SPECIAL FOCUS >> CAPITAL MARKETS OUTLOOK 2008

Tax-Exempt Bond Financing Weathers the Storm

BY JERRY ASCIERTO

AFFORDABLE HOUSING FINANCE • NOVEMBER 2007

Tax-exempt bond financing will be readily available and affordable in 2008, with industry watchers reporting that price increases were rare even as the capital markets remained in flux heading into the fourth quarter of 2007.

Additionally, demand for floating-rate debt will likely increase in 2008, as the cost of interest-rate hedges such as caps and swaps remains low, developers and lenders report.

“Tax-exempt bond rates have not been affected as much by the current capital markets volatility and lack of liquidity as the taxable markets,” said Jay Helfrich, an executive vice president who heads the affordable debt-financing division for Alliant Capital/EF&A Funding. “Developers will still favor floating rate for long-term [debt], because historically, floaters have had lower rates.”

The tax-exempt bond market will also benefit next year from increased competition from one of the industry’s heaviest hitters. Credit-enhanced bonds by Fannie Mae grew more attractive in the fourth quarter of 2007. The company moved to compete more effectively against privateplacement programs by offering better terms that will allow developers to pull out more proceeds from their deals, a trend industry watchers expect to continue into 2008.

Affordable housing developers have favored private-placement direct bond purchases over the last few years, as opposed to credit-enhanced bonds from governmentsponsored enterprises (GSEs) like Fannie Mae and Freddie Mac. Private placements offered more flexibility in terms, amortization, and loan proceeds, even though they typically charge higher interest rates than credit-enhanced bonds.

But Fannie Mae has recently changed its underwriting in an effort to win more business. The company is now more likely to consider 40-year structures, and go down to a 1.10x debt-service coverage ratio (DSCR)—and sometimes below. Such terms will likely see it win back business that was lured away by private placements the last few years. “In the past, you just couldn’t get the proceeds from the GSEs that you could in a private placement structure,” said Andy Tanner, CFO of affordable housing developer The NRP Group.

Previously, Fannie Mae required a 1.20x DSCR on loans for tax-exempt floating- rate bonds. But beginning in the third quarter, it started offering a more aggressive DSCR for such deals, sometimes as low as 1.05x.

“That will certainly make the taxexempt bond market pretty competitive in 2008,” said Todd Sears, vice president of finance for developer Herman & Kittle Properties, Inc. “We’ve started seeing this approach in proposals from the GSEs.”

Demand for floating-rate debt will be bolstered by the fact that interest-rate hedges are expected to be affordable next year. “The cost of interest-rate caps and swaps remain cheap by historical standards, so buying this interest-rate protection will make floaters attractive,” said Helfrich. “The costs for caps and swaps will remain low into 2008.”

Finding equity investors who will accept floating-rate deals without long-term interest rate hedges like a cap or a swap is becoming more difficult, even though the SIFMA index has weathered the recent capital markets volatility well. (Note that the Bond Market Association [BMA] index is now referred to as the SIFMA index since the Securities Industry Association and BMA merged in November 2006 to create the Securities Industry and Financial Markets Association.)

“In spite of the stability of the underlying index, investors are pushing more and more for longer-term caps or swaps,” said Sears. “Whereas before, they might have gone with a five-year cap or swap, they are now pushing it to 10 or 15 years. It could easily add several hundred thousand dollarsto your cost to close.”

Cap prices are at historic lows, said Tammy Ofek, president of Cap M Funding, a derivatives consulting firm. Even in August, when the price of caps nearly doubled due to the credit crisis, deals that used this interest-rate hedge still had a price advantage over fixed-rate deals. As cap rates climbed from 12 to 20 basis points for five-year terms, and from 22 to 50 basis points for seven-year terms from May to August, they still provided a significant cost savings over fixed-rate debt.

On a $10 million deal, a developer using a floating-rate construction loan could get an interest rate 1.38 percentage points lower than on a fixed-rate construction loan, generating savings of $138,000 a year (see sidebar). When converting that loan to a permanent loan structure, a SIFMA-based cap cost of 20 basis points on a five-year loan, for instance, would still offer significant savings over a fixed-rate deal.

Swaps also offer an advantage. Although the price of swaps rose 35 basis points for 15-year terms, and 50 basis points for 17-year terms from May to August, they can still provide developers with a cost savings of as much as 25 basis points over fixedrate debt.

The Federal Reserve’s half-point rate cut in September has already helped to bring stability to the troubled capital markets in the fourth quarter of 2007. Developers are reporting a stabilization of benchmark indexes like the SIFMA and LIBOR. Deals that stalled during the summer are now starting to pencil out for construction starts next year.

“That kind of stability returning to the market in the fourth quarter will certainly help going into 2008,” said Steve Hicks, CEO of affordable housing developer The Provident Group. “There was a period of time (in mid- August), where projects had to be put on the back burner, but that has started to turn around. That prospect for stabilization in the fourth quarter is giving us some comfort that we will be able to get back into the market in 2008.”