Tax-Exempt Essential Function Bonds
By Pamela Martineau
8 min read
A New Pathway to Developing Affordable Workforce Housing
Over the past three years, a new financing product has paved the way for converting privately owned apartment complexes to 100 percent public, governmental ownership with no equity contribution.
Tax-Exempt Essential Purpose Multifamily Housing Bonds, also known as Governmental Purpose Bonds, are being deployed in California and Texas to help build the stock of governmentally owned, much-needed affordable workforce housing.
Since 2019, over $8 billion of essential purpose bonds have been issued by California Joint Powers Authorities (JPAs) in over 45 deals that have created almost 14,000 units of publicly owned affordable workforce housing. Use of the bonds started later in Texas—around December 2021—with three issuances of about $200 million, creating, to date, slightly over 1,000 units in El Paso, Plano and San Antonio.
R. Wade Norris, Esq., a partner with Norris George & Ostrow PLLC, says his firm has handled about $1.5 billion of these Essential Function Bond financings with four major underwriter clients. Norris is an expert in multifamily bond financing.
“I have been doing this for over 45 years and (these bonds) are one of the most interesting developments I have seen in tax-exempt multifamily housing bonds. We almost never see 100 percent financing from the debt side that covers project costs, reserves and issuance costs in these types of financings,” Norris says.
However, Norris, like others contacted by Tax Credit Advisor, cautions that the current environment of rising interest rates makes it more difficult for the projects to pencil out.
“I think the pace of these deals will slow substantially, certainly as long as we have permanent interest rates at today’s levels or higher,” says Norris. “But some deals can still get done in the current environment. The most important point, however, is that this is a significant new category of tax-exempt multifamily bonds for financing that didn’t exist before the first deal in 2019.”
Norris and others who’ve worked to put together these deals stress that these bonds help to bolster available affordable workforce housing that is woefully lacking across the country – and particularly in high growth markets, like California and Texas.
“As long as we’ve been in the business, we’ve seen the cost of quality housing go up and up to the point that it is unsustainable and nearly impossible to produce housing affordable to middle-income tenants at 60 to 120 percent Area Median Income. These are teachers, first responders, nurses, government employees,” explains Lauren Seaver, president of Opportunity Housing Group. Opportunity Housing Group, a subsidiary of developer Blake Griggs Properties, has put together a number of these deals. “This is about 30 percent of the workforce in California. (These bonds) are a way to help solve the problem.”
How Essential Function Bonds Work
The Essential Function Bonds are issued through a Joint Powers Authority (California), housing authority or other authorized issuer of multifamily housing bonds, directly or through a controlled affiliate, to fund the acquisition of a project the issuer or its affiliate will own. Sometimes, the project needs to be built, but the bonds are typically used for existing projects. In the California market, public ownership creates an exemption from real estate taxes. As a matter of policy in California, one-third of the units are required to be rented to tenants whose incomes do not exceed 80 percent of AMI, one-third to tenants whose incomes do not exceed 100 percent of AMI and the remaining one-third to tenants whose incomes do not exceed 120 percent of AMI.
In Texas, the issuer is typically a housing authority or housing finance corporation, public facilities corporation or another controlled subsidiary. To create real estate tax relief in that state, at least 50 percent of the units must be leased to tenants with incomes not exceeding 80 percent of AMI; ten percent can be rented to market-rate tenants and the remaining 40 percent must be rented to families generally at or below 120 or 140 percent of AMI. In both states, as a matter of policy, rents are generally set about ten percent or more below current market rents.
Project Administrators Originate and Help in Closing the Deal and Administering the Project Financing
In both states, project administrators play the leading role in putting the financing plan together and administering the deals and the projects themselves. The project administrator generally locates the project, negotiates the purchase and sale agreement, puts down a one to 1.5 percent deposit, and generally helps to negotiate terms of the sale. The administrator will lose its deposit if the bond issues fail to close within the agreed-upon time frame.
As compensation, the administrator generally receives an up-front fee of one to two percent and receives a subordinate tax-exempt bond equal to five to six percent of the purchase price. They also are paid fees of about ten to 12 basis points for ongoing asset management services.
Matt Avital, principal and founder of Ascenda Capital, says his firm has served as project administrator for projects using Essential Function Bonds for workforce housing.
“We source the acquisition and put together the entire team to process these deals,” says Avital. “We take all the financial, upfront risk associated with doing these deals. We limit the risk to the government partner. When the deal closes, we stay in the project as project administrators and help in the day-to-day operations.”
Avital says his firm does the upfront due diligence as well, reviewing leases and engaging third-party engineers to inspect the properties.
“We do all the legwork on the front end and take the legwork on the back end as well,” says Avital.
Avital says the projects create a “double-ended public benefit.” They provide housing for nurses, firefighters, teachers and other essential workers, which is a public benefit. The public housing authorities also capture 100 percent of the appreciation once the bonds are paid off.
“The money they make will go right back into the community through the housing authority,” says Avital. “The housing authority makes a lot of money for the long haul.”
Seaver cautions that for developers and administrators of these deals, “The difficult part is you have to go through the city, authority or housing finance corporation approval process,” she says. “You must go to the governing bodies and that takes time. You must find a seller who is willing to give you that time to go through the approval process.”
Projects Pencil Out, Especially with Low-Interest Rates
Norris states that analyses of projects funded with Essential Function Affordable Workforce Housing Bonds indicate that the rent savings given to the middle-income tenants generally equals the real estate tax foregone, in some cases by a ratio of up to 1.5 to one. When a conservative appreciation rate of three percent per year in the value of the project is used, the ultimate appreciation in value over debt outstanding—after 15 to 20 years together with tenant rent savings—may exceed the real estate taxes foregone by a ratio of four or five to one or more.
With higher interest rates, these figures are changing. The method of financing was particularly attractive in 2020 and 2021 with interest rates as low as three percent.
“There was a tsunami of these deals in California in 2020 and 2021,” says Norris. “There were $7 billion of these bonds issued on 38 projects in California in 2021 alone.”
With higher interest rates in 2022, Norris says, “We will be lucky if we see ten to 20 percent” of last year’s volume this year.
However, despite higher interest rates, Norris says these bonds will continue to be a “significant category” of funding for affordable workforce housing projects.
“When rates come back down a bit, I think we will see these deals become even bigger,” says Norris. Another major positive development is that the tax-exempt bond funds that buy these bonds have accepted a soft principal amortization structure and rent/expense growth assumptions on these financings in high-growth markets, which substantially increases available bond proceeds. This positive development is still with us.
Seaver also says the deals have slowed in 2022 due to interest rates.
“Unfortunately, in California we haven’t been as successful in underwriting and making deals work in 2022 as we were in 2021. And that is true for our competitors,” she says. “Participants did close over $7 billion of these deals in 2021. In 2022, it is in the hundreds of millions so far because of the interest rates.”
Seaver adds that she hopes the market environment returns to a place where more of these deals can be put together.
“I see firsthand the impacts it is having,” Seaver says. “In California, the demand (for workforce affordable housing) is in the millions of units. This really is a drop in the bucket for what California needs to do to make an impact on affordability.”
