A few months ago[1] Bob Labes and I wrote a blog post about the $78 Billion Tax Bill that includes affordable housing help by reducing the tax-exempt financing requirement for a developer to receive the 4% low income housing tax credit (4% LIHTC) by 40% for a limited time only.  This got us thinking about how scarce the state allocation of volume cap is in some states and what if a developer still cannot obtain an allocation of volume cap for its project.  Is the developer out of luck?  Are there any other options?

If the developer is only looking at the 4% LIHTC, the answer is probably yes.  But don’t leave now – there’s more!  There are alternatives, which can be better than the 4% LIHTC for a developer.  

While the 4% LIHTC program has been extraordinarily successful, it offers too little for the “missing middle.”  The 4% LIHTC program has benefited households making 60% or less of the median income for their metropolitan area (“AMI”) for decades now. However, 4% LIHTC financing does not help those who earn too much to qualify for subsidized low-income housing but cannot afford market rents or homeownership (“Mid-Income Earners”). So, the inability to obtain an allocation of volume cap for financing for a 4% LIHTC program housing development could benefit a developer.  As a result, a developer could alternatively target housing for Mid-Income Earners (“Mid-Income Housing”).

Targeting Mid-Income Earners could result in higher rents being charged for such units. Where the 4% LIHTC financings may not be available, other forms of tax-exempt bond financing can support housing for Mid-Income Earners (“Mid-Income Housing”), by combining the benefits[2] of: tax-exempt interest rates, favorable underwriting terms, and property tax abatement or exemptions.

Tax-Exempt Interest Rates

The most compelling benefit of tax-exempt bond financing is that tax-exempt interest rates are typically lower than conventional borrowing rates. Because investors do not have to pay federal (and sometimes state) income tax on interest income derived from such bonds, investors require less interest to generate the same after-tax return.  This lowers overall interest rate that the investors are willing to accept for such obligations and this interest rate is passed onto the issuer/borrower. 

These types of financings are generally true “project financings.”  The bonds issued to finance these projects include amounts borrowed for coverage, debt service reserves, capitalized interest, upfront professional fees, and bond issuance costs.  Most, if not all, of the transactions borrow the full amount needed to complete the property, plus another 15% on average.  So, a lower tax-exempt interest rate is a major benefit and is particularly valuable in financings for Mid-Income Housing financings, because deal sizes are relatively large and the amount of long-term tax-exempt debt is high as a percentage of total project funding.

Favorable Underwriting Terms

Mid-Income Housing transactions are typically executed as public bond offerings and not in the form of private placements or bank loans. Retail and institutional bond investors derive more value from tax-exempt interest than commercial banks that typically buy bonds in private placements.  As a result, there are more investors willing to give much more favorable underwriting terms.  Most bonds issued for Mid-Income Housing are unrated and are sold and traded in the high-yield municipal bond market.  This market and the mortgage lending market are predominantly mutually exclusive.  The mortgage lending market typically imposes much more onerous underwriting standards, including a maximum loan-to-value (LTV) ratio (often 80–90%), a minimum debt service coverage ratio (often 1.15-to-1 or 1.20-to-1), scheduled amortization with limited or no “balloon payments” or refinancing risk, completion and repayment guaranties from the developer/sponsor and loan-to-cost limits for construction debt.

By contrast, in “risk on” environments, when bond investors are seeking yield and willing to take risk, it is not uncommon to see non-recourse project financings in the high-yield bond market featuring:

  • 100% debt financing;
  • Lower projected debt service coverage (as low as 1.10-to-1);
  • Long-term (30+ years[3]) fixed rate, callable debt;
  • Sequential pay or “turbo” amortization as opposed to fixed/scheduled principal payments;
  • “Balloon” payments or planned refinancings;[4]
  • Relatively light guaranties; and
  • Acceptance of construction risk as part of long-term debt financing (i.e., no separate construction loan).

Public and private sector actors have executed Mid-Income Housing transactions in the high-yield bond market with terms that could not be achieved in the conventional multifamily mortgage or 4% LIHTC markets.  But, all of this flexibility comes at a cost – accepting a higher risk and seeking yield usually means the investor wants more in return.  Interest rates and risk tolerances can also move dramatically in a short time based on outside factors[5] — and investors who provide favorable terms one day can feel differently for the next financing.  Those highly leveraged unrated workforce housing bonds that were popular when interest rates were near zero during the COVID-19 Pandemic are a thing of the past.[6]  The types of projects have become a lot less feasible when other contractual or state law limitations are in place.  For example, state law in California requires moderate income housing to include:

  • 10% of the units rented to residents earning at or below 50% AMI,
  • 10% of the units rented to residents earning at or below 80% AMI, and
  • The remaining 80% of the units rented to residents earning between 90% and 120% of AMI. 

With the rise in interest rates outpacing the rise in AMI, Mid-Income Housing transactions aren’t cash-flowing like they used to.  Underwriters have been forced to get more creative with structures, like capital appreciation bonds,[7] being used for these types of financings.  But, even with the increase in interest rates, this benefit combined with lower tax-exempt financing rates and property tax abatements or exemptions can help a Mid-Income Housing project cash flow. 

Property Tax Abatements or Exemptions

Property tax is often a major expense for multifamily rental housing projects.  Because taxes are paid prior to debt service, every dollar of property tax owed is a zero-sum game for net operating income available to pay debt service. So, a reduction or all out removal of the obligation to pay property tax increases NOI and thus project feasibility. Some jurisdictions provide property tax exemptions and abatements that can help finance Mid-Income Housing.

Obtaining a property tax abatement or exemption often involves engaging with the local taxing units where the Mid-Income Housing facility is located to obtain the property tax abatement or exemption. This can sometimes present challenges when a property is already subject to property taxes.  Convincing a local government to forego income can feel challenging at best, event when these projects are aimed to help residents. [8]  

While the issuance of tax-exempt bonds does not automatically result in a real property tax exemption, the forms of ownership required for tax-exempt financing of Mid-Income Housing (ownership of all bond-financed facilities by a 501(c)(3) organization or a governmental unit) frequently results in exemption of a bond-financed project from real property taxation.  Governmental ownership typically results in a clearer and more complete exemption from property tax than programs based on 501(c)(3) ownership.  However, other considerations, such as leases to private parties, which may have “possessory” interests may negate that exemption.  So, this really valuable tax exemption can be the determining factor in the structuring of your tax-exempt financing or borrower entity for the development of a Mid-Income Housing Project with governmental bonds or 501(c)(3) bonds.  More on those considerations and structures to come. 


[1] Time flies when you are having fun!

[2] It should be noted that some of these benefits are also available for Affordable Housing Projects that do not receive the 4% LIHTC as well.

[3] Subject to State law and federal tax law limitations

[4] Also subject to State law and federal tax law limitations

[5] Think of the Fed’s decision to keep raising interest rates since 2022.

[6] We are all longing for those interest rates now.

[7] Capital appreciation bonds (CABs) are bonds that compound interest until maturity instead of paying interest annually. CABs are sold at a discount, called the par amount, and the interest and principal are paid in a single lump sum at maturity.

[8] Squire’s Public Policy and Real Estate practices can help each step of the way.