(Editor’s note: The New Markets Tax Credit was slated for elimination in the House version (though not the Senate version) of the U.S. tax-cut bill. We are reposting Oscar Perry Abello’s February story for ImpactAlpha, which lays out what’s at stake.)
If President Trump is looking for a successful bipartisan idea for his speech to Congress tonight, one good candidate is the federal New Markets Tax Credit program, which attracts private investment into distressed communities. The program has more than a decade of successful investments so far.
It gets better. The New Markets Tax Credit program gives the power to choose projects not to Washington “elites,” but to organizations with accountability to the communities where the projects are located.
In 2015, Congress extended the program through 2019, with the intent of catalyzing $18.5 billion in impact investing opportunities that benefit distressed communities with quality jobs, quality healthcare and education, access to healthy food and other outcomes.
However, a tax overhaul of the sorts contemplated by President Trump and Speaker Paul Ryan means that everything is back on the table. Last month, a bipartisan group of senators and representatives introduced a bill to make New Market Tax Credits permanent.
The credits “allow us to support the most amazing and diverse and inspiring collection of organizations and initiatives to realize their ambitions for marginalized and distressed communities that can really use their support,” Antony Bugg-Levine, CEO of the Nonprofit Finance Fund, told me.
Since the first allocation in 2003, $50.6 billion in New Markets Tax Credit investments have supported an estimated 750,000 jobs, creating 164 million square feet of manufacturing, office, and retail space and financing 4,800 businesses. Every federal dollar spent in New Markets Tax Credits leverages eight private dollars, according to the U.S. Treasury.
A 2015 survey by the NMTC Coalition, which advocates for the New Markets Tax Credit program, found that $1.9 billion in NMTC allocations financed projects or loans with a total $3.7 billion in investment that year alone, resulting in more than 26,000 full-time jobs created or retained, along with nearly 19,000 construction jobs.
The survey also found that more than 80 percent of New Markets Tax Credit projects were in census tracts with at least one of three measures of economic distress. Projects in census tracts with a poverty rate of at least 30 percent got 38 percent of the credits. More than half were in census tracts with less than 60 percent of area median income, and more than half were in census tracts with at least 150 percent of the national unemployment rate.
The House and Senate bills to make the program permanent, sponsored by Republicans and Democrats, were introduced this month. Legislators had received a letter signed by more than 2,000 public and private organizations from every state. The supporters included community development organizations; nonprofit service providers; banks and credit unions; state and national trade associations and chambers of commerce, including the American Bankers Association; affordable housing organizations; schools, universities and education nonprofits; city governments, state and local elected officials and agencies; and both small and large businesses.
Not just any investor can get a tax credit for making an investment in a low-income census tract. Instead, local organizations that qualify as “community development entities,” or CDEs, apply to the U.S. Treasury to receive a portion of the annual amount of allocations of NMTCs. The CDEs then attract equity investments from larger financial institutions, typically banks, the need tax credits.
Bugg-Levine’s Nonprofit Finance Fund is a CDE, as is Capital Impact Partners, the Local Initiatives Support Corporation (LISC), Enterprise Community Partners, Chicago Neighborhood Initiatives, the Philadelphia Industrial Development Corporation, Boston Community Capital, and Hope Enterprises. So far, 334 CDEs have applied and won New Markets Tax Credit allocations, targeting economically distressed rural as well as urban areas.
The CDEs must have a primary mission of serving low-income communities, and must maintain accountability to those communities, such as through their board of directors or an advisory committee. The application process is competitive over-subscribed. In application scoring, community accountability and community outcomes have equal weight with financial and management capacity.
“The stronger applications have a connection to a local strategy of community and economic development,” said Annie Donovan, director of the Community Development Financial Institutions (CDFI) Fund, U.S. Treasury office that manages the New Markets Tax Credit program with the IRS.
In the combined 2015–2016 awards announced in November, 120 applicants received a total of $7 billion in allocations, the largest amount ever awarded at one time (the scheduling quirk that combined two selection cycles is not likely to be repeated). From 2017–2019, CDEs will vie for $3.5 billion in annual New Markets Tax Credit allocations.
Equity is Key
Nearly all New Markets Tax Credits combine debt and equity in a “Y” shaped deal structure. In a typical $10 million example, $3 million in equity and $7 million in debt feed into a single-purpose $10 million fund. That fund makes a $10 million investment, known as the “qualified equity investment” or QEI, into the community development entity. The tax credit itself is worth 39 percent of the qualified equity investment, paid out over seven years to the equity side. So in this $10 million example, a $3 million equity investment buys $3.9 million in tax credits.
Next, CDE makes a $10 million loan (minus management fees) to a business or project, or multiple businesses and projects. All are required to be located in and/or provide benefits to a low-income community. Low-income is generally defined as a census tract with a poverty rate of at least 20 percent or median family income less than 80 percent of area median income.
At the end of the seven years, with the CDE borrower generating revenue, the borrower refinances with a longer-term loan (or sometimes a tax-exempt bond) and “takes out” the debt investors. The CDE borrower is also entitled to buy out the equity investor’s interest in the single-purpose fund for a nominal price, say $1,000, unwinding the transaction.
The equity is the key. It’s often the piece that is missing or extremely limited in the communities that New Markets Tax Credits target. That’s why the program is so valuable to lenders in poor communities. The equity made available through NMTCs makes possible larger community development deals, especially deals that go far beyond affordable housing.
Banks are the biggest New Markets Tax Credit equity investors. Though big institutions like U.S. Bank, JPMorgan Chase and PNC Bank are the market leaders, smaller and regional banks are common as well. Besides getting the tax credits, banks are also motivated by their obligations under the Community Reinvestment Act (CRA). New Markets Tax Credit investments qualify for CRA credit, which banks need in order to expand via mergers or de novo branches.
Capital Impact Partners got $70 million in transaction capacity in the recent New Markets Tax Credit allocation. “Finding someone to buy the tax-credit equity investment is not hard. Raising the debt piece is harder and that’s really where the opportunities are for impact investors,” says Scott Sporte, chief loan officer at Capital Impact Partners, based in Arlington, Virginia.
Foundations are becoming more common on the debt side of New Markets Tax Credit deals. Kresge Foundation and the California Endowment have made program-related investments alongside Capital Impact Partners on New Markets Tax Credit deals in Detroit and California, respectively.
Since 2005, Capital Impact Partners has closed 64 New Markets Tax Credit deals, totaling nearly half a billion dollars, and has participated in about a dozen more as a debt investor. Capital Impact Partners has used allocations to invest in federally qualified health centers, charter schools, grocery stores in federally-defined food deserts, and facilities providing vital services for behavioral health, substance abuse, skilled nursing care for seniors and other types of projects.
The takeout financing phase, in which the borrower refinances their initial seven-year loan from the transaction, is also a potential impact investing opportunity, says Sporte. Banks have been common players, as most of the risk from the early days of a business or investment are gone but the project or business is still in an area of some economic distress (once again, qualifying for CRA credit).
LISC was part of the very first allocation in 2003, and as of this last round is the largest recipient of New Markets allocations. They’ve closed over 100 of these deals so far, totaling $860 million. In the 2015/2016 combined round, LISC got a $90 million New Markets allocation.
One of those deals was to acquire and build out a property for Commonwealth Kitchen, a shared kitchen space and food business incubator in Boston’s economically distressed Dorchester neighborhood. On the debt side of the transaction, LISC brought together loans from three other CDFIs, plus loans from the city and the state.
“One of the benefits of New Markets deals is you can bring all kinds of capital into them,” says Kevin Boes, who leads New Markets work for LISC. With part of its 2012 allocation, LISC worked with Morgan Stanley to seed a small business loan fund. Morgan Stanley capitalized both sides of the transaction, using the tax credit to subsidize part of what would have been interest on a loan. That let LISC make cheaper small business loans at longer terms than would otherwise be possible.
Rather than a 15-year amortized loan for six percent interest, to acquire or build out space for a small business, the setup let LISC offer a 30-year loan with lower interest of 3.5 percent initial interest with three years of interest-only payments. That could be followed by four years of principal-plus-interest payments and then finally resetting the interest to market-rate for the final 23 years of the loan. Such a subsidy gives a small business long-term stability in real estate cost and location, Boes says.
Another bonus in the New Markets Tax Credit program is the management fee to the CDE, which usually pays for impact measurement. It ultimately falls on the borrower to pay the management fee, typically less than five percent of the total investment, but embedded in the loan repayments on the debt side of the transaction.
“The fee does support a team of impact measurement specialists,” Sporte says. “We’ve been moving from the easier measurement of outputs to more about outcomes, so not only how are borrowers serving more people but are they reducing diabetes or other persistent disease or what costs is this reducing in the social safety net.”
The learning curve is a big obstacle to getting involved as a New Markets investor, says Sporte. The debt side is unsecured, interest-only for seven years. The markets where these deals are located are risky by design. It takes time to get comfortable, and the program has never been made permanent. Without permanency, many investors haven’t been willing to put in the time to get comfortable with something so complicated that they might only do once or twice. Maybe, finally, that changes this year.