Attorneys

• Charles R. Brodbeck

Related Practices

• Public Finance

Developers of assisted living facilities have a critical need to finance projects in the most cost-efficient way.  Yet, for a variety of reasons, lower-cost financing is generally difficult for them to access.  Today, thanks to relatively recent rules from Washington, assisted living facilities may find access to lower-cost, variable-rate financing right around the corner from someone they already know – their local community bank. Let me explain...

Historically,  assisted living and other housing projects have been financed with fixed-rate debt.  As variable-rate debt has become increasingly commonplace in the taxable and tax-exempt markets, however, many corporate and municipal borrowers have begun to rethink the use of variable-rate debt.  Some borrowers now view variable-rate debt as potentially providing a lower-cost alternative over the long run while others have embraced the concept that a mix of variable and fixed-rate debt is a prudent way to manage  their financing costs.

Although a developer of an assisted living project can borrow at a variable rate from a local bank, the interest rate tends to be based on the bank's prime rate plus some percentage and tends to be several hundred basis points above the lowest variable rate now available in the market.    

There is a way to access such lower market rates by placing what is called "lower floater" debt with money market funds.  (Money market funds have an enormous appetite for certain types of variable-rate debt and tend to borrow at the shortest end of the yield curve, which normally results in the lowest variable rate.)  This new form of financing allows the developer to maintain his relationship with the community bank and takes advantage of the unique relationship which the community bank has with its Federal Home Loan Bank.  By utilizing this low cost form of financing, the break-even point of an assisted living facility may be reduced, thereby encouraging the development of more affordable assisted living housing.

Lower Floater Debt
Some background is necessary to understand how these financings work.  It could be time well spent for those involved in financing an assisted living facility in the coming year.  The nature of lower floater debt probably is best understood by recognizing two of the requirements of money market funds which led to its development:

• The principal requirement of most money market funds is that substantially all of the debt instruments they hold must be rated (or must be issued by an entity which is rated) investment grade or better.  As a consequence, most debt backed solely by the creditworthiness of an assisted living facility or facilities generally will not qualify.  This limitation can be overcome by having a rated bank issue a letter of credit to provide additional credit support for a facility's debt.
• A second critical requirement of money market funds is liquidity - the need to be able to liquidate investments if fund investors are withdrawing more money than they are depositing – because most money markets serve as checking accounts for their investors.  The 7-day lower floater bond was developed to address this need in the tax-exempt and taxable markets.  The interest rate on such bonds is reset every 7 days and the holder (the money market fund) has the right to "put" the bonds back to the issuer of the bonds for purchase upon 7 days notice.  Both the interest reset mechanism and the put right tend to result in the holder accepting a lower interest rate than if the bonds bore a variable interest rate without a put right.

Because most issuers of bonds do not have the liquidity themselves to pay the holder the put price when the bonds are put, the bonds provide that they can be remarketed, in which case the purchase price paid by the new purchaser can be used to pay the bondholder who put the bond.  A theoretical problem is presented, however, by the possibility that the bonds cannot be remarketed for some unforeseen reason.  As a result, the letter of credit, which was described above as providing credit support, also can be structured to provide the necessary liquidity.  In other words, if the bonds cannot be remarketed, a draw can be made on the letter of credit to pay the put price until the bonds can be remarketed.

Unfortunately, a bank that issues a letter of credit to provide credit support and liquidity for a lower floater bond held by a money market fund generally has to be rated by a rating agency.  Many local banks, particularly smaller banks, are not rated, and many rated banks already have large amounts of letter of credit exposure and are not issuing new letters of credit or are limiting new exposure to their better customers.  

The Role of the Federal Home Loan Banks
This problem can be overcome by a relatively recent rule applicable to Federal Home Loan Banks ("FHLBs"), which permits FHLBs to confirm (or "back") letters of credit of their member financial institutions for, among other purposes, assisting members "in facilitating residential housing finance."  This rule creates an opportunity for nonrated banks to offer their housing customers, including assisted living facility operators, access to lower cost funds while retaining an important and profitable relationship with the developer.  In effect, the community bank assumes the credit risk of its customer, the developer, and the FHLB assumes the credit risk of its member, the community bank.

What are FHLBs?  There are 12 FHLBs, each of which serves a specific region of the country.  A little known, but important component of our banking system, they were created by Congress in 1932 to promote housing finance and are regulated by the Federal Housing Finance Board, an independent agency of the federal government.  Each is a wholesale bank completely owned by residential lenders in its area.  (For example, I work with the Federal Home Loan of Pittsburgh, which has over 375 financial institutions in Pennsylvania, West Virginia and Delaware as its members.)  

Because the FHLBs have a significant capital base and play an integral role in our banking system, they are rated "AAA", the highest rating category, by the rating agencies.  As a result, the developer of an assisted living project, whose banking relationships often are with smaller banks, can approach his bank not for a loan but for a letter of credit and, along with it, a confirming letter of credit from a FHLB to back bonds which the developer will issue.  Although the fees are not insignificant (one has to use an investment banker to find a purchaser for the bonds, a trustee to act on behalf of the owners of the bonds and certain other professionals in addition to paying the fees of the bank and the FHLB), the AAA rating of the FHLB can result in an attractive variable interest rate.  The interest rate for a taxable 7-day lower floater financing generally is based on Libor (the London Interbank Offered Rate), which is considered to be the most efficient interest rate standard and the one to which major corporations tie their borrowings.  For example, as this article is being written, the one-month Libor rate is 5.79%, while the prime rate is 8.5%.  In addition, if one is concerned with the potential for variable rates to go up over time, one can make arrangements with the bank to provide a cap on interest rates (although, again, there is a cost).

I recently worked on two transactions in which the Federal Home Loan Bank of Pittsburgh confirmed letters of credit of two different member banks, which backed bonds financing new assisted living projects.  Clearly, the developers of those projects satisfied themselves as to the benefits of this form of financing.  It is my understanding that FHLBs are eager to implement this financing vehicle on a broader scale in order to facilitate the development of housing and community development projects locally.  Developers of new assisted living projects should give it serious consideration.  More affordable assisted living facilities could result from this lower-cost financing.

This article previously appeared in Assisted Living Success.

Charles R. Brodbeck is a director in the Business and Tax Group of Cohen & Grigsby, P.C., a full-service national law firm headquartered in Pittsburgh.  He can be reached at cbrodbeck@cohenlaw.com.