months ago[1] Bob Labes and I wrote a blog post about the $78 billion tax bill, which includes a provision to support affordable housing by reducing by 40% for a limited time the tax-exempt financing requirements for developers to qualify for the 4% Low-Income Housing Tax Credit (4% LIHTC). This got us thinking about how state cap allocations are lacking in some states, and what happens if developers still can't get a cap allocation for their projects. Are developers out of luck? Do they have other options?
If a developer is only considering a 4% LIHTC, the answer is probably yes. But don't go now. There's more to come.! For developers, there are better alternatives than the 4% LIHTC.
The 4% LIHTC program has been very successful, but it doesn’t help the “missing middle.” For decades, the 4% LIHTC program has benefited households earning 60% or less of metropolitan area median income (“AMI”). But 4% LIHTC loans don’t help people who earn too much to qualify for subsidized low-income housing, but can’t afford market rent or homeownership (“moderate-income”). Thus, the inability to obtain the 4% LIHTC program’s loan ceiling allocation for housing developments can be advantageous for developers, who can target housing for moderate-income earners (“moderate-income housing”).
Targeting moderate-income earners can lead to higher rents for such units. Where 4% LIHTC financing is unavailable, other forms of tax-exempt bond financing can support moderate-income housing (“moderate-income housing”).[2] Tax-free interest rates, favorable underwriting terms, property tax reductions or exemptions, etc.
Tax-free interest
The most attractive benefit of tax-exempt bond financing is that tax-exempt interest rates are typically lower than traditional borrowing rates. Because investors do not have to pay federal (and sometimes state) income tax on the interest income earned from such bonds, less interest is required to earn the same after-tax return. This lowers the overall interest rate that investors are willing to accept on such debt, and this interest is then passed on to the issuer/borrower.
These types of loans are generally true “project financing.” Bonds issued to finance these projects include the indemnity borrowing, debt service reserves, capitalized interest, professional upfront fees, and bond issuance costs. Most transactions borrow the full amount needed to complete the property, plus an average of another 15%. Thus, a low tax-exempt interest rate is a significant benefit, and is especially valuable in financing middle-income housing, where deal sizes are relatively large and the amount of long-term tax-exempt debt represents a high percentage of total project financing.
Favorable underwriting terms
Moderate-income housing transactions are typically done as public bond issuances, not as private placements or bank loans. Individual and institutional investors derive more value from the tax-exempt interest rates than commercial banks, who typically buy bonds in private placements. As a result, there are more investors willing to offer much more favorable underwriting terms. Most bonds issued for moderate-income housing are unrated and trade in the high-yield municipal bond market. This market and the mortgage market are largely mutually exclusive. The mortgage market typically imposes much stricter underwriting standards, including maximum loan-to-value (LTV) ratios (often 80-90%), minimum debt service ratios (often 1.15:1 or 1.20:1), balloon payments or fixed amortizations with limited or no refinancing risk, completion and repayment guarantees by the developer/sponsor, and loan-to-cost limitations on construction debt.
In contrast, in a “risk-on” environment where bond investors are seeking yield and are willing to take on risk, it is not uncommon to see non-recourse project finance in the high yield bond market with the following characteristics:
- 100% debt financed.
- Reduction in the projected debt service ratio (minimum 1.10 to 1)
- Long term (30 years or more)[3]) Fixed-rate, callable debt.
- Sequential payments or “turbo” amortization, as opposed to fixed/scheduled principal payments.
- “Balloon” repayments or scheduled refinancing.[4]
- Relatively light warranty
- Accepting construction risk as part of the long-term debt (i.e. no separate construction loan required).
Public and private sector actors have been executing moderate-income housing transactions in the high-yield bond market on terms not possible in the traditional multifamily mortgage or 4% LIHTC markets. But this flexibility comes at a cost. Accepting higher risk for yield typically means investors want more in return. Interest rates and risk tolerance can fluctuate dramatically over short periods of time based on external factors.[5] And investors who get favorable terms one day may feel differently about the next loan.Highly leveraged, unrated workforce housing bonds, which were popular when interest rates were near zero during the COVID-19 pandemic, are a thing of the past.[6] Other contractual or state law restrictions make these types of projects much less feasible. For example, California state law requires that moderate-income housing include:
- 10% of units rented to residents earning 50% or less
- 10% of the units will be rented to residents earning 80% or less of the income;
- The remaining 80% of the units will be rented to residents earning between 90% and 120% of AMI.
As rising interest rates outpace rising AMI, moderate-income housing deals are no longer cash flowing like they once did, forcing underwriters to get more creative with structures like capital appreciation notes.[7] It is used for these types of loans. But even as interest rates rise, this benefit, combined with lower tax-exempt loan rates and property tax abatements or exemptions, can improve cash flow for moderate-income housing projects.
Property tax reduction
Property taxes are often a significant expense for multifamily rental projects. Because taxes are paid before debt service, every dollar of property tax reduces the net operating profit available for debt service, making it a zero-sum game. Therefore, reducing or completely eliminating the property tax liability increases net operating profit and makes the project more viable. Some jurisdictions offer property tax exemptions or abatements that can help finance moderate-income housing.
Obtaining property tax abatements often requires negotiating with the local taxing agency in the area where the moderate-income housing facility is located to receive a property tax abatement. This can be difficult if the property is already subject to property taxes. Even when these projects are intended to help residents, convincing local governments to give up revenue can seem extremely difficult.
Although the issuance of tax-exempt bonds does not automatically provide a real estate tax exemption, the ownership structure required for tax-exempt financing of moderate-income housing (all bond-financed facilities owned by a 501(c)(3) organization or government agency) often results in bond-financed projects being exempt from real estate taxes. Government ownership usually results in a clearer and more complete real estate tax exemption than a program based on 501(c)(3) ownership. However, other considerations that may have an “occupancy” interest, such as leasing to private entities, may negate that exemption. This highly valuable tax exemption may therefore be a determining factor in the tax-exempt financing or structuring of the borrower entity for the development of moderate-income housing projects with government bonds or 501(c)(3) bonds. We will discuss these considerations and structures in more detail below.
[1] Time flies when you're having fun!
[2] It’s important to note that some of these benefits are also available to affordable housing projects that don’t receive the 4% LIHTC.
[3] Subject to state and federal tax law restrictions
[4] State and federal tax law restrictions also apply.
[5] Consider the Fed's decision to keep raising interest rates beyond 2022.
[6] We are now waiting for those rates.
[7] A capital appreciation bond (CAB) is a bond that does not pay annual interest, but rather compounds interest until maturity. CABs are sold at a discount, called face value, and the interest and principal are paid in a lump sum at maturity.
