U.S. Bancorp CDC Students at Newark’s North Star Academy, one of the top-performing schools in New Jersey, are active learners. In 2009, more than 75 percent of its students qualified for free and reduced-price lunch.

Laura Vowell, Vice President and New Markets and Historic Tax Credit Investment Business Development Officer, U.S. Bancorp Community Development Corporation

The New Markets Tax Credit Program (NMTC Program) is a popular and flexible community development financing tool that may be used for both the development of real estate facilities and the funding of operating businesses. Established in 2000, the NMTC Program pairs traditional free-market forces with public resources—essentially teaming up the private sector and the federal government—to bring economic and community development to low-income communities. From job creation to increased access to essential educational, health, and retail services, and from the rehabilitation of blighted communities to the development of renewable energy sources, NMTC projects have benefited neighborhoods throughout the country.

NMTC financing allows community development corporations (CDC) and NMTC equity investors such as the U.S. Bancorp Community Development Corporation (USBCDC) to have a substantial positive impact on the communities they serve. The financial health of a project is, of course, important. Most bank CDCs are looking for returns—projects that have solid returns on investment (ROI) in the traditional sense. However, economic concerns are not a CDC’s sole criterion.

CDCs are also looking for projects that benefit their communities in multiple ways and are redefining the term ROI. Facilitating a community’s access to quality education, for example, has been identified as an important aspect of most community development programs. Therefore, charter schools have been a popular project for NMTC investment.

NMTCs are meant to encourage patient, private investment in underserved neighborhoods in the United States and its territories. Instead of direct government investment in these projects, the NMTC Program allows Community Development Entities (CDE)—which are awarded NMTC allocation through a competitive process—to turn tax credits into real capital for projects by selling them to investors. Substantially all of the qualified equity investment must in turn be used by the CDE to provide investments in low-income communities.

Charter schools are a significant beneficiary of the NMTC Program, having partnered with CDEs that have used more than $570 million in NMTC allocation authority since the program’s inception. (This figure represents the amount of NMTC allocation used for charter schools as reported by allocatees in a 2009 survey by the Educational Facilities Financing Center and outlined in the Local Initiatives Support Corporation’s "2010 Charter School Facility Finance Landscape." See "Fostering Public Policy Initiatives" for further information.)

To fully comprehend the usefulness of the NMTC Program, it is important to understand what the benefits are to the involved parties. For the project, the NMTC Program allows the operating business, in this case a charter school, to partner with a CDE that has been awarded NMTC allocation in order to receive capital with better rates and terms. By offering tax credits to investors with tax liability, the CDE attracts private capital and deploys substantially all of it to the project.

NMTC financing isn’t the sole source of financing for these projects—in fact, NMTC financing most often acts as the gap filler for projects that have already attracted the majority of their funding sources. As a result, the NMTC benefit usually accounts for approximately 20 percent of a project’s total cost. The most typical NMTC transaction is a leveraged structure in which one or more parties provide debt via loans, project-affiliate capital, and grants, and an investor provides equity in order to purchase the NMTCs. (See "Charter Schools: A Good Credit Risk to Improve Communities.")

The USBCDC, a wholly owned subsidiary of U.S. Bank, is the nation’s largest such NMTC purchaser. As an active investor in NMTCs, USBCDC has a portfolio containing more than 500 NMTC-financed projects representing $8.7 billion of Qualified Equity Investments (QEI). More than $323 million of total QEIs have helped support at least 20 charter schools.

NMTCs are an attractive investment for banks and other taxpaying organizations for numerous reasons. First, the investor can use the tax credits as a method of partially offsetting some federal or state income tax liabilities. The credit provided to the investor totals 39 percent of the amount of the QEI and flows over a period of seven years, during which time the funds must remain invested in the qualified business.

Second, because many of the qualifying projects are located in low-income communities, banks may receive Community Reinvestment Act (CRA) credit for virtually all NMTC investments within their assessment areas. (For answers to CRA and NMTC questions, including information on Community Development Loans and Qualified Investments, see "Interagency Questions and Answers Regarding Community Investment.") Not all banks, however, are limited to investing in those areas that allow them to receive CRA credit. For instance, U.S. Bank has retail banking operations in the Midwest and on the West Coast, but USBCDC invests throughout the country. Additionally, the structure of the program itself ensures that an NMTC is a sound investment, providing a solid, seven-year return to its purchaser with minimal risk.

NMTCs are well-suited for use in facility financing of permanent schools by established charter management organizations. The established charter management organizations are usually building schools of a certain critical size that is necessary to cover the fixed costs of the structured NMTC financing, and they have the track record to attract other, long-term sources.

Additionally, in order to be NMTC-eligible, projects must be in low-income communities or serve low-income individuals, which is the mission of most charter management organizations—to provide quality educational choices where there are few. Many charter schools have high student retention, offer extended school days in order to include expanded curriculums, and cultivate a commitment to excellence, which often are lacking in under-performing urban schools.

In 2009, USBCDC and the Low Income Investment Fund, a leading community development financial institution, used NMTCs to help finance the acquisition of two middle school locations for North Star Academy’s long-term use in Newark, New Jersey—an excellent example of a project that benefited its community. North Star Academy is a member of Uncommon Schools, one of the most recognized charter management organizations in the country. Of North Star's 760 students enrolled across four campuses in 2009, more than 75 percent qualified for free and reduced-price lunch, and 99 percent were students of color.

North Star Academy charter schools consistently outperform their neighboring district schools, rank among the top schools in Newark and New Jersey, and have been recognized by Bloomberg BusinessWeek and The New York Times. Because North Star is not eligible to receive state funding for facilities projects, as traditional public schools are, it used NMTC financing to help purchase the properties and secure permanent financing.

"Despite our stellar results, North Star Academy, like other charter schools, faced significant challenges in securing financing for facilities," said Michael Ambriz, chief operating officer of North Star Academy. "Unlike traditional public schools, we do not receive state funding for facilities projects, so this transaction went a long way to provide an upgraded environment for our students that promoted both their personal and academic growth." The key result of the investment was that North Star was able to continue to devote the majority of its operating funds to core academic programming without incurring additional facility costs.

Since many charter schools use the leveraged structure in their NMTC financing, they must seek and receive commitments from other sources of capital. These often include capital campaigns, grants, private equity, and debt. While established charter management organizations are able to access some sources of traditional debt capital, there are still market limitations on the amount and terms of that debt.

According to the Local Initiatives Support Corporation’s "2010 Charter School Facility Finance Landscape," lack of access to appropriate public facilities or to public funding for facilities continues to be a major obstacle for these school operators. While the charter school financing sector expanded significantly over the past two decades with the help of nonprofit community development organizations, the U.S. Department of Education, traditional lenders, and the tax-exempt bond market, the economic slowdown in 2008 and tightening of credit standards affected every private source of charter school facility financing.

Traditional lenders often view charter schools as risky borrowers due to their lack of long-term security. Fitch Ratings notes that most rated charter schools are of low investment grade (BBB) credit quality, and the sector as a whole is largely non-investment grade (BB category). Because bond rating is a key determinant of borrowing costs, charter schools are not generally eligible to borrow money at lower interest rates as would other borrowers.

Thankfully, a number of CDFI lenders, many of which also serve as CDEs, have an appetite for charter school lending, allowing them to play multiple roles in an NMTC financing structure. (See "Charter Schools: A Good Credit Risk to Improve Communities.") The downside is usually their lending limit, forcing the charter schools to use all of the sources mentioned before.

In this case, a common structure is as follows:

• The charter management organization (or other affiliate of the school) collects the proceeds of the various sources—fundraising, grants, equity, and debt—and makes a loan ("Leverage Loan") to an Investment Fund.
• The Investment Fund pools the Leverage Loan with the NMTC equity from the investor and makes a QEI, as required by the NMTC rules, to the CDE.
• The CDE then lends or makes equity investments to a newly formed, single-purpose entity, the qualified business, which then operates the school or leases the property back to the charter management organization. (To see how NMTC financing is structured, click here.)

At the end of the NMTC compliance period, the investor and the CDE or CDEs exit the transaction, leaving the NMTC benefit with the project and allowing the charter management organization to refinance any debt sources as it sees fit.

Table 3 is an example of a typical charter school’s funding sources and their project uses.

There are costs to structuring project financing in this way. Each entity must be maintained through asset management fees, and the intermediaries receive fees for their role in administering compliance. Additionally, there are fixed legal and accounting costs associated with the structuring of the transaction. Nonetheless, numerous charter schools have been successfully financed via NMTCs, and charter schools are expected to remain a popular use of NMTC financing.

Laura Vowell can be reached at (703) 740-5602 or laura.vowell@usbank.com.