It has now become clear that the surprising outcome in the recent presidential election is having significant adverse impacts on the role of tax-exempt private-activity bonds and 4% low-income housing tax credits (LIHTCs) to finance affordable housing projects. While it is difficult to assess the ultimate scope of these impacts, patterns have begun to emerge on both the equity and debt side of these financings.
Adverse impacts on the syndication of 4% LIHTCs
Those familiar with this financing model know that for 100% affordable housing projects, syndication of 4% LIHTCs typically funds anywhere from 25% to 35% or 40% of total development cost, or in a Qualified Census Tract or Difficult to Develop Area, from 35% to 45%.
As everyone now knows, President-elect Trump proposes to cut the corporate tax rate from 35% to 15%. I initially thought, “Oh No!” Even if you assume it winds up at 25% and takes a year or two to implement, that would reduce the value of the 4% tax credits to 40% of what it was before (new 15% corporate tax rate/35% present corporate tax rate). $1.05 down to 42 cents. Not good! In fact one 4% LIHTC syndicator (who had not placed the credits) walked from one of our deals a week after the election, and many other syndicators have already or are now at least renegotiating these deals, notwithstanding a signed letter of intent. We all wanted a bit of a breather, but not that much!
It turns out that in my panicked analysis about the magnitude of this impact, I was wrong. Almost all syndicators are remodeling their deals based on an assumed 20% to 28% corporate tax rate. The decrease in 4% LIHTC pricing thus far appears to fall in the range of 7 to 8 cents up to 15 to 18 cents, depending on the deal—the sweet spot seems to be 10 to 12 cents—but nothing like the 60% decline the above panicked computation would imply. How can that be? If you think about it, this drop in the corporate tax rate affects the value of any depreciation and other losses the tax credit investor is buying, perhaps in the way I was calculating, but it does not affect the value of the tax credits themselves, which is the vast majority of what the tax credit investor is paying for. A dollar of tax credits that you own still offsets a $1 check you otherwise have to write to the federal treasury. So you just spread your tax credits over a broader range of profits, but $1 of tax credits is still worth as much as it used to be worth. So let’s say the loss in pricing is 10 to 12 cents on the average. Will we see syndicators walking in droves? Is this spring of 2009 all over again?
Over the past seven weeks we have now seen renegotiations of the 4% LIHTC on many of these financings in which we are involved. This is a minority of deals that were pending post-election, but it is a growing minority and it is significant.
The chances that a deal stayed on track or will stay on track and closed by year-end or will close without significant further delay understandably appear to be much higher if the syndicator has already placed the tax credits with investors, as compared to a situation where the LOI has been written against the syndicator’s credit line without the 4% LIHTC having been sold. Especially if the credits have not been placed, a borrower should not be surprised if the syndicator attempts to renegotiate the pricing and/or other aspects of the 4% LIHTC, even at or within several days prior to a preclosing, unless the syndicator has given prior firm assurances that everything is on track notwithstanding these recent developments.
As noted above, very few deals appear to have been abandoned outright. In the one instance noted above, the "one-off” developer lost his syndication, but the developer fortunately had the financial wherewithal to simply take down the 4% LIHTC himself. In other cases, some deals pushed into 2017, but the developers have told the financing participants that they intend to restructure and close in early 2017. Many of these deals did proceed to a year-end close, and some others are renegotiating.
The chances that a deal closed or will close without major delays and that the impact on pricing and terms will be relatively benign appear to be greatest, not surprisingly, where the financing involves an active affordable housing developer with a long-standing relationship with its syndicator, and perhaps where the deal has other strengths, as discussed below, which enabled it or will enable it to stay on track.
What appears to be the range of impact on pricing? As noted above, the 4% LIHTC pricing impact appears to have ranged thus far from a low of 7 or 8 cents to a high of 16 to 18 cents, with a sweet spot of 10 to 12 cents. (The impact on 4% LIHTC deals, where losses are a bigger part of the tax credit purchase, appears to be larger than is the case on 9% LIHTC financings.) The magnitude of the pricing impact will depend in large part on the ultimate corporate tax rate assumed by the buy side and how quickly one assumes tax reform might be implemented. As noted, the models we have seen used appear to assume a 20% corporate tax rate on the most conservative end up to a 28% rate at the most lenient. One syndicator with whom we are involved estimates that the net result of all this is that for each 5% reduction in the corporate tax rate one assumes, the impact on pricing is 4.5 to 5 cents, so if you assume a 25% new corporate tax rate, one has lost 9 to 10 cents in pricing; if one assumes a 20% new rate, one has lost 14 to15 cents. Again, the average impact appears to be in the 10 to 12 cents range.
Obviously, tax credit investors are also yield oriented. With the yield on the 10-year Treasury having now risen 70 basis points (from roughly 1.8% to around 2.5% since before the election), this may also be driving the decline in 4% LIHTC pricing in addition to the proposed lower corporate tax rate.
The following example may represent the higher end of the range. In this major transaction in a strong Community Reinvestment Act (CRA) market with an active developer and syndicator, where the tax credits were financing about 45% of total development costs, the model reduced pricing from $1.14 to $0.98, a loss of 16 cents. This is effectively a 14% reduction in the 45% of the funding for the deal, or a 6 point hit to the financing! The deal has not been abandoned, but is being restructured with a tentative targeted close in the first quarter of 2017.
On the other end of the spectrum is a deal we closed, on schedule, in the third week of December, where the adjustments to the syndication from pricing of $1.04 down to $0.96 were made at the preclosing. In this case, the 8 cent, or 7.7% downward pricing adjustment, applied to 4% LIHTC, which was funding about 40% of total development costs, resulting in a 3 point hit to the financing sources on the deal.
So if the 4% LIHTC represents 35% of the funding on a number of deals, and the average drop in tax credit equity pricing is, say, 11 cents from $1.08 to 97 cents or a 10% pricing decline, let’s say on the average deal, the adverse 4% LIHTC pricing impact is a roughly 3.5% reduction in total funding sources on an “average” deal.
Adverse impacts on the tax-exempt debt pricing
In order to be eligible for the critical 4% LIHTC, under the 50% Rule at least 50% of the eligible basis of the buildings and land in the project must be financed with volume limited tax-exempt private-activity bonds under Sec. 142(d) of the code (in the form of tax-exempt bonds or a tax-exempt loan). This tax-exempt debt must be kept outstanding until the project’s place-in-service date (generally, completion of rehabilitation for an acquisition/rehabilitation financing or receipt of a certificate of occupancy on a new construction financing).
As noted above, since the election, the yield on the 10-year Treasury has risen 70 basis points from 1.8% to around 2.5%. In light of the "50% rule," virtually all of these affordable housing projects will be financed with tax-exempt debt. On today’s deals, this funding may represent roughly 60% of total funding. The run-up in rate has also adversely affected this major funding source.
Because housing paper trades at a spread to U.S. Treasuries, the run-up in long-term borrowing rates is probably higher, more in the neighborhood of 75 to 90 basis points. For example, before the election, we regularly saw permanent loan rates on tax-exempt private placement loans for the best developers in the strongest CRA markets in the neighborhood of 3.65% to 3.85%. Today, those rates are 4.5% to 4.85 - an increase of perhaps 85 to 100 basis points. An 90 basis points increase in rates on a 35-year loan amortization is roughly a 7-point reduction on a 35-year debt service constrained loan at today’s rates. If the debt is 60% of total funding sources, this is almost another 4% hit on the deal.
Mitigating the damage
So, let’s say the average hit to funding sources on the equity side is around 3% or a little more and the average hit on the debt side is 4%, we’re now looking at a sudden, unexpected potential loss of 7% of our total funding sources. Ouch! This is why many syndicators and developers have renegotiated or are now renegotiating their deals. How does one mitigate and allocate the damage?
First, assuming syndication spreads are still 8 to10 cents or a bit more in this business, one would hope the syndicators in the above example would honor their commitment to a good repeat client under the LOI and throw in at least a portion of the profit to close the deal and take no loss or a small hit. In fact, we have heard of one syndicator who has remodeled at perhaps one-half of the original spread, which seems like a laudable contribution to solving this unexpected problem. Better to do that than to walk and take some hit to the firm’s reputation and damage the firm’s relationship with a profitable, loyal client.
Second, even with a signed LOI, it would seem reasonable that a developer should expect some renegotiation on the borrower side in the weeks and months ahead. It is almost inevitable that the developer will have to at least defer and give up some portion of its developer fee to close this gap. If developer fees range from 6% to 8% to 10% to 12% on these financings, one would hope at least for deals in the current pipeline, this would be one source of absorbing this unexpected shock. We believe it is important that the borrower negotiate any partnership “adjusters” which are drafted to implement these deal changes in a way that at least a portion of the loss and risk is borne by the syndicator, and that not all of the loss and risk is borne by the borrower until the final tax credit equity installment is paid.
There may be other steps which can be taken to absorb the source of this loss and risk. Most of these steps will require some time for market players to absorb and digest the post-election developments described above. The borrower may be able to negotiate some reduction in purchase price with the seller of the land (on a new construction deal) or the land and building (on an acquisition/rehab deal), and/or get the seller to accept a portion of the purchase price in the form of a (larger) seller take-back note, which can be structured to be either tax-exempt (through a subordinate tax-exempt bond or loan of debt issued by the municipal issuer or “governmental lender”) or a taxable subordinate seller take-back note. Similarly, it may be possible to renegotiate some costs with the contractor and other parties. In some instances, if the borrower can document the magnitude of the impacts on the project financing, there may be a possibility of tapping governmental or other subordinate loan sources for some of the funding to help close the gap and preserve a financing where the development or preservation of the project as an affordable housing resource is viewed as an important community goal.
The Road Ahead
Impact on 4% LIHTC. It seems unlikely that these adverse impacts on the equity and debt side of these financings will be transitory. As noted, these types of developments can tend to freeze markets for some period of time, while developers and other participants try to “wait things out” and see whether the risk will subside or the trend will stabilize or reverse. My view is that this strategy is ill advised. With respect to tax reform, at least some level of reduction in the corporate tax rates seems likely, though the magnitude and scope of these and other reforms will not likely be known for a year or two or more. On the debt side, there are at least two unknowns.
Adverse Impacts on Muni Bonds. There is at least some possibility that tax reform will adversely affect the after-tax value of municipal bonds, and thus raise rates on this kind of debt versus other types of debt. Adverse impacts of the sort could result from the proposed reduction in corporate tax rates, but corporate buyers comprise less than 25% of today’s municipal market, and the proposed reduction in top individual income tax rates from 39.6% to 33% is not expected by most analysts to have a huge adverse effect. Moreover, as rates move higher, one would expect a spread between taxable rates and muni rates advantageous to municipal bonds to reemerge, so this traditionally lower yield on muni bonds if it does reemerge, may ameliorate the impact of higher interest rates on these deals.
Higher Levels of Interest Rates in General. Perhaps the bigger potential impact here lies in the debt market’s perception that the policies advanced by President-Elect Trump will lead to higher levels of inflation when unemployment is already reaching very low levels, and thus the level of interest rates in general will continue to rise from the recent historical 25-year lows we have seen in recent years. Even before the shocking election results, many analysts predicted that the Fed would raise the discount rate one or more times in 2017, and that we could see yields on the 10-year U.S. Treasury return over the next several years to the 3.0-3.5% levels last seen five years ago in 2011. Some analysts, in light of the election results, are now forecasting that interest rates could ultimately head even higher. For example, Jeffery Gundlach of DoubleLine Capital has suggested that in the next 3-5 years the interest rate on the 10-year U.S. Treasury could return to the 6.0% level we last saw just before the early 2000 stock market downturn.
Reflections on the Previous Impact of Rising Interest Rates on Our Business
Obviously, to the extent that the expected return of inflation and other elements of the Trump platform raise interest rates in general, that will slow things down in our business. We are financing long term (40-50 year) capital assets, not coffee at Starbucks, clothing or even washing machines or automobiles. By its nature, almost all of the purchase price of this type of asset has a heavy financing component, in our case on both the equity side and the debt side of the deal. For this reason, a general rise in interest rates always substantially slows our business down, at least until costs can adjust downward and rents can climb a bit. When interest rates move up, rents will never go up as fast as interest rates, especially in light of the recent pace of recent rent increases. This is probably the big story on the debt side. The effect could be negative, but hopefully somewhat muted, if rates do not go up too far too fast. I don’t think anyone is looking for 1981 here; we are not coming off of 10 years of 5% to 10% per year inflation as was the case in the 1970s. As is discussed below, real interest rates are very low and in some markets are still negative, and there are still serious concerns regarding recession or deflation in much of the world.
Also, a big part of the buy side on our tax-exempt multifamily housing debt are banks, and their spreads and thus profits may go up in a higher interest rate environment and they are still CRA motivated, so presumably they will still buy.
On the other hand, when debt-side market psychology changes, as it now appears to have done, it tends not to quickly reverse itself. For example, when the debt markets lost confidence in the credit worthiness of long-term municipal bonds and other forms of private long-term debt and fled to the safety of U.S. government debt in the fall of 2008, interest rates on taxable GNMA (Ginnie Mae) securities fell below that of tax-exempt long-term AA+ rated GNMA backed housing bonds in January of 2009. This “upside down,” now seemingly irrational, rate relationship has not yet reversed, although more than eight years have elapsed.
Moreover, we are coming off a 25-year down cycle in rates. If the market becomes increasingly convinced that our future involves a higher level of inflation, there is a lot of room for rates to move up from the extraordinarily low or negative real interest rates which have prevailed over the past decade or more.
If inflation is now running 2.3%, as appears to be the case, a 2.5% rate on the supposedly almost “riskless” 10-year Treasury, equates to a real interest rate of 0.20% - 20 basis points - on this 10-year paper. Since the early 1960s, this spread between the 10-year U.S. Treasury rate and the CPI has averaged 2.4%. It is certainly possible that weakness in the world economy, a slump in economic activity induced by more restrictive trade policies or other factors could ameliorate or even reverse this recent run-up in rates, but it seems more likely that the general level of interest rates, at least in the immediate future, is more likely to continue to rise than it is to stabilize or subside. As noted, the 10-year Treasury rate has gone up 70 basis points in the seven weeks since the election. If it goes up 100 basis points further over the next year if many of President-elect Trump’s proposals gain momentum, it will represent another 8-9% hit on the 60% of the deal financed with debt, or another 5% loss of proceeds on a typical debt service constrained loan. Moreover, a typical run-up in rates could be expected to cause tax credit investors to demand higher yields, which could further depress the proceeds on that side of the deal, even if by that time the reduction in the corporate tax rate has evolved in the direction the LIHTC markets now anticipate (20% to 28%), and not worse. A year from now, we could have easily lost another 6% to 8% or more on the funding side of these deals. On the other hand, some sophisticated industry players believe the recent run-up in rates may have already discounted these potential political and economical developments and the announced intentions of the Federal Reserve to further increase the discount rate in 2017, and that any further increases in rates could be less dramatic and could occur over a longer time period, if at all.
State of apartment markets
So, we have lost maybe 6% to 8% of our funding sources on these deals since the shocking election results, and we could lose more ground from rising interest rates and perhaps other circumstances relating to tax reform in the years ahead. Just as it does not feel like 1979 where interest rates were primed to spike to historical levels, nor does it feel like 1986-87, when we had just financed a four-year supply of apartments in 1985 alone to beat the effective date of the 1986 Tax Reform Act, and thus flooded the market with much more supply of these and other forms of real estate than it possibly could have been expected to absorb without the major dislocations which occurred. Moreover, we are not at the end of a 25-year cycle of profoundly increasing leverage throughout the world economy, which produced the 2008 financial crisis, and devastated real estate development as well as the world economy in general in 2009. The general U.S. economy and jobs, which support rental housing, seem to be on a fairly solid, if not exciting, footing.
On the demand side, the news is also very good. There continues to be huge demand for rental apartments. Single family home ownership in the United States has fallen from over 69% before the 2008 financial crisis to about 63.7% today, and is projected by the Urban Land Institute to decline to around 61% by 2030. Many Americans have lost their homes or can no longer qualify for single-family home mortgage loans. At the same time, continued net immigration in the U.S. and the entry of the post-World War II baby boom “echo” generation into the work force has added huge additional demand for rental housing in the United States.
It thus comes as no surprise that by some estimates, apartment rents have climbed by more than 20% in the U.S. since the recent bottom in 2009, and while rental housing starts have quadrupled since the low of 90,000 units was reached in 2009, the shortage of affordable rental housing in the United States today is greater than any time in the recent past. Studies by the Joint Center for Housing Studies of Harvard University and others indicate that the shortage grows more acute every year. While recently some “softness” has emerged in some markets for conventional rental housing, almost no markets seem to be substantially over-built, and there is no oversupply of affordable rental housing in any major market. According to the 2016 Harvard Joint Centers study, the number of American families who are severely rent burdened—paying over 50% of their income for housing—actually grew by 23% to 11.4 million from 2008 to 2014. This growing shortage of affordable renting housing has become an even bigger, higher profile political issue in many cities and states throughout the United States in the last several years.
Thus, the “good news” would appear to be that the demand for the product we are all involved in financing—affordable rental housing—relative to the supply, appears to be strong and growing, not subsiding. This is not 1985. On the other hand, we’ve just experienced, at the political level, not only in the U.S. but in other countries, some “meteor events,” the effects of which will take months and probably years to fully unfold. It seems almost inescapable that volatility and uncertainty will be higher in the immediate future; and that we will face challenges on the financing side of these deals that we have not seen during the last several halcyon years. A strategy of renegotiating and closing deals which are still viable, or with reasonable concessions can be made viable, in the current environment, would appear to be more likely to be a productive strategy than a “let’s wait and see if it gets better” approach which we have seen adopted in some prior times of sudden market change. We should all adapt, adjust and keep forging ahead.
Affordable Housing Finance published this article with the permission of the author.
Copyright © Jan. 3, 2017 by R. Wade Norris, Esq. All rights reserved. This document may not be reproduced without the prior written permission of the author.