No G.O.: Project financing without the taxpayer burden

Washington, D.C., is getting a new public school. That, in itself, sounds like no big deal, except that the last public school in the district was built 20 years ago, and financial problems over the last decade — combined with an overburdened tax base — have given D.C. a reputation as a place that could not build a doghouse, let alone a school.

In 1997, the district conducted a study confirming that its funds fell short of the $2 billion needed for school repairs. The study also identified 700 acres of land surrounding public schools, some of which it determined were commercially viable. To exploit that advantage, D.C. enacted legislation establishing a PILOT (payment in lieu of taxes) program to encourage private sector investment in which cash flow covered school construction debt service.

The district responded to the legislation’s passage by swapping nearly an acre of district-owned property for cash flow from a new apartment complex to pay debt service on $11 million worth of 35-year school bonds. As a result, the shuttered 70-year-old James Oyster Elementary School is being demolished and replaced by a new 350-student facility.

To make the project work, D.C. conveyed a .88-acre open lot behind the school to a private developer and a life insurance company. The two are building a 211-unit, privately financed luxury high-rise apartment building. The taxes on the high-rise will pay about $725,000 a year in debt service to cover the school bonds. Since the district owns the land, that money is considered payment in lieu of taxes. If the apartment building is not completed by a certain date, the insurance company has guaranteed that it will redeem the school bonds. (The developers are building both the high-rise and the school so the site works as a whole.)

The right projects

As in Washington, D.C., finance officers with a creative bent are finding innovative ways to pay for projects and services without slipping yet another hand into taxpayers’ wallets. With off-balance sheet financing, cash flow from revenues or other sources takes taxpayers off the hook. Often, those projects require a willingness to partner with the private sector, to work with divergent constituencies and to offer financial guarantees to attract investors. Projects that can be financed creatively must qualify on three counts: They must meet a compelling need; they must be financially viable enterprises on their own; and they must win investor support.

Traditionally a bastion of general obligation financing, elementary and high schools are emerging as a promising sector for creative financing efforts. The impetus for those projects can come from unlikely places. In the case of the James Oyster Elementary school, parents and the community gave life to the project.

The school is bilingual, requiring team teaching of all subjects in English and Spanish. But the building was woefully outdated and poorly configured to accommodate that type of program. “We had to find a way to secure the school’s future,” says Mary Filardo, director of the 21st Century School Fund. The concept of a public-private partnership to get the school built gained momentum in 1995 when the fund was awarded a planning grant from the Ford Foundation.

In addition, colleges and universities are turning to the off-balance sheet approach to finance student housing. In one model, a private developer builds the project, typically on or adjacent to campus, using financing of a special purpose, tax-exempt entity. Student rental fees go to the project, not to the college or university.

Creating enterprise systems

Elsewhere, city and county officials grapple with ways to pay for projects while respecting taxpayer conservatism. For example, Chicago has converted potentially self-supporting services to an off-tax-base enterprise model.

Parking is critical to Chicago’s downtown office, retail, arts and entertainment core. Underground garages built nearly half a century ago with taxpayer money had slipped behind in repairs and maintenance. Feasibility consultants demonstrated that demand in the Grant Park/

Michigan Avenue business area alone faced a deficit of 4,565 spaces. Additionally, the new Millennium Park, a key project of Mayor Richard Daley’s administration, will increase the need for parking by 23 percent.

To address the situation, Daley charged two of his top lieutenants, former chief of staff and park district general superintendent Forrest Claypool and Park District Board President Michael Scott, with bringing spending under control and turning functions that could be self-sustaining into enterprise systems. Scott proposed a policy review to determine where fees could be increased while preserving the district’s core functions: providing free or affordable access to park services and recreation in all neighborhoods.

To make the garages self-sustaining, the park district began raising fees to bring them closer to commercial levels. The result of the fee increase was a $75 million revenue bond — the district’s first since the early 1980s — used to renovate the district’s massive garages under Michigan Avenue. Fees paid by users of the parking garages will support the debt.

(Next on the agenda: Scott has asked the current parks superintendent, David Doig, to re-vamp Chicago’s vast harbor system, the largest in the United States, historically financed and maintained with taxpayer money.)

The pitfalls

Revenue bonds are not new to the municipal market. After the Great Depression, public projects supported by user fees, rather than taxes, began their ascent. Revenue bonds mushroomed after World War II when the federal, state and local governments began building a national highway system, significantly financed by toll roads.

During the ’70s and ’80s, the municipal market became accustomed to huge bond sales from electric utilities to finance growth and expansion of generating plants. The use of revenue bonds is commonplace today for water and sewer systems, municipal electric service and solid waste. Institutions of higher education also use tuition revenues or dormitory fees to finance projects. In fact, revenue bonds outpace general obligation full faith and credit by two to one.

Currently, there is a movement among finance professionals to make projects like schools and municipal parking facilities independent of the tax base, a trend that coincides with the tax limitation measures that are passed with increasing regularity by fiscally conservative voters. In Chicago, officials knew they would likely not be able to take advantage of general obligation bonds because of a tax cap.

Still, putting together privately financed public projects can be difficult and costly. Mistrust can exist between public and private sectors, and public officials who oversee projects can incur negative publicity if private partners fail to deliver as promised.

Developers and builders typically are impatient with the arduous processes and procedures of government. Projects tend to move faster and more efficiently when governments designate an individual or team to “quarterback” all stages of the process. “We went through three superintendents, two mayors and countless staff reviews,” Filardo says.

The cost of doing projects off the general government balance sheet is higher than the cost of doing them with traditional financing because there is more risk. The investment community historically has favored the Full-Faith-and-Credit pledge of local government with lower interest rates and lower borrowing costs.

Too, ratings agencies traditionally rank general government, tax-backed financings higher than revenue-backed projects. In many cases, project financing may not qualify for an investment-grade (typically BBB or Baa and above) rating.

Additionally, the structure may be too quirky to gain easy market access or fit into the tried-and-true rating analysis. (Bond insurance, acquired in both the Washington, D.C., and Chicago examples, can cut the risk considerably.)

Off-balance sheet projects are complex and pose challenges to governments that are accustomed to plain vanilla financings. Policy issues, tax laws governing the role and benefits to private sector companies, and managing multiple interests come into play.

In Washington, Filardo worked with the school project’s neighbors from the beginning. Without the community’s support, naysayers would have killed the project before it got off the ground, she says. As in Washington, persistence, a clear vision of the goal and willingness to work with many different partners, can give local leaders a hand in finding alternative financing options — a hand that is not in the taxpayer’s pocket.

Natalie Cohen is a principal and municipal underwriter at ACA Financial Guaranty, New York, which managed the deals in Washington, D.C., and Chicago. She was formerly president of National Municipal Research and publisher of the Fiscal Stress Monitor. Cohen can be reached at (212) 375-2042 or [email protected].