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Blending Yields

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Due to the COVID-19 pandemic and resulting impacts on the economy and financial markets, as well as the Federal Reserve’s raising of short-term rates to stave off inflation, interest rates and construction costs have risen dramatically, resulting in funding gaps that many multifamily affordable housing developers in the four percent Low Income Housing Tax Credit space have had difficulty filling. States, cities and localities have allocated resources to address such shortfalls, and private companies, such as Amazon, have made available subordinate loans for this purpose, but even with such other sources of capital, challenges remain. Despite these headwinds faced by developers, opportunities exist to utilize creative tax-exempt bond structuring techniques to potentially generate an additional source for these transactions, and one such opportunity is the focus of this article.

The 50 Percent Test and Short-Term Cash-Collateralized Bonds
For a project to qualify for the four percent LIHTC under Section 42 of the Internal Revenue Code of 1986, as amended (the Code), at least 50 percent of the project’s aggregate basis must be financed with tax-exempt private activity bonds (referred to as the 50 percent test). Therefore, developers seeking four percent LIHTCs must obtain tax-exempt bonds issued by a state housing agency or other municipal issuer in an amount sufficient to meet the 50 percent test.

Several structures employed in today’s tax-exempt bond market involve publicly offered, cash-collateralized bonds purchased by institutional investors via a bond underwriter. In a typical short-term cash-backed execution, the bonds have a short-term maturity (typically, three to four years) and are issued solely to meet the 50 percent test (which requires that the bonds remain outstanding at least until the project is placed in service for LIHTC purposes). Simultaneously with the issuance of the bonds, the developer and a third-party lender will close on a taxable Federal Housing Administration, Freddie Mac or Fannie Mae loan, or other taxable loan, which will serve as the permanent financing for the project. The bond proceeds are delivered by the underwriter to a trustee, deposited into a project fund, and used to purchase government obligations (such as U.S. Treasury notes), the earnings on which will be used to pay interest on the bonds. During the construction period, collateral funds from the lender or other sources are deposited with the trustee in a collateral fund to allow the trustee to disburse an equal amount of bond proceeds to the borrower for project costs. As a result, the bonds are always fully secured by cash and investments in the project and collateral funds. Once the project is placed in service, the bonds are tendered back to the trustee in exchange for the cash collateral and redeemed.

Because of the structure’s cash-collateralized nature, bondholders are willing to accept a relatively low-interest rate. If, as is the case in the current interest rate environment, this bond rate is exceeded by the rate on investments purchased with the bond proceeds, the earnings would be sufficient to fully offset interest on the bonds (such that the borrower does not pay that cost out of pocket).

However, any investment earnings over the amount used to pay interest on the bonds constitute “arbitrage” and must be “rebated” to the IRS. For example, if the proceeds of a bond yielding 3.5 percent are used to purchase investments yielding 4.5 percent, the earnings representing the excess one percent investment yield are subject to rebate. However, the Code potentially enables a borrower to use such earnings on project costs in certain cash-backed structures.

Cash-Backed Forward Structure
Under the so-called “cash-backed forward” structure, a project may be permitted to retain certain investment earnings that would be subject to rebate under a short-term cash-backed execution. The cash-backed forward structure contemplates the issuance of long-term bonds that bear interest at two different rates: an initial rate during the construction and lease-up phase, and a second rate during the permanent phase (commencing on the conversion date). The structure prior to the conversion date is nearly identical to the above-described short-term structure, with bonds sold to institutional investors through an underwriter, and proceeds delivered to a trustee to purchase government obligations. Unlike in the short-term structure, however, the bonds are delivered to a long-term bondholder on the conversion date and serve as the permanent financing for the project. Bond proceeds are disbursed for project costs upon the trustee’s receipt of collateral payments, such that the bonds are always fully collateralized. On the conversion date, the initial holders tender the bonds to the trustee in exchange for the cash collateral, the trustee delivers the bonds (in the permanent amount) to the permanent holder, and the bonds (at this point secured by a mortgage, rather than by cash) begin bearing interest at the permanent rate, which is typically higher than the rate prior to the conversion date.

Because the bonds bear interest at different rates during the two phases and the conversion date is not known at closing, the bonds typically would be treated as variable yield bonds for federal tax purposes. Under the Code, the bond and investment yield on variable yield bonds must be calculated, for arbitrage rebate purposes, at least once every five years. Conversion in these four percent LIHTC transactions typically happens within 24 to 36 months from the issuance date – well within the initial five-year computation period. Accordingly, the bond yield for the first computation period would be calculated by blending the lower rate from the issuance date to the conversion date with the higher rate from conversion to the initial computation date. Although several factors, including the actual conversion date and the amount of any paydown of the bonds, can impact this calculation, such blended yield during the initial computation period often exceeds the yield on the investments that were in place before the conversion date, resulting in no excess investment earnings that would be subject to rebate. For example, assuming bonds bearing interest at 3.5 percent during the cash-collateralized phase for 30 months and 6.5 percent during the permanent phase for 30 months, the bonds would have a blended yield of five percent during the initial five-year computation period. If the proceeds of such bonds were used at closing to purchase investments yielding 4.5 percent, then such investment yield would not exceed the blended bond yield of five percent, and therefore, the borrower would be able to apply all the earnings to qualified project costs.

For this strategy to be available, bonds during the construction and permanent phases must be treated as part of the same “tax issue.” Such a conclusion requires a determination that the bonds were not “significantly modified” at the time of conversion, and therefore, that the conversion did not constitute a “reissuance.” To make such a determination, all of the permanent phase bond terms (including interest rates, maturity date and conditions to conversion) must be established at the time of the initial issuance, and any changes to the terms at conversion must be pursuant to the original documents.

Two-Series Structures
Various two-series tax-exempt debt structures also present the potential for yield-blending, including (i) a Fannie Mae M-TEBs series combined with a short-term cash-backed series, and (ii) a short-term cash-backed series combined with a tax-exempt seller note, in each case when the short-term series bears interest at a lower rate than the long-term series. If it can be concluded that the two series constitute a single tax issue, the yields on the two instruments can be blended for rebate calculation purposes. Such a conclusion requires the two series to be treated as sold at substantially the same time (generally, within 15 days of each other), issued pursuant to the same plan of financing, and reasonably expected to be paid from substantially the same source of funds. Should the two series be viewed as a single tax issue (thereby permitting the blending of the two yields), then any investment earnings received that do not exceed such blended yield would not be subject to rebate.

In the current interest rate environment, the ability to blend yields in a cash-backed forward or two-series bond transaction may enable a borrower to retain certain investment earnings and apply them to qualified project costs, thereby narrowing funding gaps and increasing a project’s viability. Developers considering this strategy should contact tax counsel experienced in this area to discuss options for navigating the necessary structuring and federal income tax aspects.   

Alex Zeltser is a partner in the Washington, DC office of Tiber Hudson LLC, where he focuses his practice on public finance in the affordable multifamily residential rental housing space. He represents underwriters and bond purchasers in a range of tax-exempt and taxable housing financings around the country, including public offerings of rated bonds credit-enhanced by FHA, Ginnie Mae, Fannie Mae and Freddie Mac, as well as private placements and direct purchases of unrated bonds.
Robert Kaplan is a partner at McGuireWoods focusing on federal and state tax laws relating to the issuance of tax-exempt bonds and tax credit bonds by state and local governments. He represents issuers, underwriters and borrowers in bond financings involving governmental bonds, qualified 501(c)3 bonds, and exempt facility bonds.