A Developers’ Bust Is Dominium’s Boom
Dominium Development and Acquisition, LLC, is making money. That’s noteworthy only against the backdrop of an industry where plenty of companies aren’t.
The full horror of the subprime mortgage crisis and its impact on the American financial system revealed itself last fall. But in Dominium’s corner of the real estate market, the big hammer dropped a year earlier, in the fall of 2007. That was when mortgage funders Fannie Mae and Freddie Mac, bellwethers of the disaster, acknowledged that they were in deep trouble. They abruptly stopped buying Section 42 tax credits—the credits that developers and municipalities sell under Section 42 of the Internal Revenue Code in order to finance the development of affordable housing.
Dominium, of Plymouth, the largest Minnesota-based owner of multifamily housing, specializes in using tax-credit financing to develop and acquire apartment buildings in 18 states.
Fannie and Freddie had been buying about 40 percent of all tax credits sold nationally, says Dominium principal Paul Sween. Another 40-plus percent were bought by major banks—Bank of America, Wells Fargo, Morgan Stanley, Bear Stearns. With growing troubles of their own, those banks also dramatically reduced their tax-credit purchases. So did most of the nonbanking corporations that bought the remainder of the credits.
Sween says that in the fall of 2007, the market for tax credits was generating $8 billion nationally to fund developments. A year later, the market stood at about $2.5 billion. That is where it remains.
In other words, Sween says, “the supply of equity in our business has practically evaporated.”
Dominium does not expect the tax-credit market to recover significantly before 2011. For the time being, observes another principal, Armand Brachman, “Companies are getting their tax preferences the old-fashioned way: They’re losing money.”
Despite all that, in 2009 Dominium anticipates total income of $158.8 million, a 7.8 percent increase over 2008, and net operating income of $74.5 million, a 7.7 percent gain. (That’s after an 11 and 14 percent rise, respectively, in those numbers last year over 2007.) The company expects to net another $22.9 million this year by selling seven properties.
But don’t look for a magic bullet behind Dominium’s results or projections. Competitors’ development deals have fallen apart because they can’t find investors to buy tax credits from them. Sween says it’s purely on the strength of basics—long experience, intimate knowledge of the market, and a solid balance sheet—that “we have been able to get our deals done.”
“Everybody Else is Afraid”
Dominium owns 162 properties nationally as of August—a total of 13,531 apartment units. Almost half of its business is in Minnesota, where it owns 75 properties. It also manages 56 properties for other owners around the country; that adds more than 5,000 apartment units to the total that it oversees (18,714).
“You know that Warren Buffett quote to the effect that when people are greedy it’s time to be fearful, and when people are fearful it’s time to be greedy?” Sween asks. “We look at this as a great time to be buying apartment buildings.” Buildings are selling cheap and mortgage money—for those who can get it—is at historically low rates. There are great values to be had, he says, “but everybody else is afraid.” And, fearful or not, of course, most developers who would like to use tax-credit financing can’t find investors.
Getting tax-credit deals done in this economic climate is, indeed, unusual, confirms Bob Odman, assistant commissioner of multifamily programs for the Minnesota Housing Finance Agency. Minnesota Housing administers about two-thirds of the state’s $11 million annual allotment of Section 42 tax credits (which are allocated to states based on population by the U.S. Department of Housing and Urban Development). What doesn’t go to Minnesota Housing is controlled by cities and counties.
Until two years ago, Odman says, $2 or $3 of investment capital was out there chasing every $1 in available tax credits. Today, the situation is reversed. Would-be developers of affordable housing are still applying for the credits, which are granted by Odman’s agency. “But where the trouble comes up is that after we award the credits, [developers] have to secure an investor to buy them. That’s where the market problem is.”
Because of Dominium’s size, its track record, and its own healthy balance sheet, it has had far better luck than most in attracting tax-credit buyers, Odman says. For one thing, “Investors are comfortable that [Dominium] will keep a project in compliance, so they won’t have to put in more money down the road.”
“Compliance” can refer to several things. Dominium’s Ryan Lunderby says that to get tax credits from Odman’s agency (or any other), his firm promises to rent the apartments in a building to people who live at or below a certain income level. The compliance period can last for 15 or sometimes 30 years. And more than renters’ income is at issue. If the building gets run down and has its occupancy certificate taken away by the city, or if it otherwise fails as a business venture, then the tax credits are recaptured by the IRS, Lunderby says.
At that point, investors lose the remainder of their tax benefits, and will look to the developer to make good on that loss. Where they could end up actually losing money, Lunderby continues, is the point where a failing developer goes bankrupt or is removed from a project. Investors might need to find another developer or manager for the property, or manage the property themselves.
The Form-Filling-Out Business
Sween would say that Odman’s remark about keeping projects in compliance helps to explain why few major developers compete in Dominium’s market niche. (Two that do in Minnesota are the nonprofits Aeon and CommonBond Communities.) Federally supported housing initiatives—notably the Section 42 tax-credit program for investors, and the Department of Housing and Urban Development’s Section 8 rent-subsidy program—involve a goodly amount of red tape.
Under Section 8, for instance, subsidies can attach either to low-income individuals, in the form of vouchers that are transferable from place to place, or they can attach to particular buildings. About 30 percent of Dominium’s current properties are Section 8 buildings; most of its other properties have some units rented by Section 8 tenants or people who qualify for affordable housing under other government programs. If a Section 8 tenant pays, say, $200 a month for an apartment valued at $600, with the government picking up the $400 difference, “we fill out an elaborate form every month to get that $400 from the feds,” Sween explains.
“Most landlords abhor that kind of complexity and regulation,” he says. “They don’t like filling out forms. But Dominium said, 37 years ago, ‘That’s our business: We’re going to be in the form-filling-out business.’ We operate in a very small slice of the rental housing market. And we’ve gotten to be very good at it.”
Dominium has been developing, acquiring, rehabilitating, managing, and selling Section 8 housing since its founding in 1972. In the 1980s, it branched out into market-rate and luxury apartments. “But we’ve always stuck to the knitting,” Sween says. “We’re strictly in the rental-housing business. Years ago, I think we got involved in one condo conversion. And we did one office building; we say that’s why we don’t do office buildings anymore.”
Single-minded focus on apartment properties makes Dominium a very rare bird, Brachman adds. “When our competitors become proficient at this, they tend to decide, ‘Hey, boy, I can do anything else.’ So they get involved with retail or commercial projects. That’s quite different from rental housing development. They run into trouble.”
Sticking to the knitting has worked. Sween estimates that Dominium’s current property holdings have a value in the neighborhood of $1.2 billion. Nationally, the company employs more than 700 people and provides housing for about 75,000—enough to populate a medium-sized city.
After the Low Income Housing Tax Credit—that’s the Section 42 credit—was established by the Tax Reform Act of 1986 to encourage private investment in the development of affordable housing, Dominium began to focus on tax-credit development and acquisition. Section 42 offers investors and property owners a dollar-for-dollar reduction in their federal income tax every year for 10 years. For corporate investors in the right tax situation, those credits are attractive enough to justify an otherwise low rate of return for investments in affordable multifamily housing. Fewer corporations are in that situation today—a lot of them are losing money, as Brachman points out—but he says that Verizon, for instance, is still in the market.
Building Affordable, But Upscale
Developers who apply for Section 42 credits must set aside a certain number of units in a new or acquired property as “affordable” for tenants who qualify under federal income guidelines. Qualifiers can earn up to 60 percent of the area’s median income, though for many set-asides the limits are 50 percent of the median or less.
In the Twin Cities, the 2009 median income for a family of four is $83,900. Half of that would be about $42,000. Brachman says that the residents of tax-credit development projects are mostly working people—“like policemen, firemen, nurses”—and senior citizens.
One of the government’s motives in introducing tax-credit financing was to avoid concentrating low-income people in massive public-housing projects, such as Chicago’s infamous Cabrini Green. Dominium uses tax-credit financing to acquire and rehab Section 8 buildings, many built more than 30 years ago, but it also acquires credits by including affordable set-asides in new luxury apartment complexes developed from scratch.
St. Paul’s 808 Berry Place, completed in 2004, with 30 percent of its units set aside as affordable, boasts former residents including Minnesota Golden Gopher basketball coach Tubby Smith and Gopher football coach Tim Brewster. “So there are some very, very nice apartments there,” Brachman says.
Other new, upscale projects completed from 2004 to 2006 include the Landings at Silver Lake Village in St. Anthony (236 apartments, 89 of them set aside as affordable senior housing); the Bluffs at Nine Mile Creek in Eden Prairie (188 apartments, 30 percent affordable); and Stone Creek at Medicine Lake in Plymouth (132 units, 25 percent affordable).
Seesaw Markets: Rental and Owner Occupied
To some degree, Dominium’s success amid the meltdown in the real estate market is due to its exclusive focus on rental housing. “The rental market is inversely related to the home-buying market,” Sween says.
In the heyday of the housing bubble, from 2000 to 2004, home ownership rose about 2 percent. Because rental units account for only about a third of the total housing market, “when owner-occupied goes up two points, we go down four points,” Sween says. So 2004, a great year for realtors, “was not a fun time to be in our business.”
Hard times in the owner-occupied market ordinarily would be a boon to apartment landlords, but the current recession is too deep to really be a boon to anyone. While apartment owners in general “aren’t doing great, we haven’t been hit nearly as hard as the single-family and commercial markets,” says Mary Rippe, president of the Minnesota Multi Housing Association, a trade group for developers, owners, and managers of apartments and town homes.
Citing figures from a quarterly report by GVA Marquette Advisors, Rippe says that the summer 2009 vacancy rate in the Twin Cities was more than 6 percent, up from 3.7 percent a year earlier. Second quarter rents were flat compared with last year.
In Minnesota and nationally, Dominium is doing better than that. Its “same-population” revenue (meaning rents collected from the same buildings year to year), is up 3 percent nationally over last year. Net operating income on a same-population basis is up 5 percent. Dominium’s same-population figures for Minnesota aren’t quite as good—up 2 percent and 3 percent, respectively. Brachman says, “We have a lot of small-town properties in Minnesota, in areas that have suffered more in this recession than the Twin Cities.”
The Secret? Be Responsive, Know Your Stuff
It is one thing to agree with Warren Buffett’s advice about getting greedy when others are fearful. It is another to follow that advice without going broke. To prosper in its market niche today—to “get deals done”—Dominium has to do a lot of things right.
One is to make itself welcome by local officials in the places where it wants to do deals. Mike Mornson, city manager for St. Anthony, says he hopes that Dominium will become involved in another project there similar to its Silver Lake Village development on the site of the former Apache Plaza Mall.
Dominium principals showed up at chamber of commerce events and made a point of getting to know St. Anthony’s city council and city staff, Mornson says. And “every time we asked them to do something, they did it. Every time an issue came up, they dealt with it.”
Since the Landings at Silver Lake Village was completed, the ongoing management phase has run smoothly as well. Mornson says it’s often hard to get developers to return a phone call from city hall. “We’re usually calling about a [regulatory] violation or a fee that hasn’t been paid. When we call, it usually isn’t good news.” Dominium, by contrast, is “always very accessible.”
Its winning ways alone wouldn’t take Dominium far, though. Financial know-how on several fronts is what gets it to the finish line.
Finding tax-credit buyers to raise equity is only the first step in financing a Dominium project—the down payment, as it were. The company then has to find mortgage money to complete the deal.
“We come in on the debt side, not the equity [tax credit] side,” explains David Juran, executive vice president of Minneapolis investment banking firm Dougherty & Company. Juran has worked with Dominium for about 10 years to finance projects in Minnesota and other states by selling mortgages, and sometimes tax-exempt bonds, to investors. Among other projects, Dougherty was involved in Silver Lake Village, 808 Berry Place, and the Bluffs in Eden Prairie.
The mortgage market for apartment buildings has “not been functioning very well” for the past year, Juran says. If, as Sween says, Dominium is finding it “pretty easy to get mortgage money for good projects,” Juran suggests that this says more about Dominium than about the state of mortgage financing.
“They understand both the debt and equity sides as well as those of us in the financing business,” Juran says. That knowledge, together with a sound balance sheet and a penchant for creative approaches, makes Dominium “uniquely positioned to succeed, especially in a market like this.”
In fact, since the tax-credit market tanked, Dominium has been able to use its own balance sheet as a bridge in acquisition deals, Juran says. Dominium “finds lenders to put in money temporarily while it completes a project, taking the risk that those [tax-credit] investors will come in later. We’re one of the lenders they find.”
Sween tells about a creative twist on that arrangement—a deal that he says is unheard of in the tax-credit world: a “pay-as-you-go plan.” Typically, tax-credit investors put their full investment into a project up front, and receive their full tax credit in each of the 10 succeeding years. Dominium is working now with an investor that has agreed to invest and receive credits in increments.
“They will give us money every quarter, as we transfer tax benefits to them,” Sween explains. “Using our own credit, we’ll go out and borrow the money the project needs. So we’ll put in the whole amount up front; then we’ll use this investor’s payments over 10 years to pay down that loan.”
Brachman says that for the past two years, banks and tax-credit syndicators actually have been coming to Dominium, asking it to take over projects that have run into trouble. “Because of our track record and financial strength, they’ve approached us and asked us to look at those projects,” he says. “In many of our current deals, we’re stepping into the shoes of the old general partner and fulfilling the obligations the prior developer couldn’t meet.”
There are other equations to work out after financing is in place to build or acquire a property. Calculating a building’s operating costs is no problem, Sween says. Dominium can predict those with extreme accuracy.
“The real variable—the art in our business—is, ‘What will I be able to rent this for over the next 15 years?’” he says. If Dominium needs a building’s apartments to rent for an average of $1,000 a month to make its mortgage payments, the company needs to be pretty certain it can get that much. Conservative assumptions are crucial, Sween says, because “this is the easiest place to kill yourself.”
That means analyzing factors including local incomes, the existing housing supply, the employment outlook, and whether a community is growing or shrinking. “The broadest rule is that population growth tends to cure all problems,” Sween says.
But a lot of developers know the broad rules. Dominium is thriving in a horrible market because it understands the details.