Hageman Capital Managing Director Xiao Ou Yuan discussed everything you need to know about TIF bonds on a recent podcast of Ice Cream with investors, hosted by Matt Fore. The two explored the purpose TIF provides and why it benefits real estate developers and local communities. You’ll also learn Xiao’s favorite ice cream flavor – click on the video to learn more!
What The TIF With Xiao Ou Yuan
In this episode, we have Xiao Ou Yuan. Xiao is the Managing Director of Hageman Capital Group, which is a purchaser of single-site developer back TIF bonds. If you’re like me, you’re probably asking, “What in the world is a TIF?” We’re going to dig into all aspects of what a TIF is and the purpose it provides in a real estate development process. Check out Ice Cream with Investors and learn more about Matt Fore.
Xiao, welcome to the show.
Thank you so much, Matt. I appreciate you having me here.
We like to start with the difficult questions here. What’s your favorite ice cream?
It’s got to be strawberry. I’m not sure why but as a kid, I always liked strawberry-flavored anything so strawberry ice cream stuck. I always have some at home.
Are you a bowl or a cone guy?
There’s a right way to answer the question but then there’s an honest way. I’m probably a cone guy but frankly, my favorite way to eat ice cream is right out of the container.
I thought you were going to say, “There’s probably a politically right way to say this but I’d go straight in for it.” Tell our readers what the scoop is. What do you do?
My name is Xiao Ou Yuan. I am the Managing Director of Hageman Capital, which is a new entity created by Hageman Group in late 2020. Not a lot of folks know who we are but we are a family office that primarily invests in multifamily real estate around Central, Indiana in the Midwest. The family offices started with the sale of Seeds in Remington, Indiana, which gave us a lot to put to work.
In 2013, we started heavily investing in real estate. The Hageman Capital side of it is ultimately a TIF monetization arm of Hageman. With the real estate expertise we have in traditional commercial real estate, we found that it made sense to also look into being investors in tax increment financing bonds, which is a pretty common incentive in multifamily deals that we see around Indiana.
Traditionally back in the day, a municipality wishes you a tax increment financing bond, sells the bonds to the public market and then essentially writes developers a check. Those days are gone. A municipality is not willing to back the bonds with their credit, take it to market and sell it. Developers oftentimes have to find a way to monetize it.
We found that there were a lot of opportunities in the space. With TIF, most real estate developers understand property taxes but package it within a bond vehicle and a capital markets execution. That’s the side of it that we bring a lot of value to. Ultimately, what I do is lead Hageman Capital. Our job is to monetize tax increment financing bonds for developers.
I want to get into tips because this is a new subject area for me so I’m way over my ski tips here before we get this conversation going. You’re going to have to educate me. Before we get there, Hageman Capital Group has deep expertise in real estate. Can you talk to us a little bit about your real estate portfolio and what that looks like?
Predominantly, we own multifamily apartment assets. Our model is from the ground up. We like to invest in assets that we can feel, see and touch. A lot of our assets have been based out of the Indianapolis area or the greater Indianapolis area. A lot of our portfolio consists of your traditional mixed-use four-story multifamily buildings. We also own a couple of retail assets as well.
When we first started Hageman Group, were an investor in a couple of student housing projects that we have since sold. Predominantly, our assets have been in Indiana but we do have a few assets in Kansas City and St. Louis. We’ve done a project in Cincinnati as well, a couple in Georgia and one out in North Carolina. We’re generally pretty disciplined in the way that we invest in real estate and in assets that we understand. Multifamily to us has always been the arena in which we’ve deployed capital.
Since 2013, we’ve probably owned about close to $400 million in commercial real estate. Most of that has projects. Prior to Hageman, I was in the capital market for a middle-market bank. My focus has primarily been on high-yield municipal bonds. TIF falls into that category of being a high-yield municipal bond product. There are not a lot of folks in the market or in general who know bonds, specifically high-yield bonds. It seems like an obscure subject and it is. Also real estate as well.
You marry those two things together and get somebody that is maybe good at 1 or 2 things but generally can’t do too much outside of that. That’s how I joined Hageman back in 2020 to lead Hageman Capital as the office was looking to expand into other investments, chasing yield in a volatile interest rate environment.
Most of your assets were ground up. Did that mean the foundation of it is real estate? Did Hageman have a ton of experience in developments and that’s how you got into TIF?
Yes. From the ground up, the Hageman family is an agricultural family. Hageman along with his cousin started a company up in Remington called Remington Seeds. The family has a farming background. As farmers, everything they do is tangible. They see their work product daily. What they do is extremely impactful and the value they create is very obvious. It felt that same way about real estate as well. Where that model came from was the sense of we are investing in products that we can feel, see and touch. That came from the ground up. It’s a kitschy saying but it makes sense in everything that we do.
Assets you can touch, feel and see and are inflation-protected with agriculture and real estate there. Let’s go into TIFs. You mentioned what they were previously but let’s start at the 101 level for me here. What is a TIF? What’s the explanation for it? We’ll then go from there.
Tax increment financing is a moniker. I always like to use this anecdote because it’s easy to understand. Let’s say there’s a piece of dirt in your hometown that has sat vacant and is undeveloped. The municipality is collecting taxes from land, which isn’t a lot. An unimproved land is not going to generate a lot of tax revenue but if somebody were to build 200 unit apartment complex on that land, the improved value would be worth a lot. The improved taxes would be more than what the taxes would be currently on the vacant piece of land.
To incentivize a developer to put a 200-unit apartment on that land that maybe wasn’t developed, what a municipality can do is allow the developer to capture the future increment taxes. The increment, in this case, is defined as the land value versus what the developed apartment values would be and that’s the increment. What the developer would do is capture those tax increments for some time and essentially borrow money against that cashflow over time. Unimproved land has not a lot of taxes. Improved land with 200 units has a lot of taxes. That delta of those taxes is considered the increment. The financing side of it is you are leveraging against that cashflow over time.
Let me make sure I understand it. We’ve got a simple property tax of 10%. We’ve got unimproved land that is $1,000, let’s call it. The tax is $100. If we put a 200-unit complex on it, the improved value would be $1 million. If we take the same 10% tax rate, we’re talking about $100,000. A tip would say, “Over the course of 5 years, you’ve improved that value by $500,000 so we wrap that into a securitized product, essentially.”
It’s the taxes that you would pay so the $100 in taxes versus $100,000 in taxes. The difference between that could essentially be securitized and monetized.
Where do you all come into the equation? Do you help securitize it and sell it off?
We’re a pure investor in the sense that say a developer is allowed to capture a TIF for 25 years. What we would do essentially is buy that cashflow from the developer and write a check upfront to the developer. Typically, this money is used as equity. What a lot of lenders see as well is that money comes in first. In your example, we’re taking that $100,000 over the next 25 years. We pressed that value on that back and wrote a check on them.
The developer will give you cashflow streams for the next 25 years off of that.
Yes. You can think of it that way. They would ultimately pay taxes to the municipality but what the municipal is allowing you to do is capture the taxes that they may have otherwise not been able to capture. That $100,000 would normally go to the municipality but because of the tax increment financing and this is a municipal incentive, the municipality allows you to capture that increment as the investor.
I live here in Nashville. The first question and I know the answer to this but I don’t want to assume anything, is this only local to Indiana and Indianapolis or do all municipalities across the country do this financing?
I wouldn’t say all but it’s a pretty powerful municipal tool to encourage economic development. In most states, it has been prominent, especially in the past several years when development in the United States has boomed. It’s been a major tool. Especially where we are in Indiana, a significant amount of real estate development projects have some incentives simply because the market may not be able to support the product without the incentives. States like Indiana, Illinois, Ohio and the surrounding states here are all very heavy in TIF. Nationally, TIF legislations vary from state to state but I would say the majority of states have some form of TIF legislation.
When I read the headlines, and this is a hypothetical example, of Oracle moving to Nashville, they’re going to build a big campus and bring 8,000 jobs. I’m assuming there are some tax incentives alongside that to entice Oracle to move to Nashville versus New York, Austin or Indianapolis. In those tax incentives, typically they structure a ten-year no property tax if you move your headquarters here and build on it. Is that essentially what the municipality is doing, writing a TIF around that?
TIF is a little bit different in that. It hasn’t been on a single project. It could be on multiple projects in which the municipality increment taxes for multiple projects and then try to monetize or securitize those cashflows and provide upfront cash. That has been done. In our developer-back model, it’s a fancy way of saying this is a single-site TIF. It’s a tiff on a single project. That’s where a developer can see it as an abatement.
If the developer did not sell the TIF bonds with a TIF note, they would be the ones collecting the cash from the TIF. In that case, yes, it could be seen as an abatement. In your example, those are more traditional abatements occupied pieces of real estate. They’re not generating income, as opposed to developers, which their goal is going to generate income from any piece of real estate they own.
What kind of returns and cashflow are you looking at when you buy these TIF bonds from developers?
It depends on the project, location and how long the TIF is outstanding. Ultimately, my rule of thumb has always been we are typically higher than a construction loan but lower than an equities preferred return. That has to do with the risk profile that we’re in. We are first dollars in along with the developer’s equity but given that we are taxes and do sit in that senior taxing position so it’s not quite as risky as an equity position. We think of it as not as safe as a traditional mortgage in the sense that our money is going in first but we’re certainly not in equity in the 9s and 10s. We sit in between there. The range depends on the type of project, the location and how long the bonds are.
In the capital structure, do you sit below the debt or on top of the debt?
Typically taxes would sit above the debt in the capital structure. Simply because if you don’t pay your taxes, regardless of any kind of real asset that you own, the government can take it. If you don’t pay the property taxes on your house, your local government can take your house and go to a tax sale. From that sense, that’s why it’s considered senior.
If you think about the TIF incentive is about 10% to 12% of the entire capital stack, that’s where as a lender and a commercial bank, you tend to understand your taxes are not going to be from an expense perspective, the same as your overall aggregate expenses on a multifamily project, for example. That’s the side of it in which it is taxes but the money does come in first.
How is this tax? Is it taxed like a municipal bond where it’s tax-free or do you have to pay taxes on this income?
It depends. It may depend on whether or not the developer is going to effectively guarantee the payment of increment bonds. What is the use of these tax increment financing proceeds? If a developer uses the proceeds for bricks and sticks, then a lot of lawyers will say, “It’s an argument in which this is a private use.” Typically in those situations, they may not see the same tax treatment as most other municipal bonds. A lot of it is the devil in the details but in most cases, the TIF bonds that we acquire do not have tax advantages. We will have to pay taxes on the income.
My next question is going to be along the lines of inflation protection. What I’m trying to ask in this question, hopefully, it comes out right, is if the tax rate is 1% on property tax, inflation goes through the roof, COVID happens, we print a bunch of dollars, governments are in debt where they need to raise revenue, the place they typically go is property taxes, if that tax structure goes from 10% to 11%, for example, do you have escalator causes in your TIFs that says you can look at the future cashflows as well or is it only at the time that the TIF is written?
It depends on how you structure the deal. I would say a prevailing real estate concept that assesses values increase year over year. It’s for a good reason. The idea is you’re holding a real asset so a real asset should increase as inflation increases. Depending on the way that we structure it on day one, we may say, “We believe assess value is going to increase by 1% or 2% on an annual basis.” In those cases, we would typically capture those increases into our models and say, “We believe in year 15 that the tax increment revenue amount is going to be significantly higher than in year 1.”
When we press the value in that calculation in year 15 back to year 1, we’re probably going to use the higher value but that’s not always going to be possible or feasible. Simply because it could depend on the type of product and the area that we’re currently in. The most conservative way to look at it is there are no assessed value increases.
From a developer’s proforma, that’s probably good. Realistically, it’s probably not the case. It’s just from a TIF purchaser’s perspective. The most conservative method of assessing it is assuming there are no assessed value increases in the future but from the developer’s perspective, they want to see assessed value increases because they’ve already modeled that out into their proforma.
In their proforma, they’re accounting for 1.5% to 2.5% percent year-over-year increases in expenses, maybe all the way down and that includes property taxes. They want to be able to monetize those increases as well and get a bigger check upfront. There are a lot of ways to structure these deals but sometimes, the caveat that folks don’t always realize is that the municipality is also a party to this.
A lot of times, it depends on what the municipality is comfortable with. At the end of the day, this is an incentive provided by the municipal government. Understand that as you’re trying to negotiate with an investor, you’re okay with the municipality knowing that public dollars are being used to support a project.
I bet you have some interesting Excel models too. I was following you on the developer side and then you brought in the municipality. I was thinking, “This is lost revenue for them.” Essentially, this is an incentive structure so they’re going to want to make sure that we are applicable and agreeable from all angles too. It’s a tripod.
Good developers can see things from all these angles and understand that this isn’t a transaction in which it’s a zero-sum transaction. They see it as, “We need to be able to provide value and contribute the asset that the municipality wants to do and the municipality partner in our project as well. They’re giving us the funds so that we’re able to take this project and take it alive.”
The side of it that is important to keep in mind is that it’s not always a two-party transaction. Sometimes, it is a three-party transaction. It’s important to understand what is the public value that’s derived from TIF as well and understand that it’s not a developer value. It’s public dollars investing in a project that the municipality thinks will generate future higher base assessed values. They want to be able to recoup their investment in the future.
Essentially, if I’m following that correctly, by putting that 200-unit apartment complex on this block, all of a sudden, everything around you becomes more valuable so even though I gave up an incentive here, all the property values around me went up and I’m collecting higher tax revenues from those.
Also, once the TIF expires, the taxes on that 200-unit apartment goes back to the municipality so they’re able to collect that as well. It’s meant to be a very powerful tool and it has been a very powerful tool but it’s as important to understand that you have to see things from not just the developers’ angle or investors’ angle, knowing that there’s a public stakeholder as well.
What does the secondary market look like on these? We’ve only talked about you investing in new TIF creations. Is there a secondary market for this? Do you recycle your capital by selling these on a secondary market? Talk us through that.
Unlike most investors, being a family office means that you get to take a very long view of any asset that you own. We haven’t round-tripped any of the capital that we’ve already invested in TIF. The idea is in Indiana, TIF is 25 years. When we make an investment in 2020, we fully expect that we’re going to own those bonds for the next 25 years. Part of it is we don’t want to derive value from the flipping of it. To answer your question, there isn’t a huge market for it either.
Typically the bonds that we purchase are developer-back TIF bonds. They’re not those large TIF districts in which they’re rated by a rating agency with an investment grade rating or they’re not a bond in which municipalities support the TIF in addition to the TIF revenues also providing general property tax revenues in case there’s a shortfall. That’s not what we’re purchasing. We’re essentially purchasing unrated, highly, illiquid bonds which there isn’t a ton of secondary market activity.
That’s the side that we see we’re providing a significant amount of value by creating or providing liquidity in an environment where there isn’t a ton of liquidity. Most of these transactions are primary market transactions. Before a developer is building the project or has built the project, we’re stepping in to monetize that TIF stream.
I can see this being more applicable to developers as liquidity dries up in our system as we enter the back half of 2022 and go into 2023.
It’s not a surprise that the Federal Reserve is very invested in fighting inflation. One of the best tools they have is to increase interest rates. Liquidity dries up and it’s not always even private liquidity from private investors but it’s also liquidity from your traditional capital providers like banks. As banks become tighter in their underwriting too, some of these loan-to-value assumptions may get tip down significantly. If you’re a municipality looking to make sure a project happens, that’s where TIF becomes very powerful.
For a TIF district to be created and provided, there has to be a but-for test. It’s a great way to say, “This project would not have happened except for TIF came in and provided the capital to build that project.” That’s a very important distinction. The projects that have TIF wouldn’t have happened without TIF. As we are looking into a future with tight liquidity, TIF becomes extremely important in the next development cycle.
Here’s the last question. You mentioned the word developer-back. Have you ever had to foreclose or default on one of these bonds?
We haven’t but we have a few security features that ensure that we get our payment back. Historically, with single-site TIFs, because it’s not a very liquid instrument, there’s not a lot of market data to show what the default risk or foreclosure risk is in a TIF transaction but generally, that hasn’t happened. I wish I could say, “We have all this data to show you that these are the percentages in which defaults have happened in single-site or developer-back bonds,” but there isn’t a lot of that data.
To me, that’s probably a good sign. If the opposite were true that there were a lot of defaults and foreclosures, that would be very heavily reported on. The way that we structure and invest in TIF, as a group, we’re very risk-off. We find a lot of ways to mitigate our risk from big risk to assessment risk if assessed values somehow go down in the future. We have a lot of mechanisms by which we can defer or eliminate those risks. From that perspective, if one of these projects default, something is going very wrong.
You led me to the water there. What are the mechanisms for how you protect yourself against assessment values going down?
One of the most common mechanisms at least we use in Indiana is called a taxpayer agreement. The developer-back nature of it is the developers are essentially agreeing to make a payment that covers your debt service, regardless of whether the assessed value goes up or down. That’s a very strong mechanism. We’re not utilizing the developer’s balance sheet but if you think about it from a pure capital stack perspective, the only expense can’t get away with not paying is your property taxes. Of all the expenses that you can choose not to pay, you have to pay your property taxes.
Once the project is complete, our risk is significantly reduced in the meantime at the beginning of the project. The reason why our rates are essentially between a mortgage and a preferred return on equity is we’re taking on construction risk and development risk. The biggest mechanism for us has been creating an agreement with a developer in which they’re essentially agreeing to pay the taxes regardless of what their assessed values do.
It’s also an easy conversation that they can have with their lenders. That’s ultimately what they’re agreeing to in their proforma as well. It shouldn’t come as a shock if assessed values go up in the future. Simply because it’s already been modeled in the proforma but that’s the side of it that that’s how we’re able to be a risk using a mechanism like a taxpayer.
Where I was wondering about the capital stack conversation that we were having is where you sat because, in my mind, this is still the taxes. If people want to say, “Own your home free and clear,” you own it. ‘No one can take it from you.” Don’t pay your taxes and somebody will come to take that from you. I’m going to shift us into our last round. We’re calling this the Five Toppings. Our first one is, what is your favorite book or what is a book that you’ve read recently that’s given you a paradigm shift?
I probably don’t read as much as I would like to but generally, anything written by Malcolm Gladwell I’m a huge fan of. Outliers and David and Goliath are some of the recent ones. Also, Michael Lewis. I finished reading Liar’s Poker for maybe the fourth time. Frankly, I’ve never read Moneyball even though everybody loves to talk about that because it was made into a movie. I would say anything about Gladwell and I’m starting to get more into things written by Michael Lewis.
That’s two of the best storytellers of our times. Malcolm Gladwell’s podcast, Revisionist History is a fantastic tool to learn how to tell stories too. Our second one is I believe that the person you become ten years from is directly correlated to the things you do every day and the habits that you have. What are some of the things that you do every day?
One thing I do every day without fail and it sounds a little bit cheesy is before I leave the house, I make sure to tell my wife I love her. In ten years, what you do every day is going to be a reflection of who you are. In ten years, I still want to be a great husband and partner. This is something that I do to remind myself that anything I do now professionally or personally, I’m doing for somebody else on the journey with me. For me, that’s a very lovely mindset. It’s a good practice too in general and I’m sure she appreciates it.
The third one is what’s the best piece of advice you’ve ever received?
I was trying to think of something that’s maybe not too cliche but I’m lost. This is more anecdotal or at least I’ve seen a pattern with this. There isn’t anything good that happens after midnight. A lot of things can derail our lives and our careers by making bad decisions. This is an adage that I had in college that I probably didn’t follow as well.
As an adult, in your 30s, how many reasons do I have to be out at midnight? The broader scope of it is thinking about it and understanding that your decisions impact you and others around you. It’s probably not as eloquent as that. As my wife likes to call it, I have a supernatural ability to leave the scene before something bad happens.
I don’t want to brag but on New Year’s Eve in 2021, I was home by 9:00. I typically agree with that statement. That’s funny. The older you get, the more your parents’ advice when you were younger becomes more applicable. You shouldn’t find yourself in bad situations or situations where bad things can happen. What I try to control more than anything is whether I should be involved in this situation. What are the chances that something bad’s going to happen?
It’s applicable to your personal life but also to investing in real estate as well. There is this leaving the party before things get bad mentality in real estate. Smart investors and disciplined operators know when to go play golf and put the hammer down.
Our fourth one is what are you most proud of in your life?
I’ve been fortunate to have a lot of professional opportunities at a relatively young age. The thing I’m most proud of is my nonprofit involvement. I’m very civically involved and engaged with my community. I sit on a couple of boards locally. This is why I do what I do. You’re trying to make a positive impact on your community. Being involved in nonprofits, volunteering and giving back your time, talent and treasure is something that I can always be proud of. I sit on a few boards whose mission is to benefit children. That’s something in which I think, “How could you not be proud that you’re a part of it and that you are helping contribute to alleviating problems that kids have?” That’s what I’m proud of.
Our fifth and last one is if you could sit down and eat a bowl of ice cream with anyone, dead or alive, who would it be and why?
I’m a big Formula 1 fan. I don’t know if a lot of your readers are Formula 1 fans. I would love to have ice cream with Hamilton. I’m pretty sure he’s vegan so it might have to be vegan ice cream. He’s a seven-time world-driving champion. It’s a fantastic story of how he went from a middle-class kid in England to being the best at his sport in which money matters.
You hear about stories about how much his parents sacrificed to get him to where he is now. It’s reminiscent of what my parents have to do as immigrants to help support our family. Being able to share a conversation with him, learn about his perspective and talk to somebody that is at the top of their game for the greatest to ever do it would be a special moment. If I had to pick anybody, it would be him.
Did you get into Formula 1 because of the Netflix series?
I did. I started watching that a couple of years ago and I was like, “I never thought racing cars would be this gripping.” I got my wife into it. Every Sunday, we watch Formula 1 when there’s a race on. I’m sure there are bigger Formula 1 fans than we are. The Japan Grand Prix was on it at 1:00 AM so I woke my wife up and we watched the Japan Grand Prix. I don’t know if that’s something but we’re very invested in it.
I don’t know anything about Formula 1. They have done a tremendous job promoting the sport and taking different sports verticals, specifically NASCAR and others and then moving them to Formula 1. I was watching something like how Formula 1 become so popular. The underlying reason they said was so many people got hooked during the pandemic on the Netflix series and now it’s an entertaining sport. You’re following this team, the driver and all this thing. It’s interesting. It’s a fantastic conversation, Xiao. If our readers wanted to reach out to you, learn more about what you’ve got going on and learn about TIF specifically more in-depth, where’s the best place we can point them?
HagemanCapital.com is where you can learn about our efforts in TIF and also read our insights. We go into a lot of detail about how TIF is used and in what situations. We provide some ideas through the general development committee. Go to HagemanGroup.com to learn more about what we’re doing in real estate, agriculture and private equity. Those are the best ways to get in touch with us and learn more about what we’re doing.
Xiao, thanks for being on the show.
Matt, thank you so much. This was fun.