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Understanding land-secured municipal bonds
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.
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 funded by the bonds. The assessment lien is usually a fixed amount.
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.
Development risk. Until fully built-out, all landsecured bonds bear some degree of development risk. In troubled real estate markets, projects can struggle and may be abandoned by developers and homebuilders potentially leading to defaults in certain issues.
Potentially high leverage. Some bonds may come with high leverage, such as a value-to-lien ratio of only 2:1 at issuance. This means that the appraised value of the land in the district was valued at two times the amount of land-secured debt issued. 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.
Taxpayer concentration. A land-secured municipal bond can mean investors have longterm exposure to a single developer or group of developers. This characteristic is lengthened when project development slows.
Projects with significant absorption. In many cases, the real estate development benefiting 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.
Pent-up housing demand. While new home construction activity has experienced strong growth in recent years, that growth has failed to keep pace with the rapid increase in new household formations. According to analysis published by Realtor.com, roughly 5.9 million single-family homes were constructed throughout the country from 2012 to 2019, falling well short of the 9.8 million in new household formations over the same period.
Potential credit improvement. Land-secured bonds typically come nonrated at the time of bond issuance due in large part to the risks noted above. However, these risks may decline over time as vertical development occurs and property ownership within the district diversifies. Once the tax or assessment burden shifts from a concentrated taxpayer base to a more diverse ownership base, such bonds can garner an investment grade rating.
Market focus: California
The land-secured municipal bond market in California has remained relatively stable over the past decade. According to Bloomberg, the state currently has $11.8 billion in land-secured bonds outstanding, with only 2.2% classified as distressed.
The vast majority of land-secured bonds in California are issued by special tax districts known as Community Facilities Districts, or CFDs, pursuant to the Mello-Roos Community Facilities Act of 1982. Due to the long history of this financing mechanism and the relatively strict underwriting requirements, CFD bonds issued in California have historically experienced minimal distress as compared with structures in other states. A key strength of the CFD structure in California is the 3:1 value-to-lien requirement on all new bonds, which stipulates that the appraised value of all property within the specific CFD meets or exceeds the attached debt by at least 3x.
Throughout 2019, community facilities districts in the state of California issued roughly $1.32 billion in special tax bonds. While this represents a modest year-over-year increase of 8%, issuance levels remain well below their peak of $2.87 billion in 2015. Moving into 2020, California’s housing market was well positioned to post another year of stable activity. The size of the state’s labor force hit a record high, personal income levels accelerated for the tenth consecutive year, unemployment levels remained low, and the gap between new residential building permits and growth in the state’s labor force continued to widen. Furthermore, the state’s housing shortage continues to remain a top priority for Governor Gavin Newsom, whose 2018 campaign focused on a lofty plan to construct 3.5 million new housing units in the state by 2025.
The continued strength of California’s economy and the limited supply of developable land in the state’s more coastal locations has led to a significant increase in homebuilding activity throughout the more inland communities in recent years. Large-scale projects such as “The Great Park” in Irvine and “Westpark” in Roseville continue to be met with strong demand. Furthermore, land developers are increasingly working with state and local governments to alleviate California’s housing affordability crisis by sourcing opportunities in many of California’s less populated areas, such as those located in the Central Valley.
The strength of California’s CFD structure has historically buffered investors from broad-based losses.
A notable example would be River Islands in Lathrop, CA, a multi-decade project that is ultimately expected to include 11,000 homes at full build-out. Land developers on Central Valley projects such as River Islands have been working with the state to extend commuter rail service inland, ultimately providing Valley residents with affordable, viable housing opportunities with more efficient access to California’s major employment centers.
The extent of the impact of COVID-19 on California’s housing market remains uncertain. However, the strength of California’s CFD structure has historically buffered investors from any broadbased losses. During the real estate market stress between 2008 and 2011, CFD delinquency rates soared, in some cases reaching 25%, but California ultimately experienced low levels of defaults partly due to the strength of the state’s of CFD financing structures. Each individual project remains unique and must be evaluated on an individual basis, as default risk will always exist in this high yield and credit-intensive sector.
Market focus: Florida
Land-secured bonds in Florida are known as Community Development Districts (CDDs), which are secured by an annual assessment levy upon each planned lot/land parcel through maturity of the bonds. According to Bloomberg, there is roughly $7.7 billion in CDD bonds outstanding, of which about 10% are currently in default. It should be noted, however, that 94% of those defaulting bonds were issued prior to 2009. From 2015 to 2019, aggregate new money volume in Florida CDD bonds totaled over $3.4 billion while total volume (i.e., new money and refinancing) during 2019 exceeded $1 billion for a fourth consecutive year.
This resurgence in new issuance has been driven by the continued recovery in the Florida housing market and continued demand from the homebuilder community to source developed residential lots to better meet homebuyer demand. Over the longer term, the FL CDD sector is primed for continued growth with 1.5 million new households projected to be formed between now and 2025 in Florida, which ranks second only to Texas (i.e., 1.9 million households).
Over the interim, there is a high degree of uncertainty regarding the impact of COVID-19 on the housing market. Over the next several months as we wait for the dust to settle, we expect customer traffic to drop and for homebuilders to be very aggressive with incentives to prospective homebuyers in an attempt to move product. We also anticipate homebuilders being judicious about new starts and displaying caution toward acquiring new land to avoid rapidly building up excess supply, which we believe is a prudent strategy.
Despite this uncertainty, we don’t believe the degree of delinquencies and/or nonpayment by developers/homebuilders will reach the magnitude experienced during the 2008 to 2010 housing crisis. Since the prior downturn, underwriting standards have improved immensely with fewer lots and much lower leverage, and according to MBS Capital Markets, the average new deal size has ranged from $10 to $12 million.
This helps to minimize long-term development risk, as it leaves bondholders less exposed to volatile real estate cycles. New housing communities that have only recently broken ground are more vulnerable, given the lack of development to date. Nonetheless, we expect the impact to bondholders to be minimal, as most land developers and/or homebuilders will continue building if the disruption from COVID-19 turns out to be relatively short-term.
Land-secured deals deserve consideration
Well-structured, land-secured deals have the potential to provide strong collateral to investors 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 repayment is always a concern, only $239 million in bonds across nine issues are currently classified as distressed.
The Florida land-secured bond market retains an elevated risk profile relative to California. However, new issues over the past few years have generally been smaller in size, secured by a lower number of planned lots and generally less leveraged. These recent issues should fare better than those issued in the mid-2000s prior to the housing market collapse in the later 2000s.
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. The three most important factors to consider when investing in this sector are: (1) location; (2) strength of the development group; and (3) collateralization (i.e., the value of the land relative to land-secured debt issued).
Housing in the age of COVID-19
The U.S. housing market, and the land development and homebuilding sectors in particular, are cyclical and highly correlated with the health of the underlying economy. While this sector has shown strong growth over the past 129 months through February 2020, the multi-faceted impact of the economic slowdown due to COVID-19 may have a negative effect on the sector.
Weak data from economic indicators such as jobless claims and consumer sentiment have contributed to a decrease in homebuilder confidence, as measured by the NAHB Housing Market Index, to its lowest levels since June 2012. While investors continue to digest the evolving impacts to the sector from this crisis, careful investment analysis on a case-by-case basis remains imperative.
Bloomberg, California Mello-Roos CFD Yearly Fiscal Status Reports, Federal Reserve Bank of Saint Louis, Index of Default and Draw on Reserve Reports, California Debt and Advisory Commission, MBS Capital Markets S&P/Case-Shiller Home Price Indices, U.S. Census Bureau.
The views and opinions expressed are for informational and educational purposes only as of the date of production/writing and may change without notice at any time based on numerous factors, such as market or other conditions, legal and regulatory developments, additional risks and uncertainties and may not come to pass. This material may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections, forecasts, estimates of market returns, and proposed or expected portfolio composition. Any changes to assumptions that may have been made in preparing this material could have a material impact on the information presented herein by way of example. Past performance is no guarantee of future results. Investing involves risk; principal loss is possible.
All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.
One basis point equals .01%, or 100 basis points equal 1%. The Municipal Market Data AAA scales (MMD) are compilations of the previous day’s actual trades for AAA-rated insured bonds. The personal consumption expenditures (PCE) deflator indicates the average increase in prices for all domestic personal consumption. The S&P Municipal Bond Investment Grade Index consists of bonds in the S&P Municipal Bond Index that are rated investment grade by Standard & Poor’s, Moody’s and/or Fitch. The S&P Municipal Yield Index provides a measure of an investing strategy that allocates a specific percentage to bonds rated both above and below investment grade.
A word on risk
Investing involves risk; principal loss is possible. All investments carry a certain degree of risk and there is no assurance that an investment will provide positive performance over any period of time. Investing in municipal bonds involves risks such as interest rate risk, credit risk and market risk. The value of the portfolio will fluctuate based on the value of the underlying securities. There are special risks associated with investments in high yield bonds, hedging activities and the potential use of leverage. Portfolios that include lower rated municipal bonds, commonly referred to as “high yield” or “junk” bonds, which are considered to be speculative, the credit and investment risk is heightened for the portfolio. Bond insurance guarantees only the payment of principal and interest on the bond when due, and not the value of the bonds themselves, which will fluctuate with the bond market and the financial success of the issuer and the insurer. No representation is made as to an insurer’s ability to meet their commitments.
This information should not replace an investor’s consultation with a professional advisor regarding their tax situation. Nuveen Asset Management is not a tax advisor. Investors should contact a 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 the 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. It is important to review your investment objectives, risk tolerance and liquidity needs before choosing an investment style or manager.
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