Q&A/Discussing Today’s Business Trends:
Tax-Exempt Bond Financing for Multifamily Projects
Milt Pinsky is Chief Executive Officer of Banner Apartments, LLC, a family-owned real estate investment and management business. Incorporated in 1990, the company and its affiliates focus on the acquisition and management of multifamily real estate investments, including over 4,600 apartment units throughout the Midwest. The principals of Banner have also formed a 501(c)(3) corporation that acquired majority interests in 649 units of affordable housing. Much Shelist spoke with Mr. Pinsky about the challenges and opportunities of tax-exempt bond financing for multifamily real estate projects.
Much Shelist: Can you provide a brief overview of tax-exempt bond financing for multifamily housing?
Milt Pinsky: This type of financing was born out of the federal tax reforms of 1986. The federal goal is to preserve and renovate existing affordable housing and to encourage development of new affordable housing. If your project meets the criteria, and you obtain tax-exempt bond financing, you probably will also seek an allocation of tax credits. The tax exemption on the bonds lets you borrow at lower rates, and the tax credits enable you to raise equity by bringing in a partner that is interested in receiving the tax credits.
The tax code provides each state with an amount of “volume cap” based upon the size of its population. You need an allocation of $1 of volume cap in order to issue $1 of tax-exempt bonds. Each state has a method to allocate that volume cap for different uses, including industrial revenue bonds, housing bonds and other uses. Most states publish a “Qualified Allocation Plan” once every year or two, updating their process. Most states allocate some of their volume cap for tax-exempt housing bonds. Typically, you find a state or local agency willing to issue tax-exempt bonds for your project and through them you apply for an allocation of volume cap. The proceeds of the tax-exempt bond issue are lent to the project, typically at a favorable rate.
The criteria for issuing tax-exempt bonds include setting aside some units for low and moderate income residents, typically for at least 15 years. The developer can elect up front to set aside either 20% of the units for households at or below 50% of area median gross income (AMI) or 40% of the units for households at or below 60% of AMI. If it’s an acquisition, as opposed to new construction, then a certain amount of renovation is required. If you add the tax credits on top of the tax-exempt bonds, then there are limits on the rents you can charge and the set-aside period is extended, typically to 30 years. As a practical matter, developers focus on acquisition projects where the seller has owned the property for at least 10 years because credits are only available on the acquisition portion of a transaction if the seller owned it for that long. Since the amount of tax credits available is directly proportional to the percent of units you agree to rent and income restrict, most projects utilize a 100% set-aside in order to maximize the tax credit equity. Some states add additional requirements, either for obtaining volume cap and issuing bonds or for obtaining the tax credits.
MS: Is the program open only to nonprofit developers?
MP: No, both for-profit and not-for-profit developers can take advantage of tax-exempt bond financing. Nonprofits have an additional option of obtaining tax-exempt bond financing without obtaining an allocation of volume cap (so it’s not limited by the amount of the volume cap), but then there are no tax credits and the nonprofit must own 100% of the project. Typically, the tax credit equity is needed in order to make the transaction work.
MS: What types of projects are eligible?
MP: The federal government has issued fairly detailed eligibility requirements, which vary depending upon the for-profit or not-for-profit status of the borrower, and whether the projects involve new construction or existing housing stock.
For example, under Section 142 of the Internal Revenue Code, which applies to transactions with an allocation of volume cap (so you have the potential to get tax credits), housing stock must be rental only (no condominiums) and must be classified as residential (meaning full kitchens and baths, no transient tenancy, etc.).
For nonprofit housing projects without volume cap, Section 145 of the Internal Revenue Code dictates that a project must be fully owned by the not-for-profit, may not be combined with tax credits and must further the purpose of the organization. On the other hand, transient housing and single-room occupancy (SRO) projects are allowed, as is the refinancing of existing debt. There are also fewer limitations on how the funds may be spent toward land acquisition and there is no rehab requirement. In addition to the 20/50 or 40/60 set-aside, a nonprofit must set aside an additional 55% or 35% of the units, respectively (so that in either case a total of 75% of the units are set aside), at 80% of AMI.
MS: How do the tax credits work in a bond transaction?
MP: Once you get an allocation of volume cap, if the amount of the tax-exempt bonds is at least equal to 50% of the cost of the land and buildings, the development is semi-automatically entitled to 4% tax credits. The state agency has to make a determination of need, but that’s fairly easy to get if you take the time to understand all of their rules. That’s why it is typically referred to as "semi-automatic." Taken over 10 years, the credits are based upon eligible project cost and the percentage of units that are income and rent restricted. The developer brings in a limited partner that contributes “tax credit equity” and in return receives an allocation of the tax credits and typically about 10% to 20% of the cash flow and residual value. They receive no preferred return on their capital contribution. Typically, if the property is 100% set aside, the tax credit equity is about 25% to 30% of the total project cost. If the property is in certain designated census tracts, an additional 30% boost in credits and tax credit equity is available. Some states, like Missouri, also provide a matching state tax credit that results in additional tax credit equity. In a typical bond/credit acquisition/renovation transaction, about 75% of the tax credit equity comes in at acquisition, and that tax credit equity and the financing provides all the necessary sources for acquisition, funding the rehab reserve and transaction costs. The remainder of the tax credit equity typically comes in over the next two years as the project hits certain benchmarks, and is immediately paid over to the developer as a development fee.
MS: How does the borrowing process work?
MP: It is similar to the typical loan process, but with a few extra steps. Potential borrowers must first determine the state agency’s allocation of volume cap (more simply, the funds available) and the potential viability and eligibility of the project. They then identify a bond issuer, which may be the state, a municipality or some other governmental agency. Bonds may be sold in a private placement, which often provides for a simpler transaction at a lower cost, with fewer parties and a higher interest rate. The alternative is a public sale, which is typically more complex and brings with it higher costs, a lower interest rate and a credit-enhancement requirement. Many state agencies have programs where they provide the credit enhancement as well. The parties typically include bond counsel (who documents most of the transaction and makes sure it complies with the code), the issuer and their counsel, the credit enhancer and their counsel, the underwriter and their counsel, the trustee and their counsel, and a rating agency. The extra transaction costs associated with documenting a bond transaction reduce the benefit of the lower tax-exempt rate, but the availability of tax credits usually makes it worthwhile. Frequently, these transactions also include other affordable programs, such as project-based section 8 (HAP) contracts, HOME funds, Federal Home Loan Bank Grants or other state funds.
When the bonds are issued, the issuer provides a mortgage loan to the owner, who uses these funds to acquire and renovate or build the project.
MS: It sounds like a very attractive financing option. Why don't all developers pursue this strategy?
MP: First, the federal government only authorizes a finite level of financing under these programs. Each state can then allocate portions of its allotment to specific regions and municipalities within the state, based on need, desire to improve local economies, etc. Competition for this type of financing can be quite fierce in certain cities or regions.
Additionally, although the bond/credit financing can be very attractive, it is quite time-consuming to complete and submit successful applications, and process the bond documents. After you've closed, you have to demonstrate compliance with the income and rent restrictions on an ongoing basis, which is time-consuming and costly. The state agency and tax credit equity investor require a burdensome level of ongoing reporting. At Banner, we have several full-time employees whose sole responsibilities involve researching and documenting compliance with the rent and income restrictions and filing associated periodic reports.
Ultimately, developers must think carefully before pursuing tax-exempt bond financing. It’s an attractive option, but not one that comes cost-free. In general, this type of financing is most effective for larger projects (so that the transaction costs are not a large percentage of the overall costs), for potential acquisitions that need the required renovation level and where the tenancy is already low income. When the process works as intended, it preserves and improves existing affordable housing or enables the development of additional affordable housing.
For more information on The Banner Companies, we encourage you to visit http://www.bannerapartments.com/.
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