt service, using a mortgage calculator.

Step 3: Start with Total Development Cost. Subtract LIHTC equity. Subtract the maximum mortgage loan amounts. Subtract any other sources of funds (such as a grant from a foundation). The result will be the amount of gap financing needed.

Note that the Total Development Cost (TDC) is the sum of all costs of developing the project and leasing it up. The major components of TDC include land cost, site improvements, construction cost, architect and engineering fees, construction loan interest, developer fee, and any initial reserves needed to sustain the project while it is leasing up.