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When looking to improve their communities, municipalities often face a chicken and egg problem: How do you attract new real estate development in an up-start neighborhood when current rent levels don’t yet justify the construction costs of a desired development?
Tax increment financing (TIF) is one way to solve this dilemma, providing developers with the needed incentives to start building in these up-and-coming areas by improving the cash flow of the project, allowing the developer to attract capital needed to start building.
In this blog, Forum explains what TIF projects are, why investors can benefit, and how our own company has been able to participate when we find projects that are attractive.
What is a TIF?
A TIF is a tool municipal governments can use to revitalize a neighborhood, without having to raise taxes on its citizens to fund that community’s development. In short, a TIF allows a municipality to pledge the increased property taxes it anticipates from the area’s revitalization (the tax increment) toward the development of the projects that will improve the area. The tool is used across the country, financing anything from stadiums, to public transportation infrastructure to public housing.
How does a TIF work?
When a city or county identifies an area for redevelopment, it maps out a specific geographic area it identifies as the TIF district. The amount of property tax revenues the city receives from the TIF district is frozen at the current rate. For a specified period of time – usually the next 20 to 30 years – as the area improves and tax revenues within the TIF district increase, the additional tax revenues go directly toward new development in the area, or to pay bonds or reimburse the investors and developers who undertook the initial improvement projects.
For example, a city may decide to revitalize an old warehouse district by building a new stadium and multifamily housing units around it. The city would then create a TIF district that would include much of the old warehouse district. If total property taxes within that district are currently $1 million, then for the life of the TIF period, the city will only collect $1 million annually from the area to use for general city revenues. If, for example, by year 10 of the TIF period, the TIF district is now generating $10 million in tax revenues, that $9 million in incremental revenue goes back toward redevelopment or toward the investors and developers involved with the initial project.
Why might a real estate developer participate in a TIF?
A TIF allows the real estate developer to recapture the increased tax revenue it generates for a city when it constructs a new residential or commercial property. The associated tax savings are enough to encourage a builder to start construction and lease up a new property, even though current rent levels in the area might not yet be supportive of the cost without the subsidy.
While TIF projects can vary considerably, they generally provide incentives to the developer in one of two ways. Here is a scenario of each:
Scenario A: A suburban municipality wants more high-quality living spaces near a new transportation hub in its renovated downtown. While the neighborhood is starting to gentrify and is expected to grow, current apartments in the area rent for only $1,000 a month. To develop a large apartment community with a garage and amenities, rents in the building would need to go for at least $1,200 to cover the construction costs.
To encourage a developer to build in the promising area, the city can create a TIF project. Before construction, the real estate tax bill associated with the unimproved property might be only, $40,000. When the developer is done constructing a large, multifamily property, the real estate tax bill associated with the completed property may be $600,000. However, the developer is able to recapture the incremental tax increase of $560,000 ($600,000 - $40,000), which creates a substantial tax discount for the developer.
Scenario B: Another way TIFs can work is to pledge the tax savings to a bonding agency, which then subsidizes the upfront costs. In this example above, a bonding agency can essentially sell a bond tied to the future cash flows of the tax savings (in this case $560,000 a year). For our example, let’s say the agency raises $7 million. That money is handed to the developer as a subsidy to cover some part of the upfront costs.
Both examples provide the same benefit: They utilize future tax revenue to finance development of a higher-quality residential, commercial, or mix-use property than would never have been constructed without incentivization.
What do TIFs mean for investors?
The inherent tax savings from a TIF improve the net operating income associated with the property. But tax savings alone miss the bigger picture of how investors benefit. The TIF essentially encourages the developer to construct a much higher quality property in a neighborhood. This higher-quality property can charge higher rents, which means increased cash flow for the underlying property investors.
How does Forum participate?
While investors and developers can benefit from TIFs, such projects are not easily won. Competition among developers can be fierce if the property is in an attractive area. Municipalities also have a thorough vetting and due diligence process.
This is where Forum’s experience has helped. By participating in TIF projects for years, we understand the expectations of working with municipalities and know how to comply with and facilitate a public-private partnership. Our experience in prior deals also allows us to point to successful projects in other cities, giving local leadership confidence in working with us.
We are proud to leverage that experience on behalf of our clients.
Forum Investment Group is a private real estate investment firm with expertise and emphasis on generating current income and long-term value creation by accessing unique real estate acquisition, development and debt investment opportunities across the capital stack and real estate cycles. Since 2007 we’ve invested more than $2 billion in real estate and built a successful track record of high-performance investments, earning the trust of our investors and partners.
Rich Wilson- Vice President, Development
Forum Real Estate Group, a Glendale, Colorado-based real estate investment firm and affiliate of Forum Investment Group, has a focus on multifamily living and develops, owns, operates and manages properties across the United States.
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