As municipalities and states face continuing budget deficits, reduced revenues, and cutbacks in capital budgets, they are by necessity seeking creative ways to finance the delivery of essential facilities. Municipal leases provide a creative, yet straightforward, financing alternative to traditional general obligation (G.O.) debt financing. Similar to general obligation debt, lease-purchase financing enjoys tax-exempt status. Cities, counties, and states, as well as school districts are now acquiring, constructing, or renovating facilities through the use of lease-purchase financing.
A lease-purchase financing, involving capital assets of a significant size, is often financed using Certificates of Participation (“COPs”). COPs are securities that look and “feel” similar to tax-exempt bonds in that they pay the holder principal and interest on the securities. The COPs represent fractionalized interests in the lease payments made by the municipality under the lease-purchase documents. Because the COPs simply represent an interest in the lease, in most jurisdictions they do not represent indebtedness of the municipality. The proceeds of the sale of the COPs are used to pay development costs in the same manner as bonds and notes are used to finance permanent improvement projects.
Lease-purchase financing typically provides for and allows the lease payments to be “subject to annual appropriation” by the municipality. The municipality thereby reserves the right to “walk away” from the transaction without penalty if it elects not to appropriate funds for the lease in subsequent years. The municipality receives a credit for each lease payment and at the end of the lease term, the municipality can acquire full ownership of the asset at no cost or for a nominal amount (e.g. $1.00).
Benefits of Lease-Purchase Financing and Certificates of Participation
• The primary advantages of lease-purchase COPs financing are flexibility and speed. COPs allow for the immediate availability of funds for needed capital projects, and in most jurisdictions, are not subject to a voter referendum. Construction inflation can lead to substantially higher costs for those facilities that are delayed due to budget cutbacks or adverse voter sentiment.
• Financing spreads the capital costs of projects over several years. Often the general fund can handle the cost of repaying the financing over time, but not the immediate cost of the outright purchase price or construction cost of an essential facility. In effect, COPs leverage the general fund revenues to acquire the resources that are needed today. This can also be seen as more equitably matching the public user benefits to the public user cost over time. Furthermore, lease terms are typically flexible, including lease payments that escalate over time, allowing for lower initial payments.
• At the end of the lease term (upon the full amortization of the COPs), ownership of the facility can revert to the municipality. All payments are credited towards the purchase and directly reflect the cost of amortization. There is no costly arbitrage “risk premium” paid to a private developer, as is typically the case when leasing space in privately owned, conventionally financed facilities.
• Federal tax law treats a municipal lease like a bond or note of the municipality, resulting in the availability of a tax-exempt interest rate for the lease transaction. Just like municipal bonds, the lease financing must be for a qualified governmental or non-profit purpose in order to be tax-exempt, and a private party cannot be the actual beneficiary of the tax-exempt financing.
• Another major benefit of a municipal lease is that it is subject to annual appropriation and, therefore, in most jurisdictions is not considered debt of the municipality. Under a municipal lease, the governing board of the municipality must appropriate, on an annual basis, each year’s lease payments in the year that they are due. This annual appropriation feature usually provides an exception from the municipality’s normal debt limitations.
• Although lease-purchase financing is subject to the annual appropriation of funds, the capital markets have priced this form of debt very efficiently. Lease-purchase financing, or COPs, has been in existence for over 30 years with a very low level of default. The capital markets know that although a jurisdiction is under no direct obligation to make the annual lease payments, in practice, jurisdictions make these payments a top priority. First, these facilities are typically essential to the functioning of the governmental entity or its agencies, and a failure to continue the payments would deny the entity from use of the facility. Second, a failure to continue to make payments may have a negative impact on the entity’s credit rating and future access to the capital markets.
• When combined with the use of a nonprofit corporation as the nominal owner and a “turnkey” delivery process, a lease-purchase structure can expedite and improve the efficiency of facility delivery in many jurisdictions. In other words, procurement procedures can be streamlined and sub-contractors can be chosen based on the lowest “qualified” bid instead of the more common “lowest bid” process.
Special Considerations of Lease-Purchase Financing
• As noted previously, the interest rate or cost of funds associated with lease-purchase financing is slightly higher than that of general obligation debt, as may be issuance costs.
• The capital markets may also require debt service reserves, typically comprising one year’s interest and principal payments, to be raised as part of the original offering. However, reserves raised as part of the offering are an asset of the leasing municipality, and earn interest that reduces the annual net debt service. Typically, in the final year of the lease, the entire reserve is applied to reduce or eliminate the final year’s lease payment from the municipality. In certain cases, a lower-cost solution of a debt service surety reserve may be acceptable in lieu of a full debt service reserve.
However, these costs must be weighed against the savings that can accrue to a municipality by using lease-purchase financing. Essential facilities can be delivered for substantially less money and years ahead of schedule when the municipality is facing cutbacks in capital budgets, reduced revenue, and the time, expense and uncertain outcome of voter referendums. The immediate delivery of a facility can also insulate the municipality from the substantial cost of construction inflation and the uncertainty of future interest rates.
Garfield Traub Development’s Experience with Municipal Lease-Purchase Financing
Garfield Traub Development, in its role as a “turnkey” developer, has structured lease-purchase COPs financing for the following clients and essential facilities, among others:
• New York State Department of Transportation Region 1 Headquarters – The delivery of this facility involved an advantageous tax-exempt financing and lease-purchase arrangement, the first of its kind in the State of New York. The State’s general credit and taxing authority were not required. The State will make annually appropriated lease payments and will own the facility debt-free when the financing has been fully amortized at the end of the lease term. Garfield Traub’s innovative financing solution allowed the project to be delivered in record time while still taking advantage of the low-cost tax-exempt financing that resulted in the lowest cost of occupancy to the State.
• Washoe County Public Safety Training Complex – Under a creative installment sale delivery, the first of its kind in the State of Nevada, development funds were raised through the placement of AAA-insured tax-exempt certificates of participation. The certificates are secured by annually appropriated lease payments from the County, which will be offset indirectly by revenues from a sales tax bond issue. Payments will be further offset to the extent that space is leased to other tenants, and the County will own the facility debt-free when the financing has been fully amortized at the end of the lease term.
• City Court of Atlanta – Under a creative lease-purchase delivery, financing for this $62 million facility was raised through the placement of AAA-insured tax-exempt certificates of participation. The certificates are secured by annually appropriated installment payments from a specific source of revenue isolated from the City’s general fund, and the City will own the facility debt-free at the end of the lease term. The financing is “off-balance sheet” to the City of Atlanta and will not impact the City’s debt capacity.
Get the complete print out of this MUNICIPAL LEASE-PURCHASE FINANCING whitepaper now.