It's tough out there for developers. Rocked by dramatic decreases in home sales and home prices as a result of the real estate market upheaval, developers are desperately seeking cash flow to maintain operations.

Land-secured bond issues have been a traditional mainstay of developer cash flow, and developers are looking to these bond issues to assist them as they sell existing inventory. Unfortunately, land-secured bond issues have become much more difficult to do not to mention more costly as the smaller pool of investors look to minimize their investment risk and maximize their return.

Conventional wisdom suggests that investment risk decreases when a project demonstrates both a high value-to-lien ratio and some "momentum," which in both cases means that the project securing the bonds has significant vertical construction and some diversity of ownership. The result is that land-secured bonds are being issued much later in the development process, a departure from the days when bonds could be issued on the basis of land values alone, with little or no development in place.

As if there wasn't enough bad news, investors' desire for project momentum has unwittingly created two additional problems, both of which are making land-secured transactions more difficult.

The first problem is falling home prices. Because of the growing time gap between the formation of the financing district and the time that bonds are issued, falling home prices may cause financings to violate the issuer's policies about overall effective tax rates. Most issuers will not allow the amount of the special tax or assessment of a financing district to bring the total tax burden on a home including all other property taxes, assessments, and charges above a certain percentage of the home's value. A 2% effective tax rate is most common.

At the time of a district's formation, the base home pricing is established in a price point study prepared by a third-party, independent market absorption consultant. Because substantial time has elapsed since formation of the financing district, a new price point study is conducted to ensure compliance with the issuer's effective tax-rate policy. Frustratingly, home prices have declined since formation, and issuing bonds secured by the current special tax rates (which were based on the previous home prices) will violate the issuer's effective tax rate policy.

The financing team's options are now limited. The financing team can agree to amend the formation proceedings to lower the special tax rates to come within the 2% limitation, a lengthy and uncertain process that requires an election involving homeowners or registered voters. In addition, the process may prove futile as the time it takes to amend the proceedings may require that a new price point study be prepared, which may show further decreases in home pricing, requiring yet another amendment. It is a vicious cycle that can only end with stabilized home prices or a special tax rate reduction that artificially and inefficiently assumes even further home price decreases.

In lieu of the amendment process that permanently reduces the special tax rates, the financing team may simply reduce the principal amount of the bond issue. The offering can be sized so that the special tax levy needed to satisfy debt service is under the effective tax rate threshold. Unfortunately, a reduced bond issue means reduced net bond proceeds available to developers.

The second problem associated with the delay in issuing land-secured debt is homeowner delinquencies. Until recently, homeowner delinquencies have never posed much of a hurdle because delinquency rates have been historically low less than 5% and land-secured bonds were often issued prior to the levy of the first tax bill to homeowners, so there was no special tax levy to become delinquent. But with bond issues being delayed to display a project's momentum, delinquencies have the opportunity to develop. The one-two punch of rising subprime interest rates and falling home prices is a recipe for increased delinquencies. And indeed, delinquency rates are currently much higher than the historical average.

Issuers and underwriters are understandably disturbed by an increase in delinquency rates. Traditionally, bonds have been structured, and credit enhancement imposed on developers, to minimize the potential for developer default. The achievement of diversity of ownership through home sales was always looked at as the pinnacle of security for bondholders. Today, however, underwriters and issuers are struggling to minimize the impact of homeowner delinquencies. But what to do?

One approach is to size the bonds using a high delinquency assumption. A second approach is to require increased coverage ratios. Instead of having the tax rates set at 10% higher than what is needed to service the bonds the customary 110% coverage ratio some issuers and underwriters are requiring 115% coverage or higher. Not surprisingly, both of these options result in a dramatic decrease in the net proceeds available to developers. A hit to the net bond proceeds, however, is better than the third option available to issuers: not issuing the bonds at all.

At a time when developers are looking for sources of cash flow, even traditional and reliable sources such as land-secured bonds have been adversely affected by the market turmoil. Developers are not only facing the trough of the real estate cycle, but they are also encountering the law of unintended consequences. Actions that increase the security for bondholders are also creating situations that are making it more difficult for bonds to be issued, which is creating insecurity for developers counting on land-secured bonds. When the market stabilizes and it will balance will return to the land-secured transactions as well.

Robert Haight Jr. and Albert Reyes are attorneys at Goodwin Procter LLP in Los Angeles.