CASE STUDY Hedging Variable-Rate Loan Over Tax Credit Period Challenges Brooklyn Project

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Tax Credit Advisor April, 2006: Tax-credit developers are realizing that using variable-rate debt can yield big savings, particularly during the construction period. But they are also learning that these loans demand very careful handling when extended over the entire compliance period.

An instructive example is State Renaissance Court, a $48 million mixed-income rental project now being co-developed in Brooklyn by Strategic Development and Construction Group and IBEC Building Corporation.

Hesky Brahimy, a principal at IBEC, said that a little over a year into the project’s construction period, variable-rate debt has reaped impressive savings on debt service costs. He estimates that there would have been an additional $800,000 in interest expense had the project been funded with a fixed-rate loan. On the other hand, he said, it has already cost almost $1 million to set up a hedge that will cover the interest rate risk of the loan over the 15-year tax-credit compliance period. Still, Brahimy is convinced that variable-rate loans, also known as floaters, pay off.

“Trying to pull off a rental project like this is a big feat in New York City,” he said. “The key is cost control, and I think that the use of floaters be will instrumental in keeping our financing costs down over the long haul.”

Defining the Project

IBEC and Strategic Construction, both experienced tax-credit developers, have worked together on a number of projects. The genesis of the State Renaissance Court project was a 2001 Request for Proposals from the Empire State Development Corporation (ESD), New York State’s lead economic development agency. ESD was seeking a developer for a vacant lot it owned over a subway station in Boerum Hill, a neighborhood just south of Brooklyn’s downtown. Under its “Urban Renewal” guidelines, ESD required that at least 27 percent of rental units built on the site be reserved for low- and moderate-income households.

The developers responded to the RFP, proposing an ambitious two-phase project, and offering to pay $3.5 million for the site. Phase I would satisfy the ESD’s Urban Renewal requirements, combining affordable, market-rate rentals, and retail space. Phase II will provide 14 two-family market rate condominiums, to be built after completion of the Phase I project.

Phase II development costs are expected to add another $15 million to the total cost of the project. Construction is expected to begin in July 2007 and be completed in July 2008. Financing details are still being worked out.

Choosing Variable-Rate Debt

As the scope of the Phase I was being refined, the developers studied different financing scenarios. They knew that any funding plan would likely include a request to New York City’s Housing Development Corporation (HDC) for Low Income Housing Tax Credits (LIHTCs) and a substantial amount of debt.

At first, the developers considered taxable fixed-rate bond financing from HDC, given the convergence of long-term taxable and tax-exempt interest rates at the time, and the lesser issuance costs of taxables. But it quickly became apparent that HDC’s Mixed Income Program, which combines tax-exempt bond funding with 4 percent LIHTCs, was a better approach, said Brahimy. The Program required that at least 20 percent of apartment units be reserved for low-income families (earning up to 60 percent of AMI), 30 percent for middle-income families (earning up to 200 percent of AMI), and 50 percent at market-rate. The Mixed Income Program also offered low-interest-rate soft second mortgages through HDC’s New Housing Opportunities (New HOP) Program, which targets middle-income families.

By late 2004, the developers had decided to build a 158-unit apartment complex located in two connected buildings, one with eight floors and the other seven. The complex would provide for a broad mix of renters: 30 percent, or 47, of the renters would be low-income; 20 percent, or 32, would be middle-income, and 50 percent, or 79, would be market rate. HDC had agreed to take on the project under its Mixed Income Program, permitting a 20 percent level of middle-income renters rather than the stipulated 30 percent. Retail space totaling 17,000 square feet would be provided on the ground floor, with a private indoor parking garage located in the rear.

At this point, the developers were also tallying the large potential cost savings of using tax-exempt floaters. When they purchased the site in early 2002, the difference between interest rates on variable- and fixed-rate tax-exempts was over 400 basis points, with the floaters at about 1.3 percent and long-term tax-exempts at 5.5 percent. On a $30 million loan, a 400 basis point differential generates annual savings of $1.2 million

But the developers also realized that these borrowings could backfire if rates turn up. With this in mind, two alternative approaches to managing, or “hedging,” interest rate risk were considered. The team first examined the safer of the two hedging techniques, a swap, which completely eliminates this risk by exchanging the loan payment stream of a variable-rate borrower with that of a fixed-rate borrower. Eventually, it decided on a cap, the second and less expensive approach. Caps set an interest rate ceiling, or “strike price” on floaters, reducing risk, but not eliminating it.

Bond Details

As planning for the bond deal evolved, the developers needed to resolve many issues. HDC required that the bonds be credit-enhanced by Fannie Mae, Freddie Mac or a financial institution with similar bond ratings. Although HDC would be the issuer, the underwriting of the first mortgage was driven by the requirements of the credit enhancer, Brahimy explained. After American Property Financing, a New York City-based mortgage banker, was chosen as the delegated underwriter/servicer (DUS), Freddie Mac was tapped as the credit enhancer.

The bond issue would provide debt financing during both the construction period and the 15-year tax-credit compliance period. During construction, Freddie Mac would charge an annual credit enhancement fee of 45 basis points, while Citibank would provide a Letter of Credit (LOC) costing 105 basis points a year. After conversion, Freddie Mac’s credit enhancement fee would increase to 105 basis points and the LOC would no longer be required.

As the bond closing approached, the developers also wrestled with the issue of how long the cap should be in place. Freddie Mac required only a five-year cap, with the strike price set at 5.50 percent. However, WNC & Associates, Inc., the project’s tax credit syndicator, asked for a 15-year hedge covering the full tax-credit compliance period.

Working with CDR Financial Products, an investment bank headquartered in Beverly Hills, Calif., the developers were able to work out a compromise with WNC, said Brahimy. After negotiations, the syndicator agreed to accept a forward 10-year cap that would be purchased when HDC issued the bonds in December 2004 – but would not go into effect to provide interest rate protection until after lease-up and the beginning of the tax-credit compliance period. The developers also compromised, agreeing to begin accumulating an escrow at the beginning of the tax credit compliance period to provide for a successor cap in the final five years. With the initial cap set to last for 10 years rather than five, Freddie Mac accepted a renegotiated cap strike price of 5.89 percent.

CDR also helped finance the hefty upfront expense of the 10-year cap. Priced at 254 basis points and applied to the $35.2 million HDC loan, it cost $894,000. The investment bank provided a loan for 60 percent of the price of the 10-year cap, with the developer covering 40 percent. The loan is being repaid during the two-year construction period in monthly payments, with a final payment just prior to conversion, said CDR Senior Vice President Tammy Ofek

“Financing a cap is a first for us, but we felt this was a very good project,” she said.

The Completed Financing

Altogether, the developers’ financing package for Phase I totaled $48.2 million, said Brahimy. In addition to the $35.2 million floater, HDC provided another loan to the developers, a $3.5 million low-interest-rate second mortgage offered through its New Housing Opportunities (New HOP) Program. New HOP loans, taxable borrowings up to 30 years in maturity, are offered at a 1 percent interest rate. In addition, a total of $4.9 million in tax credit equity from 4 percent LIHTCs was syndicated by WNC. The remaining $4.6 million was developer’s equity.

Brahimy said that in the 14 months since HDC’s bond issue, the decision not to hedge the floaters during the construction period has paid off. He calculates that floaters have resulted in about $600,000 in average annual interest rate savings, based on the difference between the interest rate paid on the floater plus its special fees, and the interest rate and fees that would have been incurred had the bonds carried a fixed rate.

At the time of HDC’s bond issuance for the project in December 2004, the tax-exempt floater rate was 1.75 percent. With 128 basis points in fees added on – 75 basis points for the Citibank LOC, 45 basis points for the Freddie Mac credit enhancement, and 8 basis points for weekly remarketing of the bonds – interest costs for the floater totaled 3.03 percent. By comparison, long-term tax-exempt multifamily revenue bonds carried an interest rate of about 5.2 percent, to which about 100 basis points in fees are added, for a total interest cost of approximately 6.2 percent. The difference between these two final interest costs, said Brahimy, generated an impressive yield differential of about 320 basis points.

He noted that floater rates have gone up about 150 basis points since the HDC bonds were issued, from about 1.75 percent at the end of 2004 to about 3.25 percent in March 2006. This means that there is still another 150 basis point all-in differential between floater rates and what a fixed-rate borrowing in December 2004 would have cost.

Economists say that with the Federal Reserve Board near the end of its increases in short-term rates, floater rates are likely to level off, remaining well below the level of longterm fixed rates when the HDC issue the came to market. “My guess is that we will recoup all our costs in about five years, and there will be good savings from then on,” said Brahimy.