CHICAGO — Sanitary improvement districts have long been a key infrastructure development tool in Omaha. However, the districts are increasingly distressed amid the region’s lifeless housing market, and many are starting to have trouble paying back the debt they issued at the peak of the housing boom five years ago.
A small but popular tax-exempt market that is unique to Nebraska, sanitary improvement district debt is similar to so-called dirt bonds in Florida and other states.
The debt finances infrastructure improvements for new subdivisions and is paid off with special assessments levied against the new homes.
In Nebraska, SID debt is typically issued as five-year warrants and later, once the development has value, refinanced into 20-year bonds.
Most deals are under $10 million in size, unrated, and seldom traded until they are later issued as long-term debt backed by property taxes on the new property.
Most of the warrant buyers are individual investors attracted to the high tax-free yield — currently around 7%.
Dealers say the investors are aware of the risk that the project could be an empty “field of dreams” or within five years become a successful development.
“The warrants are sold as a high-risk investment,” said an Omaha-based public finance veteran who has both marketed and purchased the debt. “They’re not being sold commonly to widows and orphans.”
While the unrated warrants usually carry a 7% interest rate, subsequent bonds usually yield rates similar to A-plus-rated debt in the current market.
SIDs have been around since the 1950s. The bulk of them are created in Douglas and Sarpy counties surrounding Omaha. Of the 843 districts that have been created, some 556 have been successful enough to have been annexed by Omaha or surrounding cities, acting to boost the city’s size and tax base.
For cities like Omaha, it’s hard to lose with a SID. Developers who want to start projects within three miles of the city limits must get Omaha’s approval and the development has to connect to city sewer and water lines.
Omaha lets the separate taxing district carry the debt until it is fully developed, and then it usually annexes the development. The city has relied on SIDs to conservatively expand its boundaries for years.
“They’ve been very, very successful vehicles for land development projects,” said Todd Engle, managing director at Omaha-based Kuehl Capital Corp., a broker-dealer. “The cities very much like the use of SIDs, as it almost provides off-balance-sheet financing for them.”
A failed SID won’t extract a direct fiscal cost on Omaha as it does not back the debt. But it could mean an “opportunity cost” for the city, which will forgo a growing tax base and population, one local underwriter said.
Five years ago, amid the housing boom, Omaha-based developers were launching SIDs with confidence, local market participants said.
“Things were looking pretty good in 2005, and there were a fair amount of districts started,” Engle said. “If you were a developer in 2005, you thought, 'Gee whiz the world will never stop turning,’ and it did.”
Roughly 55 districts have been launched in Douglas County alone since 2005, and there are still about 343 SIDs that are active and unannexed in Douglas and Sarpy counties, according to John Kuehl, senior vice president and SID manager at D.A. Davidson & Co., which is one of three firms that specializes in SID transactions.
The other two are Kuehl Capital and Ameritas Investment Corp.
For years, the taxing districts had single-digit default rates, Kuehl said. That is starting to change.
“The districts having issues — whether they got worked out or [went into default] — has probably been under 5% up until this point. That’s probably going to change going forward,” Kuehl said. “We’ve lost two to three years of building.”
The collapsed housing market has left many of the new subdivisions largely empty.
With no new homeowners, the districts cannot pay the special assessments backing the debt, which is now coming due.
With no database tracking the default or bankruptcy rate of SIDs, it is difficult to establish how many are in trouble. But a recent Municipal Market Advisors report noted that three districts are in default. Other stressed districts have declared bankruptcy or are crafting workout plans with creditors.
Most local market participants said they expect the number to climb over the next couple of years. “We live in a five-year world with these SIDs,” Kuehl said.
Distressed districts and developers are faced with the only two options available to them. One is to file for Chapter 9 bankruptcy and craft a workout plan with investors and creditors.
The other is to attempt to devise a workout plan with investors. Those developments that still have hope of becoming successful in the future can seek to extend the maturity date on the debt and try to obtain a lower interest rate.
All such plans must be worked out through the Nebraska courts. “We’re creatures of the district court,” one broker-dealer said.
For Kuehl, the downturn means that he will spend much of his time in court working out either debt extensions or workout plans for those districts that file for Chapter 9 bankruptcy rather than selling the debt to investors.
He has recently worked out warrant extensions for several districts and has been shepherding one through Chapter 9 bankruptcy reorganization.
As part of that deal, the district now has 15 years to repay the debt and will give the investors an initial cash distribution of between 28 cents and 30 cents on the dollar.
“It’s not going to be fun for a couple years,” Kuehl said.
The number of new SIDs being created has slowed to a trickle, local bankers said.
It is cheaper now for developers to buy a lot on an established district than set up their own. It could be years before distressed SIDs begin to recover.
It is estimated that the Omaha region has a glut of lots that could take five years to absorb.
Housing starts have dropped to 2,450 homes last year from a high of about 5,200 in 2005, according to Kuehl.
“There are very few new deals,” he said. “There are about 15,000 lots available, so we need to absorb some of those. There probably won’t be any new subdivisions done for the next couple years.”
Despite predicting a few grim years ahead, most public finance bankers and advisers who work with SIDs said the development tool will likely be around for a long time in Nebraska.
“It was bound to happen to even the best of developers and in the best of underwriting circumstances,” one local bond attorney said. “I’ve been in the bond business for 30 years, and over time these things work themselves out.
“Will the warrant holders get 100 cents on the dollar? Probably not,” the attorney added. “But depending on when the economy picks up and home construction picks up, there will be some collections for the warrant holders, and then the district will reach a level of real estate valuation where bonds can be sold.”
