In the history of infrastructure financing, special districts have a long and impressive resume. Across the United States, special districts — such as Nevada's limited improvement districts, California's Mello-Roos Community Facilities Districts, and Texas' Municipal Utility Districts — provide financing for public infrastructure improvements in lieu of private funding outlays.

Developers, equity participants, debt providers, and regulators must increasingly contend with the impact of special district liens on secured assets as they restructure troubled assets, recapitalize real property ventures, acquire distressed real estate, protect debt or equity positions, or obtain project ownership through foreclosure or deeds-in-lieu of foreclosure. Whether capital market participants decide to buy, sell, or hold, the details of the special district that were once considered relatively immaterial often become the linchpin to successful asset resolution. Those lenders and investors that understand in detail the substance of and interplay among special district financing vehicles, municipal bonds, and real estate finance can convert that knowledge into asset optimization and profit.

The Special District Knowledge Gap

Commercial banks, savings and loans, land banks, opportunity funds, private equity investors, pensions, and other real estate capital providers have generally approved of the special district encumbrances because they traditionally have enhanced the value of the capital- or debt-provider's security with additional infrastructure capital and facilities, notwithstanding that the special district lien is superior to the lien of the lenders' security. Moreover, tax-exempt bonds bearing lower interest rates and non-recourse, off-balance sheet status add an additional piece of debt in the capital stack that limits the requirement for additional private debt or equity. Consequently, capital and debt providers rarely participate in special district formation and, in fact, often rely upon the development operators to avail themselves of special district funds to satisfy capital requirements for a project. This decoupling of money source and development concern has resulted in a huge knowledge gap on the part of secured creditors about special district financing that encumbers their real property collateral.

Now that property values have declined and capital markets have tightened, the impact of special district financings on real property valuations is rarely understood by debt and equity providers. On the other hand, those with knowledge of special districts and workout techniques can apply that knowledge to enhance asset valuations and to confidently purchase or sell debt at prices resulting in extremely high returns.

Understanding Special District Encumbrances

The first step in understanding what to do when faced with a special district encumbrance on an asset is to analyze the tax rates and methods of apportionment of the special district levy. The amount of the special district levies are fixed at the time of district formation when an appraisal is conducted, and the special district tax is sized to ensure that the overall tax rate for real property in the special district meets or falls below the established municipal bond market threshold – usually 2% of forecasted home values in the case of a residential community. If the burden of the special district levy exceeds that 2% level, it may hinder the residual value of the property because a higher-than-market tax burden thwarts product absorption. A number of more recently formed special districts sought to mitigate this risk by imposing a mandatory prepayment on a lot-by-lot basis as a condition to a developer's receipt of a certificate of occupancy when reduced property values cause the overall tax burden to exceed the 2% cap. But, while elegant in theory, the buy-down results in a cash call at a time when cash flow is scarce, resulting in less money for debt service and a lower residual value. These issues also affect creditors' decisions to sell or hold a special district encumbered asset.

Investors and lenders holding special district encumbered assets through foreclosure or negotiated transfer must pay annual real property taxes and assessment levies on such assets. Without keeping tax payments current, penalties result, and an accelerated foreclosure process ensues. Depending on the amount of outstanding bonded debt secured by special taxes or assessments, this carrying cost can be economically significant.

Strategic Alternatives

Alternatives available to debt and equity participants depend on the circumstances involved. Relevant inquiries include, among others: whether bonds have yet been issued; whether the project development is currently vacant land, a partially completed community, or a fully built-out development; whether residents live in the special district; whether the issuing agency will cooperate; whether bond moneys remain on account; whether capitalized interest is available for payment of debt service; and whether developer defaults have occurred.

Successful strategies for managing the impact of special districts under various scenarios include:

  • Lowering the tax or assessment impositions and attendant annual debt service
  • Financing of authorized improvements directly from annual assessments or tax levies rather than through bond proceeds
  • Cancelling the special district lien
  • Partially or fully prepaying the special district lien
  • Creating tax zones to match revised development products and absorptions
  • Issuing refinancing bonds, including adjustable rate, credit-enhanced, or privately-placed securities

In each case, the goal is to efficiently optimize the marketability of the asset and lower carrying costs. Local government agencies, weary from delinquencies, foreclosures, and defaulted bonds, will often work with debt and equity providers to restructure special districts in a mutually favorable manner.

Preserving Proceeds

The opportunity for a successful financial outcome is often enhanced when bonds have not yet been issued against special district levies. Customization of debt parameters and lien burdens are much easier to structure. Where debt is outstanding, however, special districts still offer ample opportunity. When property is taken back from a developer, there may be construction fund moneys, maintenance hold-backs, unclaimed deposits, and investment earnings available for financing additional infrastructure improvements or as a source of repayment for improvements already constructed.

The presence of unexpended bond proceeds can also be preserved for use by subsequent purchasers or joint ventures, thus providing a lender or investor a means of obtaining a higher market value for the project. The right to use these funds, however, does not necessarily follow ownership of the property, so subsequent purchasers of partially completed projects must quickly arrange for the continued effectiveness of acquisition agreements and other operative finance documents previously executed. In some instances, cure rights must be exercised or bankruptcy court approval obtained to access bond proceeds.

When Opportunity Meets Preparedness

Whether a lender seeking to maximize recovery on a loan, a bond trader seeking to buy low and sell high, a developer seeking to restructure a distressed development, a private equity fund seeking to profit from an opportunity purchase, or a regulator charged with appropriately valuing a real property asset, the impact of special district financing in today's real estate environment must be understood. Through careful analysis based upon strategic advice from experienced public finance and real estate professionals, financial stakeholders can navigate with clarity and optimize the opportunities presented.

Goodwin Procter LLP is one of the nation's leading law firms, with a team of 700 attorneys and offices in Boston, Los Angeles, New York, San Diego, San Francisco and Washington, D.C. The firm combines in-depth legal knowledge with practical business experience to deliver innovative solutions to complex legal problems. We provide litigation, corporate law and real estate services to clients ranging from start-up companies to Fortune 500 multinationals, with a focus on matters involving private equity, technology companies, real estate capital markets, financial services, intellectual property and products liability.

This article, which may be considered advertising under the ethical rules of certain jurisdictions, is provided with the understanding that it does not constitute the rendering of legal advice or other professional advice by Goodwin Procter LLP or its attorneys. © 2009 Goodwin Procter LLP. All rights reserved.