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HONORABLE MAYOR AND CITY COUNCIL April 16,2021 Subject:JPA-issued Bonds for Moderate-Income Housing Page 7 Compensation is not tied to performance or level of risk taken—Both the HR&A memo and other industry professionals that staff met with recently advised that financial incentives for this product should be changed to better align with property performance. These transactions are typically structured with a Series A of non-rated tax exempt bonds which need to be place with sophisticated investors due to the risk of the bonds, and a Series B which is, in essence, a deferred developer fee and generates no equity or cash for the project. The Series B bond is primarily paid from net cash flow after mandatory operating expenses are paid. As a result,there is an incentive to operate the property with low expenses. However, HR&A's analysis notes that in addition to significant upfront fees, ongoing fees paid to the JPA as property owner and to the asset manager(developer role)are fixed and are not tied to any performance in the property. Fees also escalate automatically at 3%per year, and there are reserves funded to ensure that these payments can be made in years of negative cash flow. In addition, interest payments on the B bonds, which HR&A calls"preferred equity payments," carried a 10%interest rate in the Long Beach Oceanaire transaction described above, in the event a property's cash flow cannot support payment on B bonds in a given year. While this is below private mezzanine debt interest rates of 14%or higher, public interest rates are typically far lower. As a comparison,the City charges 1%to 4% interest or uses the Applicable Federal Rate, a rate recognized by the Internal Revenue Service (IRS)as appropriate for a public entity, when it restructures its residual receipts loans for affordable housing transactions. The current long-term AFR compounding annually is 1.98%,9 approximately one-fifth the interest rate on the B Bond for this structure. Finally, it is important to note that the compensation paid to the public JPA owner and the asset manager is not tied to any development risk(presuming no rehabilitation is done on a property), and generally no upfront equity is being contributed by the property owner or asset manager. As stated,the only new revenues to the transaction are the foregone public agency property taxes. And because these projects are acquiring large multifamily properties,this means the public agencies immediately forego existing annual property taxes for the promise of future nominal affordability. Due to the short track record of the existing projects, and the difficult pandemic economy,the existing projects cannot demonstrate a pattern of meeting even those low expectations. Potential partial mitigants—In the attached Term Sheet, staff modified the compensation structure so that it would better align financial incentives with property performance. Escalation of fees at 3%per year could be allowed if performance targets were met, such as vacancy rates under 5%, but higher vacancy rates would earn escalation of 2%or 1%. Interest rates on the B bonds, so-called"preferred equity payments," should be lowered to the extent that fees relative to public benefit need to be lowered(see item below). Staff also proposes limiting the size of the B bonds and,therefore, its ongoing payments, in order to lower the overall debt on the property and to offer more affordability within each project. This concern about misalignment between performance and risk can be partially mitigated by limiting and aligning compensation and capping the B piece debt. 9 IRS,Applicable Federal Rates,Apr.2021,https://www.irs.gov/pub/irs-drop/rr-21-07.pdf.