As you probably know, states and local governments often finance projects they consider important, such as roads, prisons, or schools, by issuing tax-exempt bonds. These bonds are attractive to investors because the interest they receive from such bonds is not subject to tax, as it is with most other bonds.
Because they save on taxes, people who buy tax-exempt bonds are generally willing to accept lower interest payments, which in turn allows the Issuers to sell more bonds and thus borrow more money than they otherwise would be able to afford. As a result, Issuers of tax-exempt bonds enjoy lower borrowing costs and higher borrowing capabilities than most other borrowers.
Under IRC §142(d)), the 50 states are allowed to grant tax-exempt status to a limited amount of “private activity, volume cap” bonds. Each state is free to determine how it will allocate its allowance of these bonds among such possible projects as multifamily housing, single-family dwellings, industrial development, and so forth.
When a projects wins state approval to be financed with this type of bond, it also becomes eligible for 4% tax credits, which are almost a sure-thing because the application process for the 4% tax credits is entirely non-competitive.
Tax-exempt Bond Deals
The mechanics of financing a development project with volume cap tax-exempt bonds is somewhat complex, but well worth the time, effort, and expense.
Once you decide to apply for such financing, your first step is to line up a proper legal entity, typically a city, county, or housing authority, which is already empowered to issue tax-exempt bonds.
Your next is to induce that legal entity to petition the appropriate state authority for permission to issue the bonds you want, as a portion of the state’s allotment of volume cap, tax-exempt, private activity bonds. Part of this process involves negotiating a Regulatory Agreement in which you agree to certain restrictions on the rent and tenant income limits for some or all of the project, as well as other matters having to do with operations of the property.
You will also need an underwriter to negotiate a bond purchase agreement with your Issuing Entity, and later to market the bonds. The underwriter is a kind of “middleman” who smoothes the flow of money from bond purchasers to Issuing Entity, and ultimately to you. Some underwriters will be in a position to advise you on choosing the right bond Issuer, and may even be able to guide you through the process of applying for a winning approval of the volume cap, tax-exempt, private activity bonds you seek.
Be aware that you will also be working with a local development bond counsel. This attorney, who represents the interests of the bond Issuer and the bond purchasers, must provide a legal opinion that the bonds will be tax-exempt. This person will also be responsible for drafting and finalizing key documents, including the loan agreement, regulatory agreement, underwriter-due diligence documentation, credit enhancer documents, tax credit investor documents, and even necessary partnership agreements.
Another party to the transaction is normally a financial institution with an investment-grade credit rating ( “Aaa” or above). This institution serves as a “credit enhancer,” effectively guaranteeing that bond purchasers will receive their interest payments on time, and that the bonds will ultimately be redeemed at their full value when they mature.
Basic Elements of the Transaction
With all these entities in place, the Issuer creates the bonds, the underwriter markets them, and purchasers plunk down their money to buy them. The effect is to loan you money at significantly lower interest rates than you’d get in any other market.
However, the money paid for the bonds does not actually pass through to you. Instead, the funds are paid to a Trustee, who holds them securely under the terms of a document called a “trust indenture.” This is an agreement between the Trustee and the bond Issuer, outlining the conditions and terms under which the bonds will eventually be redeemed.
To actually receive your funding for the project, you must take out a mortgage on the property, borrowing from an established lender that is already affiliated with the deal’s credit enhancer. These funds are set aside in a restricted account, and made available to you in increments as work proceeds on the project.
Generally, you will bundle the invoices from contractors and others, and use them as evidence of your need to draw money – normally once a month – from the mortgage loan proceeds to pay your bills on the project.
As work on the project proceeds, these funds are gradually drawn down. The idea is that the funds will be depleted just when the project is finished.
However, all this time you will be paying monthly interest on the full amount of the mortgage loan, which is the same amount as the bond proceeds. Should you fail to make your mortgage payments, the credit enhancer will exercise a legal claim to the property, and use it to repay the mortgage.
Arbitrage Must Be Limited
Because the proceeds of these tax-exempt bonds are normally invested in securities that yield a higher rate of return than the bonds pay out, there is the issue of arbitrage. When the difference between these two rates is too large, the tax-exempt status of the bonds can be at risk. That’s why it’s important to work with experts who are aware of the restrictions, and of the exceptions that exist that allow tax-exempt bonds to retain their special status even when such restrictions are exceeded.
Because the entities to this deal, and each of their separate legal representatives, are all working for a fee, the costs of these tax-exempt private activity bond deals can be extremely high.
Nevertheless, the financing they provide at lower rates than other sources of funds can be very attractive.
Another attraction of these deals is the tax credits they normally carry.
While 9% low-income housing tax credits are strictly limited and available only competitively, 4% tax credits are available far more readily to partnerships using private activity tax-exempt bonds to help finance their developments.
Meeting The 50% Test
The key requirement for gaining the 4% tax credits is to design your financing so it meets “the 50% test.”
Under this test, at least 50% of your project’s aggregate basis (simply defined: the cost of the project’s land plus all its depreciable assets) must be financed by volume cap, tax-exempt bonds, plus interest earned on the bonds. If your project meets this test, then the entire “eligible basis” of the project can be used for figuring the 4% tax credits.
If your project fails to meet this test, then its ability to claim those 4% tax credits drops way down.
For example, say only 40% of your project’s aggregate basis gets financed with volume cap, tax-exempt bonds. In this case, your project does not meet the 50% test. As a result, only that portion of the project’s eligible basis that does meet the test can be used to claim those 4% tax credits.
Steps To A Volume Cap Tax-exempt Bond Financing Deal
If you like the idea of developing projects with money borrowed at 100 or more basis points below market rates, look over the steps normally involved in putting together such a deal:
1) Find a property you think makes sense to develop, and pencil in some numbers to see if this kind of financing is feasible for the project
2) Put together an experienced and enthusiastic team, including:
• A compatible underwriter
• A knowledgeable accountant
• A local developer’s bond counsel
• A willing credit enhancer
• An experienced equity partner
3) Have the bond Issuing Entity pass its legally-required inducement resolution
4) Gain a commitment from a suitable credit enhancer
5) Submit your private activity bond application to the appropriate bond Issuing authority
6) Provide suitable public notification of the project (normally just two weeks)
7) Get through your Tax Equity and Fiscal Responsibility Act (TEFRA) hearing
8) Wait for your private activity tax-exempt bond application to be approved, and your bond allocation to be awarded
9) Submit your application for 4% tax credits
10) Have you local bond counsel draft the necessary documents
11) Work with your bond Issuer to have the bond resolution passed
12) Wait for your underwriter to price the bonds and sign contracts for marketing them
13) Negotiate and sign your bond purchase agreement
14) Get through your bond closing
15) Issue your final official statement.
That wasn’t so bad, was it?
Indenture – The agreement between a bond Issuer and a Trustee that sets forth the terms and conditions, as well as procedures, under which the bonds will be repaid.
Inducement Resolution – A formal resolution approved by the bond Issuing Entity that publicly states its intention to issue new bonds.
Official Statement – Basically a marketing prospectus that underwriters distribute as part of their effort to market newly issued bonds. This document contains the information that purchasers consider when making their decisions regarding whether or not to buy the bonds on offer.
Rating Agency – Well established companies that issue public statements about bonds, and other investment vehicles, which are generally accepted by investors as reliable indicators of the risks associated with each investment vehicle.
Regulatory Agreement – A contract specifying details about the project, including the income restrictions and the reduced rental rates available to tenants who meet those restrictions, generally negotiated by the borrower, the bond Issuer and the Trustee involved with a project financed by volume cap tax-exempt private activity bonds.
TEFRA Hearing – The formal procedure by which elected officials may give their approval of a new tax-exempt bond issue.
Underwriter – An investment bank that agrees to market newly issued bonds to potential purchasers.