It’s time to leverage tax abatements – before it’s too late

“Wait a minute, what are we missing? How is this possible?”

That’s the reaction I encountered from our investors following a recent property acquisition, in which tax abatements increased our building’s valuation by $14 million, almost overnight.

Property tax abatements are probably the best kept secret in the real estate business, but it looks like it might have an expiration date: from Philadelphia to Ohio, state regulators and local bodies are starting to ask questions about the long-term viability of their tax abatement programs.

There’s no guarantee that the current process and conditions (which differ state by state) will remain the same.

So, before it’s too late, I wanted to break down the key elements of tax abatement to help investors understand if they can incorporate it in their investment strategy.

Let’s dive in.

Property tax abatement: Creating significant value, fast

There’s a shortage of affordable housing in the U.S. for the blue and white collar workforce. The government’s tax abatement programs are a way to combat this, incentivizing property investors to provide housing to families of specific income levels.

Injection of cash flow for investors

Leveraging tax abatement programs is one of the most effective ways of adding significant value to your property investment from day one.

Every state will have its own programs, but in Texas – where we focus our operations – it works like this: as the investor in an acquisition, if we agree to reserve 50% of the units in a building to tenants making 80% or less of the area’s median income, opening up the building to people who wouldn’t necessarily be able to afford to live there otherwise, the housing authorities will grant a 100% property tax abatement for 99 years.

We are required to make an annual PILOT (payment in lieu of taxes) of 15% of the tax bill, which housing authorities generally use to provide services back into the community.

With this relief to our operating costs – property taxes in Texas are among the highest in the country – our cash flow improves significantly. This drives up the value of the property, which can then be held in perpetuity while collecting the cash flow, or sold for profit after a few years, which is our approach at Alpha.

A recent transaction in DFW, for example, traded a few hundred thousand in PILOT payments for more than one million of annual property tax abatements. More color on this transaction is below.

Offset high interest rates

The boost to cash flow that tax abatements offer can, in the face of difficult market conditions, be the difference between a financially viable investment and one with little chance of providing a profitable return. Interest rates are a prime example of this.

High interest rates pose a significant challenge to anyone buying an apartment building: last year, rates were 300-400 basis points (BPS) below where they’re currently at. This shift negatively impacts valuations.

The injection of cash flow that property tax abatements generate is a hedge against this kind of market volatility. In fact, as an investor, there are few other levers at your disposal that let you buy a multi-family property and feel confident in your return on investment, regardless of interest rates.

One of our projects in Dallas, which I’ll discuss in more detail below, wouldn’t have come close to working without a tax abatement, which added $1 million a year in cash flow.

An anecdote from Dallas

Dallas is a city with high property taxes and a median income of $100,000. Our objective was to purchase a fully operational property and get it into the city’s tax abatement program, in order to add value to our investment.

In practice, that meant we needed to make half the units in the building available to people making 80% or less of $100,000. Many tenants were already at the $80,000 mark, which made our lives easier as we didn’t need to search for new tenants.

Once we were accepted into the tax abatement program, we pocketed an extra $1M a year in cash flow. This had an immediately positive impact on the value of our investment:

The building was valued at around $70 million prior to our involvement, with a market cap rate of 4%; after we bought it and obtained tax abatements, it underwent a new appraisal and was valued at $84 million, with a 6.4% cap.

That $14 million jump in value is very attractive to our investors. We can go to them and say ‘we’re adding value, not by lengthy and expensive renovations, rather by increasing cash flow through tax abatements’.

Changes are afoot

However, now that the secret is out, there’s a growing fear among investors that changes could be coming.

Legislators and local governments are realizing how much money is being left on the table due to existing tax abatement programs, and questions are arising as to whether the benefit for the community justifies this concession in tax money.

Indicative of the shifting tides is new legislation in Texas, which tightens eligibility requirements and reduces the benefits to investors, likely making tax abatement harder to obtain.

As a result, we’re exploring the possibility of expanding our operations to other states. We’ll continue leveraging tax abatement, but the conditions won’t be as favorable.

Before you get started

If you’re interested in leveraging property tax abatement in your investment strategy, I have three pieces of advice:

Partner up

From my experience, securing tax abatements is all about relationships, specifically with local Housing Finance corporations and housing authorities. While you can obtain tax abatements with no prior relationships, there are numerous layers of bureaucracy and “lobbying” efforts to navigate.

I highly recommend partnering up with an experienced player in this space to expedite the process and maximize your chances of entering your property into the program.

Have a track record

Decision-makers from local housing authorities are more likely to give you a tax abatement if you come to them with a proven track record.

They want to do business with people who know the program; from their perspective, it’s a risk to grant you the project if you have zero experience.

After all, they’re the ones who need to answer to their constituents and local politicians: if they end up in a situation where they gave up millions of dollars in property tax for a project that failed to deliver the value it promised, they’ll find themselves in a difficult position.

Come to the authorities with a track record of running tax abatement programs – or partner with a pro who does – to give them peace of mind and maximize your chances of securing the tax break.

Do your due diligence on the property

The main thing to understand is the tenant makeup of the building. As the owner of a property, there are numerous ways to verify the income of your building’s tenants, for instance requesting W-2 or 1099 forms.

If, as was in our case in Dallas, 50% of the apartments must be given to tenants earning 80% or less of the city’s median income, it would be a headache if the majority of the existing tenants earn over the median income.

You’d need to find a solution which would take time and likely delay the process significantly.

Useful resources

Here’s a selection of links to tax abatement programs across the U.S.:

• Cleveland, Ohio
• California (statewide)
• Harris County, Texas
• New York City, New York
• Philadelphia, Pennsylvania
• Portland, Oregon
• St. Louis, Missouri

Final takeaways

While it is far from a slam dunk – obtaining tax abatements requires strong relationships with decision-makers in local housing and finance authorities, and having a track record certainly helps your chances – it is one of the most effective ways to generate value and cash flow for your property investments in a relatively short amount of time.

With uncertainty shrouding the future of tax abatement programs across the U.S., now is the time to look into this opportunity and decide if it can work for you.

Modified Date & Time : 16 Apr 2024, 06:38 am

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Author

Rich Bouchner

Rich Bouchner is Senior Director of Capital Markets at Alpha Investing, a private equity real estate firm providing investors with access to institutional-grade assets with compelling, risk-adjusted returns. He has 20 years of buy-side Wall Street experience with the likes of Merrill Lynch, Brown Brothers, AllianceBernstein & Capital One.

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