Artist Space Guide
Pro Formas and Pre-Development Costs
From the outset, your preparations need to include a financial model or “pro forma” of the project so that you have a thorough understanding of the project’s finances at every stage. These finances will include the “hard costs” of acquisition and construction, the “soft costsof design, engineering, legal, etc., as well as the costs of borrowing money. The pro forma is a flexible working document that will change as different inputs and outputs occur during the process of development. It is imperative that at least one person on your team understand the pro forma.
Depending on the size and complexity of your project, soft costs can be a significant portion of your pro forma. Examples of soft costs are:
- Architectural and engineering services
- Site survey
- Environmental analysis
- Code analysis
- Legal services
- Loan fees
- Marketing materials
- Project coordinator
You will certainly incur costs before construction financing is in place. In most artist projects, the developer or group of artists has to front the money for these “pre-development costs.” Make sure you have a formal agreement or contract with anyone hired to work on the project. Someone with experience in managing a real estate project makes an invaluable team member.
Sources of Financing
When you obtain financing, you are in effect buying money. As with anything else you buy, you should shop around for the best deal. Your development consultant or attorney should be familiar with various banks and their lending policies. Every building project has a mixture of money you put into it (equity) and money borrowed from a bank (debt.)
The decision to purchase a building comes down to two issues:
- Whether the artists/group has enough equity (money) for the initial down payment;
- Whether the artists/group can convince potential lenders that they will have sufficient cash to pay the mortgage (debt service) each month and carry the operating costs.
Down Payment (Equity): A down payment refers to the money that lenders require the borrower to put into the project. The larger the down payment you make, the less you will need to borrow and the less your monthly payment will be. You will also end up spending less in interest. But if you want to maximize your annual income tax deductions, reducing interest costs would be a disadvantage.
Mortgage (Debt) Financing: A mortgage refers to both the money that you borrow to pay the purchase and renovation costs of a building and the ensuing debt. Most lenders base their maximum loan on 80% of the appraised value of the acquisition and construction costs of the building.
Financing involves a two-stage process consisting of:
- Construction Financing (interim)
- Permanent Financing
Acquisition and construction financing are usually handled by the same bank. Although acquisition and construction financing comes first, it is not as critical as permanent financing because construction lenders, notably commercial banks, need to be assured that funds will be available to pay off the construction loan at the end of the construction period. Assurance that these loans will be repaid comes in the form of a permanent (or “takeout”) commitment by the permanent lender. This form of financing limits the construction lender’s liability to the risks involved in the construction process.
In the case of condominium financing, the transition from construction to permanent financing occurs through a series of transactions as individual studios or units in the condominium are purchased by unit owners with their own mortgages.
Construction Loan Risks: Though a construction loan is less risky with a takeout commitment in place, this type of loan still involve risks, including:
- Labor problems
- Insolvency of the contractor
- Supplier problems
- Poor planning and management
Because of these risks, construction loans have the following features:
- Short terms
- Higher interest rates
- Staged disbursements: the lender distributes the loan in stages that match the phases of construction, and you pay interest on only those funds released.
- Partial financing: loans represent a percentage of lender’s estimated value of the property (typically 80%).
- Mandatory financing commitment
- Personal guarantees from the borrowers
Permanent Financing (“Medium” or “Long” Term)
A lender must feel secure that the market value of the property will remain high during the term of the loan and that the individual (in a condominium) or the group (in a cooperative) can afford the monthly carrying costs. Will there be adequate cash flow? The monthly carrying costs not only cover the debt service (principle and interest on the loan) but also must include the operating and maintenance costs.
Traditionally, the lender will make a judgment about your ability to repay the loan based upon ratios of income to housing expenses. One common formula is that one should not pay more than 28% of gross income for housing and not more than 36% of gross income for all debt. Lenders are more liberal with their income ratio on formulas for projects financed as co-ops and/or by making a case that artist studios are both places of business and living spaces.
In condos, the construction lenders may require that each of the potential buyers (or group members) obtain an individual form of preliminary permanent financing commitment.
Seller Financing: Several artist-initiated projects have used seller financing (often referred to as a purchase money mortgage) to fill a gap between the artists’ equity and the loan from a conventional lender. This type of financing is secured by a second or subordinated mortgage. For example, if the total development cost of a project is $1 million. A bank will lend $800,000, but your group can come up with only $100,000 in cash (equity). One solution to this problem is to ask the seller for a $100,000 purchase seller money mortgage, effectively reducing your need for upfront cash though increasing your overall debt.
Financing Co-ops: In co-ops, all of the artists/members are screened before the lender commits to making a blanket loan. One benefit of a co-op is that having several financially strong members can help a lender, typically a commercial bank or insurance company, accept other members with lower incomes and/or fewer assets. The length of the commitment is usually five years, although some lenders may go as long as 15 years. You can negotiate for a long-term amortization or payback period; for example, 25-30 years; even though the term of the actual loan might be much shorter. Short-term loans are somewhat common for commercial real estate projects, but obtaining a long-term commitment and a fixed-rate mortgage is better. Your objective should be to reduce uncertainty about the long-term costs of the project.
We recommend discussing these issues with a few different lenders early in the process so that the group can make an informed, realistic judgment about its ability to qualify for financing before incurring major expenses.
Whether you are applying for a conventional loan or a small pre-development loan/grant, the quality of your business plan presentation is crucial to the outcome. The business plan is a sample of your work and an extension of your competence. You and your project will be judged on the merits of your plan. It must be a first class, professional presentation. Though there is no standard format, you should include several key elements:
- Summary of project and loan request
- Developer/development team information
- Project analysis, including:
- Description of the property
- Floor plans
- Engineer’s reports
- Description of the intended market for the units in the project
- Income and expense statements
- Financial analysis for the development (a “pro forma”)
- Timetable: a detailed schedule of the development process
Tax Credits: Federal and State
Both the state and federal government provide tax credits for creating affordable housing and historic credits to people who restore certified historic structures. A “new market” tax credit is also available to mixed-use and commercial projects in economically-vulnerable areas. These credits, singly and in combination, can provide much of the equity needed for a project.
Tax credit projects are best left to experienced developers. Matching the credits to investors who can use them, meeting the detailed requirements of the programs, and servicing the information demands of the investors and the IRS are all beyond the scope of most people who are not professionally trained in these fields. Teaming up with a for-profit developer, or a not-for-profit Community Development Corporation (CDC) can, however, bring expertise and project management. Therefore, it is always wise to consider the potential for tax credits, especially if the project is large, rental, located in an historic district, or a New Markets census tract.
Low-Income Housing & New Market Tax Credits
Every state allocates the Low-Income Housing Tax Credit (LIHTC) according to guidelines set forth by the state’s Qualified Allocation Plan or QAP. Massachusetts is very conservative in allowing its LIHTC’s to support affordable housing explicitly built for artists. As a result, people developing artist space typically forego the LIHTC.
New Markets Credits are designed to bring commercial investment into lower income areas. The credit is available for investments in mixed-use projects where more than 20 percent of the gross rental income is from non-residential rentals. New Markets credits are complex in their administration, because special entities called Community Development Entities (CDE) must be formed in the ownership structure to use them. To see if these credits might apply to a non-residential arts project, start by asking your local economic development director if your project is located within a qualified census tract that meets the median income standard. When properly managed, this kind of program can bring useful funds, but it’s complex and requires significant third-party expertise.
Historic Tax Credits
The Federal Government provides a 20% tax credit to developers of certified historic renovations. The federal government also provides a 10% tax credit to support non-historic renovations of non-residential buildings over 50 years old. Like affordable credits, historic credits are fairly easy to understand (this is arithmetic, not calculus), but they still involve many crucial details you must meet correctly. Federal historic credits are not suitable for condominium or co-op (owner-occupied) projects. They are good sources for income producing properties/rental projects only, which might be sold to occupants no sooner than five years after completion.
The Massachusetts historic credits may be granted for amounts ranging from 1% to 20% of the qualified rehabilitation costs. The total for Massachusetts credits was recently raised to $50 million per year. The state regulations are similar to those of the federal credit, but state credits do not require that the credit investor be within the partnership, making them applicable to condos and co-ops.
The 10% Rehabilitation Tax Credit
If you are rehabilitating an old building for a workspace, but the building isn’t certified historic and you intend to convert it to a live/workspace, then the 10% tax credit is a good fit for your project. It does not require historic approvals. Think of it as a sort of “green” credit. The federal government is subsidizing you to keep an old building standing rather than sending it and its embedded energy into a landfill. This tax credit is available for rehabilitating non-historic buildings placed in service before 1936.
This tax credit works by letting the project’s owners take a credit off their federal income tax bill in the amount of 10% of most of the construction and “soft” development costs. Like everything related to taxes, the details are important, so proceed with an open mind when considering this source of funds. You also need to hire an accountant as soon as you can use the credits. Don’t count your chickens before your accountant has hatched them.
What are the advantages of this 10% credit?
- You don’t need to submit your plans for historic review.
- You don’t need to get your building on any historic register.
- There is almost no bureaucracy involved.
- You can make major modifications to the building as long as they meet code. It does not add to the construction or design cost at all.
- There is almost no paperwork necessary to claim the credit.
- In small amounts this credit can be used by ordinary people, not just corporations.
What the challenges of this credit?
- In large projects, the credit gets too big to use for personal tax returns, meaning you would need to bring in investors, creating upfront legal and accounting expenses. These expenses will become annual if the investors become partners.
- You need to commit to keeping the project afloat for at least five years or pay back part of the credit if you used them all upfront.
- You need to have a Certified Public Accountant (CPA), not just a tax preparer, especially in the first year of using this credit. CPAs charge per hour.
Historic credits can be combined with other forms of credits, especially when the same tax-paying entity, whether an individual or a group, uses them together. Often, historic credits are packaged with the Low-Income Housing Tax Credit, but few artist projects in Massachusetts use the LIHTC .The historic credits may also be used in conjunction with New Markets credits to help fund mixed-use arts projects.
Larger projects fare better with tax credits since the documentation costs are comparable no matter what the size of the project. The legal and accounting overhead are, however, significant. Though complex, tax credits might be just the ticket for getting a major project started.
Shorten the borrowing time: Aim to close a construction loan the day before you start the construction. Finish all the design, permitting, and bidding before you close on the purchase of the property.
Get the building into productive use as quickly as possible: Doing so means selling or renting spaces before the project is finished whenever possible.
Negotiate a cap on the construction lender’s legal fees: Arts projects require focus and concentration from the lender’s lawyers. Nothing improves focus like a cap on the fee.
Simplify the financing team: In projects with permanent financing, find a lender who will “roll” the construction loan into the permanent loan. Every new lender entails another appraisal, another lender’s attorney (plus more fees from your own attorney), and another loan origination fee.