3.3 Funding the Capital Budget
3.3.2 Types of Debt and Method of Sale
General obligation, or GO bonds, are backed by the full faith and credit of the issuing government, the ad valorem taxing power. In most states, GO bonds require a special election and are approved for specific purposes.
For example, the proceeds from the sales of bonds approved for street projects cannot be used to fund a public building. GO bonds are viewed by the municipal bond market as the most secure type of debt and therefore sell at the lowest interest rates for municipal bond debt. In most, but not all states, GO bonds must be sold by sealed competitive bid. This means that underwriters responding to the offer to issue such debt propose an interest rate the issuing government pays, with the issue being sold to the lowest competent bidder.
In some states, local governments, including school districts, are authorized to issue general obligation debt that does not require voter
approval. Often called a certificate of obligation or general obligation certi- ficate, these instruments are usually issued for small or emergency needs. In some cases, however, they are used to fund large projects that have been mandated by higher levels of government when voter refusal to approve the debt would not affect the jurisdiction’s responsibility to construct the project.
Requirements for certain minimum size and quality facilities have been imposed on local governments in several areas, but primarily schools, jails, and hospitals.
3.3.2.2 Revenue Bonds
Revenue bonds are backed by a dedicated stream of revenue produced by the capital facility funded by the debt. Utilities are most often funded with such debt and repaid with revenue from utility customers. Revenue debt does not usually require voter approval; it is sold by approval of the legis- lative body and sells in the market at rates slightly higher than for GO debt.
The interest cost differential is typically 25 basis points (0.25%) for com- parably rated issues.
Revenue bonds are often sold by sealed competitive bid, but in many cases the complexity of the project may dictate that issuers work with a single underwriter and negotiate the interest cost. The amount of time and resources an underwriter expends to prepare a bid on a GO issue is very small. However, the amount of resources needed to gain an understanding of a complex issue may be prohibitive, especially when the underwriter is not guaranteed the business. For this reason, the negotiated sale is some times preferable.
The choice of whether to issue debt through a competitive bid process or a negotiated sale is dictated either by state constitution or statute, or by local ordinance, policy, or preference. Issuing governments are advised to obtain the services of a financial advisor (FA) when considering the issuance of debt. The FA is a finance professional who follows the municipal bond market closely and understands how to structure the issue and time the market. Finance directors, even in large cities, simply do not have time to acquire the knowledge needed to bring an issue to the market. Part of the FA’s services will include advising on the type of sale that is most appropriate, obtaining the services of adequate bond counsel, and helping to market the issue.
3.3.2.3 Certificates of Participation
Certificates of participation (COP) are used to fund leased property. In such an arrangement, the government entity sets up an agency to serve as the lessor so that investors work with a single agency rather than each of the
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agencies that may occupy the building or other facility. There is also a trustee, often a bank or other financial institution, who represents the interests of the investors, receiving and holding bond proceeds, and receiving and disbursing lease payments once the project is completed.
The lessor agency issues the COPs and works with the trustee that sells the obligations. In some instances, the trustee may simply maintain the COP as part of its own portfolio. Once the project is complete, lease payments from the issuing government are sent to the trustee for distribution to the individual investors. Upon retirement of the debt the leased facility becomes the property of the government. This is often called a lease-purchase agreement.
The primary benefit of this type of debt is that, technically, it is revenue debt. That is, the lease payments are pledged by the lessor agency as the stream of revenue that secures the debt. This means that the debt may sell at a slightly higher interest rate, but the bonds do not require voter approval and may not count against a constitutional or statutory debt limit.
3.3.2.4 Tax Increment Bonds
Tax increment bonds are generally associated with a geographic area called a tax increment financing district (TIF). Pioneered in Illinois, the TIF district was conceptualized as a means of spurring economic development in blighted areas where it would not likely occur otherwise. The basic idea is to identify improvements that will produce economic development causing property values to rise. The debt used to fund the improvemnts is secured by the ad valorem property tax increase (see Paetsch and Dahlstrom, 1990).
The first step in establishing a TIF is to determine the boundaries of the district. In some states the TIF is still limited to blighted areas, but more and more local governments are using the tactic as a way to accelerate growth in thriving areas. Once the boundaries are set, each of the overlapping jurisdictions that have taxing power are enlisted to participate in the TIF.
This is critical for success and, in most instances, an absolute requirement.
For tax levy purposes, each jurisdiction freezes the assessed value of each parcel within the district and continues to bill the property owner based on that value for a specified period of time, typically five or ten years but possibly longer.
The TIF district proceeds with improvements that may include streets, sidewalks, street lighting, water and sewer lines. The agency may also demolish abandoned structures or sell abandoned property to developers at bargain prices. Once development occurs, property values are reassessed.
The incremental ad valorem property tax revenue is paid to the TIF district to retire the debt. After the specified period, the TIF district is dissolved and each overlapping district uses the new property values for its levy.
3.3.2.5 Other Types of Debt
A number of other types of debt are used in many states, including short- term instruments like anticipation notes. These are often used to fund preliminary expenses on projects such as the services of a surveyor, archi- tect, or designer. Once permanent funding for the project is secured, the short-term obligation is retired. Anticipation notes can normally be secured by pledge of any revenue source, including ad valorem property tax, sales tax, or the proceeds of a bond sale.
3.3.2.6 Development Impact Fees
The use of development impact fees has become widespread over the past quarter century. These fees, first used in Florida, California, and Colorado to help manage and limit growth, transfer part of the cost of new infrastructure to the private sector by charging developers a fee for items such as water and sewer connections, street and sidewalk projects, and parks. Abuses in the use of fees led to lawsuits from developers, who charged that juris- dictions were using the fees to stop growth by charging fees many times the actual cost of the infrastructure involved. The case law established across the country in the 1980s and 1990s produced the rational nexus standard contained in Table 3.3. This standard links the fee with the actual cost of the infrastructure and requires the jurisdiction to use the funds in a timely manner for the intended purpose. For a discussion see National League of Cities (1987); Clarke and Evans (1999); and Nicholas, Nelson, and Juergensmeyer (1991).
Table 3.3 Rational Nexus Standard for Development Impact Fees
1. Each exaction must be well-designed to meet service needs directly attributable to the project bearing the cost.
2. Where facilities are to serve more than a single development, costs must be allocated in proportion to services rendered.
3. Such facilities must be elements of a comprehensive local plan for service improvements.
4. Where facilities are to be financed by a combination of tax and impact fee revenues, special care must be taken to ensure that project occupants, who pay taxes like everyone else, are not double-billed. The impact fee calculation, in other words, must be net of anticipated tax contributions.
5. Impact fee revenues must be segregated until used and must be expended in a timely fashion (generally, within five to six years for the purpose originally designated).
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