• Calculating the tradeoff of using unrated bonds
  • Florida firm uses publicly traded bond specialist
  • Private placements not for everyone

Tax-exempt bonds offer borrowers many advantages, including low interest rates and the “automatic” availability of 4% tax credits. The problem has been the high cost of issuing bonds, a factor that has made them impractical for small transactions.
But lenders and bond market experts are making progress in cutting costs. In particular, they are proving that private placements of unrated bonds have long-term potential to reduce costs and make bonds a viable option for many smaller projects. Efforts to develop loan pools financed with tax-exempt private-activity bonds are also progressing.

For most multifamily developments, bonds issued by a government agency in a public offering require fees so numerous and costly that they become prohibitive for deals of less than $3 million. Fees for bond counsel, credit rating or enhancement, underwriters, trustees and the bond issuing agency comprise just a few of the typical expenses.

Obtaining a rating lowers the interest rate on tax-exempt bonds, but it costs more up front. It requires credit enhancement. Offering bonds publicly also requires hiring an investment banker. The cost of credit enhancement and investment banking services can total about 6% of bond proceeds, as against only 2% to 3% fees for unrated, privately placed bonds. For relatively small issues, the fee savings can outweigh the interest savings.

The direct purchase of bonds lowers issuance costs by eliminating the need for either credit enhancement or a credit rating. The purchaser in this type of transaction performs its own evaluation of the project and accepts the risk directly. Credit enhancement or rating is usually not required in a private placement, nor is an underwriter (who buys publicly offered bonds and resells them to the public), thus eliminating some of the costliest elements of a public bond placement.

Legal fees are often reduced as well, making projects as small as $1 million feasible.

Calculating the tradeoff of using unrated bonds

Although small projects may need lower issuance costs to make tax-exempt bonds feasible, the trade-off for using unrated bonds is a higher interest rate, which is necessary to offset their perceived higher risk. Moreover, the demand for unrated issues is thin and somewhat risky itself. Market dynamics could shift overnight, sending these buyers scurrying.

Still, some developers swear by direct purchases. Phil Perry of Perry Associates, Inc., specializes in rural multifamily housing using tax-exempt bonds and 4% tax credits. Of the nearly 800 units his company has created with this financing in the last three years, Fannie Mae has directly purchased the bonds on more than half.

With this program, Perry claims he saved not only substantial costs of issuance, but also substantial time completing each transaction. “It took out another legal team and another underwriter. The bond rates have been competitive with enhanced AAA rates. Without this concept and Fannie’s participation, at least 18 communities would not have the quality apartments they do today.”

Perry also includes multiple projects in each bond issuance to offset the cost of the deal, he explains. Pooling several projects this way into one bond issue with a single source of credit enhancement is another means of reducing upfront expenses. With the costs of issuance shared among the pooled projects, the cost per individual project is lowered. Because this strategy requires all of the deals to be financed by the same issuing agency, state HFAs, which typically see numerous deals, have been pooling bond projects successfully for years. But city and county agencies, which may see fewer issues in a single year than do state HFAs, may find pooling a less favorable option.

Florida firm uses publicly traded bond specialist

For the Carlisle Group, a small affordable housing developer in Florida, using credit-enhanced, rated bonds was just too time-consuming and expensive. Now, the firm relies on unrated bonds, saving the time and money it would have taken to have rated bonds issued.

A number of firms are buying unrated bonds for their portfolios. Carlisle uses the services of Charter Mac, a New York City firm that is affiliated with Related Capital, a major syndicator of low-income housing tax credits. Another firm active in the purchase of unrated bonds is MuniMae Midland, LLC. This firm also does tax credit equity syndication and bond credit enhancement.

Carlisle has done four private-placement bond deals for affordable housing projects so far. Recently, the Broward County, Fla., Housing Finance Authority issued $5.6 million in tax-exempt bonds for Carlisle to build the 108-unit Summer Lake affordables at Davie. At the time, the 40-year fixed-bond interest rate was 7.4%, only one tenth of one percent, or $5,600, per year, higher than the 7.3% “all-in” interest rate that was available for credit-enhanced bonds, Carlisle’s Luis Gonzalez said. The difference in fees more than outweighed that small spread.

As for saving time, and reducing uncertainty, Charter Mac says it can lock in terms and an interest rate for up to six months. Deals can usually be closed in about three months or less. Charter Mac sometimes will commit to acquiring tax-exempt bonds and offer a rate and terms even before a state HFA has granted a developer a bond allocation.

Many of the bonds Charter Mac buys are participating interest bonds. They bear interest at rates that include participating or otherwise contingent interest payable from a percent of net cash flow generated from project operation and/or sale of refinancing proceeds.

In 2001, the firm’s total volume of bond purchases hit the $1 billion mark, and it was delivering good returns to stockholders, seeming to indicate that the unrated bond market has depth, breadth and staying power.

Charter Mac also managed to broaden the market for unrated tax-exempts by creating a new class of shares: Convertible CRA Preferred. The idea is to hypothecate the bonds for specific projects in the Charter Mac portfolio geographically to regional banks and corporations who need credit toward their Community Reinvestment Act quotas. Strictly speaking, investors in Charter Mac, including the convertible preferred holders, own only undifferentiated shares of the entire portfolio, not particular securities within it. But the Office of the Controller of the Currency, which monitors banks’ CRA compliance, has sanctioned this hypothecation, provided that only one stockholder gets credit for each project, says Hilary Forman, Charter Mac project coordinator.

Private placements not for everyone

Unless interest rate fluctuations change the equation, though, whether private placement or credit enhancement is a better deal depends largely on the size of the bond issue. The smaller the deal, the more the balance tips in favor of private placement. Above $10 million, the interest savings obtained through credit enhancement tend to outweigh the cost savings from private placement.

But such bonds are sometimes impractical, because some state HFAs require that bonds be rated, which defeats the purpose of private placement. Others, including Florida’s, give preference to rated bonds. Gonzalez is trying to persuade the Florida Housing Finance Corp. that, because of the fixed costs in issuing rated bonds, this policy discriminates against small developers and projects of less than 150 units. The preference has been in effect for the last two funding cycles, and the competition for state bond allocations is “so fierce” that it shuts out the private placement option, Gonzalez says.

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