CHICAGO -- An Illinois housing authority has found a way to cope with the Tax Reform Act of 1986.

When tax reform and the sbusequent passage of the federal tax credit program placed tighter restrictions on the use of tax-exempt bonds for multifamily housing developments, state housing agencies throughout the nation saw the demand for tax-exempt financing drop dramatically.

Glenn Petherick, a spokesman for the National Council of State Housing Agencies, said there has been a significant downturn in state issuance of multifamily bonds since 1986, "and we haven't seen a pickup."

The story was the same in Illinois, where the Housing Development Authority found tax-exempt financing no longer worked for developers. Still, there was a need for affordable multifamily housing. A recent study by the University of Illinois found that 45% of all rental households in the state spend more than 30% of their income on housing.

"Thirty percent defines the threshold for affordability," said Ed Solan, manager of the authority's multifamily program operations. "There is definitely a shortage of affordable housing in the state."

Meanwhile, developers had already been considering the use of taxable debt because the federal tax credits program afforded a 9% credit to developers using taxable financing, compared with 4% for tax-exempt financing, he said.

Mr. Solan said that and the federal restrictions on tax-exempts led the authority to "give serious thought to developing a taxable mortgage finance program."

The Solution

What the agency devised after more than two years of searching was a taxable commercial paper program for construction and permanent loan financing of multifamily developments. The new program allows developers to avoid some of the federal restrictions while enjoying lower-interest rate financing, authority officials said.

By using a taxable security, developers would no longer have to meet the 1986 act's set-aside requirements -- that is, keeping 20% of the units for households at or below 50% of the area's median income, or else 40% of the units for households at or below 60% of the median income.

Under the agency's commercial paper program, developers would have to meet the state's requirement, which is the same as the federal requirement before 1986 -- 20% of the units for households at or below 80% of median income.

Mr. Solan said that requirement allows developers to charge higher rents than under the federal requirements, making multifamily projects feasible. Developers would not consider doing projects if they had to provide rent subsidies to the extent called for under the federal tax-exempt requirements, he said.

The taxable security also frees the authority's multifamily housing program from competing for room under the state's private-activity cap with single-family housing programs and other private uses of tax-exempt financing.

As for the federal tax credits, developers would still have to adhere to the federal government's income requirements to receive the 9% credit afforded to developments financed with taxable debt, Mr. Solan said.

"What led up to commercial paper was the possibility of accessing the lower end of the interest rate curve," he said.

The Problems

But problems still remained.

Bob Kugel, the auhtority's chief financial officer, said that because the commercial paper market only goes out 270 days, the authority would have to roll the paper over continuously to meet its loan threshold of 10 years.

"The problem we had was that commercial paper is a short-term obligation subject to fluctuations" of interest rates, Mr. Solan explained. "It's hard to make a long-term, fixed-rate mortgage based on a short-term, variable-rate security. What we had to look at was ways to reduce some of the interest rate risk of the program."

Mr. Kugel said they decided to hedge interest rate risk by using an interest rate floor, cap, or swap arrangement. He said the particular hedging instrument and how it was used depended on the specific loan financing.

So far, the authority has completed two commercial paper deals. One was a $3.2 million mortgage loan for an elderly development in McHenry County in January that incorporated an interest rate cap. The second, completed this month, was a $5.1 million loan for a 96-unit multifamily development in DuPage County that incorporated the use of a swap to a fixed interest rate, Mr. Solan said.

Through the use of the hedding vehicles, Mr. Solan said the authority is able to offer developers "a narrowly defined interest rate window."

Merrill Lynch helped the Illinois agency formulate the program and also acted as the paper's marketing agent, placing the paper through its commercial paper desk. However, Merrill Lynch officials referred all questions on the program to authority officials.

Under the Illinois program, multifamily housing developers can obtain a minimum $5 million, maximum $15 million, interest-only 10-year loan. During construction, the interest rate on the loan is 250 basis points above the commercial paper rate and will fall to 100 basis points above the rate after construction. Earlier this month, the commercial paper rate on the authority's first issue was around 5.7% range, according Mr. Kugel.

"When the loan is up, [the developer] pays off the entire loan principal and any accrued interest," Mr. Solan said.

The authority also obtained a Fuji Bank letter of credit to back the commercial paper issues. Mr. Kugel pointed out that the letter of credit allowed the authority to sell the paper off of the bank's rating of Al-plus from Standard & Poor's Corp. In addition, he said, the letter of credit is direct pay, meaning the purchasers of the paper will look to the bank for payment.

To Fuji Bank, the authority has pledged its general obligation in addition to a pledge of the mortgages financed under the program, Mr. Solan said.

The authority's board has authorized $50 million of commercial paper issuance over a two-year period that began last January. Mr. Solan said developers for 10 multifamily projects to be located throughout the state were already "in the pipeline" to use the remaining authorization. He added that Fuji Bank has agreed to provide credit enhancement for the entire $50 million of paper issuance.

As for the developers, Mr. Solan said they like the fact there is no amortization, as well as the flexibility of the program and the ability to access interest rates "at the lower end of the interest rate curve."

He added that the use of commercial paper was included in the authority's governing legislation, which allows for the issuance of notes, as well as bonds.

Mr. Petherick said the national housing agency council was not aware of any other commercial paper programs for multifamily housing. He pointed out that other housing agencies have issued taxable bonds. For example, council statistics show that out of the 76 multifamily bond issues totaling $1.1 billion sold in 1990, 16 issues totaling $48.6 million were composed of taxable bonds.

The Illinois program "sounds like an innovative way to reduce debt service costs for multifamily housing," Mr. Petherick said. "It's a good approach that may be replicated in other states."

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