Tax-Exempt Bonds: 2005 Preview

Bond financing grows more difficult

By John Zipperer

Despite plentiful tax-exempt bond financing in most states, developers are having a harder time putting together bond-financed deals. The culprits are a mixture of rising construction costs, sluggish occupancy growth, and the size of the development needed to make bond financing worthwhile. State bond agencies are responding by tailoring subsidy programs and by simplifying their application processes, but developers are still expecting it to be tough to do a bond deal in 2005.

Escalating construction expenses are hurting developers, and they’re particularly problematic in areas where rents are depressed or stalled because of tepid job growth or overbuilding. The option of scaling down a proposed development to deal with the rising costs comes with a constraint: Bond-financed projects need to include a larger number of units than 9% tax credit projects because of the need to cover bond transaction costs.

Watch the market

Tough apartment markets are a particular problem in Utah, where lenders “are seeing too much risk in this environment of low mortgage rates and aren’t seeing the competitive pricing advantage between market-rate projects and bond projects,” according to Lisa Howe, program specialist at the Utah Department of Community and Economic Development. If market conditions remain the same, she expects demand for tax-exempt bonds to drop. “It is taking much longer to put these deals together, and development and building costs are continuing to rise, causing more projects to drop out of the allocation rounds,” she added.

If and when interest rates rise more, that could have multiple effects on multifamily tax-exempt bond users. First, it could have a positive effect by decreasing the flight of renters to homeownership as it becomes more expensive to purchase a home. Second, rising rates could force single-family bond borrowers back into the

private-activity tax-exempt bond pools, where their relative inactivity in recent years has allowed unused single-family bond cap to be redirected to multifamily pools (see Affordable Housing Finance, December 2003, page 10). Third, because floating-rate debt remains popular with developers, the degree to which rates rise will affect their bottom lines by boosting the costs of interest-rate hedges such as caps and swaps (see Affordable Housing Finance, October 2004, page 26). Demand for bonds “may be slightly higher if interest rates go up,” said Melanie Reusze, tax credit allocation manager at the Indiana Housing Finance Authority.

Market challenges

Getting enough gap financing can be a problem everywhere, despite state housing finance agencies (HFAs) doing their best to match up developers with available subsidy programs. Where housing demand is not strong, rents simply are not high enough “to make the project work with just debt,” said Suzanne Roy, senior development financial planner at Realty Resources in Rockport, Maine. “Generally you need a huge amount of subsidy, which normally isn’t readily available.”

The Midwest is another market with occupancy challenges, said Hal Keller, president of Ohio Capital Corporation for Housing. “There’s a perception about the Midwest that the markets are very weak, and there have been some bond deals that have gone south. Those deals [had] just debt and equity and not enough gap financing,” Keller said.

Those economic challenges do not mean that the nation’s bond programs are themselves performing poorly. Moody’s Investors Service, which rates state HFA multifamily bond programs, “has seen considerable rating deterioration in our stand-alone local HFA Sec. 8 portfolio, given HUD’s policy of freezing rents that are above Fair Market beginning in 1997, [but] we have not witnessed this degree of rating impact at the state HFA level,” Moody’s noted in an October 2004 report. Overall, Moody’s outlook for state HFA multifamily bond programs is stable. Of the 35 state programs covered in the report, the only negative outlook is for Hawaii Housing and Community Development Corp.; the rest of the programs are positive or stable.

Overall, HFA multifamily “portfolios remain healthy and serious delinquencies and foreclosures have been carefully managed by experienced HFA asset managers, resulting in minimal portfolio losses,” according to Moody’s.

Affordable Housing Finance’s survey of state bond allocation agencies found that a number of states revamped their underwriting standards and will be demanding greater proof of the financial viability of proposed projects in 2005. Moody’s cited tighter underwriting standards and close oversight of problem properties as significant reasons for the general health of state bond programs despite some brutal multifamily markets across the country.

States get creative with bonds

Many debt allocation agencies were unsure – or unwilling to guess – what demand would be like in 2005. A typical response came from Oregon, where demand is expected to “be influenced by the pace of market recovery, interest rates and demonstrated market need,” according to John Wahrgren, manager of the housing finance section at Oregon Housing and Community Services. However, of those agencies responding to AHF’s survey, a majority expected interest in their tax-exempt bonds to continue to be strong or possibly even increase in 2005.

Agencies in states such as Alabama, Colorado, Illinois, Indiana and Maryland are encouraging or even prioritizing acquisition and renovation of existing affordable housing for bond allocation. Many other states reported that developer interest in tax-exempt bonds for preservation projects was expected to be strong again in 2005.

Preservation continues to be a popular use for bonds because it addresses a couple of important needs at once. It helps states deal with their need to keep units affordable and prevent them from switching to serving market-rate residents. It also uses less subsidy to refinance or rehabilitate an existing property than to build a new one, especially in states such as Texas or Florida, where desirable development sites are pricey and scarce. Preservation helps states spread out their tax-exempt bond cap authority if they have heavy demand.

Preservation isn’t the only priority for bond usage, and in some states developers may not see it emphasized at all. Maine reported that it likely will be pushing workforce housing in 2005 and that projects that receive bond financing will likely be workforce, seniors, or special-needs housing. Massachusetts includes preservation as a priority, but it also “will prioritize new rental housing, especially those projects that utilize green-building techniques and smart-growth principles,” according to Nancy Andersen, manager of rental development at MassHousing.

Changing markets

In recent years, states have often fattened up their multifamily tax-exempt bond caps with unused single-family and industrial bond cap. With a surplus of bond cap for multifamily developments in many states, developers have less need to go to taxable bonds to top off their financing. “We don’t see as many taxable tails these days because bond cap in most states is plentiful,” said Brian Dale, managing director of Newman & Associates. In prior years, Newman had done taxable tails with 80% or 90% of the transactions it handles.

Colorado, where demand for 9% tax credits is about twice the supply, has plans to make applicants for 9% credits provide an analysis of how their project would work if it were a 4% credit/bond deal.

In California, fierce competition for 9% tax credits has tempted more developers to try out 4% credits with tax-exempt bond financing. California’s Debt Limit Allocation Committee (CDLAC) has three important sources of subsidy available to help developers deal with high bond issuance costs and the low equity amounts raised by 4% tax credits: state HOME funds, Rural Development programs, and its Multifamily Housing Program. Those three programs used to be for leveraging 9% credit projects, but California revamped them to work with 4% credit/bond deals as they grew in popularity, according to Laurie Weir, CDLAC’s executive director.

California developers continue to have high construction costs layered on top of a prevailing-wage law that makes it “hard to make these projects pencil out,” said Terry Freeman, national director of affordable housing finance for Klein Financial Corp.

Elsewhere, developers are finding new ways to deal with the difficulties of bond-financed development. For example, Massachusetts developer New Atlantic Development Corp. is “being more creative with our deals by including some units serving special-needs populations” in order to get subsidies designed for those target audiences, said Vice President Bill Madsen-Hardy.

In Texas, where the Department of Housing and Community Affairs (DHCA) has boosted applications fees to $7,500 for the pre-application and $10,000 for the full application, seniors housing is expected to be popular among developers because “there is less community opposition,” said Robbye Meyer, DHCA’s bond administrator.

High-quality custom reprints and PDFs of this article from the print magazine may be available.

Donna Bushore FosteReprints 4295 Ohio St. Michigan City, IN 46360-7701 toll-free 866-879-9144 x156 fax 219-561-2010 dbushore@fostereprints.com http://www.fostereprints.com

Unauthorized duplication of articles in Affordable Housing Finance, Apartment Finance Today, Journal of Tax Credit Investing or HousingFinance.com is strictly prohibited. All rights reserved and all copyrights held by Alexander & Edwards Publishing, Inc. Reproduction of this publication in whole or in part in any form, on paper or electronically, without written permission from the publisher is prohibited by law.