Ratings Remain Stable In 2024; Two CDFIs Are Assigned New Ratings

The number of S&P Global Ratings' issuer credit ratings (ICRs) outstanding for U.S. community development financial institutions (CDFIs) reached 15 in 2024 from 13 ICRs in 2023. Most of these ratings have a stable outlook. Of the two newly rated CDFIs, one has a stable outlook and the other has a positive outlook, as of Sept. 30, 2024.

Management Teams' Adaptability Is Fundamental To The Sector's Stability

While several of the 15 rated CDFIs are increasing their debt to expand their lending capacity, most have kept their capital costs below market rates and have grown their unrestricted net assets. The diversification of funding sources and management's ability to adapt to changing market conditions are fundamental to the strategies of many rated CDFIs.

To attract new lending capital that can help further their social missions, some CDFIs have explored opportunities to access the capital market, extend terms with existing lenders, or used their ICR to demonstrate their creditworthiness when seeking new investors. CDFIs with publicly rated debt issuances have applied bond proceeds to pay down high interest-rate debt or to finance new loans. In our view, while CDFI growth plans and funding sources vary, we believe management teams' strengths lie in developing and executing strategies that meet their missions and fit their organizational capacities.

Rated CDFI management teams have demonstrated diligent underwriting and effective portfolio oversight through periods of market-driven pressures on loan portfolios.   Inflationary pressure, higher insurance and other operating costs, and limited external subsidy dollars delayed stabilization and take-out financing for certain early-financing projects with loans from rated CDFIs during the past 18 months. This led to weaker loan performance for some. To keep delinquencies down and mitigate repayment risk, management teams are deploying capital primarily to projects that are fully funded, have public support, and carry a strong likelihood of progressing to completion. Additional strategies in which management teams exhibit strengths include:

• Pivoting to new areas or loan types in various states or regions to address increased lending competition, spread compression, or diminished funding availability;
• Focusing on strengthening certain loan performance before committing additional capital to the same market;
• Exercising patience in lending for early-financing purposes (such as offering maturity extensions); or
• Partnering with other entities to mitigate balance-sheet risk.

Table 1

CDFIs Take On Additional Debt To Fund Their Loans, Leading To Weakened Net Equity Relative To Total Assets

Rated CDFIs have pursued growth strategies since recovering from the pandemic, resulting in weaker capital adequacy for some in 2023.   With the onset of the pandemic in 2020 and the subsequent drop in interest rates, many CDFI prepayments exceeded new loans financed, leading to muted overall loan growth. At the same time, CDFIs received funding from philanthropies, pandemic-related relief, and other grants, leading to stronger equity and net equity ratios. As those funds are drawn down, CDFIs are focusing on keeping their capital costs low while boosting their balance sheet, resulting in most taking on additional debt.

In 2023, the median increase in total debt outpaced the median increase in total assets, contributing to a general weakening of equity relative to total assets. The median decrease was 225 basis points (bps) between 2022 and 2023, compared with a median increase in the prior three years. Although five entities reported increases in their equity relative to total assets, most CDFIs generally increased their debt to expand their reach into underserved communities. Some rated CDFIs used new debt obligations in 2023 to finance lending expansions, with the median change in total debt outstanding year-over-year at 16%, higher than the median increases of the prior three years.

We consider the sector's median decrease in net equity to total assets (year-over-year) a key trend, but do not anticipate taking any negative rating actions during the next two years.  The sector's ratio of net equity to total assets decreased by a median of 87 bps in 2023, but the five-year average ratios generally improved. This is partly due to decreasing assumed loan losses in recent years that brought net equity closer to total equity. Median assumed losses fell to about 16% in 2023 from 19% in 2019. At the same time, those CDFIs experienced a more gradual weakening of equity ratios during the past 18 months, not an immediate reversion to their pre-pandemic means. Therefore, we believe capital adequacy will continue its slightly downward trend in the near-term but remain comparable to current rating levels. In addition, some rated CDFIs' five-year average for equity and net equity ratios has strengthened as the five-year period shifts to exclude fiscal 2017-2018 financial results.

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Increased loan balances aren't likely to introduce new material risks to portfolios.   Gross loan balances also increased by a median of 10% in 2023, a trend we expect will continue in the near term. We believe newly financed loans are unlikely to introduce additional risks to the loan portfolios or raise our assumed loan losses. Lending strategies, portfolio compositions, and focus areas vary greatly among the 15 rated CDFIs, with portfolio balances consisting of 10%-100% of permanent loans, and construction loans ranging from 0% to more than 90%. In our latest review of their loan portfolios, an average of 45% of outstanding balances were permanent loans compared to 41% for construction and acquisition loans. Multifamily housing remains the most common property type among rated CDFI outstanding loans, with charter schools and other commercial real estate projects comprising the other top lending categories.

As loans that were financed with lower interest rates in 2020 are repaid, CDFIs are redeploying those funds into higher-rate loans, which will likely improve their profitability.  The rise in interest rates between 2022 and mid-2024 compressed some CDFIs' profitability margins, though many remained competitive in their products, terms, and patience as a mission-driven lender. The median increase in interest expenses in 2023 outpaced a median increase in interest income from loans following years of relatively little change (2021 and 2022) for both figures. Despite this trend, the compressed net interest margin (NIM) widened in 2023 for most rated CDFIs--increasing by a median of 70bps in 2023 compared with a median decrease of 18 bps in 2022. We view this trend as a strength in CDFIs' profitability and expect NIM to increase for most rated CDFIs in 2025.

In its Q4 2024 Economic Outlook published Sept. 24, 2024, S&P Global Ratings forecast a decrease in interest rates in the near term. However, following the general election, in "After Trump's Win, What's Next For The U.S. Economy?", published Nov. 7, 2024, S&P Global Ratings wrote that the benchmark interest rate will likely be higher than forecast as the Fed seeks to address potentially higher inflation from President-elect Trump's proposed economic plan.

Should interest rates rise, we believe CDFIs will still proceed with their growth strategies, and ultimately finance the expansion of their social mission through either low-cost grants or loans, entering the capital market, or otherwise diversifying their funding sources, though the acceleration of their growth may be lowered slightly.

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Asset quality remains a strength of rated CDFIs, with delinquent loans only comprising about 1% of portfolio balances.   We attribute the sector's generally low asset quality ratios to sound underwriting and strong portfolio oversight, even for lenders of diverse property and loan types. Median nonperforming assets (NPAs) were 1.2% of total loans in 2023, in line with the five-year high. At the same time, two CDFIs reported an uptick in NPAs to more than 10% of total loans, reflecting both pressure from limited public resources to fund certain projects and construction delays that were partly caused by higher costs and interest rates during the past 12-18 months. As a result, some CDFIs have seen an uptick in maturity extensions, or overall weaker performance for acquisition, construction, and predevelopment loans particularly in some areas of the country. One-off spikes in NPA ratios are unlikely to single-handedly create rating pressure, due partly to CDFIs' portfolio management strengths, in our view; however, we might consider sustained deterioration in loan performance and delinquencies, particularly at higher magnitudes, to be a credit weakness.

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Short-Term Assets And Outside Funding Have Varied Balance-Sheet Influence

Return on average assets spiked for many in 2021 due to pandemic-related relief, but we don't expect its recent decline to pressure ratings.   In 2021, 13 of the rated CDFIs each received about $1.8 million through the CDFI Fund's Rapid Response Program, and in 2022 10 rated CDFIs received an average of $5 million from the CDFI Fund's Equitable Recovery Program. While many continue to receive grants from the CDFI Fund and other sources, we do not expect a repeat of the pandemic-era influx.

The frequency, size, and source of grant awards for rated CDFIs can vary, and lead to return on asset fluctuations, but that does not dilute their significance.   We expect the five-year average ROA ratios to remain either neutral or positive in our credit analysis of each rated CDFI. Grants offered by the CDFI Fund provide financial resources for many rated CDFIs, most commonly through the Capital Magnet Fund, excluding allocations provided through the New Markets Tax Credit program. Other federal resources include credit enhancement facilities through the Department of Education for charter school lenders, providing cushion on balance sheets should loan performance materially weaken. Although the receipt of such grant funding is not a key credit factor in our analysis, we recognize the positive credit implications for these and other similar federal awards (see chart 6).

Grants and prepayment dollars received in 2020 and 2021 that led to a spike in short-term assets on balance sheets have largely been deployed as lending capital.   Short-term asset balances decreased by a median of 6% in 2022 before rebounding with a median increase of 14% in 2023. While we consider short-term assets to total assets in our liquidity analysis, rated CDFIs also typically have access to undrawn external liquidity sources. In addition, many successfully match their short-term needs (such as upcoming debt service payments) with available liquid assets (such as maturing loan principal balances, short-term assets, or undrawn external lines of credit for unrestricted uses), a credit strength we expect will continue.

The $27 billion Greenhouse Gas Reduction Fund (GGRF) could support CDFIs' growth strategies, and those of other rated issuers in the affordable housing space.   The magnitude of GGRF awards could have varying credit implications for its recipients during the multiyear performance period. Whether funds are recognized as additional net assets for (perhaps forgivable) loans and grants, additional operating revenue (such as interest income or servicing fees), or reimbursements for staff time, how CDFIs are involved with the deployment of these funds and how they are recorded (such as off-balance sheet or through subsidiaries) will inform our view of their potential influence on creditworthiness. While the financial implications for each awardee and subrecipient will be determined during the next year and beyond, we believe rated CDFIs will adjust their organizational capacity to successfully execute on this additional mission-driven work, as evidenced by some CDFIs already hiring additional staff. (See "Your Three Minutes In The Greenhouse Gas Reduction Fund: Efficient Networks Put U.S. CDFIs In Good Position To Lead Change," published May 21, 2024).

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Our Views On Common Sectors In Rated CDFI Portfolios

Affordable multifamily housing.   In the July 9, 2024, commentary, "The U.S. Rental Housing Sector Remains Largely Stable While Expense Pressures Loom," S&P Global Ratings notes that the U.S. has largely recovered from the effects of the pandemic-related closures, but affordability challenges persist, as there remains limited, albeit slowly growing, affordable housing supply. Ongoing demand has generally kept occupancy at Section 8, mobile home, and unenhanced affordable properties high and stable, leading to consistent rental revenue. However, the age-restricted subsector continues to face challenges, including comparatively high vacancy rates and lower-than-budgeted revenue, even though revenue trends have improved year over year and recovered from the lows seen during the height of the pandemic. The high-cost structure within the rental housing sector remained consistent with 2022, with maintenance and repair, insurance premiums, and payroll-related expenses representing the largest share of operating costs.

The Nov. 7, 2024, commentary "How Could A Second Trump Term Affect U.S. Credit?" noted that a Trump presidency and Republican Congress could bring somewhat positive effects on housing affordability initiatives, but potential immigration and labor policies could have somewhat negative effects on homebuilders and developers. Drivers for the potentially positive effect on affordability include proposals involving opening federal lands for home construction or cutting regulation and permit requirements for homebuilders.

Charter schools.   S&P Global Ratings' median financial metrics for rated charter schools remained healthy in fiscal 2023, reflecting flexibility provided by federal pandemic relief funds and stable-to-increased state per-pupil revenue, per the June 25, 2024, commentary "U.S. Charter Schools Sector Fiscal 2023 Medians: Healthy Financial Metrics Amid Looming Fiscal Cliff". Spurred by extraordinary growth in enrollment levels across the rated charter school universe in fall 2022, both margins and lease-adjusted maximum annual debt service (MADS) coverage showed growth after moderating in fiscal 2022. Further supporting this improvement was the growth in state per-pupil funding, increasing in states with rated schools by a median 6% in fiscal 2023 after rising by only 3% in fiscal 2022, along with the moderating rate of expense growth, which increased by a slightly more modest 10% in fiscal 2023 after rising by 15% in fiscal 2022. These two trends, combined with the financial cushion provided by federal stimulus money, led to better financial results for charter schools in fiscal 2023. However, Elementary and Secondary School Emergency Relief (ESSER) funds must be spent by September 2024, and in many cases have already been exhausted.

In our view, the budgetary transition post federal funding should be relatively smooth for schools that have been using these funds for one-time needs only, but those that have been relying on emergency money for regular and recurring expenses could face significant operating pressures in the form of a "fiscal cliff." These pressures could continue to hamper schools with leaner management teams, less oversight, and weaker operating flexibility. Overall, reserves have remained elevated for the past three years, which could provide some cushion once one-time funds are depleted. At the state level, we believe that record strong reserves currently supporting state credit quality (See "U.S. States' Fiscal 2025 Budgets Navigate Evolving Risks As Economic Growth Prospects Wane," published May 28, 2024) will support per-pupil funding in the near term, though increases might be more modest than in recent years. We anticipate operating and balance-sheet metrics for the sector should remain largely intact through fiscal 2024, with some weakening in issuers at the lower end of the ratings distribution.

Commercial real estate.   In "Credit Conditions North America Q4 2024," published Sept. 25, 2024, elevated financing costs are pressuring asset valuations and heightening refinancing risk for most types of commercial real estate (CRE). Declining demand for office space is particularly weighing on valuations and curbing cash flow. Certain segments and regions within the multifamily sector are also facing challenges as rent growth softens. All this may ultimately lead to more broad-based, and in some cases severe, loan losses for debtholders, such as U.S. banks (with regional lenders having proportionately higher exposure to CRE than larger U.S. lenders do), insurers, real estate income trusts (REITs), and commercial mortgage-backed securities (CMBS). Higher office vacancy rates and shuttered ground-level businesses could also affect tax revenue for cities.

Small businesses.   The "Structured Finance Esoteric Quarterly Roundup: Q4 2024," published Oct. 18, 2024, noted that Small Business Administration (SBA) loan delinquencies have increased to pre-COVID-19 levels, primarily due to inflation, higher operating costs, and higher interest rates driving higher borrowing costs. However, we expect transactions backed by SBA loans to exhibit stable performance due to the strength of the structures that pay down note principal faster than the collateral, thus building overcollateralization. According to the Federal Reserve's "2023 Report On Employer Firms", small and large bank approval rates for small business loans are also back to pre-pandemic levels, while full approvals remain below pre-pandemic levels. Meanwhile, approvals at finance and online lending companies remain below pre-pandemic rates. These dynamics may continue to fuel SBA loan demand, possibly creating opportunities for smaller banks and non-bank SBA lenders to grow market share.