Measuring Up

Key Local Finance Options

Filling the Gap, pt. 2: Local Financing Options

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Building a new transportation project typically requires sponsors to combine multiple sources of funding (grants or money that does not have to be repaid) and financing (debt or money that must be repaid). As evident in the research completed by T4America, governments have a wide range of revenue options, such as sales taxes, special assessments, local option income taxes, tax increment financing, and property taxes. These revenues can be applied directly to project costs or used to as a repayment stream either for municipal bonds or private investment.

Innovative financing is one way to assemble a complete funding package—especially when a local jurisdiction can generate long-term locally controlled revenue.

Local Financing (Bonds)

Bonds are the basic way that governments—and government-created entities—borrow money. State and local bonds are often simply referred to as municipal bonds or “munis.” Bonds allow local governments to finance large infrastructure projects that would not be possible within the limitations of annual budgets. By issuing a bond, a public project sponsor can spread costs over many years for projects that typically last far longer. In return for lending the government money by purchasing a bond, investors receive a specified rate of return or interest payment.

The interest paid by the public entity issuing the bond determines the “cost of funds.” A lower interest bond allows a project sponsor to access capital more cheaply than a high interest bond. The risk of default (i.e., failing to pay bondholders back what they are owed) governs the rate of interest that a project sponsor must offer to attract investors. Interest rates follow a rule: the greater the risk that a bondholder will not be repaid, the higher the interest rate required to attract investors. Local governments can take steps to make their bonds more secure and attractive to investors. In return for reducing the risk of default, the project sponsor is able to offer a bond with a lower interest rate. For instance, a local government may lower risk to investors by issuing a bond with insurance. If the local government is unable to pay, the insurance company repays bondholders.

When building a funding package for a project, it is important to balance risk and cost. The mixture of grants, loans, bonds, and other financial tools should expose the project sponsor to an acceptable level of risk at the lowest possible cost.

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General Obligation Bonds

General obligation bonds are secured by and repaid from the general tax revenues of the borrowing government. The government issuing the bond pledges its full faith and credit to investors. In effect, the government is promising to use its full powers of taxation to generate enough revenue to repay bondholders. The strength of the full faith and credit pledge makes general obligation bonds a low-risk investment. In exchange for the security that comes from such a powerful pledge, investors are willing to accept a lower interest rate.

Benefits: The principal benefit of issuing a general obligation bond for a project sponsor it its low cost compared to other financing options. Even a modest increase in the interest rate on a bond can add millions of dollars to total project costs. The savings that result from low-cost financing may make the difference between successfully implementing a project and failing to move forward.

Drawbacks: General obligation bonds represent a promise to repay investors before making any other budgetary expenditure. This is a significant risk to the government project sponsor. If tax revenues fall below projected levels, the government must still repay bondholders. As a result, other programs and projects may be at risk of being cut or eliminated. Finally, most governments are limited in how much general obligation debt they may take on. Choosing to offer a general obligation bond may limit the ability of the government to pursue other projects in the future.

Bottom Line: The decision to offer a general obligation bond should include an in-depth analysis of its potential budgetary impacts. The lower borrowing costs associated with a general obligation bond should be balanced against the additional budgetary risks.

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Revenue Bonds

Revenue bonds are repaid from a specific source of funds. The creditworthiness of a revenue bond is determined by the strength of the specific source of funds pledged toward repayment. Bondholders do not have a general claim to government revenues. Instead, they have a claim only to those revenues pledged to retire the bond. Generally, revenue bonds are treated as a riskier investment than a general obligation bond due to the narrow repayment pledge. As a result, revenue bonds often require a higher interest rate to attract investors.

Benefits: Revenue bonds are attractive to the project sponsors who are borrowing money because they represent a lower level of budgetary risk than a general obligation bond. In addition, many infrastructure projects generate revenue that may be pledged to repay bondholders. For instance, if a local government wanted to finance the construction of a parking deck, it could offer a revenue bond that pledged to repay investors with the resulting parking fees. In this case, the local government is not pledging its full faith and credit. Bondholders are entitled to the revenues generated by the project and nothing more.

Drawbacks: Revenue bonds have a higher long-term cost for project sponsors than general obligation bonds due to the higher risk of default, which requires them to offer a higher interest rate.

Bottom Line: The decision to issue a revenue bond is driven by two main considerations: the strength of the revenue source (either generated by the project or a separate source such as a sales tax) and the desire to limit the budgetary risk to other programs and projects. A project with uncertain revenue generating potential that receives a lower credit rating (requiring a high interest rate to attract investors) may not be able to generate enough to pay a higher interest rate.

Tax Increment Bonds

Tax increment bonds (sometimes known as tax allocation bonds) are a form of revenue bond that takes advantage of the increased property tax revenues that result from the transportation investment. For example, transit projects can often increase surrounding land values and serve as a catalyst for new real estate development. As new residential and business projects are built around the transit line, the assessed value of land rises and property tax revenues increase. The increase in property taxes is dedicated to making payments to bondholders.

Benefits: Tax increment financing captures the expected benefits of a transit project in a way that helps get the project built today. Also, by only pledging incremental revenues, it can reassure people that existing revenue sources already being used for other needs will not be tapped.

Drawbacks: Tax increment bonds rely on significant new development to occur around transit stations and within the corridor. Because the potential real estate development may slow, the anticipated increase in revenues may not materialize. These bonds can require a project sponsor to pay a higher interest rate than general obligation bonds. Also, the amount of money generated this way is usually less than a regional sales tax or other broad-based tax measure.

Bottom Line: In order for tax increment bonds to be successful and a receive a high bond rating, local leaders, planners, and developers must think critically about how to maximize development potential around stations and within the corridor. This cooperative partnership should begin as early as possible. Also, tax increment financing can cover a portion of project costs, but is not likely to provide full project funding.

Financing toolsRepaymentCost/RiskBenefitDrawback
General obligation bondsFull faith and credit of governmentTypically lower risk and lower interest ratesLower interest rate can save millions in total financing costsBudgetary risk to project sponsor if tax collections are lower than expected
Revenue bondsSpecific revenue source (e.g., sales tax, property taxes, user fees)Typically a higher risk to investors resulting in a higher interest rateLower budgetary risk - investors have no claim on general tax collectionsHigher interest rates raise the cost of building a project
Tax increment bondsBuilding transit increases surrounding land values – providing additional property tax revenues used to repay bondholdersReal estate development takes time and increased revenues may come more slowly – this tends to raise risk and interest ratesBuilding transit catalyzes development – tax increment bonds tap into this development to help fund the projectReal estate markets fluctuate and forecasted growth may happen more slowly than originally anticipated

-> Next primer: read about state enabling legislation