501(c)(3) Bond Financing for Affordable Rental Housing

General:
501(c)(3) bonds are a desirable source of financing for multifamily housing, because the bonds themselves require no allocation of private activity bond volume cap or other scarce resources. The projects benefit from bond interest rates equal to or better than other tax exempt bond rates, but in lower-rent markets additional subsidies or gap financing may be needed to achieve economic viability. The interest income is tax exempt to the bond owner, and is “non-AMT” income. The lower return on the bond investment benefits the project through a lower loan rate. Other advantages of 501(c)(3) financing, compared with private activity bonds, include avoidance of the continuous rental requirements, the land and existing property limitations, and the prohibition on advance refundings. Because by definition, the owner must be a nonprofit or government entity, this financing is not compatible with Tax Credits.

This program summary is intended as a general guide to developers, to assist in the determination as to whether the 501(c)(3) bond issue is an appropriate financing vehicle for a proposed project. Additional issues will arise during the course of the transaction since all projects are different, and changes in conditions may produce new or revised requirements from those contained in this summary.

MFA will issue 501(c)(3) bonds to finance certain multifamily housing developments. This financing may be done in one of two ways:

1. As a “conduit” issuer, MFA issues the bonds used to fund the mortgage, but the credit enhancement for the bonds must be provided through other sources available to the developer of the project. Bond proceeds may be used for both construction and permanent financing, or permanent financing alone.
2. Alternatively, MFA may provide construction and permanent financing through its 542(c) loan program in conjunction with the bonds. In this case, MFA originates the permanent mortgage and obtains the permanent credit enhancement for the bonds (in the form of FHA mortgage insurance).

Project and Ownership Requirements - The following basic requirements apply:

1. Project Types:
   501(c)(3) bonds may be used to fund acquisition, new construction, rehabilitation, or refinancing of a residential rental project, as well as related costs. No minimum rehabilitation limits are imposed. Typically, projects involving fewer than 20 units are not good candidates for bond transactions because the transaction costs may be too high.
   
2. Ownership:
   The ownership of the project must reside in a government entity or a nonprofit corporation which has obtained a 501(c)(3) determination letter from the IRS. This entity will be carefully scrutinized by MFA’s bond counsel to ensure that its organizational documents, purposes, structure, and prior activities are all consistent with IRS requirements. Legal opinions from the nonprofit’s counsel will be required. If an MFA loan is provided, the entity will have to be a newly formed, single asset entity, and obtaining tax exempt status for a new nonprofit can take a long period of time.
   
3. Lease Up Requirements for Affordability:
   501(c)(3) bond projects are given a “reasonable transition period” to meet set aside requirements in the case of acquisition of tenanted projects. Typically, 12 months is allowable.
   
4. Private Inurement or Benefit:
   Management contracts must comply with applicable management contract rules relating to tax exempt government bonds. Also, the role of a private developer will be carefully scrutinized to ensure that no disallowed private benefit is involved.

Application and Processing:
Following the submission of a complete application by the developer, MFA will begin processing the request. Forms are available, and requests may be submitted at any time of year. MFA will adopt an inducement resolution, if needed, at the first or second board meeting following the submission. If all requirements are met promptly by the developer, the bond closing can occur within 60 days of the delivery of firm financing and credit enhancement commitments. The second resolution required by MFA – the bond resolution itself – cannot be passed until all credit enhancement and financing commitments are in place. The process would proceed as follows:

1. Application Submission and Application Fee Payment(s) (Bond Request and 542(c) Developer Kit Application Materials if a 542(c) loan is requested)
2. Developer/MFA Staff Meeting
3. Commitment Fee Payment, Direct Cost Deposit Payment and Inducement Resolution
4. Scoping Meeting with All Financial Interests and Counsel Represented
5. Financing and Credit Enhancement Commitments (or, for 542(c) loans, Board Approval and Loan Commitment)
6. Document Drafting
7. TEFRA Hearing
8. Bond Resolution
9. Closing

Loan Rates and Terms
When MFA is the lender using a 542(c) loan, terms will be as described elsewhere for the loan program. The loan rate is the base interest rate, and is used to determine the “all-in” rate that includes additional fees for credit enhancement, servicing, trustee fees, etc. In a conduit financing these rates and the other loan and bond terms (maturity date, call and prepayment provisions, etc.) will be based on current market conditions and negotiated by the developer, underwriter, lender and credit enhancement providers, and reviewed by MFA.

Bond Rating Requirements:
By MFA statute, ratings of A or better are required for publicly sold bond issues. Private placements must be A-rated and credit enhanced, or at MFA’s discretion, the following types of requirements may be substituted: Ownership by a single bondholder; no bond registration though Depository Trust Company; delivery of a “sophisticated investor letter” by the bond purchaser and any subsequent purchaser; and a documented prohibition against bond default. MFA’s 542(c) loans are “AAA” ratable as a result of credit enhancement through FHA/MFA mortgage insurance.

Credit Enhancement Requirements:
When a 542(c) loan is used, MFA provides credit enhancement for the construction and permanent loan periods, in the form of FHA mortgage insurance. Many other sources of credit enhancement may be proposed by the developer in a conduit financing. These include FHA mortgage insurance, FNMA securitization, and private bank letters of credit. Where letters of credit are the sole credit enhancement, the provider must be specifically approved by MFA and the minimum term would be 5 years. This requirement is to ensure that the bonds are protected during the riskiest period of the financing – construction, lease up and stabilization – to minimize refinancing and bond redemption risk. Future credit enhancement substitutions must be approved by MFA in advance of their use.

Financing Team:
MFA selects the trustee, bond counsel, and financial advisor through its own independent procedures. An investment bank may be proposed by the developer, but is subject to MFA approval and must meet MFA’s disclosure and conflict of interest provisions. Additionally, one of MFA’s banking team members must participate. The developer’s banker may select one of MFA’s banking team members, and shares and other issues may be worked out between the two.

Use Restrictions:
Use restrictions for 501(c)(3) bond issues are derived from the IRS’s nonprofit activity rules rather than from the bond rules per se. To verify the nonprofit’s eligibility for a 501(c)(3) bond issue, the housing must be used for charitable purposes, which are best demonstrated through set-asides. The IRS’s “safe harbor rule” for this determination is as follows:

1. 75% of the units must be occupied by households earning no more than 80% of median income; and
2. Either 20% of the units must be occupied by households earning no more than 50% of median income; or 40% of the units must be occupied by households earning no more than 60% of median income.

Up to 25% of the units may be offered at market rates, for tenants earning more than 80% of median income. All set-aside unit rents must be “affordable to the charitable beneficiaries”. This can usually be satisfied with “a rental policy that complies with government-imposed rental restrictions…” commonly set at 30% of the applicable income limit and adjusted for family size. This is the affordability standard that MFA will apply. Other funding sources (HOME Rental funds, for example) impose similar requirements. In 542(c) loan cases MFA might have to impose additional statutory income limits as well.

Regulatory Agreements:
The developer will enter into regulatory agreements which establish low income set-asides, reserve requirements, monitoring and compliance activities and fees, etc. Property transfers will be approved (without “deemed consent”) at MFA’s discretion based on buyer and management company experience, current fee payment status, etc. A 60-day cure period will be provided for instances of noncompliance with the terms of the regulatory agreement. Relocation plans are required where displacement is likely, and tenant income surveys may be required early on.

Fees and Expenses:
The developer will be responsible for all costs of issuance. Other direct costs of MFA, and fees will be paid as follows:

1. Application Fee due at submission of application. Ten dollars per unit, and nonrefundable.
2. Commitment Fee due prior to preparation of bond documents, in the amount of 50 basis points (0.5%) of the bond issue amount, and nonrefundable.
3. Direct Cost Deposit due prior to scoping meeting, in the amount of 50% of MFA’s Cost of Issuance. Credited against MFA’s COI and excess, if any, returned at closing. (Additional COI due to other third parties will also be the obligation of the developer.)
4. Annual Administration Fee paid with debt service, in the amount of 30 basis points per annum, in the rate.
5. Trustee Fee paid with debt service, in the amount of 3.5 basis points per annum, in the rate.
6. Transfer Fee of $5,000, plus direct cost reimbursement, due at submission of request for transfer of ownership or substitution of credit enhancement.

Additional fees must be paid for 542(c) loans, and the schedule is published separately.

Additional Financing and Subsidies:
Projects which meet the criteria of other MFA multifamily programs may be eligible for additional subsidies, including HOME-Rental (typically in the form of below market rate secondary financing), Primero Investment Fund seed money loans and/or BUILD-IT interim loan guaranties. The nonprofit ownership of the project prohibits the use of Low Income Housing Tax Credits with 501(c)(3) bonds. Further material on other programs is available from MFA.

Contact for Further Assistance:

Linda Bridge, Director of Housing Development
Mortgage Finance Authority
344 Fourth Street SW
Albuquerque, NM 87102
Phone (505) 767-2262 or, in New Mexico, 1 (800) 444-6880
Fax (505) 242-2766

Frequently asked questions