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Bond financing is a security evidencing the issuer’s obligation to repay a specified principal amount on a maturity date. Interest is either at a stated rate or according to a formula for determining that rate, and is usually paid semi-annually. Bonds may be classified according to, among other characteristics, maturity structure, source of payment, issuer, price, rating, or purpose of financing.
Bond financing is commonly used to finance the construction of large commercial projects today. Bond financing cannot be used to build or finish residential subdivisions, residential condo projects, or multifamily projects. Mixed used projects – apartments over retail – may qualify if more than 20% of projected income is from non-residential sources, such a commercial rental income, laundry income, and vending income.
Two features of a bond, credit quality and duration, are the principal determinants of a bond’s interest rate. Bond financing is cheaper than a conventional commercial construction loan. The bonds are typically issued for 20-30 years at a fixed rate.
One form of bond financing is a Credit Tenant Lease (CTL). CTLs are structured as private placement bonds that primarily focus on the creditworthiness of the tenant and the lease structure. Any credit rating above BBB is necessary and considered tradable investment grade security. The tenant is also required to have a transparent financial condition and be publically rated.
The lender is focused on the cash flow strain that is paid out by the single tenant. The lender is primarily concerned with the property type, quality and location, rather than the true value of the real estate. The ultimate credit tenant is the US Government, providing a low-risk investment much like a US treasury bond.
A CTL can be very risky for both the tenant and the lender. For example, a common CTL stipulation requires the tenant to pay rent after a certain period of construction, regardless of whether construction has been completed. Tenants are not willing to take the added risk, thereby creating a complex bond agreement.
In a fully bondable lease, the tenant looks to the landlord to maintain the facilities. If the landlord fails to properly maintain the property, the tenant will cease rent payments until the landlord resumes normal maintenance. The lender is therefore exposed to additional risk because the lender has no control over the landlord’s diligence or performance. Lenders often seek full triple-net leases, in which the tenant is expected to pay all operating expenses within the building, protecting the lender from possible landlord negligence.
Other types of bonds include affordable housing bonds, industrial revenue bonds, Build America Bonds (BAB), Industrial Development Bonds (IDBs), and Tax Increment Financing (TIF). Affordable housing bonds are used by the government to encourage and subsidize affordable housing. Industrial revenue bonds are very similar to affordable housing bonds, but they are used for creating jobs. In this instance, the government subsidizes the creation of capital for those that are creating jobs.
Bond financing has the ability to be tax-exempt if the tenant is a non-profit organization. Tax-exempt bonds provide long-term below market interest rate financing. Affordable housing bonds are an example of this because they finance the construction, acquisition and rehabilitation of inexpensive rental housing.
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