Breaking Ground
R. Wade Norris, Founding Partner, Norris George & Ostrow PLLC
By Darryl Hicks
15 min read
Tax-exempt bonds (TEBs) have their own special place in the financing of affordable multifamily housing, and few people understand how to structure deals that maximize their impact more so than Washington, DC attorney Wade Norris.
Since 1977, Norris has participated in thousands of multifamily housing bond and loan financings, totaling billions of dollars. He has also served as underwriters’ counsel or special disclosure counsel in a wide variety of general and revenue bond obligation financings.
More recently, Norris and his law partners served as special outside counsel to Freddie Mac in developing its tax-exempt loan or “TEL” structure and they played a key role in the development of Fannie Mae’s “M.TEB” tax-exempt MBS monthly pass-through structure and helped close the first eight transactions under this structure. Norris and his team have also played a leading role in developing and expanding tax-exempt essential function bonds for affordable workforce housing in California and introducing this structure in Texas.
Tax Credit Advisor sat down with Norris to discuss recent issues and trends in the tax-exempt bond market and where things may be headed.
Tax Credit Advisor: What high-level trends are you seeing in the TEB market that will help set up our discussion?
Wade Norris: If you look at what’s happened over the past three years, TEB rates came down dramatically, as all rates did, through the summer of 2020 and then plateaued. Taxable rates started going back up, while tax-exempt rates stayed low through the end of 2021. The reason for that was that we had huge inflows into tax-exempt municipal bond funds in 2019 through 2021. The tax-exempt municipal bond market is a $400+ billion-dollar-a-year market and the bond funds are about 29 percent of the buy side. Money was flooding into these funds at a rate of $5 to $15 billion a month more than was flowing out. That drove rates on all tax-exempt borrowings down to remarkably low levels. Yields on 35-year unrated tax-exempt essential function bonds for workforce housing in California fell to three percent in July of 2021. When you can finance anything at a three percent yield and you can acquire a project at a four percent cap rate, pretty much everything works. This was a major driver of what we, and others, have been doing in California and now in Texas with essential function bonds.
These bonds provide 100 percent of the funds needed to enable a governmental unit to acquire a conventionally financed apartment project and put it into public ownership and cover all the costs and reserves and the purchase price from bond proceeds. It’s a remarkable development. I’ve been doing this for 45-plus years and you almost never see 100 percent financing on the debt side, but we did on these financings in 2020 and 2021, because of these huge inflows. Participants in these financings executed on $7 billion worth of essential function bonds in California last year; 13,000 apartment units moved from private ownership to public ownership through this remarkably effective tax-exempt bond financing program.
The other major driver of these financings was acceptance by the bond funds of a soft principal amortization structure, where funds left over at the bottom of a deal waterfall after payments of operating expenses and interest on the bonds is used to amortize principal, but there are no serial maturities or mandatory sinking fund payments. This feature, together with the bond funds accepting assumed growth in rents and expenses at a three percent annual rate in these historically even higher growth markets, like California and Texas, dramatically expanded loan proceeds. That feature is still with us and strongly supports these deals.
That was the very unusual situation we had in 2021. What’s happened this year has been a dramatic reversal of the prior favorable interest rate trends. The base rate of interest for permanent borrowings, the 10-Year Treasury bond yield, was around 1.50 (percent) at the first part of the year and then almost doubled to about a 3.35 at the high point back in May. It’s now settled down to about a 2.80 yield. The spreads on everything trade above the 10-Year Treasury – including high-yield, unrated municipal bonds, private placements and other private activity bond (PAB) executions. When you get rising rates combined with increasing volatility, uncertainty, etc., you also get increases in spreads, which further raised borrowing rates this spring. In late May, if you tried to do a high-yield, essential function bond for workforce housing in California or Texas, our yield might have been, not a three percent from last summer, but a 5.50 to 5.75, almost double. That shrinks proceeds dramatically, the same way it expanded proceeds when rates were going down.
Why this almost doubling of yields? In the first four to six months of 2022, we saw dramatic outflows from municipal bond funds. As good as those inflows were in 2019, 2020 and 2021, the spring of 2022 saw weekly outflows of $2 billion, $3 billion up to a maximum of $6 billion. This spring, a lot of things slowed, even on 100 percent affordable private-activity multifamily bond deals with four percent Low Income Housing Tax Credits. Some deals dropped out. Other deals were stretched out trying to get more subordinate funds to fill gaps that had been created because loan proceeds had shrunk and tax credit equity pricing wasn’t quite as good. The pace of high-yield essential function bond issues for workforce housing slowed even more dramatically from 2021.
In July, we finally saw some inflows again. If we can get the 10-Year to stabilize around three percent, which it now seems to be doing, then we should see more inflows and more volume as we approach the end of the year. On 100 percent affordable private-activity bond deals, we’re still doing a decent fraction of what we were doing last year. A lot of governmental units are contributing more subordinate funding to make deals work. The need for rental housing is huge and has only gotten worse over the last three to five years. If we can get rates to stabilize, we may see an increase in activity on all deal types this fall. A lot will depend on interest rates.
TCA: Your law firm specializes in TEB transactions. What types of affordable housing projects are best suited for TEB financing?
WN: Previously, we could do large partially affordable “mixed-income” projects in big cities with 20 percent of the units at 50 percent Area Median Income (AMI) and the rest at market rate. That’s when states were not volume constrained, so that is pretty much out right now because the 20 or so higher-growth, volume-starved states are not going to allocate significant PAB volume to the market-rate units. So, basically, you’re probably looking at 100 percent affordable at 60 percent of AMI or below, or if we get income averaging regulations that work, we can go above and below that a little bit, but basically the market now is for 100 percent affordable deals at the 60 percent level.
What’s very important for developers to keep in mind is that in a volume-constrained state, you have to look very hard early on at the allocation system and how your project will score. If you’re in California, it strongly favors new construction, but after that, there’s a scoring system and affordability is a big part of it. Texas has a lottery system with “priorities” that are tied to affordability targets, and if you don’t have a lower lottery number and if you’re not in “priority one” in Texas you probably won’t get PAB volume in 2022. Very early on, you have to look at the multifamily volume situation in your state, how affordable is your project, how will it score and whatever processes the state has for allocating multifamily housing bond volume. If you don’t think you’re going to qualify, you may be looking at converting it to a conventional project of some sort.
TCA: What are the most effective strategies affordable housing practitioners should use to meet the 50 percent test in a rising rate environment?
WN: First of all, you need to assess your costs very carefully in a rising cost environment to make sure that when you file your application for PAB volume, you are applying for enough. If you apply for X amount, and your cost structure goes up, now that’s not enough to get you to the 53 percent or 54 percent of eligible basis for your buildings and land to trigger the 50 percent test and be eligible for your four percent tax credits. If you try to address that too late in the game it’s a big problem. The most important thing on satisfying the 50 percent test is to focus on your cost structure early on, maybe building a little cushion. If you put too much fluff in there, the volume allocator will reject it, but give yourself a little margin. There are a lot of ways of satisfying the 50 percent test if the permanent period tax-exempt debt is too small. We can use tax-exempt seller take back notes, tax-exempt tax credit equity-backed subordinate bonds and on Fannie Mae Forwards M.TEBs, a short-term tax-exempt “cash backed” series sold under the same Official Statement as the long-term M.TEB bonds.
TCA: You mentioned that you’ve seen a resurgence in 501(c)(3) TEB deals this year. Can you remind our readers how those work?
WN: This really goes back two or three years, as states became oversubscribed, developers looked for other ways to get projects done. It can be an acquisition/rehab situation, even new construction, but if you don’t have PAB volume is there a way you can make it work with a 501(c)3 bond financing? With multifamily tax-exempt bonds, there are three major categories. In each case, the issuer of the debt must be a state or a political subdivision. The first huge category is PABs where the owner is a profit-motivated sponsor usually with four percent LIHTC (Section 142(d)). On the other extreme, there are essential function bonds where the owner of the project will be a state or a political subdivision of a state. The middle category is under Section 145 of the [IRS] Code, which allows a state or political subdivision to issue tax-exempt bonds and loan the proceeds to a Section 501(c)(3) corporation owner that has certain types of charitable missions, including “relief of the poor and distressed.”
There’s a safe harbor for these financings, that generally requires the Section 501(c)(3) borrower to target either 20 percent of the units at 50 percent AMI or 40 percent at 60 percent AMI. Twenty-five percent can be market-rate and in-between units must be targeted to people at 80 percent AMI or below. The “good news” is there’s no PAB volume allocation requirement on these types of financings. The “bad news” is that the financing will not qualify for four percent tax credits, so suddenly we’ve lost what would normally be 40 percent of our funding. Oftentimes, on Section 501(c)(3) financings, there may be multiple layers of subordinate debt. It works better on projects that are being transferred to a Section 501(c)(3) that will do a certain amount of rehab, but we also see these financings on new construction projects with well-capitalized Section 501(c)(3) borrowers who can provide construction and rent-up guaranties.
TCA: One piece of advice that you gave during the National Housing & Rehabilitation Association’s 2022 Summer Institute was if your deals work today, go ahead and lock them. Please elaborate.
WN: This is not a time to be experimenting with something that is new and untested or unproven. We may be in a more volatile environment right now than we’ve been in for decades. If you look at what’s happened with the run up in rates, inflationary pressures, the war in Ukraine, the potential threat of war in the Far East over Taiwan, there’s a huge amount of uncertainty and potential volatility in the financial markets, on the debt side, including municipal bonds. It affects everything, including the tax credit equity side.
There seems to be two schools of thought on interest rates. The first, reflected in the futures markets and supported by savvy analysts, such as Alpine Micro, thinks the 10-Year Treasury has plateaued around three percent, that inflation will abate as it seems to be doing now. Yes, the short side of the yield curve will go up, but it will come back down. Yes, we’re probably in a recession, but that will probably become more clear. The Fed will halt raising interest rates and we can soldier through this, no major problem, over in six months to a year.
In the other school, are other respected economists, such as Laurence Summers and Chris Thornberg of Beacon Economics, a brilliant young economist who spoke at a conference I attended in May. He explained that in 2020, we had a $21 trillion dollar economy. The pandemic decreased GDP by $1.5 trillion. What did we do in response? We threw fiscal stimulus at it. It’s good that we did it early, because that saved us from having another 2008 crisis. But we kept doing it. We threw $7 trillion of fiscal stimulus at a $1.5 trillion problem and oh, by the way, we ballooned our balance sheet another $5 trillion. So we threw $12 trillion at a $1.5 trillion problem. No wonder inflation is up, no wonder there’s more demand than there is supply for goods, labor, you name it. You think that’s going to resolve itself in six months? This school of thought does not think so. Will it take a Paul Volcker-type response like what we saw from October ‘79 to August of ’82? Maybe something in that direction. But this is going to take a year or more. It won’t be over in six months, and it will get worse.
I don’t think anyone really knows which of these views is correct, or where the truth lies in between. But in this kind of environment, if your project pencils, if you can get the PAB volume (if required) and make it work, the last thing you want is to do anything that is going to delay you getting through to the closing table. Costs may still be rising and rates could go back up dramatically and suddenly your deal doesn’t work. Work with proven partners, work with proven structures, and get your deal closed in a timely manner.
TCA: Given these marketplace challenges are you seeing a greater willingness on the part of lenders to be innovative with their products and terms to help make deals work?
WN: Everyone is trying to do what they can to make deals work. For very strong projects with strong developers and strong markets there’s even been some discussion about a 45-year loan amortization. I don’t think we’ve seen a lot of that yet, but when we moved from 35 to 40 years several years ago, we picked up five points on loan proceeds. There are some IO (interest-only) products out now. That tends to raise the borrowing rate, but they can raise proceeds. There is some willingness on stabilized projects to do interest-only for a longer period of time, maybe three to five years, not just during the construction period or pre-conversion phase. We’re seeing more structures, for example, in private placements, where we’ll have two different lenders come into the deal. There may be one bank that loves to do the pre-conversion loan and the four percent tax credit equity, but they don’t particularly want to be involved in the perm loan phase; whereas another bank may prefer the perm phase. All of the players in these deals are doing a lot of things to make deals work, which is why we’ve seen the volume that we’ve continued to see this spring, notwithstanding the continued rise in costs and the huge runup in rates.
TCA: Where do you see the TEB market in six months? In 12 months?
WN: If the more benign interest rate scenario described above turns out to be a better description of where we are in six to 12 months—not the Volcker scenario—we will obviously be much better off. The unsatisfied critical demand for affordable rental housing in the United States is there and it’s getting worse every day. All the players—governmental, private, etc.—are going to do everything possible to come up with ways to address that. Look at this situation in California with the 2021 explosion in tax-exempt essential function workforce housing bonds. It’s a creative, innovative structure that produced a whole new category of financing. There’s been no major program for people at 80, 100, 120 percent of AMI in decades and suddenly you’ve got a new program that produced an amount equal to over 30 percent of the nation’s multifamily PAB volume for that new category of tenants in one year. We are not going to see the level of activity in 2022 and 2023 that we saw in 2021. But we can still see a robust level of activity similar to what we saw in 2018, 2019 and even 2020, which were solid years of production in affordable multifamily rental housing. It’s simply too hard to predict exactly how the next year will unfold in today’s volatile world, which is why we should stay focused on moving to the closing table!
