FINANCE

TAX-EXEMPT BONDS

Swap Meet

Freddie Mac's swap swamps the competition on tax-exempt bond deals

AFFORDABLE HOUSING FINANCE • July 2008

BY LIZ ENOCHS

It may not be the only game in town, but Freddie Mac’s swap product is the most compelling thing in the market these days for developers using tax-exempt bonds to fund their projects.

The loan product, which has been little affected by the credit crunch because it trades in the multi-trillion dollar global market for derivatives, offers borrowers an interest rate that can be as low as 5 percent, compared to rates 75 or 100 basis points higher for standard fixed- or variable- rate loans. In the tax-exempt bond market, developers typically borrow against the value of the underlying debt securities (which are issued by cities, states, or other municipal issuers) sold to finance their projects.

“The market for tax-exempt multifamily bonds is about a $6 billion to $8 billion a year market; that’s as compared to a $300 billion total municipal bond market, so it’s only about 2 to 3 percent of all municipal bonds,” said Wade Norris, a principal with Eichner & Norris, PLLC, a Washington, D.C.-based law firm that specializes in tax-exempt bond finance.

In financial markets, that’s a pretty small pool to swim in, especially compared to the derivatives ocean. “In a swap transaction, we’ve fixed our rate in a $50 trillion to $60 trillion market—the international derivatives markets,” Norris said.

Because the swaps trade in a highly liquid market, their pricing has changed little over the last 12 to 18 months, even as credit seized up in the U.S. mortgage markets.

For forward-starting swaps, meaning those in which the interest rate floats for the first two years during construction and then the variable-rate debt is swapped to a fixed rate for the following 15 years, borrowers can get an all-in rate of 5.4 percent to 5.5 percent, compared to 6.5 percent on a fixed-rate deal or a variable-rate deal with a cap.

That’s a “humongous” difference, said Norris, who noted that the pricing differential gives borrowers an extra eight to 12 points in loan proceeds on a 30-year deal. “It’s very complex, but an elegant product that produces truly remarkable results,” he said.

For swaps without the “forwardstarting” component, rates are in the low- 5 percent range. Plus, Freddie Mac offers a 40-year amortization in strong markets and will go as low as a 1.15x debt-service coverage ratio, said Paige Warren, head of the affordable housing group at Prudential Mortgage Capital. The firm handled five or six Freddie swaps last year and has another four in the pipeline, she said. Those numbers would be higher in a normal market, but with the decline in tax credit equity prices, fewer deals are getting done, Warren added.

One of Prudential’s transactions from last year demonstrates how well the Freddie Mac swap can work even on complicated deals.

A joint venture between Los Angelesbased American Communities and Chicago-based DRE, Inc., was doing an acquisition-rehab of five buildings in Los Angeles, all of which were filled with Sec. 8 tenants. The properties, which consisted of 100 units altogether, were acquired out of bankruptcy and financed with a nonprofit sponsor, which made them eligible for tax abatement.

The initial deal size was $7.3 million, but in order to meet the 50 percent test, the developers had to add another $4.2 million issue of short-term bonds, said Mark Eidson, a principal in Prudential’s Atlanta office. To qualify for 4 percent low-income housing tax credits, projects using tax-exempt bonds must finance at least half of the aggregate basis of the development with bonds.

The swap rate on the transaction was 3.885 percent, said Eidson, adding, “That rate today is probably 20 basis points cheaper.” The all-in rate, including credit enhancement and other fees, came to 4.81 percent. “Right now what’s happening is the cost of Freddie Mac credit enhancement has risen, so most swaps are sizing in the fives, between 5 and 5.25 percent,” said Eidson. Compared to the 6.5 to 6.75 percent on offer for fixed-rate bond deals these days, that’s a pretty good deal.

The Freddie swap product “was kind of an untold story for a while,” said Warren. “Borrowers are just beginning to see now what a competitive product it is.”