Article published in the June 18, 2010 Florida Real Estate Journal. Written by Jay Kelley and Keith Hyatt of Focus Management Group.
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Lenders, their borrowers, and other interested parties in development projects are faced with multiple loans that require an overall restructuring of the underlying real estate development project. This article will explore the restructuring question as it relates to real estate projects that include a Community Development District ("CDD") in their capital structure.
The constituents in a development that includes a CDD are, in addition to the lender who financed the developer, 1) the homeowners and/or lot owners, 2) the holders of CDD bonds (also known as "Dirt Bonds"), 3) the developer of the real estate project, and 4) any creditors of the CDD. Each of these parties has different interests and different responsibilities.
Today, as CDD defaults continue to escalate in record fashion, all constituents need to develop a better understanding of the issues and opportunities these CDDs create. The risk and reward equation for each of these constituencies is different during the restructure process.
CDD bond payments are typically made semi-annually, with payments due in May and November. According to Interactive Data Corp., out of the approximately $5.6 billion in CDD bonds outstanding, during 2009 the number of bonds either failing to make interest payments or drawing from their debt service reserves rose from $1.7 billion in May 2009 to $2.4 billion in November 2009.
As of November 2009 more than 40% of the outstanding CDD bonds are unable to service their required interest payments from ongoing operating cash flow. The defaults are primarily occurring in bonds issued from 2004 to 2007. The market is anxiously waiting what is expected to be a continued escalation in the number of distressed bonds which will be reported after the May 2010 payment date passes.
Background on CDDs
Developers in Florida often used the formation of CDDs to finance infrastructure for master planned communities by having the CDD issue tax-exempt bonds. The CDD is a local unit of special purpose government, established under the Uniform Community Development Act of 1980, and which has the expressed ability to act as an independent taxing district. Upon the issuance of bonds, the CDD imposes assessments against the community to obtain the funds for the payments on the bonds, including the interest and principal payments. Two types of bonds were typically used in the funding of the developer's ambitions:
- A Bonds - usually paid back more than 30 years by the purchasers of lots within the development.
- B Bonds - usually paid back over a five- to seven-year period by the developer upon the sale of each lot or parcel.
CDD assessments have the same priority as ad valorem taxes, meaning that any unpaid assessments have priority over any bank acquisition and construction financing. Assessments can be collected in one of two ways.
The usual means of collection after the developer sells the lot or parcel is for the tax collector to collect the assessments with the normal tax bill (often referred to as "on the roll"). The assessments are due at the same time ad valorem taxes are due and invoicing for such assessments are included on the same property tax bill. This is the common means of collecting A Bond payments.
The usual means of collection until a lot or parcel is sold is for the CDD to collect assessments directly from the developer (often referred to as "off the roll"). Payments are usually interest only and made semi-annually prior to the required payment to the bondholders. The final payment is due upon the sale of a sufficient number of lots or parcels, or upon maturity of the short-term B Bond, whichever is earlier.
In addition to bond payments, the CDD assesses its constituents for operating and maintenance expenses, which includes costs of field maintenance and administrative costs. These costs are allocated to property owners and are invoiced through the property tax bill. All amounts owed accrue as liens on the property and are co-equal with taxes, county or other special assessment liens.
The tax-exempt financing offered by the CDD provided the developer with a less expensive source of financing site infrastructure by creating a CDD and having the CDD issue bonds. These bonds had been viewed as low-risk, high-quality investments because the bonds held a senior lien position on project cash flows and the expenses paid were related to site infrastructure only.
That view of the CDD bonds changed when master planned communities began to fail as developers and homebuilders were unable to sell vacant lots and finished homes. Without the sale of lots and homes, the source of repayment shifts from new owners in the CDD to the current owner of the lots and homes - which is the developer, the receiver, or in some cases, the lender. When cash on hand or taxes collected do not meet operating and debt service requirements, the CDD accesses the interest reserves that traditionally accompanied the bond issue.
If these interest reserves are depleted before the real estate market, as it relates to a specific development, recovers, the bonds, and therefore the bondholders, are exposed to imminent failure. An investment asset that had been viewed as a low risk bond protected by the taxing authority of the CDD has now potentially become a total loss.
How large is the CDD restructure issue?
Within the state of Florida, the use of CDDs exploded during the last decade with a total of 576 active CDDs today. New CDDs were formed at the following pace:
- 1980-1990: 13 new CDDs
- 1990-2000: 86 new CDDs
- 2000-2005: 201 new CDDs
- 2005-2010: 276 new CDDs
Of the 576 active CDDs, prior to the May 2010 payment date, 184 bond series representing 96 districts were of a distressed nature, with the vast majority of these having been issued since 2004. Additionally, according to Interactive Data Corp., as of November 2009, there were more than $1 billion of CDD bonds issued since 2004 that were not in arrears, but secured by properties with minimal, if any, construction activity. As a result, it is expected that when the May 2010 payment data is made available, the number of distressed CDD bonds will have significantly increased from November 2009.
Conclusions
Opportunities for commercial restructure in a CDD environment are complicated by the addition of CDD bondholders at the negotiating table. These bondholders may not be accustomed to the typical restructure give and take required in a large-scale real estate restructure. CDD bondholders may come to the table with the unrealistic expectation that their bond investment is completely protected. The other constituencies in the process will need to educate the CDD bondholders and then negotiate a restructure, which may result in a reduction or elimination of the bond's value.
With the serious looming impact of the CDD failures both in numbers of districts and dollars of bonds outstanding, it is critical for bondholders and lenders to understand the intricacies of any portfolio loans in developments that include a CDD. While the long-term outcomes of any specific project, and magnitude of overall CDD failures, are not known at this time, the full financial condition of the project must be understood to accomplish a meaningful restructure. Utilizing a financial advisory firm skilled in real estate development is often a first step toward maximizing that understanding and negotiating a successful restructure. Bondholders and lenders with portfolio risk in projects with CDDs should consider expanding their internal team assigned to the project with an external advisory firm skilled in understanding the complexity of these developments involving CDDs.
Jay Kelley is a managing director at Focus Management Group, based in Tampa, which specializes in real estate restructuring, as well as turnaround and rescue plans for businesses with financial difficulties.