Municipal Bonds as Part of the Mid-Market Senior Housing Solution?

Summary: The cost and availability of debt plays a meaningful role in a developer’s ability to deliver a moderately priced, mid-market senior housing community. Tax-exempt municipal bonds have been suggested as a means of reducing debt service on development projects. This post provides the basics of using tax-exempt bonds for development, thanks to James Scribner of Red Capital. Tax-exempt bonds have attractive features, such as no recourse, flexible terms, and a 30-year term, but the higher interest rate—at 7 to 8 percent—makes them a better fit for a group that is unable to provide a loan guarantee.

Details: My previous posts have described the need for a mid-market solution for senior housing. (See, for example, here and here. Initial thoughts about a new approach appear here.) As a possible part of the solution, let’s consider the use of tax-exempt bonds to finance construction of assisted living communities. This ties in with the government’s policy that encourages creation of housing options for low and moderate income households. Under Section 142(d) of the Internal Revenue Code, buyers of the bonds get a fixed-income return that is exempt from state and federal taxes, and the developer/borrower has access to funds as long as 20 percent of the project’s residents earn less than the county’s median income. (This is relatively easy to accomplish with seniors.)

Key elements for a bond-funded development project include the following:

1. The site needs all zoning approvals and a feasibility study prior to being funded.
2. Bonds will be underwritten by a banker (such as Red Capital) for purchase by municipal bond investors (Fidelity, Pioneer or specialty group).
3. An experienced, connected law firm secures tax-exempt allocation and then documents the transaction.
4. The owner of the property provides annual certification that 20 percent of its residents earn less than the median income in the county.
5. The owner of the property charges what market will bear. There is no restriction on pricing.
6. The terms of the loan have flexibility and room for negotiation, but typically include the following:
   1. A 7–8 percent coupon
   2. Loan to cost of up to 75 percent on construction
   3. A 30-year term, but often the developer will negotiate a call provision that allows prepayment after a lockout period and payment of a penalty (for example, 3 percent if repaid in the third year, 2 percent in the fourth year, 1 percent in the fifth year, and 0 percent thereafter)
   4. A 30-year amortization, but sometimes interest-only for 3–5 years
   5. The borrower needs to draw the entire amount on day one, but sometimes the deal allows tranches to reflect actual timing of construction-related disbursements.
   6. The borrower needs to fund an interest reserve to cover debt service during construction and lease-up.
   7. No recourse or limited recourse, depending on borrower’s quality and track record

The process takes about 90 to 120 days to underwrite and document, and then the banker needs to market the bonds.

Advantages: The biggest plus is the access to development capital without having to provide a personal guarantee. Most developers are allergic to recourse, and many have difficulty providing a big enough balance sheet to qualify. The 30-year term provides a guaranteed, uninterrupted capital base for the project, if needed. On the other hand, once the construction and lease-up phases are complete, the loan can be repaid and cheaper permanent financing can be put in place, as long as pre-payment clauses are established. The developer can negotiate other terms as well.

Disadvantages: The 7 to 8 percent coupon is significantly greater than the pricing offered by banks that make construction loans. Banks, which require recourse to the developer’s corporate entity or personal balance sheet, usually charge a LIBOR-based floating rate that carries an all-in cost of around 4.5 percent. The borrower in a bond deal usually has to take down the full loan amount on day one and the meter begins ticking on the interest charge, although some deals have a draw schedule that softens the interest charge. The interest payment reserve will typically be about double that of a bank loan that funds over time on a draw schedule.

Also, the origination fees tend to be greater. Borrowers are advised to use an experienced, connected law firm that can secure the tax-exempt allocation, document the agreement, and write the offering memorandum. Legal fees often run a flat $400,000, regardless of the size of the bond offering, and the banker takes a fee for underwriting and marketing the bonds. Banker fees tend to be 1.25 to 1.5 percent. On a $10 million bond deal, fees total nearly 200 basis points. The fee drag reduces with a larger offering because of the denominator effect.

Concluding Remarks: The decision to use tax-exempt bonds involves trade-offs: a developer that can’t otherwise secure debt capital will be most incentivized to use this alternative. The developer will then pay a rate that is less competitive—perhaps not much less than the property’s yield on cost. A bank will be marginally faster and will likely charge lower fees, adding to the case to use bank debt. But there are few non-recourse financing options in the marketplace today, highlighting the main advantage of tax-exempt bonds.

The FHA’s 232 program is one of the non-recourse options and will be the topic of the next post.

Discussion: Have you used tax-exempt bonds? What has been your experience? Will you do it again? What other approaches work for non-recourse financing?