Tax-exempt bonds offer a unique opportunity to secure low-cost debt

Today, the inverted yield curve, or when long-term U.S. Treasury debt interest rates are less than short-term interest rates, has created challenges for borrowers to secure debt. This is particularly evident in the cost of capital for construction loans. Yet, sophisticated and experienced affordable housing debt providers are finding creative solutions to meet borrower needs.

At the recent Texas Housing Conference, Sam Adams, managing director with KeyBanc Capital Markets, joined other market experts to discuss the current market dynamic and the options available to borrowers. Leaning on his deep experience in the municipal capital markets, Adams discussed the demand for tax-exempt bonds and how borrowers can take advantage of reduced pricing by using products primarily funded by institutional capital providers instead of only looking to commercial banks.
 

Balancing Taxable MBS and Tax-Exempt Bonds

Many borrowers in the market today have only been active in commercial real estate post-2010. As a result, many don’t appreciate the value and benefits of tax-exempt financing. Tax-exempt paper will generally offer a lower interest rate than taxable paper, and this advantage generally increases with higher interest rates.

However, the Mortgage-Backed Securities (MBS) market has been in such high demand for the past decade that it has also offered competitive spreads compared to tax-exempt bonds. The difference between the two often comes down to investor/lender liquidity at the end of the deal, Adams noted on the panel, adding that the MBS market is a multitrillion-dollar market.

“Anyone here with a Bloomberg [terminal] could tell you exactly what a taxable MBS price is right now. But an identical credit tax-exempt municipal bond will have a meaningfully wider potential valuation. We all agree that it is the same credit, but there are fewer buyers for tax-exempt bonds,” explains Adams.

There is still significant demand for tax-exempt bonds, although it is related to the American tax benefit, so few international investors participate. Before interest rates increased, borrowers preferred the MBS market because there was a larger market to sell into if the market turned. Today, with interest rates up, tax-exempt bonds are the more attractive bet to many American investors, as they can provide superior return on a tax-adjusted basis.

“You still have that same liquidity problem, which costs money compared to the taxable MBS market. But all of a sudden, the borrower isn’t paying a third of that interest in taxes,” he says. “That’s a very big difference in today’s market, where interest rates are high. That tax-free benefit has a lot of value now relative to a liquidity penalty.” As a result, borrowers can often secure tax-exempt bonds at a much lower interest rate.
 

The Strength of Public Housing Authorities

Larger public housing authorities around the country are an attractive opportunity to take advantage of the tax-exempt bond market as well.

Adams has experience working with many of the largest local public housing authorities across the country, including those in Texas, where the conference was held. Because the tax-exempt bond market has created an opportunity to secure debt at a lower rate, Key is leveraging the financial strength of local housing authorities to create a hybrid product.

The Housing Authority secures an S&P rating, and when the deal is taken to the capital markets, the housing authority can act as a government entity. “Housing authorities typically cannot assess taxes, but they have a large portfolio and a number of revenue streams that make them a pretty safe investment. We’ve made a bit of a hybrid here.” This financial strength allows them, sometimes in partnership with private developers, to access low-cost tax-exempt debt for a range of projects, including workforce housing as well as 4% Low-Income Housing Tax Credit projects.

This is an attractive prospect for developers, who are often already working with housing authorities. Typically, the housing authority is providing soft debt or is in a subordinate debt position. Now, the housing authority has gone through the bond and rating process to borrow money at a very attractive rate to lend into the project as the primary capital provider.

“This allows the deal to look very different than probably any bank you're currently talking to nowadays,” says Adams. The model further opens the door for other attractive financing opportunities. The housing authority can borrow permanent debt, apply its credit enhancement, and serve as the lender and/or partner on a deal. Their guarantee can also allow the housing authority to do very aggressive financing, including financing 100% of the capital stack on the deal, when appropriate.
 

Weighing Public Offerings and Private Placements

In addition to opportunities in the tax-exempt bond market, Adams also weighed in on the transaction cost differential between public offerings and private placements.

Most of these costs are fixed, and there are cost differences between the two. Legal fees, for one, will be measurably higher on most public offerings. Generally speaking, however, the public offering benefits increase with the size of the deal. Larger deals are more often done as a public offering because the fees can be easily amortized into the savings created by the lower interest rates on a transaction.

But smaller deals can still work as a public offering. Adams has pursued a public offering on U.S. Department of Housing and Urban Development (HUD) deals with cash bonds, but the deal has little financial engineering involved. In addition, many new construction deals also benefit from various public offering structures.

Specifically, when it comes to cost, Adams says many smaller private placements are one-and-a-half to two-and-a-half points less than a public offering, although this becomes less relevant based on a larger deal size. “It depends, because you might get a really good private placement offer or you might not on a given transaction. The comparison has to be done deal by deal,” says Adams.

The current capital climate is undeniably challenging, but experts are looking at every angle of the deal to find and create opportunities. The tax-exempt market and the use of housing authorities, as well as weighing options like public offerings and private placements, are providing opportunities for borrowers to forge a path forward. To discuss how these insights might apply to your next project, connect with Sam Adams, reach out to your relationship banker, or find an expert.