SMALLER HOSPITALS AND COLLEGES
and affordable-housing developers will be more challenged in distributing their bonds under proposed tax reforms.
When you walk into an emergency room today clutching your insurance card, you often pass a wall of donors to that facility. You know that the physical plant you are entering would not be the same without those donors. Charitable contributions will be preserved in the tax bill pending in Congress, so, perhaps, there will be no change in giving patterns.
However, the debt service being paid figures to be much greater than it would have been in a tax exempt market. This means that in the plan of finance, certain patient rooms or operating room features may have to be foregone given the demands of the capital budget. Or the improvements might have to be phased in over time as the budget allows.
A potential 50 basis point or more move in interest costs may make a great difference in the ability to service the debt in going from tax exempt to taxable debt for all of the needs of the institution. Institutions of today may have a mix of tax exempt and taxable debt. Considering the latter, taxable debt is usually considered only when conditions are optimal.
In the last calendar year, just over $51 billion of healthcare paper was issued for all kinds of facilities. This amount represented 11.3% of total issuance for the year. The number was clearly driven to this level , in part by the amount of refunding activity in the sector.
If Tax Reform goes through as drafted, the practice of hospital finance would stand to change considerably. The interest cost consideration is just one of the many aspects that are likely to change. Fortunately, healthcare institutions already use full accrual accounting. However, even for healthcare there is a much greater level of transparency in a taxable world.
The House version of the tax bill discontinues the deduction for extraordinary medical expenses. Reports are surfacing that the Senate may be more inclined to preserve this deduction and may offset the expense with other adjustments at the margin.
Another 501(c)3 sector about to be changed if tax reform is adopted as contemplated is the Higher Education sector. Last year, Higher Education accounted for $18.5 B or 4.1% of the total municipal issuance for the year. I have already discussed the unprecedented recommendation to tax endowments of a certain size.
The concern here going forward is that the entire sector will be treated as taxable. In much the same manner as is the case in healthcare, taxable financing has been pursued from time to time when conditions have been opportune.
DRIVES UP INTEREST COSTS
However, the vast majority of financing for higher education has been accomplished on a tax exempt basis. Average credit quality in this sector is generally very high. Yet many smaller institutions with Baa/BBB type creditworthiness have also fared well in this market with relatively low interest costs.
Moving to a taxable environment will have a pronounced effect on interest costs. College affordability has been a growing concern for a number of years. Unless there is a separate revenue stream, the costs of capital are embedded in tuition. Higher interest costs are likely to aggravate already climbing tuition costs.
An additional factor is the elimination of the deduction for student loan interest. This change may force some students into thinking more about how many student loans they may be able to afford and it may have an impact on college selection. It will be interesting to see if the “free” college option is sustained in this environment.
FEWER HOUSING UNITS
Housing is another sector that has benefited from the municipal exemption and a variety of federal programs for providing low income housing. These aspects have been most influential when mortgage rates are high and qualifying for a mortgage is rather restrictive. In the current low rate environment, the tax exempt housing sector has not been quite as robust. Yet housing issuance in 2016 totaled $19.9 billion or approximately 4.4% of total issuance. Housing supply is at a critical stage in many locales.
In California, the problem is acute. In recent discussions in the San Diego market, I have been informed that a single “low” income unit may cost as much as $450,000 to construct. Tax exempt programs cannot solve that dilemma, but the programs do serve to provide more units at the margin.
As someone who has worked in the taxable world at various points in my experience, I fully appreciate that the markets are very different in character and practice. The taxable market has great demand for large transactions. Many institutional investors in the taxable world seek out and want to hold in portfolio benchmark bonds. A benchmark bond is usually much greater in size than a municipal term bond. An order of magnitude of 10 times would not be an exaggeration.
Small par size is not desirable in the taxable market. In municipals, the average size transaction last year was about $33 million. This amount does not approach the level of a benchmark bond.
I do fully appreciate that the taxable market is able to evolve and adapt to changing needs. The base line concern is that smaller issuers with lower creditworthiness are likely to pay a great deal more in interest costs. Larger structured transactions such as public private partnerships will find an even more receptive market.
The small college with an enrollment of 1,500 or the small community hospital with a hundred beds is going to be more challenged in distributing their bonds.
We are awaiting more details from the markup sessions of H.R. 1. We know that a variety of interest groups in the affected sectors have been at a fever pitch of activity since the release. In the end, the vote tally is of more immediate importance that the policy nuances. Everyone would appreciate a tax cut and would enjoy applying the released funds as they see fit.
We just want to caution that some of these freed up funds may need to be applied to purposes that have previously been bolstered by the power of the tax exemption.
John Hallacy is a contributing editor at The Bond Buyer following a long tenure in the municipal business, predominantly as head of municipal research for Bank of America Merrill Lynch. John has also spent time as an analyst and manager at S&P Global, underwriter and marketer at four bond insurance companies, and has served as the head of MAGNY and president of the Society of Municipal Analysts.