Housing bonds are becoming an increasingly popular method for real estate investors to finance affordable housing. The government-issued bonds, which come in several varieties, help incentivize investor participation in the private market while also helping compensate investors for the lower annual revenues generated by these types of projects. After all, developing or rehabilitating an apartment that offers affordable housing has similar development and holding costs to one that charges market rents, making housing bonds a valuable and necessary way for investors to participate in this industry. If you're considering investing in affordable housing, learn what housing bonds are and how they work.
What is a housing bond
A housing bond is a government-issued bond that is sold to investors to help provide the necessary capital or financing to purchase land, develop, or redevelop real estate projects such as low-income housing, industrial developments, and municipal services, among other projects.
Because the state and local tax bodies are exempt from paying taxes on interest income, the governing bodies can pass these savings on to investors by allowing them to purchase bonds for the construction of affordable housing or charge lower interest rates than could be achieved with a loan from a traditional lending institution. The bonds can be repaid from the general tax revenue, the individual borrower, or a combination of the two. However, this structure means the repayment of the bonds becomes part of the general taxpayer responsibility, and thus the amount of bonds issued per year is capped annually. Some states may even require a public vote for approval for the issuance of housing bonds.
Types of housing bonds
Mortgage Revenue Bonds (MRBs) operate like a traditional mortgage; however, they are issued at lower interest rates or provide borrowers with an annual mortgage tax credit, which lowers their overall financial burden. MRBs are commonly used for special first-time homebuyer programs and are repaid through the individual buyer or a dedicated revenue service (such as a portion of property taxes collected in a jurisdiction).
Tax-exempt bonds are the most common type of government bond and can come in the form of a private activity bond, Affordable Housing Bond, or 501(c)(3) bond. All of these offer lower interest rates than could be achieved for traditional financing by offering certain tax exemptions, such as making all interest paid to the bondholders tax exempt as long as the project will serve the public interest or meet the requirements of qualifying.
How housing bonds work
To qualify for a housing bond, developers and investors must meet certain criteria, which will vary from locality to locality. In 2021, the Internal Revenue Service (IRS) issued a statement allowing states to receive the greater of $2.81 per capita or $3,245,625 in Housing Credit authority and small states to receive a minimum of $3,217,500. If the bond is in which the project or development will not earn sufficient income to repay the bond, the burden for repaying a portion of the debt comes from taxpayer dollars, also known as a general obligation bond. To secure the public interest bond, bidding is completed through a broker-dealer to ensure the lowest-interest cost wins the bonds.
There may be requirements to utilize a certain portion of the bond proceeds, as much as 95%, toward land and construction costs for the development of a specific project, such as affordable housing. There could also be a requirement for the number of low-income housing units in the development, which can range from 40% to 60% at minimum. Many times, there are also time restrictions, such as a required number of affordable housing units being allocated over a length of time, say 10, 15, or 20 years.
Housing bonds can be a worthwhile option for investors looking for additional funding for their next rental project; however, it's important to weigh the cost for the bonds in comparison to other programs. Bond transactions require substantial professional services to underwrite and review the legalities of the project, which can cost the developer or investor as much as 5% to 6% of the total project cost. For this reason, you most commonly see the use of housing bonds with other incentive programs, such as the Low Income Housing Tax Credit Program (LIHTC), or for large development projects over $5 million in which the cost for the bonds makes sense with the size of the development.