Defaults are rising on highly leveraged workforce housing debt

One tool aimed at helping to solve California’s notorious affordable housing crisis appears to be headed for a crisis of its own.

Defaults are rising on highly leveraged unrated workforce housing bonds, primarily issued over the last few years in California to purchase apartment buildings, when interest rates were near zero.

So far, six out of roughly 45 projects have already entered Municipal Market Analytics default and impairment database for drawing on reserves funded with bond proceeds, said Lisa Washburn, MMA’s chief credit officer and managing director.

Up to $10 billion in debt of this kind, targeting housing for middle-class workers earning 80% to 120% of area median income was issued primarily from 2020 to 2022, Washburn said.

“It was done during the COVID-19 period when interest rates were near zero,” Washburn said. “Then as interest rates rose, they used even more creative structures, like capital appreciation bonds.”

The bonds had debt service funds, but they borrowed for coverage, debt service reserves, capitalized interest and upfront professional fees. Most, if not all, of the transactions borrowed the full amount to acquire the properties, plus another 15%, on average, to fill up various indenture funds, pay upfront fees to related parties, and fund the costs of issuance, she said.

“It was a very leveraged, and a very expensive, type of financing,” Washburn said.

The structure was primarily used to acquire existing multifamily housing properties and then convert them to affordable housing. The properties purchased are owned by a joint powers authority involving the local government and the conduit. The majority of the debt tracked by MMA was issued by the California Community Housing Agency, California Statewide Communities Development Authority and the California Municipal Finance Authority.

“Between 2018 and 2022, we saw a lot of JPA issuance of highly leveraged, unrated bonds,” said Erwin Tam, director of financing for California Housing Finance Agency. “With [interest] rates running up from 2022 until now, it has become a lot less feasible for them to get done. That is why you have seen the volume drop off.”

CalHFA wasn’t involved in any of those deals, though they did contemplate using the JPA structure — where they would be part owner of the property, like the private conduits on these deals — last March said Tam, who presented a report to the CalHFA board.

“If we were an owner-operator [that structure of 100% debt financing] would fit within the parameters of CalHFA’s AA-rated indenture,” he said.

At the same time, in addition to the risk to investors, loading the properties with debt puts them in jeopardy of having to raise rents, which would violate agreements with the cities that rents remain affordable.

If CalHFA were to go down use that structure, the projects would need to sustainably fulfilling the need for more affordable housing, Tam said.

CalHFA moderate income housing by state law has to include 10% at 50% area median income (AMI) and 10% at 80% AMI, with the remaining 80% between 90% and 120% of AMI, Tam said, which means some of its projects need to be focused on those with lower incomes. The highly leveraged bonds support projects that are 80% to 120% of area median income, which is considered moderate income. In Los Angeles County, the area median income is $98,200 and in San Francisco County it is $175,000, according to a June 2023 California Department of Housing and Community Development (HCD) report.

“What is being called workforce housing [where the highly leveraged bonds are concerned] is not in the traditional fold of low interest tax credits providing equity,” said Monika Suarez, managing director of the Municipal Finance, Nonprofit Finance and Affordable Housing Investments groups at Western Alliance Bank. “This was a new kind of financing where developers and municipalities were responding to the fact that the demand for affordable housing exceeds what can be financed through low interest tax credits and municipal bonds.”

Lawmakers have been on a several-year tear to try to alleviate the state’s dual housing and homelessness crises. Cities and the state have approved multiple billions in bonds to support various efforts to create more housing across the income spectrum.

To satisfy pent-up demand, the state will need an estimated 1.8 million new homes by 2025, and yet on average, only 80,000 new homes are built per year, according to the HCD. The majority of California renters — more than 3 million households — pay more than 30% of their income toward rent, and nearly one-third — more than 1.5 million households — pay more than 50% of their income toward rent, according to HCD.

The demand for low-interest tax credits by affordable housing developers has exceeded what is available under the volume cap for private– activity bonds for the past several years. It’s also usually housing for those with 30% to 50% of AMI that qualifies for tax credits, not those in the 80% to 120% range, which is funded by these bonds, Suarez said.

The only public subsidy for those highly leveraged deals was a property tax abatement, Suarez said.

“So, from a commercial bank perspective there is not a lot of equity, they are highly leveraged, they involve a lot of debt compared to equity,” Suarez said. “And that is the challenge in getting them done through commercial bank direct lending.”

 The six projects that have drawn on their coverage reserves (assuming that they all exhausted their capitalized interest accounts first) are: CCHA’s Serenity at Larkspur, Annadel Apartments, Twin Creeks Apartments and Mira Vista Hills Apartments; CSCDA’s community improvement authority’s Westgate Phase 1, Pasadena social bonds and community improvement authority, Oceanaire-Long Beach social bonds.

MMA advised investors who are holding the debt or who considering buying it to “monitor the balances of the supplemental funds available to make interest payments and maintain coverage covenants, not to mention the effects of the changes in the California real estate market, general market conditions and a hypothetical loss of the property tax exemption (if interested buyers aren’t entitled to the exemption) could have on the refinancing/repayment of the bonds.”

For investors, the bonds’ price can be tempting, especially on the secondary market, where they often come with deep discounts, said John Miller, chief investment officer and head of the High Yield Municipal Credit Team at First Eagle Investments. 

“I’ve been particularly interested in the bonds in the 60 to 65 cents on the dollar area,” said Miller, who has been buying the paper since the fund launched in January. 

Many of the deals feature reserve funds and occupancy rates in the mid-90s, “so there’s a life going forward in terms of current pay, but if there were a problem, the recovery rates on these buildings would be higher than 60% of the value of the bonds outstanding,” Miller said. 

Like many so-called story bonds in the high-yield market, liquidity “can always be a little spotty,” Miller said. “But there are more participants in this sector over the last few years as it’s become better known, and there’s certainly demand for California high-yield paper in general.”

Some of the deals have as much as $100 million to $200 million of debt outstanding with “perhaps 10 or 12 holders,” he added. “So, in that scenario it should be at least somewhat liquid.”

Other investors have shied away from the paper amid red flags of potential performance problems. 

Allspring Global Investments has sold four of the five California deals it originally bought, said Allspring senior municipal analyst Gilbert Southwell, adding the bonds sold below par. 

“It’s kind of an untested model, and now that we’re two-plus years into them, it seems like they’re not meeting projections as much as people had hoped,” Southwell said. The debt service coverage on the deals they bought lagged projections, he said. “These are standalone credits, no one else is backing them up, so we decided we weren’t going to buy anymore.” 

But Southwell said affordable housing needs will likely continue to drive issuance. “I think this is a subsector that will probably still be around, they just need to be looking at the underwriting and the cash flow models and come up with something a little less risky,” he said. “If you’re trying to generate affordable housing for people it’s a step in the right direction.”

Regulators are also tracking the deals. In a December 7 speech at the Security and Exchange Commission’s compliance conference, Office of Municipal Securities Director Dave Sanchez noted the market has recently seen the “emergence and reemergence of certain deal structures, including housing deals for essential workers and students,” that “have come under scrutiny because of questionable economics or other issues.

“We have seen certain municipal entities cede authority for issuing conduit bonds to privately run entities that are the leading issuers of defaulted bonds,” Sanchez said. “When we see deal structures and arrangements like this, it is questionable whether the appropriate gatekeepers (including [municipal advisors], [broker-dealers] and attorneys) are fulfilling their responsibilities,” he warned.

Workforce housing deals are beginning to pop up outside of California.

The ski resort town of Telluride, Colo., and its school district have sold debt to finance affordable housing for the city’s workers. The town of Vail has also sold workforce housing bonds.

Colorado is the sixth most expensive state to purchase a house and the 12th most expensive for rent, while the state is expected to add 1.72 million people by 2050, according to a report released by Democratic Gov. Jarid Polis, who has made housing a top priority.

In Massachusetts, the towns of Nantucket and Wellfleet have also sold workforce bonds. 

Texas has seen several deals, according to the law firm Norris George & Ostrow PLLC, which said it closed the first such deal in December 2021. Last year the Dallas Housing Finance Corp. issued $48 million of bonds and used the proceeds to acquire a 125-unit apartment building for conversion to affordable workforce housing, according to a release from the law firm firm Locke Lord, which worked on the financing.