Fannie Mae has struggled with the challenges of financing the debt for 9% low-income housing tax credit (LIHTC) transactions since the early 1990s, when it initiated its forward-commitment product. The reasons for this have a lot to do with the nature of these transactions, which tend to be complex and small, but also, Fannie Mae's product was neither profitable nor efficient for lenders or borrowers. However, recent changes to the Fannie Mae forward commitment program may begin to address some of those challenges.

From the outset, the cash forward commitment (not to be confused with the bond credit-enhancement forward commitment) was designed to eliminate permanent-loan interest-rate risk by locking the interest rate during the construction period. But in order to lock the Fannie Mae rate through the construction phase, the permanent loan was funded but held back during the construction period, until the property achieved stabilized occupancy. Consequently, developers were required to pay interest on their permanent loan during the construction phase AND pay fees for a backstop (a letter of credit, guaranteed investment contract, or investment agreement) to protect Fannie Mae against construction risk.

Additionally, negative arbitrage, or the difference in interest rate between the backstop and the permanent loan, could reach as much as 4% of the loan amount in today's interest-rate environment. This expense, added to the administrative burden of holding back the permanent-loan funds with another party to the transaction, made the cash forward commitment an unpopular Fannie Mae product. Meanwhile, Fannie Mae's bond credit-enhancement forwards were well received in the marketplace.

At the end of July, Fannie Mae made an announcement to its 26 Delegated Underwriting and Servicing (DUS) lenders about a new unfunded forward-commitment pilot. The way it works is that a developer receives a commitment from a DUS lender for a permanent loan locking in the current interest rate as if the loan were funding immediately, say 7% on a 30-year loan. The developer pays a 2% commitment fee plus an add-on to the interest rate that varies based on the duration of the forward commitment, term of the permanent loan, points paid upfront, and the yield curve. With the unfunded forward-commitment pilot, Fannie Mae will fund the permanent loan at stabilized occupancy instead of during the construction phase.

This is an important innovation to the forward-commitment program because it eliminates the negative arbitrage and because developers know what their costs are in advance of the permanent phase. Construction lenders and syndicators will also benefit from the added level of certainty about the construction take-out loan size and cost.

It is too soon to know what effect Fannie Mae's unfunded forward-commitment pilot will have on the affordable housing industry in the immediate future. But Fannie Mae and its lenders view the pilot as a breakthrough that has the potential to increase loan volume for the cash forward execution. "Those [DUS lenders] expert in LIHTC and bond financing will get deeper market penetration," said Daniel Cunningham, director of Fannie Mae's National Affordable Housing Team. "A smoother execution results in greater efficiency for all parties-lenders, borrowers and syndicators."

The only significant drawback of the unfunded forward-commitment pilot is that the fees and interest-rate add-ons cost twice as much as comparable products from life companies and other competition. "Once lenders give Fannie Mae feedback, pricing will get fixed," said Chris Tawa, principal at Lend Lease Mortgage Capital, a Fannie Mae DUS lender. "I see many ways to improve pricing, but now we have the model."

Efficient product mechanics and competitive forward-commitment pricing are only part of the challenge facing Fannie Mae in the 9% LIHTC debt sector. These are tough deals to underwrite, with the circumstances surrounding them becoming more complex and challenging.

Softening markets are seeing LIHTC properties compete with market-rate developments, and certain submarkets are becoming saturated with new LIHTC developments that compete against each other.

Another growing concern is the decline in soft money from the state and local levels resulting from a combination of budget deficits and tax cuts. Ultimately there is less soft money to spread across more transactions as more credits are allocated nationwide.
Taken together, this combination of forces has developers looking to conventional lenders to fill project financing gaps. Interest rates, now at all-time lows, can bail out projects for the time being, but lenders are extremely concerned about the economic integrity of 9% LIHTC deals. "There is lots of cheap money chasing these deals," said Jeffrey Stern, president and CEO of EMI Capital, a Fannie Mae Special Affordable Housing lender. "We are doing more business than ever and being more cautious than ever."

The reality for most DUS lenders, which range from publicly held full-service financial services companies to mortgage brokers with a few satellite offices, is that they don't aggressively pursue 9% LIHTC transactions. Aside from the complex nature of these credits, profitability is a fundamental issue for loans that are generally well below $3 million. "You don't make a business out of 9% LIHTC loans," said Tawa.

"Our client base is not oriented [to 9% LIHTC], and we looked at where we can spend our resources," said Jay Helfrich, executive vice president of American Property Finance, a Fannie Mae DUS lender, "Most of our borrowers focus on acquisition/rehab, refinances, and new-construction bond projects."

Even Fannie Mae's five Special Affordable Housing lenders, which focus exclusively on tax credit and bond financing using Fannie Mae's DUS underwriting guidelines and financial products, are challenged in their pursuit of 9% LIHTC debt financing. "We compete for it when banks don't want to," said Stern.

The amount of time and money to underwrite, process and service a loan of $3 million or less is about the same as for a $20 million loan. Although Fannie Mae recently addressed this issue for conventional loans by designing the 3Max Express product to reduce the time and cost of processing small loans, debt on 9% LIHTC deals is only eligible for the 3Max Express product with Fannie Mae's approval.

But the market niche for 9% LIHTC debt is extremely low-risk, and therefore potentially profitable for Fannie Mae and its DUS lenders. In Ernst and Young's "Understanding the Dynamics: A Comprehensive Look at Affordable Housing Tax Credit Properties," a study of more than 7,800 LIHTC-financed properties nationwide, the properties were shown to have a foreclosure rate of .14% compared to 0.4% to 2% for other classes of real estate. Additionally, the study also found that the average property in this category performed well, with 94.2% occupancy, a 1.35-to-1 hard-debt-service coverage ratio, and $20,380 of cash flow per year ($345 per unit). "I'm bullish on 9% deals if they're done correctly," said Keeley Kirkendall, executive vice president of ARCS Commercial Mortgage, a Fannie Mae DUS lender.

Fannie Mae's mid-year 2003 loan volume was $1.2 billion in multifamily affordable housing, defined as properties with 20% of units restricted at 50% of area median income (AMI) or 40% of units restricted at 60% of AMI; $854 million of this amount was bond credit enhancement.

Although Fannie Mae's forward-commitment product has undergone many transformations since its inception, elimination of interest-rate risk, competitive pricing and fixed-rate loan terms of up to 30 years have been a constant. The unfunded forward-commitment pilot will not be the final stage of this product's evolution, but lenders said it is a step in the right direction.