“Entitlement Finance”: New Tools for Public/Private Cooperation

By now, everyone is familiar with the term “entitlements,” which refers to the bundle of agreements that se­cure a project’s long tenn develop­ment rights. However, due to the substantial level of “value added” impact that entitlements have on property, a new form of project fi­nance must now be considered. De­fined as “entitlement finance,” this process of financing refers to the cash and cash equivalent project assistance available from local government. 

In the “good ol’ days,” nearly all entitlements could be determined from the zoning map and code. Today, however, zoning is only part of the picture. Every property is subject to a different bundle of land use and each in essence a zone unto its own, and causing each real estate project to become, in the eyes of the public sector, a de novo discretionary action. 

Elements of Entitlement 

In today’s real estate environment, both the players and components of entitlement represent a broad range of issues and concerns. In addition to the public sector and the private de­velopers, others who are likely to be found at the negotiating table include community activists, equity investors, tenants, non-profit groups, and single purpose regional agencies such as the AQMD or the LACTC.

In addition to land use and zoning envelope concerns, other issues which these players typically discuss are traffic and transportation manage­ment, environmental mitigation, project design and planning, regional air quality conformance, congestion management, growth management plans, project timing and phasing considerations, land use restrictions, and lastly, the public/private transac­tion. In fact, out of this long list, the public/private transaction may be the only good news in today’s world of project approvals. 

For most real estate transactions, the key words relate to money. More often than not, cities and other public agencies either have money, will get some in the future, or have discretion­ary approval powers which can translate into monetary savings for the developer. Thus, as entitlement approvals become more complicated, entitlement financing becomes more sophisticated. 

Entitlement Finance: What Is It and Where Does It Come From? 

Entitlement finance describes direct or indirect assistance from a public entity to a private real estate interest in order to improve the finan­cial feasibility of a real estate project. Typically, these monies come from three sources, including: (1) city and/or agency powers and statutes (i.e., tax increment monies, bond proceeds pursuant to State or local bond issue, special trust funds representing col­lected fees and exactions); (2) project-­created values (i.e., sales tax receipts, bed tax receipts, property tax receipts, and other project-generated funds); and, (3) added value discretionary approvals (these approvals, some­times referred to as envelope en­hancements, are directly convertible to value for purposes of both public and private financing).

Prop. 13 and Entitlement Finance

In the world of entitlement fi­nance, one milestone event effectively created the field: Proposition 13 and its companion legislation, Proposi­tion 4 (the Gann Initiative). Prior to Prop. 13, cities and coun­ties could readjust the property tax rate, as needed, subject to political considerations, and could revalue property annually.

With Prop. 13, tax rates were set at a nominal one percent of value, and property was to be reassessed only when a legal transfer occurred. Tax rates on assessed property value went from, on average about 2.0% to 2.5% of value in the mid-1970’s, to 1%. To add insult to injury, the year follow­ing the passage of Prop. 13, Prop. 4 was enacted, pegging the growth of county and city budgets to the growth in population, plus a small increment attributable to inflation.

Necessity (Deficits) Yields Inven­tion (Revenues from Real Estate)

However, cities and counties got smarter while they got poorer. Once the State stopped funding local gov­ernment in 1981-1982, cities in par­ticular needed to find another revenue source. Enter the real estate developer, bringing with him the hot market of the mid-and late-1980’s.

New development projects meant money to cities. Municipalities relied on property tax, hotel bed tax, and sales tax revenues generated from real estate projects. Cities competed against each other for retail malls, auto dealerships, and other land uses which brought in dollars. 

For those cities who played this “cash box zoning” game well, stan­dard tools of the trade included the use of redevelopment powers for land assembly and tax increment financ­ing, the use of other city monies to pay for public infrastructure im­provements, and the pledge to reim­burse a portion of project-generated taxes back to the developer. The cities hired consultants to make sure that the taxes they were gaining from these transactions were, on a present value basis, worth more than the in­centive packages they were giving away to attract these deals. 

The State Legislature cooperated as well during the 1980’s, enacting a series of statutes which essentially allowed cities to lend their tax-exempt status to private developers, for the purpose of paying for project-related public improvements. Legislation such as the Mello-Roos Community Facilities District Act, which aug­mented and extended existing assess­ment district concepts, and the Infra­structure Financing District Act, are both variations on this theme. 

The Menu of Mechanisms 

All in all, cities got pretty good at figuring out how to give you money at the front end in order to get more money over the long term. As the accompanying table illustrates, the public sector and pri­vate developers have a variety of mechanisms to satisfy the dual objec­tives of each party. 

And as public sector experience with entitlement fi­nancing mechanisms has evolved, it has become common that somewhere in almost every City Hall is a public official who knows a lot about public finance and a lot more about the fiscal benefits from private real estate de­velopment.

Certainly in today’s tough real estate market, the deals have become scarcer and cities have become more selective. Nonetheless, a rule of thumb that we believe will hold true for the rest of the 1990’s says that if the private developer achieves political support from the city and community acceptance from the neighbors, then there are numerous ways that the public sector can structure the transaction to permit the developer appropriate access to public monies and/or mu­nicipal discretion in order to benefit both city and developer. More importantly, in today’s restrictive financing environment, entitlement financing can be used either to expand equity or credit to enhance a project. It may, in fact, be the only way to make a project financeable. 

Entitlement financing can take three forms: cash; cash equivalents; and the “borrowing” of a municipality’s tax exempt status. Each mechanism provides benefits in different ways to a developer, mu­nicipality, and the ultimate user. In some respects, the new public/private transactions represent the new “bazaar” where developers and city staff haggle over development fees, exactions, public financings, density bo­nuses, etc.

Cash: The Root of All Deals 

In the simpler days, the developer and redevelopment agency would pencil out a project, determine the appropriate subsidy amount and then the agency would either provide pub­lic improvements or “write down” the land to make the project feasible. 

Over time, however, cities and redevelopment agencies realized that there was little benefit putting their money into the project before the de­veloper had truly performed. Also, “watchdog” groups were taking a closer look at individual projects, how the public assistance was provided, and on what terms. Furthermore, many agencies with new project ar­eas are strapped for up-front cash, which makes it more difficult to pro­vide up-front monies. 

The new cash tools, then, repre­sent a mechanism for leveraging the public revenue flows that are derived from a project. Cities and redevelop­ment agencies, through tax alloca­tion bonds or reimbursement agree­ments, seek to leverage the property tax revenues, tax increment, and/or incremental sales tax revenues to re­imburse developers for public improvements associated with a project. Mello-Roos financing is a typical ve­hicle used to funnel money back to a project from the tax increment or incremental sales tax created. The Mello-Roos district is utilized to ac­quire various public facilities, and then the tax increment or incremental sales tax generated by the project is utilized to reimburse the developeror is pledged directly to the repayment of the bonds. This latter mechanism is similar to a tax allocation bond structure, in which the developer has little or no liability. 

Cash Equivalents: Barter at its Best 

Cash equivalent techniques in­clude mechanisms such as density bonuses, changes in land use and transfer of development rights (TDR’s). They also include several less obvious items such as deferment or phasing of fees and exactions and the definition of what constitutes public and private activities. In many ways, the cash equivalent tools repre­sent the best and perhaps the only opportunity for developers and cities/agencies to achieve what each wants within the constraints of developer and municipal budgets. 

These techniques have been around for a long time, and their use often allows the developer and the city to enhance the overall value of a project, thereby making it feasible. 

The less obvious way to provide money to a project is through the deferment or phasing of fees, exactions, or environmental mitigation costs. This accomplishes two things for the developer. First, it reduces financing costs, as the developer does not need to borrow money for these fees from the construction lender or from the equity partners. And sec­ond, the developer faces less risk in the project than if all of the fees were required up front. This lowering of risk often enables developers to ac­cept a somewhat lower rate of return to make a project feasible. 

Borrowing the Public Sector’s Tax Exempt Status 

A final mechanism for improving the feasibility for real estate projects is through the use of public financing tools to provide for “public” infra­structure. These techniques involve not only the tried and true assessment districts under the 1911, 1913, and 1915 Improvement and Bond Acts, but also the newer Mello-Roos com­munity facility districts and public lease financing. 

These techniques are utilized to provide long-term, lower cost financ­ing to projects for the provision of public improvements such as streets, certain public utilities, flood control, etc. 

Rather than financing these im­provements upfront through private construction financing and then pass­ing these costs on to homeowners through higher prices and tenants through rents, the long term tax ex­empt market becomes the vehicle for providing financing for these improvements. The homeowner or other ultimate user still bears the cost of servicing this debt (paying for the improvements), but the debt service is based on rates that are between 2 to 3 percentage points below other long term financing rates. 

The newer use of public lease financing, or certificates of participa­tion, in public/private transactions represents a more sophisticated bridging between borrowing the pub­lic sector’s tax exempt status and pro­viding cash infusions to projects. How this works is the subject of a future article. 

What the Public Sector Gets 

While the preceding discussion has focused on the benefits to a devel­oper utilizing entitlement financing techniques, just as important are the benefits to the public sector. In a well-­balanced negotiation, the benefits from entitlement finance will be di­vided between the developer through increased profits and the public sector through public benefits such as parks and open space, public facilities, etc. 

The public sector also gains bet­ter planned projects and projects that better meet the needs of the surround­ing community. Finally, the public sector gains from the creation of addi­tional public revenues that can be used to fund other projects within the City.