CDFA Spotlight: Bond Financing for Not-for-Profit Projects By Stan Provus

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This article, written by Bill Brice, covers the use of 501(c)(3) bonds. Bill indicates, “IDBs have largely been used by those seeking to fund larger owner/user commercial properties used in manufacturing. Now however, because of legislative changes, this kind of financing has been made available to not-for-profit corporations.” Bill is a former CDFA board member and formerly the Finance Project Manager for the Phoenix Industrial Development Authority.

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In the world of commercial real estate financing, IDA is an acronym for Industrial Development Authority. Historically, IDAs have offered a very attractive method of financing, called Industrial Development Bonds or IDBs, which have largely been used by those seeking to fund larger owner/user commercial properties used in manufacturing. Now however, because of legislative changes, this kind of financing has been made available to not-for-profit corporations, specifically those determined by the Internal Revenue Service to be a charitable organization within the meaning of IRS Code Section 501 (c)(3), or a Charitable Corporation.

The chief benefit of such bond financing to a Charitable Corporation is that the borrowing is at a substantially reduced cost. This is because the purchasers of such tax-exempt bonds will accept a lower interest rate than would be demanded on a borrowing where the interest income earned is subject to federal and state income tax. Indeed, the interest rate on an IDA financing may be 20-30% lower than on a taxable financing, depending on market conditions, terms of the financing and other factors. And while the major consideration as affects IDA financing is the tax-exempt nature of the interest revenue earned on the bonds by the bondholder, this is not the only attraction. The term of the bond financing may stretch as long as 40 years in some cases, significantly reducing the cash flow requirements to service the debt. And if these factors weren’t enough, bond financing is eligible to be used for 100% of the project costs.

In contrast to the bond applicant who is a manufacturer, the Charitable Corporation is not constrained by the rationing of bond financing dollars based on the per capita formula used in all states. Bonds for manufacturing projects and a number of other types of private activity bonds are subject to dollar limits imposed by Congress on how much of this type of money shall be made available in each state based on a specified formula. That formula currently assigns each state an annual ceiling on tax-exempt private activity bond financing of $75 per capita. This allocation is referred to as “volume cap” and every manufacturing project is subject to the volume cap made available for such projects in each state. An attractive feature of using tax-exempt bonds to finance charitable corporations is that these projects are not subject to the volume cap ceilings and can be processed in a timely fashion without regard to the delays as may be encountered in obtaining volume cap.

Some (not all) of the general requirements that apply to 501(c)(3) bonds include the following: (a) the property financed must be owned by the Charitable Corporation or a governmental unit, (b) the bonds may be used to acquire existing facilities, and do not require substantial rehabilitation to be accomplished, (c) the bond proceeds must be used substantially in furtherance of the charitable purpose of the Corporation and not in an unrelated business activity and (d) use of the project is confined to the Charitable Corporation or a governmental entity. The permission that use and ownership of the project may reside in a governmental entity is noteworthy, because here in Arizona we have seen multi-million dollar projects for the construction of new buildings to be occupied by state administrative agencies financed by use of this type of Industrial Development bond. These projects fall under the category of lessening the burdens of government, another permitted category of use. We have also seen this kind of financing provide funds for YMCA improvements and expansion and the enlargement of a nature museum in Phoenix. It is also a permitted use to finance residential rental property for family units as long as this activity is in furtherance of the exempt, or charitable, purposes of the Charitable Corporation. The same can apply to low-income housing with some additional qualifiers.

With these considerations in mind then, what are some of the advantages and disadvantages of tax exempt IDB financing?

Advantages

Lower Interest Rate. I have already cited the lower interest rate. This rate may be 20-35% lower than the rate on a regular commercial loan. The difference between the prime commercial rate and the typical IDB rate is naturally greater with a higher prime. However, even at today’s low commercial rates, not every applicant can expect to receive a prime rate loan. So a worthwhile rate savings may very well still exist. To illustrate, if a company or not-for-profit could qualify for a conventional (taxable) loan at an interest rate of 7% today, that company could conceivably borrow through an IDB at perhaps 4%. Depending on the size of the borrowing and other factors, clearly an IDB can result in very substantial interest savings.

100% Financing. Another benefit of IDB financing is that as much as 100% of the project costs may be financed. Usually with conventional taxable commercial borrowing, the applicant is expected to have an equity or cash injection into the project. Through IDB financing, additional monies can be made available that enable the borrower to use its equity for working capital or other needs.

Long Term Maturity. The maturity of the typical real estate related IDB will run 20 to 25 years, with no call or balloon. The term could range out to 40 years. This relieves the borrower of having to contend with a balloon in 7 or 10 years and the attendant costs and uncertainty of arranging alternate financing or facing a rate increase with the existing lender. And the costs involved in finding replacement financing are identical to those of new financing, which can be substantial (new appraisal, environmental, title, etc.).

Disadvantages

Processing Time. There are several parties to every IDB issue, and the actions of the various parties takes time. Probably at a minimum, there will be the borrower, the authority, the bond purchaser and legal counsels retained by each of these three parties. So you likely will have some six parties to the transaction. Moreover, the transaction may also have to be approved by a state agency as well. This process translates to a longer period of time to complete the transaction and the borrower needs to be aware of this. In every case however, the borrower should obtain a preliminary approval (i.e. Official Action or Inducement Resolution) from the appropriate authority before paying any costs of the project to be financed.

Issuing Costs. The IRS Tax Code limits the costs of issuance of the IDB that may be financed with IDB proceeds to no more than 2% of the proceeds of the IDB. The borrower must pay costs in excess of this amount from other sources. Roughly, issuing costs can range upwards of 3% of the financing or more, obviously depending on how complicated the transaction is. These costs are mostly the necessary administrative and legal expenses. Figuring out the relative cost advantage or disadvantage of using IDBs for a given project is akin to figuring the relative savings on any residential mortgage refinance. In other words, the borrower, or you acting on behalf of the borrower, determine what the issuing costs are compared to the costs involved in non-IDB financing. The difference in costs must then be compared with the interest savings to be realized. And how long it will take for the borrower to recover the added bond issue expenses through the lower monthly payment on the bond financing. It usually starts to make economic sense to consider IDB financing for projects of upwards of $1 million. And IDBs can be used to obtain as much as $10 million or more for any particular project depending on the type of private activity bond and other factors, so clearly it is the larger projects that most benefit from this program.

The author wishes to thank Messrs. Bob Olson and Chuck James, bond attorneys with the firm of Squire, Sanders & Dempsey; a law firm of international scope that offers expertise in handling bond financing transactions. Also Mr. Bryant Barber and Ms. Maria Spelleri, attorneys with the law firm of Lewis and Roca in Phoenix, Tucson and Las Vegas.

This article is intended to provide accurate and authoritative information in regard to the subject matter covered. The author and CDFA are not herein engaged in rendering legal, accounting or other professional services, nor does it intend that the material included herein be relied upon to the exclusion of outside counsel. CDFA is not responsible for the accuracy of the information provided in this fact sheet. The information provided has been collected from a variety of sources. Those seeking to conduct complex financial deals using the tools mentioned in this document are encouraged to seek the advice of a skilled legal/consulting professional.