LOS ANGELES — Residents of Hawaii’s largest public housing facility began returning to renovated units this month. They enjoyed the fruits of a public-private partnership that supporters worry will not be replicated in the future because of threats to the status of tax-exempt bonds that underpinned the project’s financing.

Renovations to the 555-unit Towers at Kuhio Park, near Honolulu’s airport, will cost $135 million, of which $66 million was financed with tax-exempt bond proceeds.

“It will definitely have an impact, because the interest rates will go up and the cost of capital will increase, which will decrease the amount of deals that get done and the amount of affordable housing that gets built,” said Mike Hemmens, director of Citi Community Capital, the community development lending and investing division of Citigroup, which structured construction and permanent financing for the project using the bond proceeds.

There are typically two ways that affordable housing construction is financed — through 9% tax credits, which is taxable debt, or with tax-exempt bonds, Hemmens said. But developers of large projects of 200 or more units typically use tax-exempt bonds.

“The size of the 9% deals is dramatically smaller,” Hemmens said. “It would dramatically affect the creation of affordable housing.”

The Kuhio Park project, which guts and reconstructs the exterior and interior of the 48-year-old housing project, represents the first P3 between the Hawaii Public Housing Authority and a private developer.

New Jersey-based Michaels Development Co. and local development partner the Vitus Group were selected through a request for proposals process in May 2009.

Before the state’s decision to issue the RFP, the blighted property had been the subject of several lawsuits and the state had repeatedly applied for and been denied federal housing grants, according to Makani Maeva, a director of the Vitus Group.

The garbage chutes didn’t work, only one of the six elevators was operational in the 16-story building, and the property needed a serious security upgrade, he said.

“The state was losing $2 million a year on the property and was looking for someone to come in and finance it,” Maeva said.

Michaels Development and the Vitus Group worked with a finance team that included AEGON USA Realty Advisors and Citi Community Capital.

Construction on the project started in May, and when completed in December 2012, Maeva said, the developers will have spent $58,000 per unit to completely renovate the interiors with modern kitchens and new floors, windows, doors, plumbing, and electrical fixtures.

The existing property will be transformed from blighted to island-inspired, with a vibrant paint scheme for the façade and redesigned entrance, according to the developer.

During the next phase of the project, the joint venture will renovate the 198 low-rise apartments that are also part of the development.

The entire project will cost $314 million, Maeva said.

The renovations are being funded primarily through the $66 million of bonds and $45 million in low-income housing tax credits equity.

A team of corporate partners, led by AEGON, is providing the low-income housing tax credit equity.

Through the LIHTC program, corporate investors receive tax benefits in exchange for their equity investment in affordable housing.

The bonds were issued through the Hawaii Housing Finance and Development Corp.

Acting as the servicer of the bond mortgage loan, Citi closed a tax-exempt issue that provided a permanent loan for the project with credit enhancement from Freddie Mac for the $66 million.

Piper Jaffray & Co. was the underwriter.

When they priced in May, the bonds carried Standard & Poor’s AAA rating based on Freddie’s enhancement, since downgraded to AA-plus after the agency downgraded the United States’ sovereign rating.

The bonds were split into two tranches of $33.65 million of short-term and $32.35 million of long-term debt. The short-term Series 2011B bonds are October 2013 term bonds.

The long-term Series 2011A bonds are fixed rate, mixing serial and term bonds with a final 2029 maturity.

The Hawaii Public Housing Authority provided seller financing for the acquisition of the improvements, as it will continue to own the underlying land.

Under the agreement, the developers signed a 65-year ground lease that requires the units remain low-income housing, said Wilfredo Tungol, a projects specialist in the HPHA director’s office.

Supporters say projects like Kuhio Park might not reach fruition if any of the recent threats to the status of tax-exempt financing that have emerged in Washington come to pass.

In September, President Obama proposed a plan to bar investors from using tax-exempt bond interest and other tax exclusions to reduce their income tax rates below 28%.

The proposal was deleted from Obama’s jobs bill before its eventual defeat this week in the Senate, but it is one of several limits on tax-exempt bond interest that have been floated in Washington as the federal government contemplates deficit reduction.

The issue is also being reviewed by the congressional Joint Select Committee on Deficit Reduction, which means it will not be fully resolved until December, said Garth Rieman, director for housing advocacy and strategic initiatives at the National Council of State Housing Agencies.

“There is still uncertainty for investors surrounding the pricing of tax-exempt bonds,” according to Rieman. “The hope is it will not impact pricing too much while investors wait for the committee to clear up the uncertainty now surrounding the bonds.”

Entities that benefit from issuing tax-exempt bonds are concerned that investors would not want to buy tax-exempt bonds or would demand huge interest-rate premiums if such proposals actually come to pass.

“It would impact the ability of state agencies to get a private development partner,” Tungol said. “The fact that state agencies can issue tax-exempt bonds is one advantage to buying into a public housing project.”

Tungol said Hawaii did a feasibility study before it issued the request for proposals seeking a developer and it was deemed the best way for the state to handle the project.

Given Hawaii’s budget difficulties, Tungol said the state would have been hard-pressed to make the project a reality on its own.

The deficit reduction committee has to file its report by Nov. 23 and a decision will be made regarding the recommendations in December, Rieman said, adding that between now and then there is likely to be a lot of uncertainty.

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