Caveat Emptor: Joint Ventures With For-Profit Real Estate Developers

“Here’s the deal,” the consultant says. “We will take care of everything – all the paperwork, the financing, the construction, and even the property management – all you have to do is sign a few papers, and you will own 75 units of affordable housing. You don’t need to do a thing.” She hands over a three-page document, flipping to the last page. “This agreement gives us your authorization to act in your behalf. It’s really a formality, because we trust you, but you know how the state is.” She gestures at the signature line with a pen held out for you. You take the document and flip through it. Words like “payment of consultants fees,” “ownership of papers and information,” “partnership to be formed,” “tax credit applications,” and “property management” catch your eye, momentarily.

“You’re sure that all we have to do is sign and you can take care of everything else? Boy, that would be great. We really need some low-income housing here in Western City.”

It is now four years later. The project was completed two years ago. On your desk is a letter from the IRS telling you that your agency’s tax-exempt status is being reviewed for noncompliance with IRS regulations. Buried in the legalese is a reference to your tax credit partnership that the consultant put together for you. And there are other problems.

Occupancy rates are low, perpetually hovering around 70 percent. Many of the tenants owe rent. Every time you drive through the project you see moving trailers, people either moving in or moving out. You see litter and garbage all around and the dumpsters overfilled. The buildings look old, paint peeling and trim work missing or seriously warped. The last time you stopped by the on-site office, the manager did not know who you were, could not find the current rent roll, and was not sure what the income eligibility requirements for renting were.

The last monthly status report from the property management firm (the original consultant) was four months old. Your board wants a status report and explanation for the financial drain on the agency budget resulting from not receiving the equity payments from the investors as promised by the consultant.

What’s wrong with this picture? What went wrong? You thought you were getting a great deal. Why, if it hadn’t been for the consultant these units wouldn’t even exist.

Unfortunately, the above description is not so unusual. In the last year I have observed three different agencies involved in similar transactions and have heard stories of many more. We are observing a trend of for-profit developers and consultants seeking out inexperienced nonprofit organizations and offering deals to create affordable housing projects that require the nonprofit agency to exert no or very little time or resources. There is real danger in such deals. For example, the USDA Section 515 Rural Rental Housing Program almost disappeared after the Government Accounting Office found widespread fraud and abuse in the program. The Department of Housing and Urban Development banned nonprofit agencies created by for-profit developers from qualifying as Community Housing Development Organizations (CHDOs).

Why Are These For-Profit Developers Approaching Nonprofit Agencies?

Tax credit allocations are seriously oversubscribed almost everywhere. Many states find that applications for HOME Program funding far exceed the available resources. Both the HOME Program and the Low-Income Housing Tax Credit Program (LIHTC) have set-asides for nonprofit developments. Some states find these set-asides under-utilized. By “partnering” with a nonprofit developer, for-profit developers are able to gain access to financing for their projects.

Do’s and Don’ts

When you are approached by a for-profit developer offering to put you in a real estate transaction, what should you expect for your participation? We offer the following checklist of do’s and don’ts.

Assess Your Assets

    Don’t think that you have little to offer. When a for-profit developer approaches you to participate in a project, it is only because your agency’s status provides access to financing resources not available without you. If the developer could have financed the project without your participation, you would never have gotten the call in the first place. You have something the developer wants. Don’t be so fast to compromise your assets.

Participation

    Do demand an active role in the project. This includes design, planning, financing, construction, and management. As in other aspects of life, the adage “You get what you pay for” is more true than you think. You should expect to be regularly involved in critical decisions and project planning and management.

Mission


    Do check the project’s fit with your agency’s mission. If you are a social service provider, why are you moving into the housing development field? Has the board considered and studied the proposed change in agency activity? Do you have a plan for moving into the field? How do you propose to pay for the staff resources and time necessary for development?

Assistance

    Don’t undertake a project just because there is a need for affordable housing. Good intentions will not make up for bad decisions or bad projects. Before you enter a real estate transaction with a for-profit developer, take the time to seek the advice of an independent, objective third party. If you do not know who to talk to, ask other nonprofit organizations or the state or local participating jurisdiction (in the HOME program) for referrals. Talk to someone other than the for-profit developer.

Money

    Do require that you receive the majority of the developers fees. The developers fee is compensation for the risk and cost of development and for the cost, time, and expense of compliance monitoring, record keeping, and reporting required by the HOME Program, the Low Income Housing Tax Credit Program, USDA Rural Housing Services (formerly Farmers Home Administration) rental and farm worker housing programs, state funded programs (usually state Housing Trust Funds), and all social lenders. Similarly, conventional permanent lenders also require regular payments on their loans. All these activities involve cost and risk to the agency. The developers fee partially compensates for these expenses. The developers fee is not compensation for market studies, attorney’s fees, accounting fees, land holding costs, syndication costs, architectural or engineering fees, or other such items. Most cost budgets include these items as separate line items.

Control

    Do require that all communications be carried out through your agency. If you do not control the communications, you will often find that you control and know nothing. If you are a CHDO and intend to seek HOME Program funding, you are required to exercise “effective management control.”

Contracts

    Do require that all consultants, contractors, and property management contracts be let only on a competitive bid basis. Further, require the for-profit developer to disclose all associations and ownership interests in these third-party entities. Sweetheart deals often turn out to involve more cost than competitive bidding procedures.

Developer qualifications

    Do insist on seeing a resume from all the developers’ principals, a list of all developments and statement of qualifications and experience with the type of project proposed, a copy of all professional licenses, and banking references.

Financial capacity

    Do require current financial statements prepared by an independent third-party accountant. Require an original signature on the accountant’s cover letter. Require the developer to disclose all financial interests in other projects.

Review, Question, and Analyze

    Don’t sign anything without first closely reviewing it; then have your corporate attorney review it, then have your board review it, then have someone else take a look at it. Invariably the proposed agreement will need significant revision before it is suitable for signing. If the developer is pressuring you to sign it immediately, “because time is of the essence and we have deadlines,” it’s probably best not to sign without a lot of review and consideration. The fact that the developer waited until the last minute is a warning of things to come.

Training

    Do demand that the developer spend as much time training you and your staff as is necessary. If you don’t already know something about development, how do you expect to learn unless there is a transfer of information and education? If the developer isn’t willing to train you, then what makes you think he’ll keep his word to keep you informed? Keeping you informed and actually having your input is training.

Developer fees

    Do insist that the for-profit developer match your financial investment in the project. If you have to defer some of the developers fee, make sure the for-profit company defers the same amount on the same terms imposed on you.

Project viability

    Don’t blindly accept those complicated spreadsheets. Question the underlying assumptions. Spreadsheets don’t make for long-term viability if the underlying assumptions are unrealistic. Long-term viability is crucial; you will be committing to maintaining the project for at least 15 years and probably much longer (30-50 years).

Exit strategy

    Do require the developer to help design the project with an exit strategy (for you) in mind. The developer’s exit strategy is typically simple – at the end of construction, the developer is long gone. You need an exit strategy for the long-term, say 15 to 30 years in the future.

What do you have to lose? Everything. First, your tax-exempt status could be in jeopardy. Second, if you are a CHDO, you are required to materially participate in the development and decision-making. Third, if the project fails, it’s your agency, not the developer, who the tax credit investors will turn to for financial compensation. If this occurs, your agency will probably be forced into bankruptcy and lose its existing federal and state contracts and programs and closure.

Active Participation is the Key

If you exercise care, pay attention to the details, and actively participate, partnerships with the for-profit development industry can and do work. Agencies that exercise due diligence and actively participate in the project have forged solid and mutually beneficial relationships. The operative words are “mutually beneficial.”

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