In December 2000, the Community Renewal Tax Relief Act authorized and established the New Markets Tax Credit (NMTC) and New Markets Venture Capital (NMVC) programs to stimulate private investment in low-income communities. The NMTC program aims to subsidize and increase the amount of equity investment in low-income communities via investments in qualifying businesses by allowing investors to take a tax credit equal to 39 percent of their equity investment in a certified community development entity (CDE). The program leverages the expertise of sophisticated financial intermediaries to channel equity to neighborhoods in need of reinvestment.
Although the NMTC program has generated over $50 billion in financing for businesses, critics charge that it manifests too strong a bias in favor of real estate investment and results in overly complex transaction structures. This article proposes a solution designed to simplify the transaction structure and augment the amount of investment available to businesses in low-income areas by: 1) transforming the NMTC program into a pure real estate investment vehicle, and 2) reauthorizing the NMVC program to funnel non-real estate financing to qualifying businesses.
Through fiscal year 2008, 65.3 percent of NMTC loans and investments flowed to real estate projects. Certain characteristics of the program help explain this tilt. First, such investments raise fewer compliance concerns than non-real estate investments; real estate is fixed geographically and cannot "move out" of compliance. Further, a real estate project necessitates a longer investment horizon than an operating equity investment in a business, reducing the likelihood that a CDE will face a return of its capital within the seven-year holding period and have to scramble to reinvest that capital. The reduced compliance risks help simplify the transaction structures for these deals as less third-party expertise is required, reducing both transaction costs and closing time.
Second, real estate investments offer greater profitability margins due to securitization effects, better economies of scale on transaction costs for these larger investments, and the opportunity to package NMTC credits with local, state and federal incentives on real estate projects. If tax credit investors see a higher potential for return on capital for real estate investments due to these factors, they may be able to avoid having to solicit a leveraged investor for transactions. Eliminating the need for a leveraged investor not only streamlines the transaction structure, potentially reducing third-party fees, but it can also reduce the loan payments over the term of the loan.
Given NMTC's demonstrated success with real estate investments, I propose that the CDFI Fund streamline the program and end the issuance of tax credits for non-real estate investments. These projects can instead be serviced through alternative federal programs, including a resurrected version of the NMVC program.
Transformation of NMTC into a pure real estate program will increase the scale of projects and the size of NMTC investment. By limiting the scope, CDEs will expend larger "chunks" of their allocation on a single project, increasing the likelihood that they will fully utilize their allocation within the stipulated five-year period. Further, an increase in project size will reduce the impact of third-party fees and costs by spreading them over a larger project, since legal and consulting fees are typically fixed irrespective of project size.
In addition, on a real estate project, the property itself will necessarily secure the investment of a tax credit investor or leveraged lender. This securitization lowers investor and lender risk and thus the interest rates charged to the business over the term of a debt investment. A below-market-rate loan can yield positive benefits, such as allowing the business to keep more of its operating capital over the term of the loan for future refinancing needs and encouraging the developer to offer more favorable lease terms to tenants.
Lastly, transforming the NMTC program will simplify deal structures while retaining the program's community reinvestment mission. In a pure real estate program, the CDFI Fund can hold applicants for tax credit allocations to an even higher standard since an "apples-to-apples" comparison will be more easily made across applicants and their proposed investments. The CDFI Fund would also be able to improve its capture of data regarding job creation and community impact since allocatee business models and project deal structures would be more likely to share similar characteristics.
To accommodate non-real estate investments, the CDFI Fund should explore the reauthorization of the NMVC program to funnel investment to small businesses. Housed within the Small Business Administration (SBA), the program guarantees debentures of certified venture capital companies and offers matching grants for operational assistance provided to qualified businesses. Although the venture capital program has been largely dormant while the tax credit program has thrived, it retains the potential to help offset the unmet equity needs of businesses in underserved areas, as well as providing needed technical assistance.
With respect to the NMTC program, many venture capital companies remain on the sidelines, unable to work within the 7-year investment horizon and scared off by compliance challenges associated with short-term operating investments. However, venture capital investors are more flexible than traditional tax credit investors and have a higher risk tolerance. Under a reauthorized NMVC program, SBA debenture guarantees and matching grants for operational assistance would capitalize upon these strengths and encourage venture capital investment in non-real estate entities. It would also allow for transaction structures that permit participating venture capital companies to retain and leverage their flexibility and investment approach.
Multiple U.S. representatives and senators have co-sponsored legislation to reauthorize the NMVC program, but all have been unsuccessful. In addition to these political hurdles, there are also the financial and practical implications of shifting non-real estate investments to this reauthorized version to consider.
The appeal of a tax credit program like NMTC is that it requires little initial outlay from the government; rather, its cost is the opportunity cost of lost tax revenue. Eliminating non-real estate investments from the NMTC will lower the cost of program administration, realized through less time and expense required to review allocation applications and simplified compliance audits due to fewer types of permissible NMTC investments. The CDFI Fund will also save on administration costs by shifting responsibility for non-real estate investments to the SBA. However, reauthorization of the NMVC would require Congress to allocate a considerable amount of money to the SBA in a time of budgetary constraint. This reality must be considered, as well as the SBA's capacity to accommodate non-real estate investments previously covered by the NMTC program.
Additionally, the CDFI Fund must evaluate relevant practical considerations. From an administrative perspective, the NMTC program can grandfather in non-real estate investments made by CDEs with current NMTC allocations and modify future applications to reflect its forward-looking pure real estate focus. The CDFI Fund and SBA must also assess whether SBA regulations governing the size of eligible businesses would eliminate any investments previously covered by the tax credit program, and change them accordingly. Also, this transition is likely to disproportionately affect CDEs established or controlled by nonprofit entities, since this segment makes the majority of its investments in business-related projects. Accordingly, the CDFI Fund may explore whether nonprofits can remain involved through partnerships with NMVC companies to provide additional funding or technical assistance within the NMVC program.
Lastly, the CDFI Fund and SBA can lobby Congress to ensure that any reauthorizing legislation includes language to align the geographic focus of the NMVC and NMTC programs so that both programs target the same communities. The language is already nearly identical, but precisely mirroring the geographic targets of these programs will enhance their ability to increase the frequency, concentration and scale of private investments in low-income communities and may even encourage end users to layer NMTC and NMVC investments on the same project.