“[There is] a huge knowledge gap on the part of
secured creditors about special district financing... .”
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.
