There are three categories of operating expenses real estate investors should consider, says Chris Germain, an investor in apartment buildings and rental properties: fixed expenses, variable expenses and reserves:
Fixed Expenses
Fixed expenses are operating expenses that do not vary with occupancy. Real estate taxes and insurance costs are the most type of common fixed expenses. Although these expenses vary from year to year, they do not increase or decrease with the occupancy level and are not subject to budget control by the management.
Real Estate Taxes
Investors can obtain real estate tax information on any project from public records or the local tax assessor’s office. The block and lot numbers are typically required, although only the project address is required in some jurisdictions. The local assessor’s office can also provide the applicable tax rates (state, county, school and sewer tax, as applicable), the projected changes in assessments or rates and their probable effect on the project’s future tax liability.
According to Germain, in instances where a property is newly constructed and not yet assessed, taxes are estimated by developing a comparative analysis of the tax liability of recently constructed competitive projects. (See “Expense Comparables,” below). In addition, the borrower will often submit a letter from the local assessor’s office that will contain an estimate of the project’s tax liability. The Underwriter should also contact the local assessor to obtain this information.
Real Estate Tax Abatements and/or Exemptions
Local municipalities frequently offer tax abatements or exemptions to stimulate the development of affordable and/or market rate multifamily housing. Abatements reduce existing taxes by an amount equal to a certain percentage of capital improvements performed on a property. Exemptions temporarily offset increases in assessed value due to capital improvements, new construction or the conversion of commercial buildings.
In order to determine eligibility for these benefits, investors must develop a good understanding of the conditions set by the applicable jurisdiction for obtaining and maintaining tax relief. In some jurisdictions, such as New York City, tax abatements are programmatic; in others, tax relief may be negotiated on a project-by-project basis. Investors should obtain and review a copy of any tax agreements from the taxing authority in order to reflect the taxes accurately in the underwriting proforma.
Tax abatements and exemptions may be permanent, fixed for a specific term, or declining over a period of time. The terms and conditions of the tax relief will affect the calculation of operating expenses and NOI, and therefore will have an impact on the final loan amount.
Permanent Tax Abatements and Exemptions
In instances where all or a portion of taxes are permanently abated, the NOI and loan amount should be calculated using the reduced taxes in the Operating Expenses section. In addition to fully explaining the tax abatement, the Underwriter should note the amount of the unabated real estate taxes in an addendum to the Closing Memorandum.
PILOT Agreements
Payment In Lieu of Taxes (“PILOT”) agreements are similar to permanent tax abatements. Under such agreements, projects make a fixed payment rather than paying property taxes over time, or may pay taxes on the land but not on the improvements. PILOT agreements can vary greatly, and the Underwriter and Legal Unit must review them carefully.
Temporary Tax Abatements and Exemptions
In some instances, taxes are abated for a specific term, on either a fixed basis or a declining basis. When taxes are abated for a limited term (rather than permanently), expenses for the project will eventually increase. This may occur gradually, as previously abated taxes are phased in, or abruptly, as the abatement ends and the project is subject to full taxes. As taxes increase, the funds available for debt service may decrease.
It may be possible to adjust the amortization schedule to include higher principal payments in low tax years if this is allowable according to the mortgage insurance or credit enhancement program being used, with principal payments decreasing as taxes increase (this is called “accelerated amortization”). The Underwriter must ensure that the minimum Income-to-Expense or Debt Coverage Ratio (“DCR”)-the ratio of NOI to debt service-that is required by the applicable credit enhancement program is maintained throughout the term of the loan.
As an example, New York City’s primary tax abatement and tax exemption programs, “J-51″ and “421‑a”. There are two types of J-51 abatement, one for moderate rehabilitation of occupied buildings and the other for the moderate or substantial rehabilitation of vacant or partially occupied buildings. The amount of taxes abated is determined by the cost of the construction. There are several types of 421-a tax exemption programs, which are for new construction projects. The term and the amount of taxes exempted vary based on location (Manhattanvs. other boroughs) and whether the development includes subsidized, affordable housing. (See Appendix O for descriptions of J-51 and 421-a programs.)
Other Public Impact Fees
Utility tap fees, school district fees or other fees may be levied by local municipalities on new developments to offset the anticipated impact of a new project on the local infrastructure. In some cases, a project will have to contribute significant funds to a new sewer system or other utilities to be provided by the local municipality at some time prior to the maturity date of the Fund loan. In such a case, the project should be underwritten to insure that its projected value could allow the project to cover such costs either through the current financing or through refinancing of the Fund loan. As with taxes, these fees may be permanent or include increasing or decreasing amounts over time, and should be underwritten accordingly.
Insurance
Insurance premiums are the aggregate cost to maintain insurance coverage for the project. Such insurance always includes fire and extended coverage (e.g., acts of nature such as tornadoes and hurricanes) as well as owner’s liability insurance. Depending on the project, elevator, boiler, plate glass and other forms of insurance may be required. Investors should confirm the level of coverage, determine if it is appropriate and make any necessary adjustments to the expense. If the project is to be included in a blanket policy, the limits that apply to the project must be consistent with Fund insurance guidelines.
Ground Lease Payments
A developer may lease rather than own the land under a project. Ground leases are acceptable as long as the investor’s attorney has reviewed the lease terms to ensure that they do not conflict with any legal requirements, says Chris Germain. Ground leases must be fully subordinated to the mortgage, and, for SONYMA-insured mortgages, the lease must be 25% longer than the mortgage term.