Idea Transcript
Understanding Land-Secured Municipal Bonds Market Commentary
May 2017
LAND-SECURED MUNICIPAL BONDS primarily finance basic public infrastructure projects such as roads, water and sewage lines, lighting, traffic lights and other essential components of real estate development. This financing tool generally supplements the overall capital funding plan of a development project. These bonds are referred to as “land-secured” because the obligation to pay special taxes and assessments that ultimately pay debt service on the bonds typically attaches to the land itself.
Land-Secured Bonds Have Specific Financing Structures Land-secured bonds are usually issued through special taxing districts, which are independent governmental units that exist with varying degrees of administrative and fiscal independence from local governments. The laws governing the structure and sale of land-secured bonds differ by state. However, the structures, debt security features and issuance procedures share many similarities. Fundamentally, a land-secured bond works like this: ▪▪ Within the special taxing district, a tax lien is placed on property benefitting from the public infrastructure constructed with proceeds from the bond issue. This lien is paid off over time via periodic assessments or taxes. ▪▪ The revenues generated from the assessments or taxes are used to pay debt service on the bonds. The special tax or assessment lien is senior to any mortgage on the property. ▪▪ Land-secured bonds are usually initially unrated but have the potential to earn investment grade ratings over time if both development progress and taxpayer diversity reach certain thresholds. The two basic types of land-secured municipal bond structures include: Special tax districts. Bonds are secured and payable by a tax levied annually on the property within the district. The amount of the tax levied on property owners to help pay for the debt service must be reasonable, but may change based on higher or lower project costs, tax collections and other variables. Special assessment districts. Bonds are secured by a special assessment lien on property within the district. The amount of each assessment lien is based on mathematical formulas that consider how much each property will benefit from the infrastructure improvement derived from the bond-funded project. The assessment lien is usually a fixed amount.
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Thomas Berry Vice President Senior Research Analyst
Phil Traven, CFA Assistant Vice President Research Analyst
Ryan Rosberg, CFA Vice President Senior Research Analyst
Ellen Rossi Vice President Senior Research Analyst
Leading the Way in Municipal Bonds Since 1898, Nuveen has been a pioneer in municipal bonds, helping to build lasting value for investors. This municipal bond heritage is reflected in the way Nuveen Asset Management manages portfolios today.* ▪▪ 119 years of experience ▪▪ 25 credit research analysts ▪▪ $122.0 billion in municipal bond AUM Through ongoing publications, the team is committed to helping investors understand today’s pressing issues. * Nuveen, LLC traces its history back to 1898. Nuveen’s asset management business was established in 1989. Nuveen Asset Management credit research analysts and municipal fixed income assets under management as of 3/31/17.
Understanding Land-Secured Municipal Bonds
May 2017
In both types of bonds, the tax or assessment burden shifts from a concentrated taxpayer base to a more diverse base as development occurs in the district.
RESERVE FUNDS. A debt service reserve fund is generally funded with bond proceeds at issuance and provides a measure of cushion if tax delinquencies in the district cause tax revenues to be insufficient to make a full debt service payment.
Security Features Support the Bonds
Sector Status is Mixed
While land-secured bonds are generally viewed as a higher risk sector at issuance, these risks may decline as additional vertical development occurs and taxpayer diversity increases. In addition, these bonds carry other noteworthy credit features:
Sector Positives PROJECTS WITH SIGNIFICANT ABSORPTION. In many cases, the real estate development benefitting from the bond-financed infrastructure is either complete or substantially complete. These bond issues generally feature diversified tax bases that reduce the risk of large-scale delinquencies, as well as strong collateral coverage given the degree of completion of improvements and construction. Bonds with these characteristics are generally viewed as investment grade quality.
VALUE-TO-LIEN RATIOS. The value-to-lien ratio represents the degree of leverage in the bond financing. It is calculated by dividing the value of the land within the district (or individual parcels thereof ) by the district’s outstanding debt (or the debt allocable to individual parcels).
Certain land-secured bonds stipulate a value-to-lien ratio of 3:1 or higher, thereby REPOSITIONING OF UNDERLYING REAL ESTATE. seeking to provide investors a measure Over the past several years, developers, A HIGHER VALUE-TO-LIEN RATIO of security against future declines in land home builders and investors have become could potentially provide a stronger values, as well as some protection against increasingly active in transacting the incentive for a property owner or the variables involved with the appraisal underlying real estate outright or acquiring mortgage holder to pay taxes and or process. A 3:1 ratio means that the property bank facilities secured by a mortgage on assessments due on that property. value is at least three times the principal the real estate. As a result, development has amount of the bonds sold, plus all other resumed in some projects that were stalled bonds outstanding issued by the district. This during the real estate downturn. ratio is not a guarantee of credit worthiness. However, a higher CONTINUED HOUSING MARKET IMPROVEMENT. Housing starts value-to-lien ratio could potentially provide a stronger incentive have remained on an upward trend over the last several years, for a property owner or mortgage holder to pay the taxes and or with starts reaching approximately 1.3 million in February 2017 assessments due on that property. If taxes are not paid on time, on a seasonally adjusted basis from a low point of 478,000 in foreclosure may commence. April 2009. Starts remain comfortably below levels that typically FORECLOSURE COVENANT. Municipalities issuing bonds have no exceeded 2 million units per month in early 2004 to early 2006. legal obligation to pay the bond debt if revenues from taxes or Housing demand remains strong and home prices continue to assessments are insufficient. However, the municipal issuer has rise, given the a limited supply of developed lots, a labor shortage the right to foreclose against delinquent property owners once for construction workers in many markets and continued overall delinquencies reach a specified level. The method and length of population increases. The S&P/Case-Shiller U.S. National time it takes to foreclose and sell property or tax liens varies across Home Price Index reached a 31-month high in January 2017. states. However, such ability might have little or no effect on forstalling a default.
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formation of a CFD requires a two-thirds vote from existing property owners, whereas the formation of an Assessment District requires a 50% ballot approval.
Sector Negatives
DEVELOPMENT RISK. Until fully built-out, all land-secured bonds bear some degree of development risk. In troubled real estate markets such as occurred in 2008 to 2011, many projects stalled or were abandoned by developers and home builders, which led to ROUGHLY HALF OF THE LANDdefaults in certain issues. In some cases, more SECURED BONDS issued in the than half of the land obligated to make tax United States originate in California. payments to pay debt service on the bonds consisted of undeveloped property.
California Structures May Offer Advantages
CFD bonds have experienced minimal distress compared to structures in other states such as Florida and Louisiana. Although there were some distressed CFDs due to the severe downturn in the real estate market in the late 2000s. California CFDs have held up well with very few defaults, primarily due to these factors:
HIGH LEVERAGE. Many deals issued between 2004 and 2008 came with high leverage (proportion of the total capital structure composed of land-secured debt), such as a value-to-lien ratio of only 2:1 at issuance. In certain cases, especially where a portion of the property securing the bonds remains undeveloped, the value of the undeveloped property may fall below the amount of the land-secured debt allocated to that property. In these situations, the property owner or other interested party (such as the bank lender) is not economically motivated to pay their special tax obligations.
▪▪ Disclosure and structuring improved due to the lessons learned from defaults in the 1990s. For instance, a significant amount of vertical development has now typically occurred before bonds are issued. ▪▪ Districts are controlled by a city, county or government entity (versus developer-controlled in states such as Florida). ▪▪ An appraisal is required by policy, which is not always required in other states.
TAXPAYER CONCENTRATION. A land-secured municipal bond deal can mean investors have long-term exposure to a single developer or group of developers. This characteristic is lengthened when project development slows.
▪▪ The foreclosure process is aggressive and can begin quickly (approximately 180 days after delinquency) by stripping the special tax portion of total tax bill and beginning the judicial process.
Market Focus: California Development in California over the last few decades has increased the issuance of land-secured municipal bonds. Roughly half of the land-secured bonds issued in the United States originate in California.
▪▪ A minimum 3:1 value-to-lien ratio is required by law. ▪▪ Development and financing is phased, often with multiple owners at issuance. The developer frequently puts up its own money (since infrastructure is needed to begin development) to be reimbursed when bonds are issued.
Overview Two types of land-secured bonds are issued in California: ▪▪ Special Tax District or CFD bonds (Community Facilities District) are issued under the Mello-Roos Community Facilities Act.
▪▪ While property is generally largely developer-owned at bond issuance, it is eventually transferred to a diversified pool of land owners and the investor effectively holds a limited tax general obligation bond.
▪▪ Special Assessment District bonds, or simply assessment bonds, are based on the 1915 Bond Act.
▪▪ California has a large economic base and we believe it will likely recover faster than weaker markets.
CFD bonds are most common and frequently finance infrastructure for new development on the local government level. CFDs provide more flexibility to address shortfalls due to delinquencies, such as the ability to increase taxes (within limits), and are less of a legal burden to prove the specific benefit of the infrastructure improvement project to the property. However,
▪▪ Bonds are typically sized such that the maximum amount of special taxes that can be levied produces debt service coverage of 1.10x to 1.25x. This offers some measure of protection against delinquencies.
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annual special assessment levy upon each planned lot/land parcel through maturity of the bonds. Approximately 600 individual CDDs have been created, collectively issuing roughly $16 billion in total par (new money and refunding). Florida CDDs experienced a wave of defaults, bankruptcies and foreclosures between 2008 and 2011, involving bonds issued during 2004 to 2008 when underwriting standards became very lackluster.
Current Market Shows Significant Improvement Although California was roiled by the housing downturn from 2008 to 2011, only a small handful of CFDs defaulted. The market has dramatically improved, with the California landsecured sector enjoying significant credit improvement. Property values have recovered significantly and homebuilders have resumed development on projects once mothballed, leading to substantial new home absorption. In addition, land values in certain markets have increased as homebuilders put money to work acquiring land for future deals.
Few vertical construction and home closings occurred before the housing market began to bottom, which left many developers and landowners to pay the entire annual assessment burden. This effectively ruined developer pro-forma projections that assumed quicker build-out schedules. More than 200 individual credits went through some type of work-out situation, including unscheduled draws on the debt service reserve fund, failure of borrowers to replenish reserve funds and monetary defaults. Since 2012, heightened restructuring activity has occurred on these work-out situations. Restructurings have often involved bifurcating deals to create separate security features between developed and undeveloped land.
Given the resurgence of California’s economy, there is strong housing demand and a shortage of lots in more coastal locations. This demand has led to success for some of the few large-scale developments like The Great Park in Irvine and Sendero and Esencia within the Orange County Rancho Mission Viejo Masterplan. As evidence of the strength of California CFDs, there is roughly $13 billion in mello-roos bonds outstanding across over 900 CFDs and, according to the California State Treasurer, there were only four draws on reserve funds in 2016. This is a very low number given the size of the market and testament to the strength of the market for California land secured bonds.
Exhibit 1: Florida’s CDD Market Activity Has Increased Since 2012 New Money
During the real estate market stress between 2008 and 2011, CFD delinquency rates soared, in some cases reaching 25%. However, debt service was still paid due to the excess debt service coverage, the sponsoring municipalities’ ability to increase the tax levy and strict foreclosure rules for special tax delinquencies. California passed a critical test in 2008 to 2011 by weathering such a difficult period. However, each project is unique and must be individually evaluated, as default risk will always exist in this high yield and credit intensive sector.
Refunding
Combination
Market Activity (Millions)
$1200 $1000 $800 $600 $400 $200 $0
Market Focus: Florida
2011
2012
2013
2014
2015
2016
Source: Federal Reserve Bank of St. Louis.
Florida’s land-secured municipal bond market has continued to rebound over the past 36 months following heightened distress during the housing crisis. Many deals previously in default have been successfully restructured and market activity has intensified, fueled by a recovering real estate market and better structured deals.
Certain markets like Tampa-St. Petersburg-Clearwater, FL (MSA) and Miami-Fort Lauderdale-Pompano Beach, FL (MSA) have experienced strong recoveries in construction activity, with housing starts increasing at tremendous rates. From 2010 to 2012, development mainly occurred on lot inventories that developers purchased during the recession. Subsequently, developers have been acquiring and developing raw land to satisfy home buyer demand, which has resulted in increased bond issuance.
Overview Land-secured bonds in Florida are known as Community Development Districts (CDD) bonds, which are secured by an
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the sector during the last cycle. Recent deals are much smaller, providing funding for specific phases of development. This helps minimize long-term developer risk given a lower number of lots and thus a shorter anticipated build-out schedule.
Exhibit 3: New Housing Starts Are Driven by Demand Tampa-St. Petersburg-Clearwater Miami-Fort Lauderdale-Pompano Beach Statewide Home Sales (Units)
12,000 10,000
The emphasis on less speculative development activity has also led to much lower leverage profiles. Less horizontal infrastructure is being funded upfront, and remaining improvements are expected to be funded once the project proves successful. Similarly, bank debt is virtually non-existent today. Lenders are reluctant to provide that type of financing given their subordinate status versus bond debt. This has resulted in greater developer equity invested in deals and a less leveraged capital structure.
8,000 6,000 4,000 2,000 0
2010
2011
2012
2013
2014
2015
2016
Source: Federal Reserve Bank of St. Louis. Data from 1/1/10 to 12/31/15.
The strong pace of construction in recent years has resulted in significant absorption of developed lot supply. Vacant developed lot (VDL) inventory is considered at equilibrium when supply ranges from 24 to 48 months, depending on the region and the entitlement cycle time. Replacement lots are needed for developers to produce more new homes. As new community development districts are established to create VDLs, public improvements needed to develop raw land are commonly funded through bond issuance.
Land-Secured Deals Deserve Consideration While the sector experienced significant stress during the real estate downturn of recent years, we believe that well-structured land-secured deals have the potential to provide strong collateral to investors open to taking on additional risk, and may merit investment consideration on a case by case basis. The California “dirt bond” market seems to have a fair number of positives because of the solid security structure of popular Mello-Roos bonds. And, although delinquencies are always a concern, we see limited stress with only 0.44% of outstanding deals distressed as of April 5, 2017.
Current Market Sees Renewed New Issuance The Florida CDD sector has historically been a good source of supply for the high yield municipal bond market, and new issuance has returned with a vengeance over the last three years. From 2014 to 2016, an aggregate of $1.46 billion par of nonrated new money bonds were issued ($426 million in 2014, $389 million in 2015 and $645 million in 2016). This level of market activity was up almost 140% versus only $614 million of new money issuance occurring from 2011 to 2013 and directly after the most recent housing downturn. Despite the recent upturn in bond issuance, new money supply remains well below levels of 2004 to 2006, when issuance was north of $1 billion annually.
The Florida land-secured bond market retains an elevated risk profile relative to California land-secured bonds. However, new issues over the past three years have generally been smaller in size, secured by a lower number of planned lots and overall less leveraged. These issues should fare better than those issued in the mid-2000s, when the real estate market was stressed. Land-secured municipal bond analysis requires seasoned knowledge of individual credits and sound understanding of local markets. Analysts must apply a disciplined approach in assessing the credit characteristics of each deal, while maintaining a prudent understanding of the macroeconomic factors affecting the sector. ▪
Many communities at the time of new issuance remain incredibly raw, with very little vertical build-out and highly concentrated land ownership. However, underwriting standards have adjusted in other areas to address issues that decimated
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For more information, please consult with your financial advisor and visit nuveen.com. Index of Default and Draw on Reserve Reports, 2000 - 2015, California Debt and Investment Advisory Commission www.floridacddreport.com Urban Analytics U.S. Census Bureau
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RISKS AND OTHER IMPORTANT CONSIDERATIONS This report provides general information only. Neither the information nor any opinion expressed constitutes an offer or an invitation to make an offer, to buy or sell any investments or related securities. The analysis contained herein is based on the data available at the time of publication and the opinions of Nuveen Asset Management Research. Information is current or relevant as of the date indicated and such information may become outdated or otherwise superseded at any time without notice. Certain information contained in this report is based upon third party sources, which we believe to be reliable, but are not guaranteed for accuracy or completeness. This analysis is based on numerous assumptions. Different assumptions could result in materially different outcomes. Past results are no guarantee of future results. The report should not be regarded by the recipients as a substitute for the exercise of their own judgment. All investments carry a certain degree of risk, including possible loss of principal, and there is no assurance that an invest ment will provide positive performance over any period of time. Bonds and other fixed-income
Bloomberg Federal Reserve Bank of Saint Louis MBS Capital Markets LLC, S&P/Case-Shiller Home Price Indices
investments are subject to various risks including, but not limited to interest rate risk or the risk that interest rates will rise, causing bond prices to fall; and credit risk, which is the risk that an issuer will be unable to make interest and principal payments when due. An investment in any municipal portfolio should be made with an understanding of the risks involved in investing in municipal bonds, such as interest rate risk, credit risk and market risk, including the possible loss of principal. The value of the portfolio will fluctuate based on the value of the underlying securities. Clients should contact their tax advisor regarding the suitability of tax-exempt investments in their portfolio. If sold prior to maturity, municipal securities are subject to gain/losses based on the level of interest rates, market conditions and the credit quality of the issuer. Income may be subject to the alternative minimum tax (AMT) and/or state and local taxes, based on state of residence. Income from municipal bonds held by a portfolio could be declared taxable because of unfavorable changes in tax laws, adverse interpretations by the Internal Revenue Service or state tax authorities, or noncompliant conduct of a bond issuer.High yield or lower-rated municipal bonds carry greater credit risk, and are subject to greater price volatility. Nuveen Asset Management, LLC manages strategies that may invest in California and Florida municipal bonds. This material is not intended for use in the promotion or sale of any Nuveen investment product. CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute. Nuveen Asset Management, LLC, a registered investment adviser, is an affiliate of Nuveen, LLC.
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