CreaTIFity helps cities find development dollars
Mountain View, Calif, created a regional park, complete with golf course, clubhouse, lake, amphitheater and restaurant. Downtown Los Angeles created Skid Row housing. Two vastly different projects with one major thing in common – they would not have been possible without tax increment financing.
Tax increment financing (TIF), also called tax allocation financing, can provide city managers with a tool to target city borrowing for specific redevelopment purposes. More than 35 states currently authorize tax increment financing, although the majority of the activity has been in California, where municipalities have issued TIF bonds for 40 years. Many other states with authorizing legislation, such as New York, have yet to see their first tax increment bond.
But recent trends suggest that tax increment financing is spreading to first-time states and that TIF bond issuance in other states, like Michigan and Illinois, seems to be increasing.
Tax increment financing was originally seen as a targeted financing mechanism to help rundown areas and inner cities. In fact, the language in California’s legislation demands that the financing be aimed at “blighted areas.”
“Blighted,” however, appears to be a broad term that encompasses not just areas like South Central Los Angeles but parts of high-fashion havens like Palm Springs. Still, according to the legislation, 20 percent of any bond proceeds or tax increment revenues must be set aside for low- and moderate-income housing.
In L.A., proceeds from tax increment financings have helped build low- to moderate-income housing, supporting infrastructure, utility lines and commercial projects. But they also support a number of social programs, including child care in project areas. “We think that’s what tax increment financing was intended to do,” says Pierre Lorenger, executive director of the Los Angeles Community Redevelopment Agency. “There’s no magic about it. It’s just a revenue stream. We’re basically just taking a mortgage on our cash flow stream.”
No state has effective restrictions that would preclude the proceeds from being used to bring in, say, a mall, and in fact, malls are one common result of tax increment financings (California is trying to clean up the abuses inherent in the system). Additionally, a number of high-income communities prefer to sit on bond proceeds rather than use them to build low-income housing. Nationwide, a number of law suits are challenging cities on just that issue. Many of those are frivolous, but they can result in delays that effectively kill anticipated projects.
Despite all that, tax increment financing offers city managers a number of advantages. First, it reallocates a portion of tax revenues normally flowing to other overlapping jurisdictions, such as counties and school districts, and puts those revenues into the hands of a city or city-controlled redevelopment agency. Overlapping taxing entities do not immediately lose any tax revenue from the formation of a TIF district, yet the revenue produced in the future from tax base growth goes to the city.
Second, the city’s general obligation is not pledged. A default by a tax increment district will not affect a city’s bond rating unless it stems from common economic causes.
Tax increment bonds are the obligation of a specific tax increment district except when other security is pledged. Third, taxpayers’ rates do not change. Tax increment financing is a reallocation of tax revenue at existing tax rates, not an additional tax.
The fourth advantage, and the one that accounts for much of TIF’s recent popularity, is a result of the spread of tax limitation movements like California’s Proposition 13.
“Proposition 13 cut back many of the resources this agency had counted on,” says Lorenger, whose redevelopment agency is one of the country’s most active with 25 project areas. “Revenue was cut back more than 60 percent. But we already had made plans and raised expectations, so we had to find some way to meet those expectations.”
Lorenger, who has worked for the agency for 17 years, has seen a boom in tax increment bonds, partly because of Prop 13. He estimates that had it not passed, the agency would have been able to put off issuing bonds for nearly a decade.
Prop 13 and its progeny have placed severe limitations on the ability of local governments to issue bonds. In California, cities cannot issue bonds without a two-thirds vote of the residents.
In Oregon, Measure 5, a property tax limitation measure, has helped prompt a number of cities into looking at tax increment financing. Keizer, for example, is using TIF bonds to finance major infrastructure improvements aimed at providing its downtown area with an identity. “We’ve built a major storm drain, and we’re now in the process of undergrounding utility wires,” says Keizer City Manager Dottie Tryk. “We have a strip development in the middle of downtown, so we’re trying to do some aesthetic things to create a downtown identity.”
Tryk notes that the rehabilitation of Keizer’s downtown without tax increment financing would have been “very difficult because of the political, no-tax climate here.”
Because most TIF bonds do not fall under the same bonding restrictions as general obligation debt, Many cities have started to issue them in lieu of GO bonds for general obligation-like purposes.
This trend in turn has produced increasingly restrictive state limitations on the use of bond proceeds in states like California with its long history of using tax increment financing.
Finally, tax increment bonds are attractive because they “pay for them, selves.” In other words, the infrastructure financed by the bond proceeds helps attract new private development, which in turn generates additional tax revenues. In Mountain View, for instance, tax increment financing in the Shoreline Regional Park special district has prompted construction of a vast recreational area that has spawned impressive residential development that subsequently helped the area lure several high-tech businesses.
The Shoreline Park district, the only TIF district of its kind in the United States, has about $50 million in outstanding debt, according to Patty Kong, assistant finance and administrative services director for the Mountain View Shoreline Regional Park Community. “The TIF was for infrastructure support,” she notes. “We have closed landfills and built the development, and that is primarily where our revenues come from now. We could not have done it without tax increment financing. The city did not have the means to finance these projects.”
There is, of course, a down side to tax increment financing. Few investors looking for investment grade debt are likely to buy bonds for a district unless already existing revenues can support debt service. Problems in three large Colorado TIF districts, Englewood, Littleton and Arvada, have helped bring home the risks of stand-alone TIFs dependent on speculative future growth.
Arvadal for instance, attempted to rehabilitate an old historic district but failed to lure enough retail merchants to the area.
When the developer pulled out of the project, Arvada was left with $54 million worth of tax increment bonds it was struggling to pay.
Tax increment financing works better, from an investor’s point of view, as an ongoing project area with tax increment revenue already in place. Thus, to the extent tax increment districts provide ongoing support for redevelopment activity over a period of time, TIFs work fine.
They can also provide project takeout financing after a private development is complete or allow a city to take off its GO pledge from a TIF once a TIF district has developed sufficiently.
TIFs are also attractive because of the special powers of eminent domain that state law often gives redevelopment agencies, allowing them to assemble scattered private parcels for redevelopment purposes. TIFs may grant a city special abilities to enter into contracts with private developers or enter into development partnerships with other governmental or quasi-governmental entities. For example, TIFs may allow a city the right to contract with schools for joint developments or flood control districts to help build flood mitigation projects.
Creating A TIF District
A TIF district is mapped out in a redevelopment plan. The current assessed valuation of the district is recorded, and underlying taxing entities, such as school districts and counties, levy their normal tax rates upon this base assessed valuation and receive tax revenues from it.
When the district’s assessed valuation grows above the base, the difference between total district assessed valuation and the base valuation is called the incremental valuation. The same tax rates apply to the incremental valuation as to the base assessed valuation; however, tax revenues produced by the incremental assessed valuation are remitted to the city’s redevelopment agency to be used for its purposes and pledged to bond debt service.
Incremental tax rates are outside the city’s control, a key feature of the TIF process. The city is dependent on the tax rates of all the overlapping taxing jurisdictions in the TIF district. The dependence on the tax rates of other jurisdictions has led to temporary problems in states like California, where voter initiatives limit tax rates, and in Michigan, which drastically reduced local property taxes for schools. Historically, such sweeping revisions to tax laws have caused selected bond ratings to fall below investment grade, although additional private development or subsequent changes to state law have usually restored TIF credit quality.
The most resilient TIF districts have plenty of open land where new development can grow the district out of its problems.
Roads and utility lines in industrial parks, low- and moderate-income housing in urban areas, street re-routing in congested districts, landscaping along deteriorated boulevards and land acquisition for new development sites are frequent uses for TIFs.
In general, TIF bond ratings fall below a city’s GO bond rating, reflecting the more limited nature of a small district within a larger municipality.
This is not always the case, however. Detroit, for instance, has a tax increment bond rated higher than its GO rating. That is because the TIF district, which included a new office development, was carved out of an area that had seen more than $377 million in recent development – including the downtown Renaissance Center – and thus had an already impressive tax base.
Occasionally, a TIF district encompasses a single taxpayer, posing special challenges. A single-taxpayer district may have a difficult time receiving an investment grade rating without an existing rating on the sole taxpayer. Yet a rating on the taxpayer does not automatically translate into the same rating on the TIF bond for a number of reasons.
The taxpayer may sell its property to a lower rated entity if the facility is not essential to its operation. Its assessed valuation may drop because of economic changes or legal disputes, and agreements with an assessor setting minimum valuations may not be enforceable. Tax rates also may change.
Rating criteria at Standard & Poor’s for TIF bonds follow a number of factors, including the economic trends of the TIF district. As a general guideline, existing taxpayers should provide enough revenue to meet all future debt service in order to receive an investment grade rating. No set coverage ratio of revenues-to-debt service, however, will determine a given bond rating. Rather the level of debt service coverage is examined in relation to the diversity of the tax base.
Bond analysts examine whether maximum annual debt service can still be covered if the top taxpayer suffered, for example, a complete fire loss. Could debt service still be covered if the top three taxpayers declared bankruptcy and no longer paid taxes? The top five? In this respect, the true diversity of a tax base is measured by the assessed valuation of the top taxpayers divided by district incremental assessed valuation as opposed to total district valuation.
Thus, more than one taxpayer can potentially account for more than 100 percent of the incremental tax base; i.e., if any one of several taxpayers goes bankrupt, the redevelopment agency loses all tax increment. Bankruptcy of a taxpayer causes particular concern, as federal bankruptcy law forestalls local tax foreclosure action.
If coverage of debt service is sufficient for a given rating category, it should be locked in with an additional bonds test prohibiting additional debt issuance without a minimum coverage ratio. Bond analysts tend to focus on the additional bonds coverage test rather than on a high level of current coverage.
The incentive to issue additional debt always exists, since tax rates will not go up, and the city is essentially taking revenue that would have gone to the overlapping jurisdictions.
Additional bonds tests vary widely, but they typically require 1.25 times coverage of future maximum annual debt service by revenues to be produced from the current assessed valuation roll.
Sometimes a portion of bond proceeds can be escrowed separately outside the additional bonds test, if the portion is backed by U.S. government obligations or investments of a quality equal to the bond rating of the district. Bond proceeds are then drawn down into parity debt only when they can be supported by current revenues. Additional bonds tests that include projected revenues from construction not currently on the assessor’s roll severely weaken the test.
Even buildings waiting to be placed on the assessor’s roll may fall far under expected valuations when actually finalized on the tax roll after tax appeals. Sometimes credit can be given for the scheduled roll-off of known tax abatements. Most bond issues create a debt service reserve equal to maximum annual debt service.
Except for tax collection costs, no “operating expenses” should come before payment of debt service in the flow of funds.
Concentrated tax bases can occur in different guises. Many taxpayers can occupy a single shopping mall, presenting similar fire or economic risk. A particular type of property, like computer equipment, may be depreciable. Another – cars at an auto dealership, for example – might be moveable. And state tax laws may affect just one type of property at the expense of other types.
In general, the larger and more diverse the district’s economic fundamentals, the better the rating. Sometimes county tax collection and remission practices can help mitigate dependency on timely payment by a major taxpayer by guaranteeing, under selected conditions, payment of levies on a timely basis.
Furthermore, litigation is always a possibility, particularly for a state’s first TIF bond. The reallocation of taxes creates winners and losers and, thus, an incentive to attack the constitutionality of authorizing legislation. Failing that, litigation has addressed the legality of hearing procedures, the process of eminent domain and legislation establishing the TIF district.
While not often successful and occasionally frivolous, litigation does have the effect of delaying development. Salt Lake County, Utah, for example, refused to hand over tax increment revenues to Salt Lake City for several years, until litigation over the state authorizing law ended. Ideal authorizing legislation would specify penalties for non-payment of funds.
These kinds of lawsuits are so common in California that many redevelopment agencies willingly enter into tax-sharing agreements with overlapping taxing jurisdictions to forestall potential delays.
Factors Affecting Ratings
Numerous factors, from upcoming voter initiatives and changing state taxation laws to concern over hazardous waste sites and floodplains, can affect a TIF bond rating. The most important rating factors, for most bond issues, include the size of the district, current coverage of maximum annual debt service, concentration of taxpayers, the additional bonds test, historical growth trends and the acreage available for new development or redevelopment.
Still, tax increment financing has been growing in the United States. TIFs have not experienced the default rates of other types of California special district debt during the state’s current economic downturn, mainly because most bond issues already had “coverage in the ground,” a term meaning that enough assessed valuation is already built to support tax increment debt service.
Previously, TIFs in California had been strained by Prop 13, which drastically reduced tax rates and rolled back assessment years. However, of the 55 TIFs rated by S&P before Prop 13, none has ever defaulted, although a few dropped below investment grade for a time.
Similarly, TIFs in other western states experiencing recent tax limitation initiatives appear to have survived, albeit under stress. Ironically, states that passed tax limitation initiatives now find that TIFs that survived with adequate debt service coverage gained creditworthiness because of the creation of a more stable tax rate at a mandated “floor.”
In areas experiencing rapid development, TIFs may quickly gain strong creditworthiness, as well as serve city managers as a useful tool for directing new growth or ameliorating previous blighted conditions.
David Hitchcock is director of public finance, Western Region, Standard Poor’s, New York.