Frustrated Market-Rate Developers Turn to Tax-Exempt Bonds

The construction financing market has come a long way since the depths of the Great Recession, but not far enough for many market-rate developers.

Lenders continue to target only the surest bets—backing only the most well-heeled developers—and balk at almost everything else, still shell-shocked from a downturn that ravaged their balance sheets. But for all those developers struggling to attract construction capital, listen up: Sometimes serving a public purpose—even in just 20 percent of your building—can kick-start a long-delayed development.

Consider Portrero Launch, a 196-unit mixed-use development in downtown San Francisco being built by Martin Building Co. In early 2009, the developer submitted an application to the Federal Housing Administration (FHA) for a $50 million construction loan. But a year and a half later, the FHA suddenly stopped processing the application. Martin was developing another project with FHA funds—a loan that took 20 months to close—and the agency wanted to see how that project performed before approving another deal with the firm.

Frustrated, and unable to find conventional debt from banks, the developer went back to the drawing board. Though the plan all along was to build a luxury Class A deal, Martin instead applied for tax-exempt bond financing—which came with low-income housing tax credits (LIHTCs)—and easily won an allocation.

“Within 60 days, I had a loan approval from Citibank, which felt miraculous,” says Patrick McNerney, founder and president of the San Francisco–based firm. “And the reason they moved so swiftly was because it was now a tax-credit project, and the bank wanted Community Reinvestment Act [CRA] credits.”

The use of tax-exempt bonds requires the developer to set aside 20 percent of the units for those earning up to 50 percent of the area median income (AMI), while the other 80 percent remains market-rate (aka, an “80/20” deal). And while McNerney believes in the social value of mixed-income development, it wasn’t as though he was on a social mission.

“I’d love to say it was altruism,” he says, “but I was just really struggling to attract financing."

One Santa Fe
Meanwhile, downstate, in Southern California, that same struggle inspired market-rate developer Bill McGregor to pursue a similar strategy on his own long-delayed project.

In January, the McGregor Cos. broke ground on the $160 million One Santa Fe, a 438-unit mixed-use development in the arts district of downtown Los Angeles. The project was conceived seven years ago, but the recession derailed that vision and prodded the developer to use tax-exempt bonds for the first time in the company’s 25-year history.

“Securing a construction loan was proving to be somewhere between extremely difficult and impossible,” says McGregor. “As we got further downstream, it became clear that the best financing package we could put together would have affordability inherent in it.”

The developer received funds through the New Issue Bond Program, and the bonds were credit-enhanced through an $86.2 million FHA-backed loan. McGregor also received LIHTCs, which provided roughly $8 million in equity when they were purchased by Goldman Sachs Urban Investment Group. 

“It’s more complicated than the average deal, by far,” says McGregor. “But this project would not be where it is today were it not for the opportunity to put together an 80/20 deal.”

Gap Financing
McNerney’s $80.4 million Portrero Launch is set to open in September—but when it does, the affordable units will serve even lower-income tenants than the 80/20 program requires. The developer applied for a $1.4 million Infill and Infrastructure Grant through California’s Proposition 1C program, and that money only goes to affordable housing deals—the more deeply affordable, the more likely they are to win a grant.

“I volunteered to set units at 30 percent AMI so that there was a higher likelihood of getting the award,” says McNerney. “I pieced together every source possible that I could, in order to make this project move forward.”

McGregor’s One Santa Fe also found some gap financing by virtue of its affordability. The developer scored a $4 million loan from the Los Angeles Housing Department, though the financing was conditional. The loan required two-thirds of the affordable units to be targeted at those earning up to 40 percent AMI.

“That $4 million was one more piece of a complex puzzle, and the fact is, each one of those pieces in the capital stack was critical,” says McGregor. “If you pulled any of the pieces out, then the whole thing doesn’t work.”