Unit 3 – Process: Sourcing Financial Resources for Community Development Initiatives
Now that you’ve had an opportunity to evaluate the macro and micro environmental factors that affect your community development initiative, developed your plan and brought together the relevant partners to execute your business plan, it’s time to match the money with the idea. In this section, we’ll discuss the different types of capital that can be deployed in community development initiatives, how to increase your chances to access that capital and the current trends that are taking place in community development finance. Throughout this section, we will focus on the fifth key principle of assembling successful community development projects—adaptability.
Financing community development can be complex and often requires both patience and adaptability. Why? Funding sources initially conceived may not come to fruition, while other funding that hadn’t been considered in the planning process might prove necessary to ensure a project is fully capitalized.
Types of Capital or Financing for Community Development Initiatives
As mentioned previously in this guide, the community development field is broad and encompasses many aspects of creating opportunities for individuals living in LMI areas, from investing in a variety of commercial real estate developments to investing in people, infrastructure and more. The financing sources that support this work are no less varied. It is quite common to finance community development initiatives with multiple sources of funding—private capital; philanthropic grants; incentives offered by local utilities; local, state and federal government grants and subsidies; and more. In some instances, community development corporations use their operating funds to help support a new initiative, in the form of either debt or equity. While government grants and subsidies could continue to decline over time, there are a number of private enterprises and individuals who are more engaged than ever in community development finance, which some refer to as “impact investing.” Let’s walk through some specific examples of the types of debt, equity and grants that are available to community development practitioners.
Financing community development initiatives through debt is a fairly common approach. Unlike traditional capital markets, there are unique forms of debt that are advantageous for community development practitioners. The advantages typically include less stringent underwriting requirements and/or below-market interest rates. Which entities typically offer loan products specifically designed for community development practitioners?
Community Development Finance Institutions
Financial institutions do not always have the capacity to spend the required time to source and carefully underwrite community development initiatives. As a result, an increasing number of them are investing in community development financial institutions (CDFIs). CDFIs, which aggregate capital from banks, foundations and individuals, have developed the expertise to prudently lend for different types of activities—commercial development, residential development, small business, community health care centers, charter schools and others. CDFIs operate in both urban and rural areas, and each one is certified by the U.S. Department of the Treasury. To put the CDFI field into perspective, there are more than 1,000 CDFIs across the country with assets totaling well over $25 billion. The Reinvestment Fund, IFF and the Low Income Investment Fund are all examples of established CDFIs. To find which CDFIs operate in your area, visit the U.S. Treasury’s Community Development Financial Institutions Fund website.
Foundations are often thought of solely in terms of entities that give a portion of their money away each year to nonprofit organizations while investing the remaining amount in capital markets. While foundations are largely centered on grant-making, which is an important source of capital that will be discussed later, it is becoming increasingly common for foundations to invest a portion of their assets (non-grant-making funds) in what is known as program-related investments (PRIs). PRIs complement the social impact derived by grant-making while also generating a modest return on investment. PRIs come in the following forms of financing:
- Interest-free or below-market-rate loans to a nonprofit organization
- Purchase of a promissory note of a nonprofit organization
- Purchase of a participation in loan to a nonprofit organization
- Low-interest-rate deposit with a bank or other financial institution linked to lending for a charitable purpose
- Equity investment in a for-profit entity
The primary purpose of these investments must be to accomplish charitable or other tax-exempt purposes, excluding political lobbying efforts. The Gates Foundation and F.B. Huron Foundation are pioneers in making PRIs.
Investment firms are often thought of as institutions whose sole purpose is to maximize profits for their clients. With the advent of donor-advised funds (DAF), investment firms such as Vanguard, Charles Schwab, Fidelity and others, in addition to community foundations, provide their clients an investment vehicle to make charitable contributions. These funds are becoming increasingly popular because they give individuals immediate tax benefits for future charitable contributions. In addition to securing billions of dollars in charitable contributions, investment firms are also looking at ways their institutions can leverage this investment vehicle. One example of how an investment firm has worked with their clients to further community development involves Charles Schwab and the Grameen Foundation. Schwab has used DAF assets as a guarantee to secure cheaper debt financing for Grameen, which focuses on microfinance opportunities for LMI populations in several countries, including the U.S.
Individuals via Crowdfunding
Given the advent of online crowdfunding (also referred to as peer-to-peer platforms), individuals are playing an increasingly important role in community development finance. A host of websites now make it easy to understand the opportunities to finance community development initiatives and what the particular capital needs might be, whether that is debt, equity or credit enhancements (grants, loan guarantees, etc.). Some of the more commonly used platforms that individuals can use to specifically fund community development initiatives include Kiva Zip, Causes and ioby. (For more on crowdfunding, search "ioby" on FedCommunities.org.)
You might be familiar with private equity firms that invest in startup companies like Pandora, Twitter, Tesla and a host of others. Since 1986, the same idea has been applied to the social sector as well in the form of tax credit investments. The idea behind tax credits is that developers sell them to individuals or corporations that have a tax liability; in return, the buyer receives an equity stake in the real estate development.
Both individuals and corporations have invested in thousands of community development projects throughout the country. As co-owners, these investors tend to take a more active role in the operations of the project than do lenders. Typically, investors remain owners in community development projects during the time in which tax credits are at risk, meaning that if a project falls out of compliance (e.g., approving an ineligible person to live in an affordable housing development), the tax credits are not eligible for redemption by the investor. Once the tax credit compliance period ends, ownership interest in the real estate development is typically sold or donated to the co-owner of the development or a third-party investor. The following illustrate two of the more popular tax credit vehicles in which investors have an equity stake in community development initiatives.
Low Income Housing Tax Credit (LIHTC)
This national tax credit program, which passed in 1986 and provides nearly $1 billion per year to affordable housing developers, is overseen at the national level by the IRS and administered locally by state housing finance agencies. Tax credits are awarded to states based on population. In 2015, the federal LIHTC was equal to $2.30 for every resident in a given state. Housing developers who plan on building or rehabbing affordable rental housing units, which have to maintain affordable rents for at least 15 years, apply to a state housing finance agency for credits. If awarded, developers will sell the credits to an investor to raise funds for the construction/rehab of affordable rental housing units. Investors fall into two categories—direct investors and syndicators. Direct investors are typically entities that have 1) a tax liability, 2) a CRA need and 3) capacity to source and underwrite affordable housing investment opportunities. Syndicators play a role similar to that of a CDFI, sourcing and underwriting affordable housing investment opportunities as well as raising capital from investors.
In addition to the federal credit, some states (16 as of 2015) have passed their own tax credit to complement the federal credit. This provides additional subsidy for an affordable rental housing project. The LIHTC compliance period is 15 years, at which point ownership interest is often given to the co-owner and developer of the project, generally referred to as the General Partner.
Who are the major investors of LIHTC in your area? Unfortunately, the IRS does not maintain a comprehensive listing of equity investors per MSA, state or region. However, it would be worthwhile to contact your state housing finance agency to get this information.
New Markets Tax Credit (NMTC)
Signed into law in 2000, the NMTC program, administered by the U.S. Department of the Treasury (Treasury), finances real estate development in LMI communities. Unlike LIHTC, which finances residential real estate development, NMTC finances commercial real estate development. NMTCs are allocated on a competitive basis to community development entities (CDE), which are intermediaries designed to aggregate funding for community development initiatives. All CDEs are certified by Treasury. Since the program’s inception, more than $40 billion in tax credits have been allocated to CDEs, which has supported the construction of charter schools, community health centers, child care centers, grocery stores and more. The NMTC compliance period is seven years. You can find more information about CDEs, including eligibility and benefits of certification, as well as information on New Markets Tax Credits, on the U.S. Treasury's CDFI Fund website.
While debt and equity capital are important finance tools for any community development practitioner, the life blood for any nonprofit is grants. In 2014, an estimated $358 billion was donated to charity. There are four primary sources of philanthropic giving:
It is important to remember that individuals provide substantially more funding to charity than corporations and foundations. Of the total amount given to social causes, just over 70 percent comes from individuals.
For more information on grants and philanthropy, check out the following resources:
Minimizing Risk through Credit Enhancements
In order to offset the inherent risks associated with LMI areas, credit enhancements are often necessary to spur investment. Credit enhancements take many forms, including loan guarantees (as we saw in the previous Charles Schwab example), letters of credit provided by a financial institution, property tax abatements that make it easier for debt service payments to be made, and more. These are examples of reducing or minimizing a community development project’s financial risk. There’s also operational risk. The best way to minimize that risk is to work with partners with strong track records of success. Often, this includes working with partners who have a history of using data to continually inform decisions while also possessing the ability to adapt and adjust tactics when necessary.
Emerging Approaches in Community Development
Until recently, the focus in community development has been on real estate development. This is largely because the financing vehicles for real estate have been well established as there are clearly identifiable sources of income by which a loan, for example, can be repaid. As a result, we have seen many units of affordable rental housing built, commercial enterprises located in historic buildings in LMI areas renovated, community health centers built and so on. A shift is taking place in the minds of community development funders who are creating vehicles to target capital (other than grants) toward “human capital” community development initiatives. In other words, how can more funding be invested in people instead of just buildings? Until very recently, there was no vehicle to invest in or lend to human capital projects. This is changing with the advent of social impact bonds (SIBs or Pay for Success), which are part of a larger movement to not only invest in people but to specifically invest in interventions that have been proven, through rigorous evaluations, to have positive social impact. The assumption behind SIBs is that certain societal challenges cost the government much more than what it would cost to provide services for prevention or early intervention. For more information on SIBs/Pay for Success, visit Nonprofit Finance Fund’s Pay for Success Learning Hub.
In addition to SIBs/Pay for Success, we are likely to see a continuing trend of collaboration among organizations, in some cases working across sectors. This is due to a number of factors, such as the federal government strongly encouraging or requiring collaboration as part of the procurement process. Two examples of this are the Promise Neighborhoods Initiative, administered by the U.S. Department of Education, and Choice Neighborhoods, administered by the U.S. Department of Housing and Urban Development. These efforts bring together a variety of social service providers, administrators in K-12 and higher education, real estate developers, hospitals and others to undertake comprehensive community development. Like the federal government, many philanthropic funders are either encouraging or requiring organizations to collaborate on various initiatives. Examples of philanthropic-led collaborations that have spread across the country include StriveTogether and Ready by 21.
As organizations collaborate, we will likely see changes to traditional financing, which has almost exclusively been sourced through personal relationships developed between nonprofit developers and lenders, investors and government agencies. With the passage of the Jobs Act of 2012, the limitations on crowdfunding as an equity investment were reduced. As a result, we will probably see the continuing emergence of online platforms that match community development projects with the needed funding (debt, equity, credit enhancements). CapNexus is an example of this particular platform; there are likely to be several more in the future that serve as clearinghouses for matching community development investment with opportunity.
Summing it Up
Source, Layer and Adapt
Coming up with the money isn’t always a straightforward process. While funding sources to support community development initiatives can be found at the local, state and federal levels, it often takes a combination of several types of funding to fully capitalize a project, and the sources are not always immediately apparent. Further complicating the process, funding sources tend to be in constant flux. As a result, it is not only necessary to be resilient and determined to successfully complete your project, it is also critical to adapt to the circumstances as necessary. Adaptability, therefore, is a key core principle, and becomes especially important as we understand that the sources of funding that successfully capitalized one initiative are likely to be different from those that capitalize the next project.
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