Partners (Winter 1996)

The following article is an excerpt from a guide prepared by Dr. Larry Meeker, vice president at the Federal Reserve Bank of Kansas City. In his article, Dr. Meeker discusses the tools and techniques of community development lending, which includes the effective use of grants and subsidies.
An Introduction to Doing the Undoable Deal

The project almost works -- but not quite. With just a few more dollars, a new business can get started or an existing one can expand, new housing can be built or older housing can be renovated. It may be a business owner who is looking for a way to make a deal work, or community leaders looking for ways to provide new jobs, additional goods and services, or more affordable housing. The bottom line is, the dollars, the collateral, or the expertise are not quite there and other alternatives are needed to make the deal work.

This article offers a map for finding your way through the maze of those alternatives. A sampling of federal financial and technical enhancements is included, but those programs -- both public and private -- will change as our communities change and our beliefs evolve regarding how to best balance individual and societal responsibilities. What is needed is a method to locate possibilities, not just a listing of currently available programs.

Community development lending is complex and evolutionary by its very nature. Gap financing that was formerly available through federal programs may instead be available through a state or local government, through nonprofit agencies, or privately funded foundations. Or it may not be available at all; some projects that were doable in the past may not get done in the future. Other "undoable" deals will get done, however, by partners who have found creative new ways to make projects work. What will not change is the need for community leaders, lenders, and development resource people to form partnerships and work together to improve their communities.

Regional, state, and local programs, as well as those of private foundations and involved corporations can also be added to the map. As the appropriate role of government in community and economic development is reconsidered, enhancement programs will change accordingly. The necessity of analyzing financing gaps in projects and finding alternatives for filling those gaps, however, will not change.

Lenders are facing increasing pressure to participate in community and economic development projects. Part of the pressure is in response to Community Reinvestment Act (CRA) responsibilities. But the interest often goes beyond that. Like other community members, lenders too are adversely affected by urban decay, economic disinvestment, and the lack of a diversified economy. The problems are often easy to identify. The difficulty is in finding widely acceptable solutions. A frequent suggestion is to undertake more community and economic development projects. This is the question facing lenders: Is it good business?

No Term for Marginal Projects

The financial literature is replete with terms describing different types of financing -- consumer finance, real estate finance, and commercial lending to name just a few. There is no term, however, that describes the financing of marginal projects and borrowers.

Proposals with insufficient or uncertain cash flows, too little collateral, or that pose excessive interest rate risk or overhead costs are simply not done. For most lenders, their obligations to protect depositors' funds and earn profits for shareholders preclude excessive risk taking and inadequate profit margins. Indeed, these tenets of lending are basic, and lenders and their regulators pursue them vigorously.

Agencies Providing Assistance

Despite these perceived difficulties, many undoable deals may be doable because of their eligibility for financial and managerial assistance. Various government and philanthropic entities provide assistance to projects that aid economically disadvantaged individuals and communities. The basis for that assistance ranges from job creation and support for minority businesses to housing low-income individuals.

Many of the federal agencies providing this assistance are well known - the Small Business Administration (SBA), Rural Development (RD), and the Department of Housing and Urban Development (HUD). The state and local government programs, along with the philanthropic programs, are less familiar but are often as supportive as the federal programs. The process of using these program enhancements to make undoable deals bankable is termed development finance.

Article Objectives

This article has two objectives: (1) to examine the structuring of development finance deals, and (2) to address the problems associated with institutionalizing development finance lending. In both cases, the prevalent issues are the same as in conventional lending. Standard credit analysis principles guide the structuring of individual deals; overhead costs and interest rate risk considerations guide the decision to institutionalize the activity.

The Development Finance Process

The starting point to understanding development finance lending is not the alphabet/numbers soup of government and philanthropic programs - CDBG, HUD, NHS, EDA, LISC, UDAG, GNMA, SBA, 221(d)(2), 235, 504, 312, and so forth. These programs are the caulking that fill the financial and managerial gaps in individual projects and mitigate the internal costs and risks associated with development finance lending. They are resources that can make deals work, but only after a thorough project analysis.

The critical issues and decisions associated with development finance lending are easily understood when analyzed sequentially (see chart). The upper portion of the chart, the project analysis, addresses credit issues associated with structuring individual projects. The lower portion (highlighted in beige) addresses internal or organizational issues associated with development finance lending.

The project analysis section of the chart (upper portion) begins with credit analysis. Development finance projects are treated like any other project the lender considers and are subject to the same underwriting criteria. Projects that initially pass the credit test without enhancements are eligible for conventional financing. By definition, development finance projects will fail the test until enhancements are used.

For projects that fail the credit analysis, weaknesses or gaps are identified and matched with appropriate enhancements. Since the enhancements usually produce additional financial support, the project cash flows change. This change requires another credit analysis.

Projects often cycle through this process several times to obtain the optimal combination of enhancements. It is a discovery process which the Hungarian chemist, Albert con Scent-Gyorgyi, once described as "seeing what everybody has seen and thinking what nobody has thought." If the project can be made creditworthy, however, there is no guarantee it will be funded by a lender. Much depends on the lender's motivations and business constraints.

The following sections explore the credit and institutional analyses individually.

Credit Analysis Issues

The credit analysis part of the development finance process focuses on protecting the lender's funds. Lenders, in contrast to equity investors, demand a high probability of repayment and use the credit analysis process to obtain that assurance. Projects that pass a variety of credit tests are financed; those that do not are not financed.
"...seeing what everybody has seen and thinking what nobody has thought."

Operating Expenses and Net Operating Income From expected cash flow, operating expenses must be met first. These expenses include the daily costs of operations, utilities, and management; property taxes; insurance; maintenance and repairs; and a reserve for replacing capital items. Deducting operating expenses from gross income leaves net operating income.

Net operating income is the primary source of loan repayment. A measure often used to evaluate this source is the debt coverage ratio (net operating income divided by debt service expense). Projects with a value greater than 1.0 can service debt from operations.


If cash flow fails to service debt, lenders seek a secondary source of repayment in the form of collateral - typically the asset being financed. Loan to value ratios are a common collateral measure, comparing the value of the property to the loan against it. These ratios are usually less than 80 percent and vary according to the nature of the collateral.

Acceptable ratios are lower with specialized properties such as single-use manufacturing facilities and with properties in disadvantaged locations. Whatever the property, the appropriate measure of its value is its market value, not the amount invested. In the case of many community development projects, collateral value is considerably less than the construction simply because of the property's location.

Ownership Incentive

Another factor lenders consider in evaluating a project is ownership incentive. Even if a project produces sufficient cash flow to service debt, owners should get a sufficient return on their investment to ensure their continued interest.

A common measure of ownership incentive is the cash flow rate (cash flow divided by the owner's investment). With many development finance projects, these rates are far below the typical 15-20 percent minimums often required by investors. However, this deficiency need not pose problems. Equity investors in development finance projects are often satisfied with other incentives such as tax benefits or even the fulfillment of community service objectives.

While credit decisions are largely financial in nature, other factors are also important. Perhaps most important is the borrower's character. An honest, committed borrower with the knowledge and experience to succeed with a project is essential. Also, knowledge of the community and the local economy is essential to making sound lending decisions. If a project involves the leasing of commercial space, the creditworthiness of the lessors is also important. Factors such as these must be considered and may be cause for denial.

If the project passes the credit tests, it can be funded with conventional resources. If it fails, however, a decision must be made about pursuing credit enhancements. This decision will depend on the project's eligibility for credit assistance and the willingness of the project sponsor to expend the effort to undertake further analysis. Assuming the decision is to proceed with further analysis, the next task is to identify project gaps and enhancements.

Gap and Enhancement Analysis

Lenders and investors have numerous reasons for not funding projects - such as weak sales projections, high overhead, inadequate management experience, insufficient collateral, and newness of a business. These deficiencies can be broadly classified as return, risk, and management gaps. Each represents a sound basis for not supporting a project.

Marginal Debt Coverage

Low return is perhaps the most common project deficiency. Simply stated, income does not exceed operating expenses by a wide enough margin to justify either debt or equity funding. The debt coverage and cash flow ratios may be too low. A variety of enhancements are available to augment return by increasing project income or lowering expenses.

Today, income supplements fall into two basic categories - rent subsidies and tax credits. The Section 8 housing certificate and voucher programs administered by the U.S. Department of Housing and Urban Development are the nation's rent subsidy programs. Under these programs, HUD helps low-income households obtain adequate housing by issuing certificates or vouchers for the difference between the cost of adequate housing in the market area and the renter's ability to pay. These payments thus enhance the landlord's revenues.

Unlike rent subsidies that enhance operating revenues, tax credits do not alter a project's financial statements. However, they are integral to the financial analysis of a project because they produce important returns to investors that emulate project income supplements.

At the federal level, for example, tax credits exist for low-income housing and the preservation of historic buildings. Both allow investors to obtain federal tax credits for contributions of goods, services, and cash to approved organizations, including venture capital funds.

Expense Reduction Measures

A wide range of programs are available for reducing expenses. Local governments often use real estate tax abatements to reduce operating expenses and augment cash flow available for debt service and equity holders. Tax increment financing is another form of tax abatement that uses taxes for property improvements. Interest rate subsidies can be provided in the form of below market rate funds provided by local bond issues. A direct rate buydown in which a third party helps make interest payments is another form of subsidy. Compensating balances and blended rate financing can also serve to subsidize interest payments.

Equity grants, in the form of property or cash may be available to reduce expenses by lowering the amount of debt that will be required.

Corporate and foundation grants to project sponsors are also popular, as are investments by national and local community development organizations. Community Development Corporations (CDCs) are equity investment vehicles for national banks, state member banks, and for bank holding companies.

A conventional technique often used to lessen the debt service burden is to extend debt maturities. A final means of reducing operating expenses is the use of small business incubators. Incubators allow small businesses to share common facilities and office personnel and many incubator tenants can access technical expertise from nearby colleges.

Risk Gaps

Cash flow, collateral and management also present potential risk gaps. Cash flow risk can be mitigated by stabilizing income and expenses through the various subsidies. Collateral risk can be offset through the use of loan guarantees or equity financing, for example. Management depth and expertise is a final project-related concern. Two significant resources are incubators and management consultants.

All of the enhancements bring constraints along with subsidies. These constraints may include job creation requirements or housing disadvantaged people. All the constraints must be satisfied.

Successful completion of the credit analysis process does not guarantee project financing. The lower portion of the chart depicts the institutional issues that must be addressed before the funding decision is made. However, a well-packaged deal taken to the appropriate financial institution can become "doable".

For a full reprint of the guide, Doing the Undoable Deal, please contact the Federal Reserve Bank of Atlanta.
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