CDFA Spotlight: Tax Increment Bonds: Ratings & Non-rated Structures

*Source: Tax Increment Financing with Bonds session at the 2006 CDFA Annual Summit. Presenters: David Hitchcock, Director, Standard & Poor’s; Fran Busby, Managing Director, Bank of America Securities.

Tax increment financing (TIF) captures the future tax benefits of real estate improvements to pay the present cost of those improvements. It is a financing strategy designed to make improvements to a targeted project area or district without drawing on general fund revenue or creating a new tax. TIF can be used for a variety of purposes, from streetscape upgrades to water and sewer infrastructure, to parks and greenways. One way to cover the upfront costs of these improvements is to issue of tax increment bonds, with debt service paid by taxes generated by development within the designated project area or ‘district.’

Part I: Rating TIF Bonds
Adapted from S & P presentation

Tax increment bond ratings are tied to the performance of the TIF district, not the city’s general obligation. As a result, the rating of tax increment bonds in a city is different than that city’s general obligation rating. Rating tax increment bonds hinges on local economics, trends, and taxpayer diversity, with taxpayer diversity being the most highly correlated statistic.

Taxpayer diversity is calculated as a percent of incremental assessed value, not of total assessed value – that is, the assessed value gained following the establishment of a TIF district. As cities establish larger TIF districts, taxpayer diversity (and bond ratings) improves. However, creating large districts – sometimes the size of an entire city – may conflict with targeted redevelopment objectives.

Raters also look at (a) whether the district could survive the loss of one or more top taxpaying tenants, (b) how debt service could be managed in the case of broad-based decline of assessed value decline, (c) real estate trends and historical assessed values in the designated area, and (d) the types of properties located or developing in a TIF district. The assessed value of hotels is the most volatile, followed by warehouses, commercial, condos, and last residential.

Tax increment bonds ratings by Standard and Poor’s (S & P) run from AA- to BB-, with a total of 351 public ratings in 2006, up from 158 in 1996.

• Many issuers opt to offer TIF financings on a non-rated basis. Keep in mind that it is virtually impossible to secure a rating on a TIF project upfront without recourse to the local governments credit. Non-rated TIF financings provide a means of risk management for balancing competing public policy concerns. Sophisticated municipal issuers perceive non-rated TIF bonds as an appropriate way to manage risk in certain circumstances.
• This approach provides upfront financial incentives to the desired project.
• Allows for strong capitalization via TIF bonds at the initial stage of development, when the project requires assistance.
• “Fire-wall of Risk”: since the bonds are non-recourse, a local government’s general credit and tax payers are not placed at risk for payment of debt service.
• Rather, institutional bond purchasers shoulder this risk, and are compensated for doing so in the form of yield.
• Some local governments re-finance (i.e. take out) the non-rated TIF bonds with their rated GO bonds, once the project has stabilized and have advanced beyond the early years’ real estate development risk.
• At this point, the higher coupon, non-rated TIF bonds are replaced with lower interest rate, investment grade bonds. At this point, the local government perceives the project risk level has reached an acceptable level and is appropriate to “fold into” its general obligation base.

• The bonds are purchased by institutions, primarily mutual funds and occasionally property/casualty insurers.
• A typical fund will keep a portion of its portfolio in non-rated securities for yield reasons.
• Most major mutual funds buy non-rated TIF bonds. Most analysts will have reviewed non-rated TIF credits around the country.
• There is an established set of credit criteria for non-rated TIF bonds.
• Institutions find non-rated TIF bonds attractive due to their yield coupled with the opportunity for capital gain.
• Most municipalities require that the bonds be marketed in large denominations to ensure that the bonds are held by institutions.
• The national standard is $100,000 denominations, although some states have higher requirements.
• States are moving away from investor letters as this requirement, if it has any teeth at all, profoundly affects interest rate on the bonds. Many (if not most) institutions by-laws prohibit purchase of transfer-restricted securities. For those that do, capital valuation procedures are considerably more costly than for non-rated securities.

• It is difficult to estimate the “political” side of the process, which often requires significant information sharing between local government and developer. Local governments are making a significant financial commitment and usually require education and dialogue prior.
• All investors/lenders (i.e. bonds, private lenders, equity investors) will want to make sure that the overall plan of finance “hangs together”. Quite often, the bonds and loans close simultaneously. This “parallel track” can also affect the schedule.
• Setting aside these two variables, the bond sale/underwriting process is approximately 3-5 months.
• While offered publicly, the sales process is closer to a private placement, involving considerable analyst review including site visits.

• Long term, fixed rate bonds. Generally, term bond structure with sinking fund amortization of principal.
• Large denominations (usually $100,000), but no transfer restrictions or investor letters.
• Non-recourse to either the issuer or to the developer.
• Pledged revenues vary but a typical pledge is a security interest in the TIF revenues and any “back up” special assessment. Back up special assessment is levied to extent necessary to fund any “gaps” in TIF revenues.
• Publicly offered to institutions via limited public offering. Sold to institutions. Prospectus is a limited offering memorandum.
• Funds and accounts are trustee-held.
• Costs of trustee, continuing disclosure, and annual preparation of cashflows/assessment roll is imputed into annual cost. No additional cost to the municipal issuer.
• 2-3 years capitalized interest reserve funded from bond proceeds.
• Debt service reserve fund.
• Quarterly continuing disclosure is the industry standard for non-rated TIF bonds.
• Debt service coverage varies based on type of TIF revenue and other security features.

• The cover carries clear and bold disclaimers on non-rated status, limited pledge of revenues, and non-recourse nature. Also language about limited offering to institutions/accredited investors.
• Focus of prospectus is on the project and its economic viability.
• Very limited disclosure on the municipal issuer, since bonds are non-recourse.
• Bondholders Risks sections.
• Typical appendices include: engineers report, forecast of TIF revenues, bond cashflows, market study, bond documents, continuing disclosure agreements.