Financing Focus

Affordable Money

Nonprofit and private developers can take advantage of tax-exempt bonds.

With the ever-increasing need for more affordable housing, both nonprofit and for-profit developers must consider every available below-market-rate financing program to make such projects economically feasible. Viable sources may be 501(c)(3) bonds for nonprofit developers and private-activity bonds, which are available to for-profit developers. State and local governments issue these bonds as a way to finance affordable housing.

Using these tax-exempt bonds requires a high level of sophistication, and their transaction costs may be steep, often 3 percent to 5 percent of bond proceeds. Tax-exempt bonds generally require loans of at least $5 million to be worth the effort, which may make them impractical for small deals. However, multiple properties can be bundled together in a single bond issue to take advantage of economies of scale.

Despite these limitations, both 501(c)(3) and private-activity bonds provide wonderful flexibility. They generally are always available, whereas low-income housing tax credits usually are allocated only once or twice a year. They offer extremely attractive interest rates, often over a 30-year term. While the rates fluctuate with the bond market, they recently hovered around 6 percent. Also, the time frame is relatively short: A bond transaction can close within a three-month time period.

The Bonds Explained

State and local government agencies issue 501(c)(3) bonds on behalf of nonprofit organizations exempt from federal taxation under Internal Revenue Code Section 501(c)(3).

The bond debt amount states can issue in a given year is flexible, so competition generally is less than the tax-credit program. However, nonprofits cannot have more than $150 million in bond proceeds outstanding at any one time on all their multifamily developments.

Public issuers such as state housing finance agencies, local redevelopment agencies, and public housing authorities also allocate private-activity bonds to for-profit developers through annual funding cycles. There is a cap on how much private-activity debt states can issue, so competition may be fierce. For-profit developers can couple private-activity bonds with low-income housing tax credits -— either the noncompetitive 4 percent program or the highly competitive 9 percent program.

Typical Underwriting Standards

Government-sponsored entities such as the Federal Home Mortgage Association purchase many 501(c)(3) and private-activity bonds after they are rated investment grade by agencies such as Standard & Poor's and Moody's. Underwriting standards for these bonds tend to be quite strict because a higher grade directly corresponds with a lower interest rate.

For a bond to achieve a high investment grade, the project must have considerable debt service coverage, generally 1.50 or more. The ratings agencies often require high operating, replacement, and debt service reserves. Credit enhancement, such as a letter of credit or insurance that reduces the bond purchaser's risk of loss should the property fail to pay its debts, also may be required to mitigate risk. High ratings such as AA or AAA mandate credit enhancement.

In addition to the grading of each bond deal, the borrower's financial and management strengths are critically important. Issuers review the developer's property management ability and experience carefully. Typically only developers with fairly substantial balance sheets and established track records can attract tax-exempt bond financing.

These programs work extremely well with large mixed-income properties and in some markets can be the only form of financing required if the project is not in a redevelopment area or special district where other financing tools are available. In many cases, subordinate debt is permitted. Given the 1.50 debt service coverage typically required for the bonds, ample room for a second loan generally exists, but lenders may have to forego some of their traditional rights such as the ability to foreclose.

Using Tax-Exempt Bonds

The first step in using either 501(c)(3) or private-activity bonds is to assemble your own team: knowledgeable real estate brokers, consultants, financial experts, and counsel. Consult with other affordable-housing developers who have used these bonds. Make sure your advisers have specific experience with the property type you are seeking to finance. More important, make sure they have a good working relationship with the issuer you are considering. You also must make sure that your project meets the issuer's social goals; otherwise, it will show little interest.

Issuers vary considerably in their levels of expertise in multifamily bond financing. Some states have excellent housing finance agencies with extensive multifamily experience. In other communities, a local jurisdiction such as a county or city housing finance agency may be a better bet. The transaction costs often are lower than with state agencies, but the trade-off may be a less-experienced issuer.

The Internal Revenue Service requires that nonprofit and for-profit owners of multifamily projects developed with bond financing set aside either 20 percent of the units for households earning less than 50 percent of the area's median income or 40 percent of the units for households earning less than 60 percent of the area median income. In addition to choosing one of these two set-asides, developers must hold rents at a reasonably affordable level, which generally is interpreted to assume rents of no more than 30 percent of the selected income thresholds. Local inclusionary housing laws and state housing policies also may apply. Furthermore, developers either must indicate their intent to finance with tax-exempt bonds in their IRS exemption applications or request bond financing authority from the IRS.

Tax-exempt bonds are not for the faint of heart. Like any other financing type, think of them as other valuable pieces of your commercial real estate financial toolbox. Surround yourself with knowledgeable financing experts to successfully obtain tax-exempt bond financing for your affordable-housing projects.

J.R. Chantengco, CCIM

J.R. Chantengco, CCIM, is president of the Triwest Group, an affordable-housing and mixed-use developer in Bonita, Calif. He also chairs the San Diego Community Housing Corp. and is secretary of the California Housing Partnership Corp. Contact him at (619) 656-8850 or


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