Infrastructure needs across the United States are growing exponentially, yet the ability to fund these demands requires considerable resources and commitment. Land-secured financings represent a viable and creative tool to assist infrastructure development in the United States. While this type of bond financing possesses myriad high yield attributes, they have widely received acceptance beyond the institutional buyer with retail investors exhibiting strong demand.
While California can be considered the pioneer of land-secured deals boasting the largest and most developed land-secured financing market, other states maintain successful land-secured programs in support of infrastructure development for residential and commercial growth through property-based assessments tied to the levy of special taxes.
While the Federal Highway Administration states that special assessment mechanisms are authorized in all 50 states, the legal structure is not a one-size-fits-all framework throughout the country. Florida, Colorado, Texas, Nevada, Arizona and Utah contribute to this important sector and I expect continued expansion and market acceptance.
California Mello-Roos bonds provide additional yield and income opportunities relative to traditional investment-grade general obligation or essential service revenue bonds given that investors assume real estate development risk. These structures also provide a source of portfolio diversification in a high-tax state seeking municipal bond tax-exemption. In my opinion, a well-structured Mello-Roos land secured financing with proper due diligence and disclosures can offset the inherent credit risks associated with this sector.
Mello-Roos background and market acceptance - With the enactment of the Mello-Roos Community Facilities Act of 1982 (named after two state legislators), California municipalities were given a viable financing alternative to fund basic infrastructure needs within a planned community-based real estate development.
Such activity is funded with Mello-Roos special taxes supporting a broad range of new development that would otherwise likely be financed through property tax levies prior to the implementation of Proposition 13, in similar fashion to how parcel taxes and impact fees play a role in infrastructure improvements. Successful and enduring application of the Mello-Roos financing vehicle has been driven largely by the availability of high growth areas with undeveloped sites throughout California.
Tightly structured legal and security provisions, including a fully funded reserve, a debt service coverage requirement, an additional bonds test, capitalized interest, a covenant to foreclose on delinquent property, ongoing demand for critical infrastructure development, proven developer track records, and the ability to eventually attain investment grade status and bond insurance for a segment of the Mello-Roos space have attracted the retail investor. Mello-Roos issuance comprises about 90% of California's non-rated municipal bond market.
Mello-Roos bonds are typically sold to finance improvements in developing areas. Most securities are issued in advance of substantial private development or before the property is owned by the ultimate occupant of the completed project. Bondholder security derives from a first lien on an established special tax levied to pay debt service and, if necessary, to replenish bond reserve funds. Given that the special tax is collected on the local property tax bill, a troubled development that results in a tax delinquency may produce a draw on the reserve fund.
The breadth and depth of public services and facilities that can legally be financed through Mello-Roos bond issuance tend to be more extensive as compared to those capital projects involved with more generic special assessment bond underwritings whereby there is typically a specific benefit to individual properties.
Back in 1988, California's population was just under 28.5 million. In the late 1980s, many demographic projections placed the state's 2025 population at about 50 million. Fast forward 37 years, and California's 2025 population approximated 39.5 million. Although short by about 10 million people from estimates, growth was still significant. During this time, student enrollment and construction costs for new school facilities grew commensurately with the state's population growth.
Proposition 13 was enacted in 1978 as a constitutional amendment and effectively limited the ability of California's local governments to finance infrastructure requirements through the marketing of general obligation bonds, thus creating a problem solved by the law authorizing Mello-Roos debt issuance.
Example Mello-Roos projects include police, fire and ambulance services, public schools, parks, childcare facilities, streets and roadways, as well as flood and storm protection assets and general water system infrastructure. It can be expected that the number of Mello-Roos financings accessing the municipal capital market will remain active as demand for paper stays strong, financing alternatives are constrained, and area development within the state continues to expand.
Although certain key risk characteristics underlie the market for Mello-Roos financings, it is important to remember that this is a 45-year-old structure that has evolved favorably over time to tighten up fundamental credit attributes to make these bonds more suitable for retail investors. One notable difference today versus the earlier years of Mello-Roos bond issuance is that public agencies prefer to have development underway prior to issuing bonds.
It was more common in the past to see developers lacking the expertise to successfully navigate the development life-cycle. Today, public agencies typically require experienced developers with equity in the ground plus builders in contract to purchase lots from the developer before issuing bonds. Key risks surrounding Mello-Roos financings include:
- A limited and concentrated taxpayer base
- Volatility in assessed valuations and market comps
- Impact from housing dislocation
- Environmental concerns
- Low value to lien ratios since land is generally undeveloped. Note that the California Debt and Investment Advisory Commission requires a minimum of 3:1 value to lien ratio to issue bonds, yet the vast majority of deals today come to market with higher ratios
- Questionable projections and assumptions; uneven cost, absorption and feasibility analytics
- Although strong, there is questionable developer experience at times; pending fraud cases
- The development will proceed more slowly than planned or stop far short of completion, causing financial burdens for the property owners that could lead to the non-payment of both property taxes and Mello-Roos special taxes
- Lack of proper disclosure and compliance
- Lack of adequate attention and surveillance during capitalized interest period; pre-market site visits are essential
- While the sector has proven its endurance with expanded retail investor acceptance, certain Mello-Roos financings may encounter limited secondary market liquidity
Formation of a special tax Mello-Roos District
- The Mello-Roos Community Facilities Act authorizes a levy of a special tax to fund the purchase, construction, or rehabilitation costs associated with any real or other tangible projects with a useful life in excess of five years that are linked to growth-driven increases in demand.
A Mello-Roos Community Facilities District (CFD) can be created by any political subdivision within California provided that authorization exists to establish and offer a designated project/service. Typically following a public hearing, the formation of the CFD, the levy of the special tax, and authorization to issue debt are submitted to CFD property owners for a vote.
If 12 or more registered voters reside in a CFD, a ⅔ majority vote in favor of the tax and bond issuance is required. If there are less than 12 registered voters residing in the CFD, the vote will be made by landowners, with each landowner having one vote per acre or portion of acre owned. If the special tax is not to be levied on residential property, the vote can be by landowners who would be subject to the tax, even if there are 12 or more registered voters.
CFDs can be formed to include non-contiguous areas without regard to size or form. This notable feature makes it easier to form a CFD, secure voter approval and issue debt. It is therefore not unusual for a CFD to be established with as few as one or two landowners or developers.
Generally, Mello-Roos special taxes may be easier to approve than parcel taxes as developers typically own the land on which they are building and can unanimously pass the Mello-Roos special tax prior to construction. Upon completion of construction, special taxes transfer to new property owners without requiring a new vote.
Creation of the Mello-Roos special tax
The Mello-Roos Act requires voters to establish a maximum tax rate. However, the tax may not necessarily be set at the maximum rate and it must be levied as long as there are bonds outstanding. The tax cannot be reduced as to impair the CFD's ability to meet timely debt service. The Act does not expressly state how the special tax is to be apportioned or what the tax is to be based upon.
The one restriction precludes property value from being used as the basis for the special tax. In many instances, CFD special tax structures reflect an acreage tax crafted to closely resemble a property tax. Typically, the special tax is based upon the varying levels of benefits derived from different property classifications. The tax rate can vary by land use and zoning and the rate could change over time in response to development status.
With this in mind, conservative structures may preclude a decline in a parcel's tax rate from its original level due to changes in zoning or ultimate development density for methods of apportionment that differentiate tax rates by land use. Furthermore, the conservative design of the taxing methodology should demonstrate that debt service on the proposed bonds can be fully supported by the tax rates applicable to properties in their respective stages of development at the time of issuance. If property is undeveloped, the tax on undeveloped property should be assumed in determining the adequacy of the special tax, and not a higher rate that may apply to developed property.
Credit structure
Bondholder security derives from a first lien on the special tax levied to pay debt service and, if necessary, to replenish bond reserve funds. The special tax is (i) pari passu with local property taxes with both being senior to any private debt on the property and (ii) collected on the local property tax bill. When landowners pay taxes in a timely fashion, the special tax would not likely have to be imposed at the established maximum rate.
Conservatively, the special tax should be initially levied to generate 1.1x debt service coverage. This is done by the special tax consultant and is generally a requirement for bond issuance by the municipality before the underwriter becomes involved. If, for example, a particular tax levy was not producing at least 1.1x debt service coverage, there would be a resultant decline in the par value of bonds. The flexibility to increase the special tax to the maximum rate provides added security should a landowner become delinquent.
With a Mello-Roos financing, the special tax can be raised to the set maximum rate before the reserve fund would be applied. Accounting for possible tax delinquencies and to ensure timely debt service, a cash funded debt service reserve fund is typically sized in accordance with IRS regulations: the lessor of maximum annual debt service; 10% of par; or 125% of average annual debt service. Tax payment delinquencies can arise from specific property owner distress or simple administrative glitches such as a late mailing of county tax bills.
In the early stages of development, there is typically limited property owner diversification with the developer often being the largest taxpayer as well as the party responsible for payment of the special tax. In these situations, it is generally advisable to conduct a careful analysis of the developer's/merchant builder's track record, reputation and overall financial condition.
Some developers are publicly traded and thus there is generally more disclosure and transparency with these participants compared to others. Bond issues that are sold to reimburse developer outlays, perhaps for subdivision improvements, and engineering, architecture, and site preparation costs, may signal a greater level of developer equity investment and overall development progress. Development risk tends to be the greatest when Mello-Roos bonds are newly issued for initial funding needs.
While there are various types of special assessment bonds having different enforcement mechanisms and state delinquency and foreclosure rules, new development financings depend heavily upon successful community build-out where the lots are sold to individuals. A careful analysis of the area economy including transportation/highway links, competition from similar projects, business activity, demographic and population patterns, environmental issues, area housing performance, and property absorption expectations must be part of the overall feasibility assessment.
Covenant to foreclose
Mello-Roos financings are structured with a covenant to commence judicial foreclosure proceedings with California's Superior Court within 150 days should a delinquency of a special tax installment arise, yet delinquency triggers may vary from transaction to transaction. A delay in timely debt service would be conceivable, yet highly unlikely, if the reserve fund was depleted and the special tax was set at the maximum rate.
A purchaser of foreclosed property would only be required to pay delinquent and current property taxes and assessments, including the special tax. While a developer bankruptcy could result in disruption of special and property tax collections, I am not aware of any court pronouncement that has diminished the amount of the Mello-Roos taxes.
During the foreclosure phase, it is important to have unambiguous guidance under the bond indenture regarding identification of appropriate parties authorized to provide direction and clearly defined bondholder rights and remedies.
Land value and value to lien
While bondholders have a first lien on special tax revenue, ultimate credit advancement for a Mello-Roos financing derives from the value of the land over time. A CFD financing comprising undeveloped land should include an independent evaluation of land value through a MAI appraisal and absorption study.
Again, the standard for unrated Mello-Roos financings is a minimum 3:1 value to lien ratio. Rated Mello-Roos transactions would typically require significantly higher value to lien ratios. The closer the project is to completion, the greater the value of the land, with property owner concentration risk being the highest at the beginning phases of project development.
Capitalized interest
Under the Mello-Roos Act, CFDs have the ability to structure bond issues with a capitalized interest period up to 36 months. This helps to offset insufficient early-stage tax revenue during initial build-out. As development occurs, credit quality should improve subsequent to the capitalized interest period. This assumes rising population, increasing property values with development, and advancing value to lien ratios.
Capitalized interest is a fundamental security element providing interim liquidity and is widely favored across investor cohorts. It is there to offset developer headwinds and allow adequate time to build, market and sell homes and to support stabilization of the tax base.
Teeter Plan provides mitigation for CFD delinquencies
California's Teeter Plan provides a unique alternative to the distribution of tax revenue and helps to ensure a stable cash flow for covered districts against a backdrop of delinquent taxes. Under the Teeter Plan framework, a county remits 100% of expected CFD revenue, including property taxes and Mello-Roos special taxes, directly to the CFD regardless of whether or not 100% of CFD revenue has been collected. The county would receive the interest and penalties accrued to the delinquent taxes. The Teeter Plan extends to most California counties, and coverage under the Teeter Plan would provide credible bondholder support with respect to Mello-Roos investing.
15c2-12 disclosure requirements
SEC Rule 15c2-12 continuing disclosure requirements apply to Mello-Roos financings. Requirements include provisions for issuers/obligors to provide financial and operational disclosure information on an annual basis as well as certain enumerated material event notifications on a timely basis. It would be appropriate for new disclosures to include revised value to lien ratios, updated delinquency information, and property holdings for the largest landowners.
Summary
Mello-Roos financings offer California local governments a funding technique to meet ongoing growth demands and they are particularly beneficial for undeveloped or underutilized areas. The risks associated with unrated Mello-Roos financings are largely mitigated by certain legal and security provisions assuming properly structured transactions. Many Mello-Roos financings have done very well from both a credit and trading perspective.
Certain developers have extensive expertise in this space and their projects tend to experience timely build-out and completion. Many project areas are highly desirable with links to strong economic centers. As homes are sold, property owner diversification expands with rising property values and more secure bondholder protection.
