The Role of CDEs Awarded to New Markets Tax Credits

HOST: Welcome to the Cherry Bekaert Tax Beat, a conversation about tax that matters.

BROOKS NELSON: Welcome to this edition of the Cherry Bekaert Tax Beat podcast. Today's episode is a conversation about New Markets Tax Credits. We previously did a podcast from the perspective of the borrower; today we will change our focus and look at the lenders. We will unpack acronyms and the seeming complexities around this program.

BROOKS NELSON: Joining our conversation is the leader of our New Markets Tax Credits practice at our firm, Laurel Tinsley.

LAUREL TINSLEY: Hi. Thank you for having me.

BROOKS NELSON: Where are you talking to us from today, Laurel?

LAUREL TINSLEY: I theoretically am in Greenville, but I am physically in St. Louis.

BROOKS NELSON: Joanne, as always, Sarah McGregor. How's it going today, Sarah?

SARAH MCGREGOR: It's going great. I am virtually and actually in Greenville, South Carolina today.

BROOKS NELSON: Don't let your avatars duke it out in the hallway or anything like that.

SARAH MCGREGOR: That's right.

BROOKS NELSON: I'm Brooks Nelson, partner of City of Enrichment, as I normally am. A little background: the New Markets Tax Credit Program has been around for more than 20 years. It was established to incentivize business investment in economically challenged communities around the country. It is a popular and successful program.

BROOKS NELSON: Presumably sometime this upcoming fall the Treasury will announce a new round of roughly $5 billion in credits to go along with this program. Awards go to more than 100 community organizations that will then fund private business projects. Laurel, why don't you cover the basics for us? What are New Markets Tax Credits? What are CDEs? What are CDFIs? Why is this a great program? Why do we care?

LAUREL TINSLEY: NMTCs is the friendly term we use for New Markets Tax Credits. As you mentioned, the program has been around for about 20 years. The idea behind New Markets Tax Credit financing is to provide patient capital within low-income communities to fill financing gaps.

LAUREL TINSLEY: Often, in low-income communities, appraisals and other factors don't support the loan-to-value or the rehab costs needed to support building new projects or expanding existing facilities. The New Markets Tax Credit is a flexible tool to fill that gap.

LAUREL TINSLEY: CDEs and CDFIs are the two types of organizations that are allowed to seek allocation of tax credits from the CDFI Fund. CDEs are community development entities certified by the CDFI Fund. They must have more than 60 percent of their activities focused on low-income communities and providing funding to those communities.

LAUREL TINSLEY: CDFIs are community development financial institutions, also certified by the CDFI Fund, which is a division of the U.S. Department of the Treasury. CDFIs are more aligned with traditional lending. They often have small loan programs and community development lending within a defined service area.

LAUREL TINSLEY: Each CDE and CDFI designates a service area—city, state, local, regional, or national—and provides funding within that designated region as approved by the CDFI Fund. They are designed to understand what is needed in their service area and how to best drive impact and development into low-income communities.

SARAH MCGREGOR: Laurel, you and I were having a conversation about patient capital and what that means. Can you share a little about that?

LAUREL TINSLEY: Patient capital in the community development space means capital that is there to support the startup period. Low-income communities may have higher rehab costs and a longer time to stabilization, so patient capital provides flexibility.

LAUREL TINSLEY: Patient capital ranges from philanthropy and grant dollars to more flexible lending terms. For example, some New Markets structures include no principal repayment within seven years to allow time to stabilize the project. There may also be additional reserves to support the investment during that period.

SARAH MCGREGOR: Brooks mentioned that the Treasury will soon, or we hope soon, announce a new round of credits to successful CDE and CDFI applicants. What are the elements of a good, well-executed application?

LAUREL TINSLEY: If you know exactly when they will announce, you would need a crystal ball. People expect announcements any time after September, which is when they announced last year. Timing varies because the CDFI Fund administers many programs.

LAUREL TINSLEY: Successful applications share some common elements, but the New Markets Tax Credit Program is specific. A common difficulty is that organizations may track data from one perspective but need a different perspective for New Markets.

LAUREL TINSLEY: Start by figuring out who you are and where you serve your community—your mission, vision, and values. If you value something, you must be measuring it. If you are not measuring it, that indicates you may not be valuing it.

LAUREL TINSLEY: You need a foundation so you can maintain a coherent voice through the lengthy application. Two sections are graded by outside readers: the business strategy and the community outcome section. Those two parts drive the CDFI Fund's decision.

LAUREL TINSLEY: If those sections are not cohesive and coherent, you will not score high enough to be considered. The number of applicants ranges from about 200 to over 300 each year, and awards range from 70 to 100 applicants depending on the CDFI Fund's approach that year.

BROOKS NELSON: When you say 70 to 100, you mean 70 to 100 applicants receiving awards?

LAUREL TINSLEY: Yes. About 70 to 100 applicants receive awards. Awards range from as small as $10 million to the high end of around $75 to $80 million. New CDEs with small track records may seek smaller allocations. The awards and the number of recipients vary each year.

BROOKS NELSON: Can we clarify what is actually being awarded—the dollars or something else?

LAUREL TINSLEY: The CDFI Fund awards tax credit allocation authority. As a CDE or CDFI, you receive the authority to allocate credits to a project. When the CDE allocates credits to a project, an investor invests in the structure and claims the tax credit on their tax return.

LAUREL TINSLEY: The program is complex: the project receives upfront subsidy and financing through the structure, the CDE obtains the award from the CDFI Fund, and the investor receives the New Markets Tax Credit on their tax return. The investment typically remains with the project through a seven-year investment period.

SARAH MCGREGOR: With only a third to a half of applicants receiving awards, what have you learned from previous award rounds?

LAUREL TINSLEY: There are many paths to success. I steer people away from copying other organizations. Go back to your mission, vision, and values. Your track record in the community determines how you should propose future New Markets activity.

LAUREL TINSLEY: If you suddenly propose activities you have not historically done, you may lose points. You must demonstrate a track record. You can set a one-, three-, or five-year plan to expand into new areas, but the core of what you do must remain consistent with your history.

LAUREL TINSLEY: If you ask for a substantial portion of your allocation to fund activities you have no track record in, the CDFI Fund may view you as inconsistent and score you lower. There is room to diversify gradually, but you must show intentional use and a logical progression from your track record.

SARAH MCGREGOR: Is it a chicken-and-egg situation? Does a developer seek funding, or does the CDE go out to find projects and developers?

LAUREL TINSLEY: CDEs exist because they have expertise, management staff, and underwriting experience specific to low-income communities. They are embedded in the community and use NMTCs as a tool in their toolbox when they find the right opportunity.

LAUREL TINSLEY: CDEs and CDFIs are supposed to find projects in their service areas, but projects can also approach them. Projects that approach CDEs should understand how CDEs get their money and align their proposals with the CDE's stated mission.

LAUREL TINSLEY: If a CDE's mission is job creation and your project creates no jobs, you are unlikely to be a strong fit. A CDE may carve out a small portion of its allocation for a new initiative, but if you are asking for a large portion that does not align with their mission, you will face challenges.

LAUREL TINSLEY: Some CDEs focus solely on job creation. The job creation element of the NMTC Program targets low-barrier-to-entry jobs that may include on-the-job training and job ladders. These positions are still important in many low-income communities where access to quality entry-level jobs remains limited.

BROOKS NELSON: From your perspective as an advisor, how do you help ongoing or startup CDEs who want to enter the business? What is our firm's role in that?

LAUREL TINSLEY: We conduct an initial assessment. For organizations that have not applied before, we review their organizational data and help them develop a plan. We do not recommend applying without understanding where the gaps are.

LAUREL TINSLEY: You want a solid foundation and to know which pieces of the puzzle are already in place and which are missing. The application includes multiple sections: products, track record, pipeline, business strategy, service area, and community outcomes.

LAUREL TINSLEY: Some organizations have strong answers in one section and weaknesses in others. They may need to gather additional borrower information to align their track record with their proposed pipeline. Others may lack management capacity or a history of outside capitalization.

LAUREL TINSLEY: Management capacity and operations are not graded sections, but the CDFI Fund reads them to assess whether the organization can take an allocation. Weaknesses in management may result in no award or a very small allocation.

LAUREL TINSLEY: For applicants that previously received an award but were unsuccessful recently, we analyze strengths and weaknesses and identify needed changes. The CDFI Fund looks at historical practices, underwriting, and impact monitoring. If you cannot demonstrate a history of those activities, they will ask you to come back when you have that history.

LAUREL TINSLEY: Successful preparation often takes time. Organizations that hurry and submit without preparation rarely win on their first attempt. We often spend over a year with clients to strengthen data collection, internal training, and track record alignment.

BROOKS NELSON: What should organizations be doing now to get ready for the big announcement?

LAUREL TINSLEY: Get things off your desk that you can complete now to give yourself time during the application season. The application period is a mad dash. If you are a repeat applicant, you may be managing deployment of current awards when the next round opens.

LAUREL TINSLEY: Typically, within a month or two of awards being released, the new round opens. You have five to six weeks to prepare the application, so prepare management capacity updates, advisory and governing board information, and any organizational changes now.

LAUREL TINSLEY: Work on your pipeline. The pipeline is often the last piece to a successful application. You must build a track record of existing investments and have a pipeline that is significantly similar to that track record. If your pipeline diverges too much, it may hurt your competitiveness.

LAUREL TINSLEY: If you wait until later in the fall to pull together your pipeline, it will be much harder to prepare when awards are announced.

BROOKS NELSON: Thank you, Laurel. Sarah, any final observations?

SARAH MCGREGOR: There's a lot happening among organizations right now. They are focusing on what they can do for their communities and their missions. For anyone seeking to benefit from New Markets Tax Credits for their projects, aligning with a CDE's mission will create a better fit and a more likely candidate for success.

LAUREL TINSLEY: One last point: you do not need to copy another CDE to win. There is room for diverse approaches. There is a collaborative spirit in this industry, and many paths to success. We need more diversity and different approaches, and that is welcome.

BROOKS NELSON: CDEs are often smaller organizations. Focus on what you do well and bring in advisors like Laurel and our team for support. There is both science and art in putting together a strong application.

BROOKS NELSON: This concludes our conversation about New Markets Tax Credits. Quick disclaimer: we are not providing tax advice on this podcast. Please consult your tax advisor, hopefully at Cherry Bekaert, to discuss information from today's podcast.

BROOKS NELSON: Check the firm's website at CBH.com for the latest guidance and materials on this and other tax and business topics. Please like, share, and subscribe. Thank you, Laurel, for joining us, and thank you to our listeners for spending your time with us.