Developers using floating-rate debt for new construction are increasingly able to get simplified, lower-cost transactions that combine construction and permanent financing, along with a forward-starting swap that gives them the benefits of floating interest rates during the construction period and a synthetic fixed rate during the permanent financing period.
“There’s not a borrower out there who wouldn’t like a more efficient process and cheaper pricing,’’ said Steven Fayne, managing director of GMAC Commercial Mortgage’s Affordable Housing Division. “There’s no shortage of ability to find a construction lender. But the ability to offer a borrower coordinated financing packages on these projects – there just aren’t a lot of [lenders] who do that well.”
Developer Walton Communities, based in Marietta, Ga., found such a lender in SunTrust Community Development Corp., which has developed a AA-rated product for long-term credit enhancement of low-floater bonds using its forward-starting swap, dropping closing costs as much as 40% compared to a typical Fannie Mae or Freddie Mac deal. SunTrust executives said this one-stop, off-the-shelf product provides efficiency and cost savings.
This tool works best with entrenched developers, such as Walton, that want to tap low-floater financing during construction/lease-up without the cost of a cap, according to Derrick Brown, first vice president at SunTrust. Keith Davidson, a partner at Walton, used the SunTrust forward-starting swap on two recent affordable housing deals, including the mixed-income Walton Reserve development in Atlanta. It allows “ultimate flexibility,” which keeps Davidson from considering agency options.
The $15.3 million Walton Reserve deal is a strong example of how the tool worked in their favor. The bonds were issued as 32-year bonds with a letter of credit agreement from SunTrust to provide for a 30-year amortization of the debt after a 24-month construction/lease-up period. The bonds floated at the Bond Marketing Association (BMA) rate for 24 months, with the forward-starting swap rate coming in at 3.85% for years two through seven. Funds will be escrowed to purchase a cap in year seven if swap rates are not favorable. Most banks are willing to go out two to four years on enhancement with a letter of credit, but SunTrust takes its deals out 11 years with an evergreen feature that requires it to notify a borrower in the seventh year if the letter of credit is in jeopardy. The only negative for Davidson with this structure is that the bank enhancement includes a recourse provision, which doesn’t exist with agency deals.
“We couldn’t do these projects with only a two- or three-year credit enhancement,” Davidson said. Although he is still exposed for four years after year 11 of the tax credit period, the flexibility to transfer over to other enhancement options and the lower transaction fees are worth the risk.
SunTrust’s letter of credit is not assumable by buyers, but it has no prepayment penalty. The underlying bond issue is a 30-year interest-only loan structured through the letter of credit agreement. This preserves flexibility so that the letter of credit can be replaced with another facility and/or the bonds can be refunded with another lender.
“In these transactions, we’re an equity partner,” said Paul Woodworth, SunTrust senior vice president. “We’re in there for the long haul, not in a syndication mode.”
Proliferation of forward swaps
GMAC has spent the last 18 months developing a one-source transaction that delivers a full financing package to developers, from construction and permanent financing to bond enhancement and equity, as well as specialized products, including mezzanine debt through its subsidiary Newman Financial.
Unlike traditional construction financing, this tool allows the borrower one point of contact for the entire financing process, eliminating duplication and removing competing interests that have long stretched out the financing process when multiple lenders and third parties are involved.
This also translates into cost savings on origination and processing fees as well as administration costs, potentially substantially reducing necessary upfront transaction dollars, said Fayne. GMAC uses this tool to regularly fund deals with Fannie Mae and Freddie Mac construction takeout loans, but it will also structure deals with permanent debt funded off its own books.
GMAC’s $1 billion in affordable housing deals for 2004 is matched by only a few other lenders that have enough market weight to compete by offering a full spectrum of comprehensive financing services rather than pricing. This competitive edge wins business because borrowers have to depend on only one lender. “We will never be the low-cost provider,” Fayne said. “Developers do business with me because we deliver what they need.”
Affordable housing lending giant CharterMac also offers a single-source financing package on tax-exempt bond deals. It uses a draw-down structure, which effectively closes a bond deal without funding it, providing the dollars as needed over the course of construction, said CharterMac Executive Vice President James Spound.
Unlike a traditional bond funding, this tool allows a developer to pay interest only on money that has been used. The delay in paying some of the debt lets a project support more debt because the cost of the interest that needs to be capitalized into a construction budget is reduced.
Caps versus swaps
There are two basic ways to hedge interest-rate risk on new construction variable-rate bond financing. An interest-rate cap purchased by the borrower from a third-party provider protects the lender from rate spikes by paying the lender the difference between the cap strike rate and the floating rate of the cap, if the floating rate is more than the strike rate (see Affordable Housing Finance, October 2004, page 26).
Alternatively, interest-rate swaps based on the BMA rate are negotiated transactions between borrower and swap provider. The borrower agrees to make the swap fixed-rate payments and the swap provider agrees to pay the BMA rate. These payment obligations are netted, so if the fixed rate is greater than BMA, then the borrower pays the difference. If BMA is greater, the swap provider pays the difference.
“Tax credit syndicators want fixed-rate obligations for protection,” said W. Kimball Griffith, director of Freddie Mac’s Affordable Housing Group, which is offering its own forward-starting swap with increasing regularity. “But they are getting used to this synthetic fixed rate provided by this interest-rate swap,” he added.
Caps have been attractive alongside low interest rates, making them relatively inexpensive to buy. But swaps are gaining appeal as rates rise because they offer this synthetic fixed rate and remove the cash outlay necessary for the initial and replacement caps. The forward-starting swap allows a borrower to have both a floating interest rate during the construction period and a synthetic fixed rate once the swap begins.
Freddie Mac participates in the forward-starting swap by providing a swap credit-enhancement agreement supporting the monthly payment obligations and the termination-payment obligation.
Griffith believes that nonprofit developers in particular must ensure that they thoroughly understand floating-rate and termination risk and the value gained from maintaining a floating-rate period. Forward-starting swaps work best for borrowers that understand the intricacies of a swap, and that want a fixed rate during the permanent loan period and a floating rate prior to the start of the swap.
Using the floating-rate feature of these swaps minimizes negative arbitrage, which is the amount lost because unused construction funding costs more than the developer can earn via short-term reinvestment during construction.
Some borrowers may choose other financing methods after analyzing this structure, such as fixed-rate bonds, or, if permitted by their tax credit investor, floating-rate bonds hedged by an interest-rate cap instead of a swap.
“The comparison needs to be the long-term cost of fixed-rate financing versus the long-term cost of the forward-starting swap transaction, including the termination exposure associated with a swap,” Griffith said.