How conduit multifamily bonds can be dangerous to portfolio health

When market practitioners think about credit stress points and those sectors that contribute to the mix of impaired or defaulted municipal securities, multifamily housing revenue bonds issued through local conduit entities typically make the top five. The distinctions between local conduits and state housing finance agencies (HFAs) are rather stark.

Conduits generally lack ongoing fiscal management and oversight, do not issue debt under well-secured parity indentures, do not maintain balance sheets with an accumulation of substantial fund balances that are often pledged for debt repayment and do not provide a general obligation pledge of unrestricted assets.

Conduits are generally not positioned to assume an interventionist role before covenant violations appear and reserves are tapped. They lack the resources to elevate surveillance activities, coordinate with other deal stakeholders, make key principal substitutions where appropriate and respond to area economic and demographic shifts. Conduits are also unable to initiate changes to the bond transaction in an effort to avoid a forced sale or distressed liquidation.

No issuing authority wants to see bonds sold under its name default or lose their tax exemption. Investors should discriminate between issues from an ongoing authority with fiscal management capabilities and financial resources versus a shell issuer set up to pass through tax exemption, whereby investors assume full real estate risk.

Other red flags include limited or no equity contributions, significant rehab and deferred maintenance needs, antiquated underwriting models and a questionable developer track record. Today's underwriting standards must account for higher insurance premiums (thanks to rising climate-related events), post rehab or sale property tax reassessments and special assessments or elevated utility costs.

While many conduit multifamily bonds are sold in the public market, others can be a direct bank purchase or private placement. These types of buyers may be better equipped to assume real estate risk.

There are many examples of failed conduit multifamily bond financings that involved a combination of lack of market liquidity, developer bankruptcy, property foreclosure and/or project acquisition. The emergence of weaker economic conditions ? or a singular economic shock ? could be the cause.

Gross mismanagement, faulty revenue and expenditure projections and rental/occupancy breakeven assumptions, unexpected fire and water damage and other maintenance issues, code violations and poor credit structures have all contributed to project failure. Deferred maintenance and code violations could result in greater vacancies, rent concessions and heavier regulatory oversight.

Also relevant for muni market stakeholders is a distinction between impairment and default. Impairment is typically forward looking, indicative of deteriorating credit fundamentals and elevated risk of default. With impairment, obligors may have the time and ability to right the problems and avoid default.

For a conduit multifamily housing revenue bond, an impairment scenario may find bonds trading at significantly depressed levels following a heavy drop in occupancy with associated erosion in debt service coverage and drawdowns on reserves. Impairment does not necessarily equate to payment default as principal and interest requirements are generally still being met, and not all impairments result in payment default.

Importantly, if conduit multifamily financings without enhancement fail, financial and operational erosion tend to evolve over a period as opposed to an abrupt demise. Nevertheless, aggressive cash burn can accelerate the process.

Oftentimes, impairment can correspond with an event of technical default, such as a rate covenant violation. Bond documents may allow a defined period to cure the technical default. Both technical default and payment default represent a breach of the contractual arrangement between bondholders and the obligor and so the market should not make a legal distinction between these two types of default from this perspective. However, there are some very clear distinctions between the two.

With technical and payment defaults, legal bondholder rights and remedies take hold, but they may be more nuanced in a technical default, where remedial actions tend to be more administrative with a notification and monitoring process. Should positive circumstances fail to progress, more onerous solutions can be pursued by bondholders, such as acceleration of debt and management replacement.

Commonly, a debt restructuring or foreclosure on the multifamily property can be pursued by creditors through the bond trustee in the event of payment default. Depending on bondholder consent, workouts can provide covenant relief. This may include waiver of a debt service coverage requirement or replenishment to certain reserve accounts.

When I began my career in the municipal bond market, my initial focus was on housing bonds, with redemption analysis consuming almost equal time as credit analysis. Throughout the years, I've spent a great amount of time reading through official statements and bond indentures, hunting down transaction principals, and scraping the municipal repositories for material event notifications.

My experience has drawn me to the full spectrum of conduit multifamily property stakeholders including developers, project managers and marketing representatives. While many were professional, informative and sensitive to my role in the capital markets, others were rude, disinterested and clearly untrustworthy.

I can recall speaking with a representative of a conduit issuer about a multifamily rental property located in a mid-atlantic state. After further research, it was determined the property was a haven for drug traffickers. Of course, this was an extreme situation. However, the market has witnessed a number of failed conduit multifamily projects for reasons that involve a combination of unforeseen economic events and gross mismanagement.

Apart from state HFA multifamily financings, conduits behave more like leveraged real estate loans with many of the associated trappings. While many conduit multifamily deals carry a form of federal support, such as Section 8 subsidy payments, GSE enhancement or FHA mortgage insurance, non-recourse conduit deals without enhancement carry the highest risk of non-performance.

A GNMA/FNMA collateralized structure can be used for single- or multifamily mortgage revenue bonds and offers investors a very strong credit structure that insulates the bonds from the challenges of the real estate market and offers better market liquidity. Bond proceeds are used to acquire mortgage collateral as opposed to a housing agency directly originating loans. The underlying mortgage pools are posted as collateral for bond security, providing more predictable cash flow and attracting prime quality ratings.

The use of FHA insurance in multifamily housing bond financings was designed to provide capital market access to various borrowers and enhance the marketability of the bonds they sell. FHA insurance has provided a source of high-quality investment with continuity of tax-free income. The FHA structure is commonly used for healthcare and multifamily mortgage revenue bond financings for construction and permanent financing as well as for acquisition and rehabilitation. Debt service on the bonds is paid from repayments on mortgages.

What may be less intuitive to the casual investor is the fact that FHA does not back the bonds, but rather the underlying mortgages that repay and secure the bonds. FHA insures against losses on mortgaged properties ensuring the mortgage revenue stream that repays the bonds will continue even if the mortgagor defaults. Thus, this insurance feature is very different from the coverage provided by the municipal bond insurers, which guarantee timely payment of principal and interest on the bonds.

Section 8 is a rent subsidy program. It does not provide insurance coverage either on the underlying mortgage or on the bonds. The subsidy is based upon an apartment unit basis as opposed to an overall development. Section 8 requires that a contract rent be set for every unit and the units must be occupied by tenants eligible to receive housing assistance payments from HUD.

Typically, the contract rent may not exceed the HUD-determined fair market rent for similar housing in the market area. The contract rent is derived from a percentage of the tenant's income and the monthly housing assistance payments. Contract rents are adjusted annually. The difference between the contract rent and the Section 8 subsidy is the tenant's responsibility. An event of mortgage default would not necessarily interrupt housing assistance payments. However, vacancies and events of non-compliance can trigger reduced subsidy payments, or even complete elimination. Section 8 subsidies are less widely used today as part of the financing structure.

While numerous reasons surround a conduit multifamily project failure, enveloping regulations were designed not only to preserve the tax-exemption, but also to hold developers to more stringent occupancy and income requirements. Much of today's municipal market framework can be traced back to The Tax Reform Act of 1986 (The Act), which gave a more formal definition to private-activity bonds in the Internal Revenue Code and placed state volume caps on private-activity bonds. Private-activity qualification must test for private use of proceeds and security repayment.

Prior to The Act, multifamily bonds could be used to finance more market-rate housing and there were less restrictions on tenant income and rent levels. These more relaxed requirements created fertile ground for abuse and opened up questioning regarding public purpose benefit.

Through The Act and subsequent legislative action, congressional intent was to provide affordable housing to substantially lower-income households by establishing more accommodative set-asides. While tighter depreciation rules and extension to the qualified project period (length of time that a project must adhere to income and occupancy restrictions) created additional developer disincentives, multifamily issuance, although variable, has remained a meaningful contributor to overall housing volume.

A longer qualified project period extends regulatory oversight. To offset the elimination of accelerated depreciation and passive losses, and to incentivize affordable housing, The Act established the Low-Income Housing Tax Credit (LIHTC). As a source of equity capital, the LIHTC is targeted to support affordable rental housing that sets aside units for low-income tenants, complies with long-term affordability rules and preserves specific rent requirements.

In its simplest form, a developer sells tax credits to financial institutions and other institutional investors, with the investors providing project capital in exchange for future federal tax credits. The new equity can lower mortgage needs, reduce debt service and allow developers to charge below-market rents.

Data suggests many issuers of multifamily housing bonds continue to operate within the constraints of guidelines. Prior to The Act, multifamily housing bonds were not subject to state volume caps on private-activity bonds, but now they must compete for cap allocations against student loan bonds (less significant today), qualified industrial development bonds, and various "exempt facility" bonds. Qualified housing bonds tend to be the largest users of volume cap allocations.

In a post-1986 tax reform world, more stringent requirements evolved with state HFAs, as opposed to conduits, becoming more disciplined and imposing tighter security covenants and better disclosure standards. In response to active multifamily defaults, rating agencies raised their credit standards for investment-grade multifamily housing bonds, including imposing stronger coverage requirements, higher reserves and active stress-testing.

The 2008/2009 financial crisis and the COVID pandemic created historical stress points for multifamily housing. Responsive actions included more conservative underwriting practices and a closer analysis of lease-up risk and floating rate exposure. A greater use of FHA mortgage insurance and other types of credit enhancement provided the stronger security package necessary to market these types of bonds.

Those conduit issuers without these better structures were left to their own devices. In my opinion, The Act and subsequent legislation did a good job shaping eligibility standards and accounting for low-income housing affordability needs. However, they were not crafted with investment suitability, ongoing compliance and enforceability and credit structure in mind. Tighter regulations under The Act and altered depreciation rules significantly changed the economics of multifamily bond financings.

The main force behind construction of a proposed project shifted to economics rather than tax incentives. Perhaps on the surface this may appear positive in that it weeds out marginal bond issues. A deeper dive, however, tells us this may not be the case, as many of these issues historically carried some type of external credit enhancement in support of market access.

Further, many current tax-exempt multifamily housing conduit bonds are sold without credit enhancement, such as FHA mortgage insurance, project-based Section 8 subsidies or some form of GSE collateralization. Conduit multifamily issues are generally viable where some form of federal credit enhancement is employed. Keep in mind, however, such enhancement does little to assess redemption risk.

Lower market income occupant requirements and/or a larger percentage of units set aside for low-income residents can translate to increased rents for the non-restricted units in order to subsidize the restricted units. In many markets, the ability to increase rental prices may be difficult to accomplish or sustain on an ongoing basis.

Institutional buyers must give careful consideration to those factors that affect the economic viability of multifamily issues, including the background, experience and integrity of developers as well as the overall viability of underlying assumptions and projections. This is especially true in a volume-capped market where demand for paper may exceed supply. Economic viability can be viewed as key to continued preservation of tax exemption for multifamily bond financings, especially for conduits.

I think it is safe to say a prospective buyer of bonds in New York or Boston generally has no in-depth ability to judge demand for multifamily housing or competitive rent levels, in, for example, a rural Kentucky county. Of course, I give deference to site visits and appropriate lead time to review the documentation, speak to the banker and principals and conduct sufficient due diligence.

I also recognize that larger investors employ professionals within the appropriate disciplines necessary to render sound opinions. But at the end of the day, there is a great deal of information to parse for what is essentially a leveraged real estate transaction.

I would also point out that while there are better chances of ongoing compliance, credit enhancement is not a panacea for continued compliance. The operating demands necessary to sustain tax exemption under stricter guidelines could pose economic stress on individual multifamily projects. The project remains as multifamily housing subject to compliance in order to preserve tax-exemption through maturity.

Under current rules, non-compliance could subject bonds to federal taxability retroactive to the date of issuance. Further, tax-exemption can only be restored under limited circumstances. Failure to maintain tenant income set asides can result in non-compliance and current rules subject low- income multifamily properties to recurring review.

Generally, stricter occupancy requirements make it more difficult to assess a project since so much depends on the ability to achieve above - market rents to further subsidize restricted units. In strong markets, such as parts of New York and Boston, this may be less of a concern where it can be easier to rent at higher levels. Real estate markets, however, do change. In certain areas of the country where the demand for multifamily rental housing is not as strong, the ability to support low-income subsidized units may be weak.

Compliance and enforceability are essential to multifamily market acceptance. Covenants and deed restrictions legally bind a developer to remain in compliance. Legal compliance, however, tends to be subject to market demand at increased rents for an extended period. Thus, compliance is a function of greater economic risk, and developer bankruptcy can become a worst-case scenario.

Concluding thoughts

Clearly, not all multifamily bond financings are created equal. State HFAs offer an established entity with a strong track record, an attribute that is desirable by many institutional investors. Conduits, however, generally do not have the bandwidth to establish a strong record in screening developers and projects and they typically lack sufficient knowledge of local market conditions and an ongoing staff for monitoring compliance.

Not all unenhanced conduit multifamily deals are bad. Nevertheless, the structural weaknesses that I have identified require careful consideration when looking at these credits. Most bond investors lack the appetite to own real estate and I recognize that there is a limited audience for these structures. Certain areas are experiencing softening rents in oversupplied markets with rising operating expenses.

Given the rising experience of default/impairment in this space ? although we are not seeing a systemic failure ? perhaps it makes sense to reevaluate the risk/reward equation and determine whether there is sufficient real estate workout expertise on hand. Again, not all conduit multifamily bond issues have structural backstops, such as deep reserves and/or federal support programs.

While there are natural buyers when problems arise ? such as hedge funds, distressed investors and other opportunistic funds ? who have the tolerance for restructurings, forbearance agreements and covenant negotiations, these investors may be looking for additional risk premium. They tend to prefer long duration assets and are willing to give up liquidity.