FINANCE

CONSTRUCTION LOANS

Developers Choose Swaps for Security

BY BENDIX ANDERSON

AFFORDABLE HOUSING FINANCE • FEBRUARY 2008

Swaps have taken over from caps as the first choice of price-conscious borrowers using loans funded by tax-exempt bonds.

That’s because, after the subprime mortgage meltdown sent the capital markets into wild fluctuations in the summer of 2007, swaps became the safest and cheapest way to shave a few dozen basis points off the interest rates that developers were paying during the construction period of their loans, which typically run for the first couple of years of the loan period.

“A lot more people are turning to swaps,” said Timothy Kemper, managing principal for the Atlanta office of Reznick Group, an accounting firm that helps borrowers structure bond deals.

Swaps can deliver both savings and security, with a fixed interest rate that is 30 to 50 basis points cheaper than comparable fixed-rate loans, now in the mid-5 percent range, according to Chris Tawa, senior vice president for MMA Financial, LLC.

To create a swap, an outside investor guarantees a fixed interest rate to the borrower. The investor agrees to pay the difference when the floating rate of the underlying bonds rises higher than the guaranteed rate and receives the difference when the floating rate is below that rate.

There are no up-front costs to do a swap. The costs of creating the structure are included in the fixed interest rate paid by the developer.

In contrast, a cap, which prevents the interest rate on a floating-rate loan from rising beyond a certain level, is paid for with an up-front fee at the time the instrument is created. The price is usually less than 1 percent of the total loan amount.

The maximum interest rate on a floating-rate loan with a cap is typically 150 to 200 basis points higher than the fixed interest rate created by a swap. A lower cap would be prohibitively expensive, said R. Wade Norris, a tax-exempt housing bond specialist and partner with Eichner & Norris, PLLC, based Washington, D.C.

About half of the developers that use tax-exempt financing take out loans funded with floating-rate bonds, said Kemper of the Reznick Group. The majority of those borrowers are now fixing the interest rate on their loans synthetically with a swap, he said.

A swap does involve serious risks. The fees for breaking a swap agreement can be devastating. The exact size of the fee depends upon interest rates at the time the swap contract is broken. If floating rates are high and the investor is making lots of money from the swap, the borrower may have to pay the maximum fee of up to 25 percent of the size of the loan.

Also, swap contracts often are extended to cover the 15-year permanent period of a tax-exempt loan as well as the construction period. In this case, the swap would make it more complicated to eventually refinance the property, because the swap contract is connected to the original financing. If the borrower eventually defaults on the loan, that would break the swap contract and trigger the fees.

Conservative borrowers choose fixed-rate bonds

The other half of the developers that use tax-exempt bond financing take out fixed-rate loans funded by fixed-rate bonds. It’s much simpler that way, said Kemper.

With a fixed-rate bond loan, the borrower gets the security of a fixed interest rate without having to go through the extra complexity of a swap, though the fixed-rate bond loan will be more expensive.

For small nonprofits using tax-exempt bond financing to renovate aging affordable housing properties, the simplicity of a fixed interest rate bond loan is worth the cost. Many of these developers have a hard enough time becoming comfortable with low-income housing tax credits, without trying to weigh the risks of swaps, said Bill Kelly, president of Stewards of Affordable Housing for the Future, an advocacy group.

Developers are turning away from private-placement tax-exempt bond mortgages, said Timothy Kemper, managing principal for the Atlanta office of Reznick Group. Private-placement deals offer borrowers fixed-rate tax-exempt financing with lower transaction costs, which otherwise would total from 3 percent to 5 percent of the loan amount. However, interest rates for these loans have become uncompetitive as the small universe of banks and institutions that once purchased private-placement bonds have lost interest. Many banks have little use for tax-exempt bonds now that losses have shrunk their tax bills for the year to zero, said Kemper.