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Post-Recession Land-Secured Debt Financing

Land-secured debt is secured by the value of the property within a defined area and the taxing power of a quasi-public entity that is established with the purpose of financing local improvements. For over a century, it has been an attractive option to both developers and public agencies in the financing of water, sewer, and street improvements, but may also be used for public facilities such as parks, institutional buildings, and transit infrastructure. Developers like land-secured financing because interest earnings from the bonds are exempt from both state and federal income taxes, making the bonds cheaper than private financing. Also, up to a certain level of taxation, sellers are not compelled by buyers or mortgage lenders to lower home sales prices, meaning at least some of the debt service burden is passed on to homeowners. As a result, assessment liens tend to add value to property, creating a satisfactory return for a developer’s initial investment in the district formation. Public agencies also see land-secured debt as an attractive public finance option. They are willing to overlook the negative sentiment towards higher property taxes because land-secured debt is neither a general nor a limited obligation of the agency and is non-recourse. True to its namesake, land-secured debt is secured only by the underlying land.

The Achilles’ heel of this mechanism stems from the same foundation as its strengths. The stakeholders are happy as long as property values and market expectations are stable. However, in periods of market recession, attractive recovery options are slim. Homeowners are responsible for a tax that at best does not decrease and at worst increases despite delinquencies and foreclosures of lower-valued properties in the district. Developers are tempted to abandon unfinished projects as a result of the now burdensome assessment lien. Bondholders are faced with the choice of foreclosing on the land or enduring missed payments. And lastly, public agencies are forced to deal with the political backlash from homeowners and may see a rise in rates for their own general and limited obligation debt, even though landsecured debt is not an agency obligation.

Since defaults are particularly messy, it may seem that the prospect of non-recourse up-front infrastructure financing is too good to be true. However, recent default data suggests that the structure of special districts may have a greater impact on default risk than a weak housing market. 

Not all of the areas of the country hit hardest by the recession have experienced widespread bond defaults. The housing crisis has affected the markets in Arizona, California, Florida and Nevada similarly (see Box 1). Although Florida experienced smaller price declines than other hard hit states, it is home to over 80 percent of the land-secured bonds currently in default.

Each state takes a different approach to land-secured finance. This article explores how special districts in various states have fared in the two most recent housing recessions.

California Community Facilities Districts

Land-secured debt has been an option for infrastructure finance in California since the Improvement Bond Act was enacted in 1915. Since then, several related laws have been enacted, providing additional versatility and flexibility. In 1982, the Mello-Roos Act authorized the creation of Community Facilities Districts (CFDs), which may use special taxes to finance nearly any public improvement. Throughout the 1980s and early 1990s, 1915 Act bonds were still preferred by most jurisdictions until the Right to Vote on Taxes Act of 1996 placed stringent requirements on assessments. Thereafter, CFDs experienced a surge in popularity and remain the preferred infrastructure finance mechanism.

According to Stone & Youngberg, a leading underwriter of municipal bonds in California, only two of the over 400 outstanding

CFD bond issuances in California are in default. This is surprisingly low considering that certain regions of California have been hit by the recession as hard as any in the nation.

A unique aspect of California CFDs is the active role that the sponsoring public agency plays in the district formation and financing process. The council or board of the sponsoring public agency must authorize the creation of the CFD and the sale of CFD bonds. Also, the agency name appears on the residents’ tax bills next to the special tax as well as the bonds themselves. Cities and counties are wary of having their name appear in the local newspaper next to that of a bankrupt developer, even though the bonds are non-recourse.

CFD bond defaults have also been shown to hurt the ability of agencies to issue general obligation debt. This risk led most California cities to either delay issuance or place additional constraints on CFD bonds in 2006 and 2007, such as increased value-to-lien requirements, supplemental reserve funds, or demands for vertical development prior to issuance. Such restriction originated from the agency’s financial advisor or senior staff as a result of discussion with other nearby agencies. This change resulted in a significant slowdown in issuance and increased demand for CFD bonds in the months before the recession hit its full stride.

Florida Community Development Districts

In 1980, Florida passed the Uniform Community Development District (CDD) Act, establishing the procedures for creating special districts to finance infrastructure improvements. Since then, over 600 CDDs have been formed, 438 of which were formed between 2003 and 2008. The widespread use of CDDs has much to do with the streamlined formation procedure. To establish a district, the developer must file a petition with the Florida Land and Water Adjudicatory Commission (FLWAC) or the local county. Neither agency has discretionary authority over the formation process. Rather, the statute provides a regulatory checklist and procedural authority.

As with many special districts (and in contrast to California CFDs) an independent CDD board is established to levy assessments, issue bonds, and make debt service payments. The board members are initially selected by landowner election on the basis of acreage, giving the developer a majority vote in board elections until the project nears build-out.

At this time, over 168 CDDs are in default, with at least 20 more expected to default in the coming years. Declining home values and new home sales are the underlying cause of these defaults. However, over 200 CDDs were formed during the period between 2006 and 2008. Bond sales accelerated at a time when signs of a recession were appearing but the municipal bond market was still strong. The developers were able to use CDDs to issue bonds based on then-current property appraisals despite worries of an impending slowdown. After 2008, a number of projects were blindsided by the impact of rock bottom sales prices and volumes, forcing developers to abandon their projects or attempt to reorganize their debt with the help of the CDD board, the members of which were still elected by the majority landowner.

Special Districts in Other States

One state that has not had the mettle of its special districts tested recently is Texas, where the housing market has remained healthy. However, in the late 1980s, Texas experienced a number of special district defaults as a result of a housing slump. The state’s Municipal Utility Districts (MUDs) bear a strong resemblance in form and function to Florida’s CDDs. Even though the problems were not as widespread as those that Florida is currently experiencing, Texas imposed stringent new requirements on MUDs in 1995, requiring developers to provide a letter of credit for 30 percent of the bond amount before issuance. Since 1987, developers have also had the option of forming a Public Improvement District (PID), which requires more public agency control and discretion than the older MUD law. At this time, no special districts in Texas are in default.

Colorado also experienced a real estate slowdown in the late 1980s. A few of its Metropolitan (or Metro) Districts were forced to raise the ad valorem special assessment levels to make up for declining home values, resulting in public outcry. However, Colorado has not made substantial reforms to its legislation as Texas did. Rather, Metro Districts are now placing absolute percentage-based limits on the levy pledged toward bond issuances. Even though the municipal bond market was tolerant of this type of risk when bonds were sold, it is likely that Metro Districts will have trouble selling landsecured debt in the future without providing an assessment formula that can handle declining home values.

 

Conclusions

Box 2 describes aspects of the programs within some of the states with the most land-secured debt issuances. The principal similarity among states with periods of widespread defaults appears to be the ability of current landowners to elect members of the special district board. This creates a situation where the decision to issue debt and make debt service payments is strongly influenced by the payers of the assessments. This makes the assessment payments somewhat discretionary and allows the landowner to delay foreclosure, calling into question both the taxexempt status of the bonds and the idea that they are secured by the underlying land.

District structure is not the only factor in bond defaults. Illinois utilizes an assessment structure with heavy public agency involvement and a variety of checks and balances, but is experiencing a glut in assessment district defaults as a result of a prolonged decline in home values. However, the unprecedented defaults in Florida when compared with California and Nevada are a direct result of the ramp-up in bond sales during the period between 2006 and 2008. This increase in debt issuance likely would not have occurred if there were more checks and balances in the CDD formation and debt issuance process.

As a result, Florida’s state, county, and municipal borrowing costs are well above the national average and not reflective of the actual debt loads of the agencies.

Even though special district bond defaults are  strong public financing mechanism and are non-recourse to public agencies, widespread defaults have the ability to affect the health of state and municipal debt markets. States that have enacted government oversight and statutory restrictions on the issuance of land-secured debt have managed to avoid widespread defaults in the wake of the housing recession. As such, it is in the best interest of states to maintain a measure of public scrutiny and control over the land-secured debt issuance process due to the higher potential for default when executive oversight is the responsibility of the landowners.

 

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