Episode #3: Preserving Legacy: Success Stories in Real Estate Revitalization

Monarch Perspectives

Click here to listen and learn. Follow along with the transcript below.

Steve LeClere:
Welcome to Monarch Perspectives. I’m Steve LeClere, partner at Monarch Private Capital, focused on affordable housing.

Rick Chukas:
Greetings, and welcome to another episode of Monarch Perspectives. I’m Rick Chukas and I’m joined by my co-host, Steve LeClere. Today we’d like to delve into what’s going on in the historic tax credit space. Historic tax credit transactions are encountering headwinds in terms of sourcing debt, in getting the capital stack put together.

As I suspect Steve, you may be seeing this in low-income housing transactions as well.

Steve LeClere:
Absolutely, Rick. Good to be with you today. As you mentioned, there have been a number of challenges in putting deals together, interest rates chief among them, that impact primarily the debt financing on these transactions, and how we’re able to make ends meet, and put all the pieces together necessary to make the transactions work. And these clearly have spillover effects in LiTech, and I’m sure they impact many aspects of historic transactions as well.

Rick Chukas:
Exactly. And to gain a deeper insight into what’s going on, we’re honored to have Philip Welker as our guest. Philip is managing director of BNA Associates headquartered in Nashville. Philip and his firm have firsthand experience in working with the historic tax credit, and have undertaken a number of rehab projects, including the very successful Clermont Hotel in Atlanta. A warm thank you for being here, Philip.

Philip Welker:
Thank you Rick, Steve. Happy to be here. Let’s dive in.

Rick Chukas:
Philip, at the moment, what are some of the challenges in getting any real estate transaction closed?

Philip Welker:
I can speak more specifically about hotels, because that’s what we’ve been more involved in. And we’ve got a historic hotel transaction up in Knoxville right now we’re trying to close. It’s really just debt equity, raising all the capital.

I think equity right now, what we’re hearing seems to be either sitting on the sidelines, waiting for more distress. Or trying to really evaluate what equity-like returns should be in this market, given there’s a 5% risk-free rate, an 11% rate on senior loans.

On the debt side, the traditional lenders are being cautious because they’re seeing a lot of capital outflows from banks going into money market funds and other non-traditional investment sources that have had lower interest rates for the past 10 years. And also, they’re starting to see a big increase in pressure from regulators. So any kind of construction financing, anything without cashflow in place, is challenging.

Especially as you get into the hospitality market, which some see as, maybe potentially been overbuilt in some markets. We’re definitely seeing the fund debt pick up. They’re actively working to try to fill that void. But given the lack of interest from traditional banks, they’re seeing such a large volume of interest that we’re seeing them even be more selective.

Steve LeClere:
So given that the equity and debt markets have been somewhat chilled by the runup in rates, and thereby the runup in expected investor returns, how are transactions made easier by the introduction of the historic credit? Or does the introduction of the historic credit complicate matters further?

Philip Welker:
Well, it does a little bit of both. What makes a historic tax credit transaction easier is both when equity and debt sources see that incentive in place, right? So they’re looking as the cost basis being brought down. It’s kind of subsidizing the project to maybe give a competitive advantage against non-historic tax credit projects.

But what makes it more difficult is after you pass that initial hurdle, the devil’s in the details. And so when you get into the transaction documents. And then things get brought up like non-disturbance agreements with lenders, just to protect the tax credit investor and the sponsor. But really, even all parties from a negative effect of a recapture event, in the event that a project doesn’t work out before the compliance period’s over.
The same kind of goes for the equity investors and the fact that they know that they’re going to be locked in for a five-year hold period after a construction period.

And with that comes the uncertainty of what that market might look like in year six when you’re out of compliance. A lot of times we go into these projects thinking, hey, the economy’s good. Now, let’s build something. And when you’re done with the project, you want to go ahead and immediately sell it and try to monetize it. But then you got to hold to it.

A good example is, when I got started, my first projects were historic tax credit projects. And I built a number of residential conversion condominiums in Knoxville, and held onto them for five years and rented them. And when it came time to sell, 2007 came around and we entered a lease purchase agreements for both of them. And then when 2008 came around, neither of them ended up closing. 23 years later, I still owned those properties.
So they would’ve been great to sell in 2005, but it just, I wasn’t out of my compliance period yet.

Rick Chukas:
Philip, you mentioned hospitality is clearly in your gun sites currently. Are there specific real estate product types that you think are a better use of the historic tax credit?

Philip Welker:
I think anything like office, or retail, or industrial, where you can get a lease agreement that extends beyond the HTC period is ideal. I mean, I think investors and everybody likes to see that. But outside that, between market rate residential and hospitality, I think it’s a pretty even impact on the economics to an investor.

Hospitality has a slight disadvantage in the fact that a smaller percentage of the capital stack comes into a hotel. Because a lot of costs like furniture, fixtures, equipment opening inventory, payroll. And then the third party fees and interests that are allocated towards those items are ineligible for tax credits.

So potentially during the project, if those costs increase, you’re not getting the offset increase in credit to help absorb them. On the multifamily side, you definitely see, or you get a higher a senior loan debt leverage. You’re seeing HTC represent a much larger share of the overall equity stack.
And then when costs overrun on a hard cost basis, you’re kind of riding that with you. Because you don’t have a lot of the ineligible costs you do on the hospitality side.

Steve LeClere:
So taking a step back just for a second, maybe it would be helpful if you could give a bit more of an overview on how the historic program works, generally at a high level. And then what it’s like working with the consultants, the architect, the state historic preservation offices, and the National Park Service that really administer this program, and make these deals work from the front end. Because there’s a long period between when you put in a part one application and when you start swinging hammers on-site.

Philip Welker:
Yeah, right. Correct. Well the program, I think in its current iteration, dates back to 1986. And it’s a 20% credit against a certain eligible, pretty much your hard project cost. And you can take those credits and either use them yourself, or monetize them as most people do. And that goes into your capital stack.
So out of say, a hundred percent funding in a project, by the time you sell your credits and stuff, you might have 10 or 15% of that credit providing your funding. And so in doing those projects, the more prepared you are for what the requirements are and knowing the expectations, the smoother the process is going to be.

I always advise developers getting into it to go ahead and read and study the National Park Service guidelines for Historic Preservation. It’s a great document that outlines best practices, with illustrations of ways to go about restoring something and ways to not go about it. We even take those guidelines and reference them in our contracts we do with designers and contractors, just to make sure they’re aware of them.

I generally find state preservation offices, SHPOs, as they call them, the National Park Service, to be very helpful and resourceful in getting projects done. Everybody has the same goals. They want to see projects preserved. And so developers, especially if you can relate to what their requirements are, and you know the ropes, and you’re not proposing things to them that are controversial, really goes a long way to build their confidence in you and make the process a lot smoother.

And I always advise, definitely retaining the expertise of an HTC consultant to go ahead and file your part one, your part two, and your part three. Their ability to describe the project, and your rehabilitation efforts in words and in a method that the SHPO and National Park Service can definitely relate to will help those applications immensely from edits and other kind of revisions.

Then I always advise that retaining the expertise of an HTC consultant that has experience in that project’s jurisdiction, and specifically with that state’s SHIPO, is always a leg-up. And have an HTTs consultant, be able to file your part ones, part two, and part three.

And hiring architects. It’s always good to hire architects that have experience in adaptive reuse. I don’t think they necessarily have to have historic preservation experience. I think as long as you have the right HTC consultant on-board to help guide the architect on how to document the finishes, and what’s qualified rehabilitation expenditures and what’s not, that can be a process you can work through and be learned.

But having the ability to know how to adapt modern codes to old buildings is probably the most critical skill in working with an architecture on a preservation project.

Rick Chukas:
Philip, as you know, when we’re talking to institutional investors, we’re talking about impact investing. Which obviously includes jobs creation, sustainability, et cetera, and there’s been a fair amount of discussion about how the historic credit really helps communities create jobs and promote sustainability.

Interested in your thoughts about that, what you’ve seen, and what you’ve witnessed on the particular rehab projects you’ve undertaken.

Philip Welker:
Yeah, I mean, absolutely. I think for job creation specifically, it’s more than just during the development period, and for a specific project.
I mean, generally you see entire communities benefit from having their entire historic fabric woven in. With both the new development, it creates more visitation from tourists. We see increased patronage from the local community. We see expanded tax bases in areas that, maybe it hit some distressed.
I started my career and cut my teeth in downtown Knoxville. And in the 1990s, for the most part, it was a ghost town in downtown. And slowly buildings were converted into residential loft communities. Retail followed it, hotels. Now you have a lot of live entertainment. It’s a destination for restaurants. Downtown Knoxville has just completely reemerged as an amazing tax base and community center for the citizens of Knoxville.

Regarding sustainability, the important part of the HTC process is that it reuses building stock, and it doesn’t create as much landfill. I think that’s the biggest sustainability benefit from the historic preservation process. It just always kills me how much waste is created, specifically by these sports stadiums, when they’re built and used for only 20 or 30 years, and then they’re torn down for a new stadium. That’s a lot of material that goes back into a landfill and stuff.

It’s expensive and difficult to take an existing property, pay what the current property owner wants, only to have the building on that piece of land not be able to be reused.

Steve LeClere:
Philip, circling back to the challenges in raising equity for projects. You mentioned in your overview of the program that developer can either take the historic credits themself, or they can bring in a third party historic tax credit equity investor. Can you speak to the challenges of bringing in a third party historic equity investor, versus how that might be similar or different from sourcing traditional sponsor equity or private equity on a more conventional asset?

Philip Welker:
Anytime you have more parties involved, there’s more complication. My experience is, in bringing in a third party tax credit investor, it’s a much more structured investment than sponsor equity. A lot of times it’s kind of working with a lender and the fact that the way you structure a deal, they fund the deal, and on the documentation side.

Whereas on the sponsor equity side, it’s always a lot looser. Because the investment always has the promise of unlimited upside, to where the tax credit equity side’s a lot more structured in. This is how much money that we’re investing, this is kind of our payout, and we kind of contractually feel like we’re going to get an exit at a certain period in time, at a certain strike price.

I think it all really comes down to the quality of the third party equity investor, and their willingness to take risks with you and work through issues. I mean, no project is perfect. But groups that like you all that have had a lot of experience with these things, you know the ropes, and you do them, it obviously makes the process a lot smoother than trying to transact with a group that might be even a degree or two further away from the actual source of the HTC money.

Steve LeClere:
Rick, that might be your first ever client testimonial.

Rick Chukas:
Wow.

You’ve done, I know, both traditional debt and what we consider fund debt. And I think clearly in today’s environment, we’re seeing much more fund debt come into projects. Other than getting your hands on the cash and finding willing borrowers, what are the challenges today of each, in your experience?

Philip Welker:
Well, traditional debt, the bank debt’s, definitely the stricter availability. Just their lack of ability at this point to really take on new construction projects.
But then for the projects and the developers, there’s always the recourse risk, right? So there’s just the trade-off between interest rate and risk.
As you alluded to, the fund debt is definitely a lot more available today. At a much higher cost, obviously. My experience with fund debt is, you can almost get them to do anything as long as you pay them for it. Traditional banks, not so much.

We’ve tried offering some balance sheet lenders like, well, what if we paid you a little bit higher rate, or we did it this way? And it’s no, our credit committee in our box is this. And again, a lot of that has to do with the regulatory process over traditional banks versus not being in the fund debt world.

Steve LeClere:
So given the costs of debt capital, be it the regulatory restrictions impacting banks and their ability or willingness to lend. And then debt funds scooping in to fill that gap, but at a much higher price, equity returns being higher than we’ve seen required in other years, just given the runup and the risk-free rate. What are you seeing in terms of how deals are being put together right now, and what capital stack of a deal you’re going to do two years from now is going to look like?

Is it going to require some additional sources, some gap funds from states or cities to fill in those holes? Or do you think you’ll be able to still balance out a deal with debt and equity just from different sources?

Philip Welker:
You could still balance out a project with debt and equity from traditional sources. I don’t know at this point that I see a real increase in state and government incentives playing much of a role, at least in the kind of projects that we’re doing.

I mean, we’ve always had those there, right? So our Knoxville project’s got a pilot in place, and we’ve got the historic tax credits. Our Clarksville development project has a tax increment package in place. And those are tools that have always been around. I don’t see new things being invented or used by municipalities to help deals along, at least not yet.

I think you’re starting to see a lot of interest in the preferred equity space. And again, I think that comes back to equity investors trying to find what’s the right compensation for project equity at this point. They’re having difficulty believing that they should go in on an equity basis and get anything in the high twenties. They still want returns that are in the low to mid-teens.

But they feel like they can, because debt is 11%, they want to come in and play a preferred equity role in that 13, to 17, to 19% range. You see new products like PACE coming into the market that add a new layer of complication to things. But I don’t think more complication is something that the market wants. I think the market creates vehicles to work around certain structural requirements like PACE, that eventually will improve and simplify in the future.

Rick Chukas:
I have always said historic rehab is not for the faint of heart. As you know, Philip, probably better than anybody else. Oftentimes, you don’t know what you’re getting into until you’re in there, peeling the layers of the onion skin back. And clearly there has no how-to handbook on historic rehab. I think experience is a great teacher.

So in that vein, any particular lessons that you’ve learned from the rehab deals that you’ve done?

Philip Welker:
When doing historic tax credit projects, and you’re doing your market analysis, I think you need to make sure to price in the demolition and other stabilization costs in with the land when evaluating a historic tax credit project versus a project that does not have historic tax credits. If you’re doing a ground-up hotel or a ground-up building.

The other one is, really be proactive in submitting National Park Service Amendments throughout the project, rather than waiting to the end after the work’s been completed. I think the more frequently you can keep them updated, even on a monthly basis, the more informed they feel throughout the process and the more helpful they can be in addressing the challenges that you happen to uncover that are unknown during a rehab project.
The other lesson I’ve learned in rehabilitation projects over the years is, it’s always better in the long term to go ahead and take advantage of historic tax credits on eligible hard costs on the front end. By going ahead and replacing major building systems, replacing roofs that might be halfway through end-of-life.

Rather than, well, I can save a little bit of money today by putting off this improvement for another 6, 8, 10 years. Go ahead and create a brand new building today, and take the tax credits against it. Versus potentially ending up with some deferred maintenance later.

Steve LeClere:
So Philip, given the focus on hospitality that seems to have been the trend for BNA in recent years, what does the future hold? Do you expect hospitality continue to be the focus? Or an expansion into other types of redevelopment?

Philip Welker:
Yeah, and I think hospitality will continue to be the main focus. I mean, we’ve built up a management company, and we’ve got just an incredible team around us that knows how to manage those assets. And so we’re going to continue to expand into markets that look a lot like the markets we’re already in. Which are kind of secondary and tertiary markets that have a demand for certain design lifestyle hotels, but don’t have those hotels yet.
But then we’re also kind of going back to the markets they’re already in, and looking to do secondary projects. Knoxville’s a good example. We’re doing our second hotel in Knoxville. I’d love to come back and do another hotel in Atlanta if we could ever find the right project to fit that. But generally, if it’s not hospitality, we look to invest in projects that have both a social and economic impact on their communities.

One being a Riverview Square project in Clarksville, Tennessee we’re doing right now. None of it is sort tax credits. We’re actually taking a 1980s, 156-room hotel and converting it into a Hilton DoubleTree. The county’s building a public parking garage on 1.4 acres that we donated to them for that purpose.

And what that did, is that freed up over 130 surface parking spaces in front of our hotel that we’re going to turn into 50,000 square feet of entertainment retail. And this is all about getting a critical mass together to help build out and encourage downtown development in Clarksville.
We want to do historic preservation projects. I think to us, they’re just a lot more rewarding, and that’s why. We’ve taken on the Andrew Johnson project in Knoxville. It’s an important structure for that community, and so I think that’s always got a special place in our portfolio.

Rick Chukas:
Well, Philip, appreciate very much your insights into the world of historic rehab and redevelopment. Very, very insightful, and congrats on the continued success of BNA Associates. Steve, as always, you’re a heck of a co-host and thank you all.

Philip Welker:
Rick, Steve, it’s been a pleasure.

Steve LeClere:
Pleasure, Philip. Thanks for the partnership. Rick, always happy to ride your coattails and follow your lead on these podcasts.

Rick Chukas:
That’s a wrap.

Steve LeClere:
Thanks for joining us on this episode of Monarch Perspectives. We hope you will follow and subscribe so you never miss an episode.

Rick Chukas:
Be sure to rate and review us wherever you get your podcast. To learn more about Monarch Private Capital, please visit monarchprivate.com.