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Municipal Bonds

Understanding land-secured municipal bonds

Municipal Credit Research Team
Experienced sector specialists represent one of the industry’s largest credit research teams dedicated to municipal investing.
photo of a construction site

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 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:

The 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.

Limited tax districts. Bonds are secured and paid from an annual limited ad valorem tax levied within the district. The amount of the tax lien is determined by the amount of reimbursable public infrastructure costs within the district, along with underwriting standards that evidence the district’s ability to pay debt service as vertical development occurs. The tax rate is capped at a not-to-exceed tax rate, meaning the assessed value of the district must reach a certain level in order for the district to generate sufficient revenues to pay debt service.

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.

Sector risks

Development risk. Until projects are fully built-out, all land-secured 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 that investors have long-term exposure to a single developer or group of developers. This characteristic is lengthened when project development slows.

Sector strengths

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.

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.

California: remaining relatively stable

The land-secured municipal bond market in California has remained relatively stable over the past decade. According to Bloomberg, the state currently has $8.8 billion in land-secured bonds outstanding, with only 3.4% 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 three times.

Throughout 2022, land-secured municipal bond issuance in California was good, with aggregate issuance across the state of roughly $1.9 billion. This is up significantly from the $1.4 billion during 2021, matching the record year set in 2015.

Moving into  2023, California’s housing market has experienced some pricing pressure, but continues to be well-positioned to post another year of strong activity, as demand for single-family homes continues to accelerate faster than new homes are completed. In April, the median price for a single-family home in California was $815,000, representing a -7.8% decline from the prior year with a 38.7% increase demonstrated over the past five years. Homebuilders are expected to continue to capitalize on these dynamics and work to narrow the gap between the ever-increasing demand for single-family homes and the supply of existing homes.

California’s housing market continues to be well-positioned to post another year of strong activity.

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.

Florida: primed for continued growth

Land-secured bonds in Florida are known as Community Development Districts (CDDs) and are secured by an annual assessment levy upon each planned lot/land parcel through maturity of the bonds. From 2018 to 2022, aggregate new money volume in Florida CDD bonds totaled more than $4.5 billion, while total volume (i.e., new money and refinancing) during 2022 exceeded $1 billion for a seventh consecutive year.

This resurgence in new issuance has been driven by the continued recovery in the Florida housing market since the downturn of 2008 to 2011 and the ongoing demand from the homebuilder community to source developed residential lots. They remain thirsty for new land opportunities given the continued in-migration and high-income job growth within the stater.

An outsized percentage of new issuance over the past several years has originated around the broader Tampa area in the counties of Hillsborough, Manatee, Pasco and Polk. According to a recent market update by Zonda, sales of new homes within the Tampa MSA declined almost 17% year-over year to an annualized rate of approximately 9,700 units during the month of May, but this level remains above pre-pandemic levels. Furthermore, the current Tampa housing market is roughly 6% undersupplied, which ranks #3 nationally according to John Burns Real Estate Consulting. This bodes well for market activity through the end of 2023, with much of this existing supply/demand imbalance attributed to the fact that Tampa ranks second nationally in net migration over the past 12 months among large U.S. metropolitan areas with populations in excess of 1 million.

During the first half of 2023, prospective homebuyers have focused on the new home market given the lack of resale inventory, as many existing homeowners are reluctant to list their homes in the current rate environment. Despite elevated mortgage rates, homebuilders are benefiting by actively using incentives to improve affordability, consisting of not only base price reductions but also buying down mortgage rates. Given their healthy balance sheets and better wherewithal to adjust pricing and offer incentives, we anticipate homebuilding entities to continue taking market share over the intermediate term. As has been witnessed recently, this should benefit construction/sales velocity within master-planned residential communities in which we maintain exposure.

Colorado: spurred by population growth

The vast majority of land-secured bonds in Colorado are issued through special taxing districts called Metropolitan Districts (MDs) and are generally paid from a limited ad valorem tax pledge levied within the district. Most districts consist of residential communities, so their credit quality – especially that of early development state districts – is highly correlated with the strength of the housing market. This is because new home construction and valuation establishes the tax base in the district to support the repayment of the bonds.

The housing market, both nationally and within Colorado, has experienced strong price appreciation over the past several years until facing recent volatility. The S&P CoreLogic Case-Shiller CO-Denver Home Price Index increased 68% from May 2018 until reaching its peak in May 2022. Subsequently, prices declined 10% from May 2022 through January 2023 – reflecting increases in mortgage rates and a softening economy – before rebounding and increasing 4% from January 2023 through May 2023. The national index trended similarly over the same time periods.

Land-secured issuance in the state increased significantly in recent years but has declined precipitously year to date in 2023. Total new issue volume grew from less than $100 million annually post the Great Recession to more than $1 billion in 2018, a record high $2 billion in 2021, and $1.7 billion in 2022. However, issuance has plummeted year to date, with only $127 million in MD bonds issued through 01 July 2023. The precipitous decline is largely due to higher interest rates causing issuers to delay bond issues and a more challenging high yield municipal market.

Ongoing population growth, particularly along the Front Range, is the main driver of home construction and supports the credit quality of MD bonds. From 2010 to 2022, the state’s population increased by 16% (1.3% annually), ranking Colorado as the sixth fastest state in growth rate and eighth in terms of population increase. The state is expected to follow similar albeit slightly lower growth trends over the foreseeable future.

Overall, favorable demographic trends support the Colorado housing market and the credit quality of Colorado land-secured credits. The biggest concern surrounds affordability and high mortgage rates. The increase in mortgage rates over the past 15 months has brought some uncertainty to the housing market, as evidenced by recent volatility in home prices. But recent trends appear positive, as new homes sales in May reached the highest pace since February 2022.

Favorable demographic trends support the Colorado housing market and the credit quality of its land-secured credits.

Further, existing home sales remain low versus historical averages, as homeowners with low interest mortgages are reluctant to move. This has pushed buyers into the new home market, thereby supporting the credit quality of MD bonds, particularly those in the early development stage.

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 3.4% of the $8.8 billion in land-secured bonds outstanding are classified as distressed.

The Florida a 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.

Colorado issuance climbed to a record high $2 billion in 2021, and $1.7 billion in 2022. However, 2023 issuance has seen significant declines due to higher interest rates. Colorado’s land-secured credits have a similar risk profile to credits issued in Florida, with affordability remaining a concern. However, underlying fundamentals along with favorable demographic trends should continue to support the market.

Land-secured municipal bond analysis requires seasoned knowledge of individual credits and sound understanding of local markets. The three most important factors to consider when investing in this sector are location, strength of the development group and collateralization (i.e., the value of the land relative to land-secured debt issued).

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.

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Endnotes

Sources

New Construction Data and New Household Formation statistics: FRED; California: Bloomberg and California Association of Realtors; Florida: MBS Capital Markets attributed to the new issuance data within Florida. Colorado: S&P Case-Shiller for the home price appreciation, Bloomberg for the issuance data, and https://worldpopulationreview.com/states for the population data.

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. Performance data shown represents past performance and does not predict or guarantee 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. For term definitions and index descriptions, please access the glossary on nuveen.com. Please note, it is not possible to invest directly in an index.

Important information 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 financial professional regarding their tax situation. Nuveen is not a tax advisor. Investors should contact a tax professional regarding the appropriateness 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.

Nuveen, LLC provides investment solutions through its investment specialists.

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