Today, the inverted yield curve has created challenges for borrowers to secure debt. The curve describes the condition when long-term U.S. Treasury debt interest rates are less than short-term interest rates. This is particularly evident in the cost of capital for construction loans. Despite these challenges, sophisticated and experienced affordable housing debt providers are finding creative solutions to meet borrower needs.
In particular, borrowers are taking advantage of the lower-cost option of tax-exempt bonds, primarily funded by institutional municipal capital providers instead of only looking to commercial banks.
Balancing Taxable MBS and Tax-Exempt Bonds
Many borrowers in the market today have only been active in commercial real estate since 2010, which means they didn’t work through the 2008 financial crisis. As a result, many don’t appreciate the value and benefits of tax-exempt financing. Tax-exempt financing will generally offer a lower interest rate than taxable financing, and this advantage generally increases with higher interest rates.
However, the multitrillion-dollar mortgage-backed securities (MBS) market has been in such high demand for the past decade that it has also offered competitive spreads compared to tax-exempt bonds. The difference between the two often comes down to investor/lender liquidity at the end of the deal.
Anyone with Bloomberg Terminal could tell you exactly what a taxable MBS price is right now. But an identical credit tax-exempt municipal bond will have an implicitly wider potential valuation. Most agree that it is the same credit, but there are fewer buyers for tax-exempt bonds.
There is still significant demand for tax-exempt bonds, though it is related to the American tax benefit, so few international investors participate. Before interest rates increased, borrowers preferred the MBS market because there was a larger market to sell into if the market turned. Today, with interest rates up, tax-exempt bonds are the more attractive bet to many American investors as they can provide superior return on a tax-adjusted basis.
The same liquidity problem exists, which costs money compared with the taxable MBS market. But all of a sudden, the borrower isn’t paying a third of that interest in taxes. That’s a very big difference in today’s market, where interest rates are higher. That tax-free benefit has a lot of value now relative to a liquidity penalty. As a result, borrowers can often secure tax-exempt bonds at a much lower interest rate.
The Strength of Public Housing Authorities
Larger public housing authorities around the country offer an attractive opportunity to take advantage of the tax-exempt bond market as well.
Because the tax-exempt bond market has created an opportunity to secure debt at a lower rate, savvy lenders can leverage the financial strength of larger local housing authorities to create a hybrid product.
Select housing authorities can secure an investment grade credit rating, and when the deal is taken to the capital markets, the housing authority can act as a credit guarantor. Some housing authorities typically cannot assess taxes, but they have a large portfolio and a number of revenue streams that make them a pretty safe investment.
This financial strength allows them, sometimes in partnership with private developers, to access low-cost tax-exempt debt for a range of projects, including workforce housing as well as 4 percent Low-Income Housing Tax Credit (LIHTC) projects.
This is an attractive prospect for developers, who are often already working with housing authorities. Typically, the housing authority is providing soft debt or is in a subordinate debt position. Now, the housing authority has gone through the bond and rating process to borrow money at a very attractive rate to lend into the project as the primary capital provider.
In this instance, the deal could look very different than any bank option a borrower is considering nowadays. The model further opens the door for other attractive financing opportunities.
The housing authority can borrow permanent debt, apply its credit enhancement and serve as the lender and/or partner on a deal. Their guarantee can also allow the housing authority to do very aggressive financing, including financing 100 percent of the capital stack on the deal, when appropriate.
Weighing Public Offerings and Private Placements
In addition to opportunities in the tax-exempt bond market, there is also a transaction cost differential between public offerings and private placements.
Most of these costs are fixed, and there are cost differences between the two. Legal fees, for one, will be measurably higher on most public offerings. Generally speaking, however, the public offering benefits increase with the size of the deal. Larger deals are more often done as a public offering because the fees can be easily amortized into the savings created by the lower interest rates on a transaction.
But smaller deals can still work as a public offering, such as Department of Housing and Urban Development (HUD) deals with cash bonds. In addition, many new construction 4 percent LIHTC deals also benefit from various public offering structures.
Specifically, when it comes to cost, many smaller private placements are 1.5 to 2.5 points less than a public offering, though this becomes less relevant based on a larger deal size. A borrower might get a really good private placement offer — or might not — on a given transaction. The comparison has to be done deal by deal.
The current capital climate is undeniably challenging, but experts are looking at every angle of the deal to find and create opportunities. The tax-exempt market and the use of housing authorities, as well as weighing options like public offerings and private placements, are providing opportunities for borrowers to forge a path forward.
— Sam Adams is managing director, affordable housing public finance, for KeyBanc Capital Markets.