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A few months ago(1), Bob Labes and I wrote a blog post about the $78 billion tax bill that promotes affordable housing by reducing the tax-free financing requirement for a developer seeking to receive the 4% Low-Income Housing Tax Credit (4% LIHTC) by 40% for a limited time. This got us thinking about how tight the state allocation of the volume cap is in some states and what happens when a developer still doesn’t receive a volume cap allocation for their project. Is the developer out of luck? Are there other options?

If the developer only considers the 4% LIHTC, the answer is probably yes. But don’t go now – there’s more! There are alternatives that may be better for a developer than the 4% LIHTC.

Although the 4% LIHTC program has been extraordinarily successful, it provides too little to the “missing middle.” The 4% LIHTC program has benefited households earning 60% or less of their metropolitan area median income (“AMI”) for decades. However, 4% LIHTC funding does not help those who earn too much to qualify for subsidized public housing but cannot afford market-rate rents or homeownership (“middle-income earners”). Thus, the inability to obtain a volume cap allocation to finance a housing project under the 4% LIHTC program could benefit a developer. As a result, a developer could alternatively create housing for middle-income earners (“middle-income housing”).

Targeting middle-income individuals could result in higher rents for such units. Where the 4% LIHTC financing is not available, other forms of tax-exempt bond financing can support housing for middle-income individuals (“middle-income housing”) by combining the benefits (2): tax-exempt interest rates, favorable underwriting terms, and property tax reduction or exemption.

Tax-free interest rates

The most compelling benefit of tax-free bond financing is that tax-free interest rates are typically lower than traditional loan rates. Because investors do not have to pay federal income tax (and sometimes state income tax) on interest income from such bonds, they require less interest to achieve the same after-tax return. This lowers the overall interest rate that investors are willing to accept on such obligations, and this interest rate is passed on to the issuer/borrower.

These types of financing are generally true “project financing.” The bonds issued to finance these projects include amounts borrowed for coverage, debt service reserves, capitalized interest, upfront fees and bond issuance costs. Most, if not all, transactions borrow the full amount needed to complete the property, plus an additional 15% on average. So a lower tax-free interest rate is a big advantage and is especially valuable in middle-market housing financing because the transaction sizes are relatively large and the proportion of long-term tax-free debt relative to total project financing is high.

Favorable underwriting conditions

Transactions for mid-income housing are typically conducted as public bonds rather than in the form of private placements or bank loans. Private and institutional bond investors extract more value from tax-free interest than commercial banks, which typically purchase bonds in private placements. As a result, there are more investors willing to offer much more favorable underwriting terms. Most bonds issued for mid-income housing are unrated and are sold and traded in the high-yield municipal bond market. This market and the mortgage loan market are overwhelmingly mutually exclusive. The mortgage loan market typically imposes much more stringent underwriting standards, including a maximum loan-to-value (LTV) ratio (often 80-90%), a minimum debt service coverage ratio (often 1.15:1 or 1.20:1), scheduled amortization with limited or no “balloon payments” or refinancing risks, developer/sponsor completion and repayment guarantees, and borrowing cost limits on construction loans.

In contrast, in risk-on environments where bond investors seek returns and are willing to take risks, non-recourse project financings in the high yield bond market are not uncommon, which have the following characteristics:

  • 100% debt financing;
  • Lower projected debt service coverage (up to 1.10:1);
  • Long-term (30+ years(3)) fixed-rate, callable debt;
  • Sequential repayment or “turbo” amortization as opposed to fixed/scheduled repayments;
  • ‘Balloon payments’ or planned refinancing;(4)
  • Relatively low guarantees; and
  • Assumption of the construction risk within the framework of long-term external financing (i.e. no separate construction loan).

Public and private sector players have executed mid-income housing transactions in the high-yield bond market at terms that could not be achieved in the conventional multifamily mortgage or 4% LIHTC mortgage markets. But all this flexibility comes at a price—taking on more risk and earning more return typically means the investor wants more in return. Interest rates and risk tolerances can change dramatically, even in a short period of time, due to external factors(5)—and investors who offer favorable terms today may have a different mindset the next time they finance. The highly leveraged, unrated workforce housing bonds that were popular when interest rates were near zero during the COVID-19 pandemic are a thing of the past.(6) These types of projects have become much less feasible when other contractual or federal restrictions apply. For example, California state law requires that middle-income housing include:

  • 10% of the units are rented to residents earning 50% of the AMI or less.
  • 10% of the units are rented to residents earning 80% of the AMI or less, and
  • The remaining 80% of the units are rented to residents earning between 90% and 120% of AMI.

As interest rate increases outpace the increase in AMI, cash flows in mid-income housing transactions are not as high as they once were. Underwriters have had to get more creative in using structures such as capital appreciation bonds (7) for these types of financings. But even with rising interest rates, this benefit, combined with lower tax-free financing rates and property tax reductions or exemptions, can increase the cash flow of a mid-income housing project.

Property tax reductions or exemptions

Property taxes are often a large cost in multifamily rental housing projects. Because taxes are paid before debt service, every dollar of property taxes owed is a zero-sum game for the net operating income available to pay off debt. So reducing or completely eliminating property tax liability increases net operating income and therefore the viability of the project. Some jurisdictions offer property tax exemptions and reductions that can help finance middle-income housing.

Obtaining a property tax abatement or exemption often requires contacting the local tax authorities in whose jurisdiction the middle-market housing facility is located. This can sometimes be challenging if a property is already subject to property taxes. Convincing a local government to forgo revenue can prove difficult at best, even when these projects are aimed at helping residents.

While issuing tax-exempt bonds does not automatically result in a property tax exemption, the forms of ownership required for tax-exempt financing of mid-income housing (ownership of all bond-financed facilities by a 501(c)(3) organization or a governmental entity) often result in a bond-financed project being exempt from property taxes. Government ownership typically results in a clearer and more comprehensive property tax exemption than programs based on 501(c)(3) ownership. However, other considerations, such as leases with private individuals who may have “ownership interests,” can negate this exemption. So this truly valuable tax exemption can be the deciding factor in structuring your tax-exempt financing or borrower for developing a mid-income housing project with government bonds or 501(c)(3) bonds. More information on these considerations and structures follows.

(1) Time flies when you’re having fun!

(2) It should be noted that some of these benefits are also available to affordable housing projects that do not also receive the 4% LIHTC.

(3) Subject to limitations under state and federal tax law

(4) Subject to limitations under state and federal tax law

(5) Consider the Fed’s decision to continue raising interest rates since 2022.

(6) We all crave these interest rates now.

(7) Capital Appreciation Bonds (CABs) are bonds that accumulate compound interest until maturity rather than paying interest annually. CABs are sold at a discount, called par value, and the interest and principal are paid in a single lump sum at maturity.

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