It is no secret to those familiar with the affordable multifamily rental housing industry—need dramatically outpaces supply. For the 11.5 million extremely low-income households in 2012 there were only 3.3 million rental units affordable and available to them.1
Although government programs that provide rental assistance to individuals and economic incentives to investors and developers have existed for decades, astute minds are constantly looking for new policies and efforts to help alleviate the daunting gap between demand and supply. One manner in which government organizations at the federal, state and local levels support affordable housing is by serving as the issuer or legal entity to issue tax-exempt bonds. Tax-exempt bonds are used to help finance specific housing projects and the proceeds can be used to fund loans to developers.
While there are a number of unique financing methods available to affordable housing developers, the purpose of this article is to compare execution levels available in the current market for short-term, fixed-rate, tax-exempt bonds with taxable loans and traditional tax-exempt housing revenue bonds. For the comparison, we will examine the differences in regard to 4% low-income housing tax credit (LIHTC) transactions that carry bond maturity terms of 15 to 20 years, timing that coincides with the compliance period of a new syndication.
Over the past several years, tax-exempt securities have averaged higher interest rates than comparable taxable executions and this continues to be the case on the long end of the yield curve. However, due to recent market movements, it is necessary to analyze the cost feasibility between a short-term, taxable cash-backed bond structure and the more traditional tax-exempt structure.
Short-term, fixed-rate, tax-exempt bonds are collateralized by cash and serve to take advantage of the interest rate inversion present in the market since early 2008. While the structure requires an issuance of short term tax-exempt bonds, the underlying mortgage loan is a long-term taxable loan. This taxable structure has been economically favorable over the past few years for a number of reasons, including lower permanent borrowing costs that can result in additional net proceeds due to reduced debt service, reduced issuance costs and negative arbitrage savings, the latter of which occurs predominantly on new construction projects. Additionally, the structure complies with 4% LIHTC requirements that at least 50% of aggregate basis of the building and land must be financed from tax-exempt bond proceeds in order to qualify for the full value of the 4% LIHTCs.
Traditional tax-exempt financing is available to nonprofit and for-profit entities. These funds are often paired with 4% LIHTCs because they can be reserved along with an allocation of tax-exempt private activity bonds, providing an important source of equity to the transaction.
Figure 1 provides a snapshot of the underlying indices which are indicative of taxable and tax-exempt execution levels. The 10-year U.S. Treasury rate was selected as the taxable index while the 10-year AAA GO was selected as the tax-exempt index. These indices are most relevant for taxable and tax-exempt debt priced in the 15 to 20 year maturity range. In a traditional rate environment, taxable execution levels are higher than that of a comparable tax-exempt security because interest received from the tax-exempt security is exempt from federal and most state income tax. Investors will thereby accept a lower rate of return.
In 2008, you will note that the taxable rate evidenced by the 10 year U.S. Treasury index decreases below that of similar tax-exempt executions, thereby creating an inversion of the taxable and tax-exempt rates. Prior to 2008, a more traditional interest rate environment was present with tax-exempt rates well below taxable comparables.
In order to evaluate the execution of the taxable and tax-exempt medium-term bonds, we analyzed Thomson Reuters data of yields over the past three years (Figure 2). The shaded area indicates the spread, or difference in rates, between the two financing options. From 2011 to 2013, the spreads were negligible, with taxable yields slightly lower than tax-exempt. In that case, there was a need for the short-term, fixed-rate, taxable cash-backed bond structure. From late 2013 on, tax-exempt securities have continued to decrease in yield. Heightened investor demand, decreased tax-exempt issuance and subsequent product scarcity have driven tax-exempt yields lower causing spreads to widen and tax-exempt yields to drop below similar taxable rates.
While traditionally offset by the lower interest rates, it is important to consider the additional fees in the cost comparison of taxable versus the tax-exempt issuance. The additional costs associated with the issuance of tax-exempt bonds include bond counsel costs, underwriter counsel, bond underwriter fees, initial and ongoing trustee and issuer fees and rating agency fees. While the total fees will depend on the size and location of the issuance, 40 basis points has been selected as a standard cost threshold for analysis purposes. Figure 3 illustrates the spread between the taxable and tax-exempt execution and includes a line to illustrate the cost threshold. Due to the recent widening of the spreads and significant trajectory illustrated below, instances where the spread is greater than the cost threshold indicate favorable tax-exempt execution.
The analysis performed herein does not provide overwhelming justification for either financing method, rather it supports that a detailed analysis must be performed prior to beginning any 4% LIHTC financing. Deal specific issues such as size, location, timing and issuer will impact the economic analysis and feasibility determinations. For developers, it is critical to work with a lender that continually monitors and evaluates the changing markets to ensure that financing options are properly assessed. Only then can it be determined which product best fits the specific project needs.
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1. Joint Center for Housing Studies of Harvard University, “The State of the Nation’s Housing,” (2014).