TIF Case Study by William T. Conard, partner in the Bricker & Eckler Investment & Structured Finance Group.

Secondary Offering Products
and Tax Increment Financing

A popular financing technique often employed in connection with real property development is "tax increment financing," also known as TIF. The basic concept, which differs from state to state, is to capture the increase in real property taxes associated with the development of property so that amount may be devoted to certain costs of development. While every jurisdiction has its own variation on this theme, a number of common elements exist, including:

• Abatement of some portion of the real property taxes payable as a result of the increase in value of certain designated property for a definite number of years;
• The agreement of the property owner, generally the developer, to make payments in lieu of taxes (PILOTS) in an amount equal to the taxes abated; and
• The application of the PILOTS to permitted development costs.

Again, every state has different statutes relating to the use of TIF and PILOTS, but often bonds may be issued in anticipation of the receipt of the PILOTS to create a construction fund. The bonds may or may not be tax exempt, depending upon the use to which the facilities financed by such bonds will be put. Under some statutory authority, tangential infrastructure of a public nature may be financed, while in other instances costs more directly associated with the development may be financed. Retail shopping developments have often benefited from the use of TIF techniques.

Developers typically find TIF arrangements useful because the financing uses as a source for debt service amounts the developer would be required to pay absent a tax abatement (i.e., the PILOTS) and devotes such revenue stream to the payment of some costs integral to the development of real property. When properly structured, the resulting bond issue can bear interest at tax-exempt interest rates, which require that less of the revenue stream be devoted to interest, thus increasing the amount of project costs that can be financed from the PILOTS.

The Problem

On occasion, the use of TIF techniques and bond financing will not solve all difficulties associated with a project. In some cases, a developer may be required, either legally or politically, to make what can best be described as equity contributions for certain purposes or in certain manners. In some cases, the credit worthiness of the governmental issuer may not be particularly strong, with the result that the bonds supported by the PILOTS may bear interest at higher than optimal rates. Likewise, when the debt service payments are restricted to the PILOTS, it is not unusual for the bond market to be reluctant to buy the bonds at any price when a project is still in the "Greenfield" stage. It is also possible that the bond market may be unreceptive to the purchase of such bonds unless they bear interest rates almost as high as taxable bonds.

There have been instances when the combination of these and other factors have resulted in the purchase of the bonds by the developer. Such a purchase provides the "equity contribution" and provides for the previously described construction fund. The developer is usually comfortable with the risk of the investment because in most development situations, the developer is the initial owner of all the taxable property and generally continues to own the largest share of the real property for some time. In such a role, the developer's risk of non-payment is essentially that it won't "pay itself" in that the PILOTS are applied to debt service on the bonds. However, the use of the developer's funds for this purchase may have the effect of reducing the rate of return to the developer and tying up capital or credit lines that could be more effectively used for other purposes.

Bricker & Eckler's Solution

One solution to the issue raised is the use of secondary offering devices to sell the bonds held by the developer. After a period of time has elapsed, projects are more seasoned and the bonds will be more attractive to lenders and bond purchasers in the secondary market. The use of partnerships and grantor trusts, combined with purchase options and credit enhancement, if properly structured, can provide a number of benefits to the developer including:

• Proceeds of the sale of the bonds can be used to retire borrowings by the developer to carry the bonds.
• Capital reserves employed to purchase the bonds can be reimbursed.
• The effective interest rate paid by the developer can be lowered in a manner similar to a refunding without the necessity of involving the governmental issuer of the bonds.
• A spread between long and short-term interest rates can be employed to pay certain expenses, as well as provide a stream of income for the developer.
• The overall return on the project can increase as a result of the smaller size of the equity invested by the developer.

Every secondary offering product has its strengths and weaknesses, so every solution won't fit every problem. Partnerships, grantor trusts, custody receipts, and coupon strips are among the secondary offering products that, alone or in combination, can assist developers who hold TIF supported bonds in increasing the rate of return, lowering the cost of funds and improving the viability of many real estate development projects.

For more information, contact William T. Conard at 614-227-2351 or wconard@bricker.com.