Underwriting Subsidies in an Uncertain Environment

​The final FY18 federal budget will likely be much different than the president’s “skinny budget” proposal, but nevertheless, the threat to eliminate programs like Community Development Block Grants and severely cut others like Section 8 housing vouchers underscores the risk associated with subsidy programs.  Carefully evaluating all capital grants, operating subsidies, and credit enhancements is essential to effective risk management for CDFIs.
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How best to address the uncertainty?  Strong underwriting and prudent monitoring.

1. Verify program requirements independently. Understanding program guidelines and conditions on subsidy awards is essential to sound underwriting.  If a subsidy source is involved in the phase of the project you’re financing (such as a construction subsidy that will come in during your construction loan term), make sure to review the executed grant agreement prior to closing.  Key terms to consider include conditions precedent to funding, retainage, limitations on funding reimbursements versus costs incurred, and events triggering repayment.  If a subsidy source is part of your planned take-out, you may not be able to get a signed (or even draft) grant agreement. Instead, go to the funding agency’s website to read about the program terms, and call the agency to discuss terms if you need clarification.
2. Understand the source of subsidy funds.  Are funds coming from the municipal, state, or federal government?  Has funding for the subsidy already been approved, or will it be approved as part of a future year’s budget?  The answers to these questions determine the risk involved.  A closer look may be necessary for particularly important subsidies—for example, if a project works with a HAP contract but doesn’t without it, you may want to read into the current politics around HUD funding.  If a municipal subsidy is key to the plan, you may want to call around to understand how internal politics, newly elected leadership, and unwritten priorities might affect who receives a subsidy.
3. Consider the borrower’s experience.  A borrower’s experience obtaining and using a specific subsidy source provides a barometer of the likelihood that they will be able to access it again.  When underwriting a subsidy whose exact value may change (based on tax credit pricing, for example) or which will be uncommitted at closing of your loan, borrower experience may help mitigate the risk that the planned subsidy is reduced or falls through.  A borrower who survived the recession and has a history of cobbling together various funding sources to make projects work may be more likely to push a challenged project through successfully than one who is newer and has fewer relationships with funders.
4.  Monitor closed loans with an eye toward subsidy risks.  Making sure your loan administration team understands your expectations for when subsidy will come into the deal is vital for effective oversight of construction draws.  To monitor subsidy sources of take-out, set up checkpoints (either through the loan review process, milestone covenants in loan documents, or informal ticklers) to get updates on the status of subsidy applications, commitments, and closing timelines.  The earlier you identify an issue, the easier it may be to resolve.
5. Keep watch on portfolio-wide exposure.  Over-exposure to a single program or funding source is a key form of concentration risk that is often overlooked.  Is 50% of your portfolio dependent upon Section 8 payments from tenants?  LIHTC rates holding steady?  Take-out by a state-funded program?  Consider tracking subsidy exposure and adjusting your risk position through geographic dispersion, new business development in a different financing product or lending sector, or by allowing subsidy exposure to inform other lending parameters.  Concentration risk may be unavoidable, but any CDFI can take steps to reduce the size of the risk.

We hope you will use some or all of these strategies to proactively monitor and mitigate risk for your institution.  Exposure to subsidy risk goes hand-in-hand with community development finance—let’s make smart risk management just as common.

Would you like a hand implementing any of these ideas?  Give us a call: (518) 599-0482.