The Popularity of Bonds

10 min read

Are we on the verge of a volume shortage?

It has now been documented that many cities and states face a critical and growing shortage of affordable rental housing. Single family home ownership in the United States has fallen from over 69% before the 2008 financial crisis to about 63.7% today, and is projected by the Urban Land Institute to decline to around 61% by 2030. Many Americans have lost their homes or can no longer qualify for single family home mortgage loans. At the same time, continued net immigration in the U.S. and the entry of the post-World War II baby boom “echo” generation into the work force has added huge additional demand for rental housing in the United States. It thus comes as no surprise that by some estimates, apartment rents have climbed by more than 20% in the U.S. since the recent bottom in 2009, and while rental housing starts have quadrupled since the low of 90,000 units was reached in 2009, the shortage of affordable rental housing in the United States today is greater than any time in the recent past. Studies by the Joint Center for Housing Studies of Harvard University and others indicate that the shortage grows more acute every year.

At the same time, cities, counties and states across the United States face increasing funding demands for education and social needs, deteriorating infrastructure, ballooning pension obligations and other financial burdens, often with declining revenues. In such times, it is imperative that city, county and state officials maximize any external sources of funding which can be brought to bear to address the critical shortage of affordable rental housing which exists in so many communities.

A huge source of such external funding is the federal 4% Low Income Housing Tax Credit (or the “4% LIHTC”). As those active in affordable housing are aware, on a 100% affordable project the 4% LIHTC can be syndicated for an amount of money sufficient to cover 25-35% of total development cost or, for projects in a “difficult to develop area” or “DDA” or a “qualified census tract” or “QCT,” as much as 35-45% of total development cost.

It is estimated that the federal 4% LIHTC program and the even more powerful, but almost always dramatically over-subscribed (by a factor of 4 or 5:1) 9% federal Low Income Housing Tax Credit Program provided funding for roughly one-third of the slightly over 400,000 total rental apartments started in the United States last year. Either the 9% or 4% LIHTC is involved in almost all U.S. affordable rental housing. The regulatory compliance track record since these two programs were enacted in the early 1990s has been virtually unblemished, and the default rate, even in the darkest days of 2008 and 2009, has been almost non-existent.

Underutilized financing
Since it is clear that 4% LIHTC, like 9% LIHTC, is a vital federal subsidiary for affordable housing, one might ask, how much of this subsidy is available? The answer is, ironically, in most, but now not all, jurisdictions, much more of the 4% LIHTC federal subsidy is available each year than is presently being used. To be eligible for the 4% federal LIHTC, the so-called “50% Rule” under Section 42 of the Code requires that at least 50% of the eligible basis in the buildings, plus land, be financed with volume limited tax exempt private activity bonds (a term which includes tax exempt “loans”) under Section 142(d) of the Code, and that these bonds be kept outstanding until the project’s placed-in-service date (roughly the issuance of a certification of occupancy for a new construction project or the completion of rehabilitation for an acquisition/rehabilitation project). The purpose of the 50% Rule was, in the absence of adding another separate state authority allocation mechanism as was created under the 9% LIHTC program, to “piggyback” on each state’s system for allocating this tax exempt private activity bond volume for multifamily housing to only the most meritorious (from a public policy standpoint) of the projects applying for these federal tax subsidies. In 2007, the highest year, states used only 58% of their allowed private activity bond volume allocation; in 2014 that percentage was 38%. In recent years, more than half of the nation’s private activity bond volume has remained unused.

Under Section 146 of the Internal Revenue Code, each state is allocated in each calendar year, tax exempt private activity bond volume equal to the greater of, in 2015 (i) $301.5 million or (ii) $100 per resident (both limitations are indexed annually for inflation).

Double bang for the buck
Private activity bonds are debt obligations which serve a designated public purpose, but where the facilities are privately owned. Types of private activity bonds include single family mortgage revenue bonds, multifamily affordable rental housing bonds, industrial development bonds, pollution control bonds, student loan bonds, bonds for certain privately-owned airport, dock and wharf facilities and certain other uses. Each state is allowed to allocate its volume among these categories as it sees fit. Some states, like California, allocate a major share to multifamily rental housing. In California, approximately $2.9 billion or roughly 76% of the $3.8 billion total private activity bond volume for 2015 was allocated to multifamily housing. Two arguments suggest that this is sound state policy. First, the growing shortage of affordable rental housing is one of the most significant public policy issues faced by many cities, counties and states for which a solution is urgently needed. But the second reason is even more compelling: an allocation to tax exempt affordable multifamily housing bonds versus other private activity bond sources is the only use of private activity bond volume which not only provides low rate debt financing, but also triggers another huge (25-45% or more of total development cost) federal subsidy on the equity side through the 4% federal LIHTC. No other use of the state’s private activity bond volume provides this dramatic, powerful, double “bang for the buck.”

One might attempt to quantify the magnitude of the annual loss of federal subsidy from expiring bond volume as follows: A reasonable estimate is that in a typical affordable multifamily rental housing financing, the tax exempt private activity bonds might represent about 60% of total development cost, with tax credit equity and other sources providing the balance. This suggests that $60 million of private activity bond volume might be associated with roughly $100 million of affordable rental housing. If federal 4% LIHTC can be syndicated for, say, 30% of total development cost, as discussed above, then the expiration of $60 million of private activity bond volume might be associated with the loss of roughly $30 million of federal 4% LIHTC subsidy. To say the same thing a different way, for every dollar of private activity bond volume which expires unused, a potential federal housing subsidy equal to roughly half that dollar amount is lost.

Once a state’s yearly private activity bond volume has been allocated, if not used in that year, the issuers to whom the volume is allocated can file an election with the IRS to carry the volume forward for three years for use by other eligible projects of the same type, but if not used during that carry-forward period, the volume simply expires. The sad fact is that until very recently, in almost every state outside of New York and a few other states, each year, tens of millions, and in some cases hundreds of millions, of dollars of bond volume expires, which, if it could have been utilized, would have provided additional millions of federal funding for affordable rental housing.

In response to this, over the years, a number of states, like California, have increased the share of their total private activity bond volumes devoted to multifamily. In addition, many state and local housing finance agencies have adopted policies which encourage the use of this major potential federal subsidy. For example, in the last three to five years, the state housing finance agencies in California, New Jersey and other states have broadened their programs from strictly balance sheet financed products, to also serve as “conduit” issuers for financings credit enhanced by FHA/GNMA, Fannie Mae and Freddie Mac, as well as private placements of non-credit-enhanced bonds or loans with banks and other financial institutions. They have also eliminated artificial developer fee caps, detailed architectural design requirements and overly burdensome, duplicative loan underwritings to facilitate private activity bond financings and thus to prudently encourage more effective utilization of the huge, desperately needed federal subsidy represented by the 4% LIHTC.

Excess turning to shortage
The world of excess private activity bond volume is quickly becoming a thing of the past. In 2016, for the first time in almost two decades, in certain states, the demand for tax exempt multifamily housing bond volume has begun to exceed the available supply. While this has caught the industry off guard, in retrospect, this is not surprising. Just as total multifamily rental starts have more than quadrupled since the 90,000 low in 2009 to roughly 400,000 last year, the portion of those units comprising affordable apartments has probably quintupled or more. As a result, in 2016, it is believed that the demand for multifamily private activity bond volume will exceed supply, not only in New York State (where this has long been the case), but also in Massachusetts, Connecticut, New Jersey, Minnesota, Utah and possibly other states. These states have finally exhausted their three-year carryforward for multifamily private activity bond volume from earlier, low-demand years. In 2017, if the demand for affordable rental housing continues to grow, a number of additional states will join this list.

California provides a compelling, and frightening, example. In 2015, the California Debt Limitation Allocation Committee (CDLAC) allocated almost $2.9 billion to multifamily, up from $1.5 billion in 2014 – an increase of 2.5 times! –and $1.2 billion in 2013. Moreover, the 2015 allocation for single family housing revenue bonds increased almost $1.5 billion from $225 million in 2014 to $1.7 billion last year. If the remainder of 2016 and 2017 shows this type of continued strong demand, CDLAC estimates that carry-forwards may be exhausted and there could be a significant shortage of private activity bond volume, including volume for multifamily, in 2018. We appear to be quickly heading back to the 1990s, when the demand for multifamily housing bond volumes substantially exceeded the supply in many states.

A call to action
This is a wake-up call. What is needed is for the development community in states where this is now or may soon become an issue to work with the state bond volume allocator to ensure that a higher percentage of the state’s total private activity bond volume is directed to multifamily projects for 2017 and beyond. Developers should also work with the volume allocator and the issuers active in multifamily housing bond finance to reallocate any unused multifamily volume among issuers to those who will make the federal filings to preserve this increasingly scarce, valuable private activity bond volume resource for use on affordable multifamily projects in future years. In an increasing number of states, the need to devote a higher share of the state’s total private activity bond volume to multifamily projects and to preserve unused multifamily volume for 2017 and beyond is now obvious and compelling.

The time to act is now!

R. Wade Norris is a partner at Norris George & Ostrow PLLC. Mr. Norris is widely recognized as one of the country’s leading experts in the field of multifamily housing bond finance. Mr. Norris has over four decades’ experience in over 3,500 tax-exempt multifamily housing and other bond financings totaling over five billion dollars, primarily as Underwriter’s or Purchaser’s Counsel or Special Bond Matters Counsel to the Borrower. Mr. Norris has often played a major role in developing new financing techniques in this area of finance. In the past 10 years, these include development of, among other products, the Country’s largest tax-exempt bond and loan bank private placement program; short-term cash-backed tax-exempt bonds used with FHA, RD and other low-rate taxable loans; the Freddie Tax-Exempt Loan or “TEL” structure; and, most recently, Fannie Mae’s M.TEBs tax-exempt monthly MBS pass-through structure. Mr. Norris’ paper entitled “Introduction to Tax Exempt Multifamily Housing Bonds” is widely regarded as the industry’s leading introductory article on tax exempt multifamily housing bond finance. Mr. Norris is a member of the Georgia State Bar and is a member of the State Bar of Georgia, the Bar of the District of Columbia and the American College of Bond Counsel.