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What a great idea! Project-based bonds


“Only invest in companies that an idiot can run because sooner or later, one will.” ~ Warren Buffett

In order to address their state-mandated, Regional Housing Needs Assessment quotas, more and more California municipalities are eager to allow private, for-profit housing developers to joint venture with a quasi-governmental joint powers authority to issue tax-exempt bonds backed by the revenues of individual housing development projects. This type of debt is called “project-based” and it is typically "non-recourse," meaning neither the municipality nor the developer has any financial liability (unless they commit fraud or some other actual crime).

This is being heralded as the solution to what’s called the missing middle: “homes for people who earn too much to qualify for low-income housing and too little to afford today’s spiraling rents.” Unfortunately, these municipalities are not considering the possible downsides of using “other people’s money” (the individual, corporate, and institutional bondholders).

According to this scheme’s apostles, it’s a great deal for sides. The city/county gets housing without encumbering their general obligations or risking their credit ratings and the developer gets to build it without risk in the event of default on the debt. The only collateral for the debt on the project is the project, itself.

Unfortunately, this is a case of collective amnesia and it’s not a good omen, especially considering the precarious nature of our economy, at the moment.

The template for this scheme has been pioneered by a JPA called the Community Housing Agency (CalCHA). It was formed to issue California tax-exempt bonds throughout the state. CalCHA is located in the most unlikely place possible, in the heart of Kings County, California (1,392 square miles in size and a population of approximately 152,000). Unlike Marin County or most of the Bay Area, Kings County is predominately an under-developed, agricultural community located north of Bakersfield (according to the U.S. Census, the largest industries are agriculture, forestry, fishing, and hunting).

The Kings County Board of Supervisors exploited an SEC loophole that allows it to create a pass-through agency under the direction of a hired third-party, a for-profit financial "advisor," to underwrite tax-exempt, municipal bond deals for other agencies and to finance private developer-owned housing projects, without any direct liability.

CalCHA and Kings County collect fees for structuring and administering this debt with zero risk or downside, regardless of how the actual development performs. And since “everybody” knows that the housing need in California is enormous, demand will always be there so it’s considered a sure bet, right?

What could possibly go wrong?

In the aftermath of the 1980s Savings and Loan crisis, project-based debt on multi-family housing development was disallowed on federally-funded projects because of the unprecedented default rate in the ensuing economic downturn.

Projects failed to generate sufficient revenues to service the debt and some projects were never even completed when the subsequent economic slowdown hit. “Owners,” who were nothing more than non-recourse LLCs, declared bankruptcy and abandoned the properties. Tenants left when upkeep went downhill or were forced to move as a condition of resale by the debt holders who were getting "crammed down" to next to nothing on their original investment. The projects eventually sold for pennies on the dollar in subsequent "work-outs."

But how could this have happened when there was high housing demand?

The rental rates on the projects underwritten by these schemes are set at affordability levels based on local “median income” statistics. This is all well and good if local incomes are rising, but what happens if they start falling… as they do in an economic recession… or a really long economic recession? And what if at the same time there are high rates of inflation that become persistent and last for years?

Starting to sound familiar?

During times like these, construction costs and operating expenses continue to rise. The cost of insurance, labor and materials and supplies, salaries for management employees, healthcare and benefits, maintenance, and service providers (that pool still has to be cleaned), replacement reserve requirements, and everything else rise faster than the project’s rents that are stagnant or may even be falling if the “median income” in the area falls, even though housing demand theoretically remains high. And what if all this is happening when interest rates are rising higher than anticipated, so there is no opportunity to refinance debt for a longer term at lower rates, to avoid default on that debt?

You get the idea.

The truth is that even under the best circumstances a hundred things can go wrong with a real estate investment even with the best intentions (e.g., a catastrophic fire, flood, or earthquake and it turns out the project was under-insured, managers fail to maintain the property, etc.). It’s not an investment one wants to enter into if it’s run by people who know nothing about real estate development: i.e., CalCHA and the city and county governments that run the JPA that is underwriting the debt.

And let’s be honest, private developers (who are the biggest beneficiaries of this newfound largess) have a tendency to be overly “optimistic” in their assumptions about the project’s projected revenues and ultimate success. Yet, they have no incentive to stick it out to make it work. The debt is non-recourse to them, personally, so it’s easy to just walk away and hand the bondholder the keys. Besides, most developers have built-in fees collected upfront, at the closing of the deal. So, it may even be more profitable for them to default on the bonds.

If what happened in the 1990s is a harbinger of what’s to come, these projects typically end up being foreclosed upon by the debt holders and eventually sold to vulture funds who buy the “distressed” debt for 10 cents on the dollar and rehab them as market-rate housing, and the lawyers and real estate brokers are the only ones who see any money.

What is that old saying about those who don’t know history…?


Bob Silvestri is a Marin County resident, the Editor of the Marin Post, and the founder and president of Community Venture Partners, a 501(c)(3) nonprofit community organization funded by individuals and nonprofit donors. Please consider DONATING TO THE MARIN POST AND CVP to enable us to continue to work on behalf of California residents.