Nonprofit organizations looking to issue bonds for capital projects, or to refinance existing debt face one of the toughest financing environments in years due to rising interest rates and recent changes in tax laws. Each organization’s financial situation and funding needs are unique. Careful, expert analysis and advanced planning are critical for all organizations today to be able to structure the most efficient long-term financing vehicles to help fund new projects.
This need to plan is true whether a nonprofit is new to the debt markets, adding to existing debt, or has a maturity or debt re-pricing event two years down the road. The pressure on interest rates is real and growing. Ten-year Treasury rates have risen more than 125 basis points or 60% since Labor Day, 2017—with more rate hikes expected in 2019. Rates are still low by historical standards; nevertheless, rising rates curtail borrowing capacity and impact key capital project decisions.
In the midst of these rate hikes, bank direct purchase tax-exempt bond rates have increased due to the corporate tax-rate changes that went into effect on January 1, 2018. The typical discount factor used by banks for these bonds changed from 68% to 79%, increasing borrower interest rates. The combined impact of these changes means that a nonprofit that might have financed a project at 2.5% before the changes in both market rates and the tax code, could now face tax-exempt rates of 4.5% or even 5%.
Borrowing Options Remain Varied
What hasn’t changed for nonprofits are borrowing options. All manner of taxable debt instruments remains available, such as lines of credit supporting capital campaign collections, taxable term loans, leases and mortgage facilities. Still, by comparison, tax-exempt instruments offer lower interest rates and are therefore advisable for larger projects requiring longer repayment terms.
For most small and mid-sized Nonprofits their best—and perhaps only—tax-exempt option is a direct purchase tax-exempt bond. Fortunately, there is still a strong appetite among regional banks to purchase these bonds. Meanwhile, larger, publicly rated Nonprofits have more tax-exempt financing options, including variable and fixed-rate public issues which make sense for higher amounts and often come with fewer covenants and collateral requirements but with varying interest rates based on bond term.
Customized Analysis and Solutions
Given this backdrop, what can Nonprofits do to maximize long-term borrowing capacity and flexibility, and thus their ability to take on new projects? Critical to this effort will be teaming up with banking partners that offer creative, customized financing solutions and expert analysis in three areas: peer comparison, debt capacity and cost/benefit views on various debt structures.
Creative Financing Solutions
Tools such as interest rate derivatives can help protect against interest-rate risk in a rising rate environment. A Non Profit seeking capital for a new building would typically take out a floating-rate loan or bond during construction and convert to a fixed-rate when construction is complete. But in a rising interest-rate environment this strategy carries significant rate risk. Instead, the Non Profit can partner with a bank to design an interest-rate derivative with a forward starting rate lock based on the project completion date. This rate reduces risk, improves the Non Profit’s forecasting and its ability to service the new debt.
Non Profit organizations are not all alike. Organizations within the same sub-sector (higher education, elementary and secondary education, human services, membership, advocacy, research, conservation groups, NGO’s, etc.) have similar performance characteristics but they differ significantly across sub-sectors. Thus, an informed peer comparison analysis gives borrowers a valuable view into their own performance vs. those of similar organizations.
This comparison—offered by bankers with expertise in the particular sector—can define key performance indicators (KPIs), help set realistic performance objectives against those KPIs, and provide insights on the prudent level of debt and type of financing instrument. Metrics typically include cash flow, debt service, operating performance and balance sheet measures such as leverage and liquidity.
The simplest debt analysis looks at the current level of debt and infers a debt coverage value. A more thoughtful analysis will also use peer comparison information to assess additional capacity and consider the impact of future projects and capital investments.
All of these inputs help to define a responsible level of debt for planning purposes. A clear idea of debt capacity is also important if the borrower wants to fund a project using a combination of debt and fund-raising. Knowing debt capacity is vital in order to set appropriate and realistic fund-raising targets.
Changes in interest rates and tax rules continue to shift the cost/benefit analyses. For example, if the upfront fees on a taxable loan are $40,000, while the upfront fees on a tax-exempt bond are $150,000, a comparative cost/benefit analysis needs to factor in the size of the issuance and its duration to determine if the higher upfront fees of a bond are worth paying.
And it’s important to conduct these analyses well in advance of when the organization will need to issue debt. Consider this: many borrowers’ rates did not adjust upwards after the tax rate changes went into effect, but their rates are likely to jump significantly at the maturity or rate reset date – especially given that interest rates are likely to rise further. These Nonprofits need to start planning today for those higher rates even if they don’t need to refinance for several years. A Non Profit might decide it should lower its debt levels or restructure its debt before the next reset, and by working ahead could give itself time to plan for fund-raising or other alternatives.
Adjusting to New Terrain
The facts on the ground—higher interest rates and a less advantageous tax code—are putting pressure on Nonprofits looking to issue debt and plan for projects. In response, they must work proactively to put themselves on solid footing. By teaming with expert bankers, not only can Nonprofits access creative, customized financing solutions, they can also gain insights into three critical areas for future planning: peer comparison, debt capacity and cost/benefits.