The advantages and disadvantages of the various financial alternatives available to municipal authorities
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{This article was written by Russ McIntosh, HRG's director of financial services, and published in the Pennsylvania Municipal Authority Associations's magazine, The Authority.}
Every expansion, upgrade, or new construction project must be funded, and a variety of financing alternatives are available for your consideration. Each alternative will have an impact on a long-term cost of service to be paid by your users. Each one is different, and each strategy has both positive and negative aspects. So how do you know what most preferential alternative for you and your users will be?
For many authorities, finding the right source of financing presents an immediate challenge. As soon as your project becomes public knowledge, you will likely be contacted by a variety of individuals seeking to help you secure the necessary funds. In order to properly evaluate all of the various financing strategies, you must understand the strengths and weaknesses of each of the available financing vehicles.
For example, public financing through federal or state agencies at subsidized interest rates is not always the best approach, and conversely, tax exempt revenue bonds do not always represent the least preferable approach either. In a moderate interest rate environment, an authority that must undertake a project which consists primarily of the construction of Act 339 eligible facilities, may find it in their long-term best interest to find a source of financing other than PENNVEST. This is because facilities constructed with PENNVEST funds are not eligible for the annual Act 339 subsidy. Other factors such as timing, flexibility and project size may affect the selection of a financing method.
In the sections that follow, we will discuss the advantages and disadvantages of the many forms of project financing available to municipal authorities. We will also discuss financing options for homeowners who require assistance to pay their tapping fees and installation costs. Additional guidance on the selection of professional advisors is also provided.
Short-Term Financing
Loans from local banks often represent a good alternative for funding the preliminary costs for large projects or the entire cost for small projects. Large and small are, of course, relative terms and will depend upon your authority's financial resources, the size of your community and other similar factors. Probably the best way to decide whether or not a bank financing is right for you is to ask how soon the bank can be repaid. If the answer is less than five years and the amount of money involved is within the lending limit of your bank, a bank loan probably represents the most cost-effective and readily available source of financing.
Bank loans do not need to be repaid solely from customer revenues. They may be repaid from the proceeds of another loan. Short-term debt is frequently repaid when a project's permanent financing is settled. The magic behind repayment over five years is that many banks do not like to make long-term loans at tax exempt fixed interest rates. Usually, the loan amount represents a fairly substantial percentage of the banks local lending, and there are many variables that bankers need to consider when making a tax exempt interest loan. One significant variable they must consider is the possibility of future changes in the U.S. tax laws or the treasury's arbitrage regulations. These changes could have an adverse impact on the profitability of these types of loans.
For projects that require a larger amount of money than can be comfortably borrowed from the local bank, regional banks are typically a good source. The authority may also choose to sell short-term project notes. Again, payment in two to five years may be made either from revenues (like tapping fees or front-foot assessments) or by including the amount in a long-term borrowing. Often, interest on the loan or notes is included in the borrowing.
Short-term notes are generally issued to provide large amounts of money to undertake a project through some prescribed milestone or to finance several smaller projects over a period of several years. For very large projects where preliminary costs may exceed $1,000,000.00, the notes may be issued to pay these costs and then refinanced as part of a permanent financing after construction bids have been received. Under some circumstances, the authority may wish to borrow enough money to provide for both the preliminary costs and the construction of the project. This may be useful if the permanent financing is being provided by some federal or state agency, if there are several stages to a project, or there are other circumstances that make calculation of the long-term debt amount uncertain.
Short-term notes are not a financing vehicle for everyone, however, since very stringent treasury regulations govern the issuance of such debt. The state may limit such notes if they must be guaranteed by your sponsoring municipality or municipalities. Also, the success of such a financing is dependent upon specific marketing conditions including the size and credit worthiness of the authority, issue size and the general economic forecast and activity.
Long-Term Financing
Long-term financing (or permanent financing as it is sometimes referred to) is usually necessary in order to distribute the cost of major capital improvements over many years. It is also sometimes useful for growing communities, where the authority can employ this method to distribute the cost over a larger population base over time. Low tapping fees and long repayment terms help shift the burden of paying for the needed facilities to a time when there are more people to share in their cost, and the construction of facilities with excess capacity can often encourage this growth. For communities with very stable or declining populations, however, the reverse is true. Higher tapping fees and shorter repayment terms are more appropriate since the maximum number of people to benefit from the project are currently living in the community.
Several sources of long-term financing are used in Pennsylvania , including different grants and loans. The loans have interest rates ranging from 1 percent per annum to whatever the current market demands, and the terms will vary from a short 10 years to a long 40 years. Descriptions of the various types of long-term financing available in Pennsylvania are described in the following sections.
Pennsylvania Infrastructure Investment Authority (PENNVEST)
PENNVEST is governed by a Board of Directors (which is chaired by the governor) and administered by the PENNVEST staff in conjunction with Pennsylvania Department of Environmental Protection. PENNVEST provides twenty year construction loans at subsidized interest rates based on the county unemployment rate, commonwealth cost of funds, and affordability factors. Interest rates may be as low as 1 percent but are subject to increase to a predetermined rate after five years.
An application for construction funding is generally not considered for approval by the PENNVEST board until:
- An Act 537 Plan is approved (for sewer projects) or a feasibility study is approved (for water projects).
- Project design is complete.
- DEP permits are issued or the project is verbally approved by DEP.
- Technical evaluation and priority rating of application by a DEP representative is concluded
PENNVEST applies prescribed health, safety and environmental criteria in determining funding priority. A maximum of $11 million per project for a single municipality is available, and grant funding authorized by statute is limited to $250,000 for sewer projects.
The application process is very streamlined, and administration is fairly easy compared to other federal or state agencies. Local or project counsel is required to render enforceability and rate opinions and obtain approval of the Department of Community and Economic Development for municipal guaranty. Construction cannot commence until funding is approved and a written consent to proceed ("Letter of No Prejudice") is received from PENNVEST. Monthly progress reports must be submitted to PENNVEST during the construction period.
Authorities who opt to finance their projects with PENNVEST funds will enjoy many advantages of the program:
- It offers the lowest interest rates available.
- It may accept subordinate or party lien position in order to accommodate outstanding debt.
- The issuance costs are low.
- There is no negative arbitrage.
- A trustee is not required.
- However, there are also disadvantages to consider, as well.
- The board meets only three times each year.
- Approval is uncertain.
- It's sometimes difficult to coordinate project and financing timetables.
Undertaking design without a commitment for permanent financing is risky because PENNVEST may provide only partial funding and coordinating two financing agreements simultaneously is a complex process.
Although PENNVEST offers an advance funding program for especially needy communities, such loans are difficult to obtain, and no grants are offered through this program. Interim financing may be necessary to speed up the project and meet DEP commitments. Other disadvantages of this approach include the fact that borrowing may be limited to a term of no more than five years and must have a short call feature to allow current refunding with PENNVEST loan proceeds. Also, sewer projects funded by PENNVEST will lose Act 339 annual operating grant eligibility.
If federal funds are used, then Federal requirements under Title II and Title VI of Water Quality Act apply to project (Davis-Bacon Act, etc.).
Rural Utility Service (RUS)- U.S. Department of Agriculture
(Formerly Farmer's Home Administration - FmHA)
RUS provides long-term fixed rate financing (40 years) for qualified municipal utility projects. Eligibility is based on the reasonableness of estimated user charges and the median household income (MHI) of the municipality's residents. Grant funding also available if qualified and necessary to make the project affordable. The availability of loan and grant funds is determined in the federal budget, and competition among applicants in Pennsylvania is strong.
RUS loans offer a low interest rate – of just 5 percent for low income municipalities or an equally advantage rate for others based on average municipal bond rates and the longest fixed rate term available: 40 years. This will generally, but not always, result in the lowest annual debt service payments available. Overall, grant eligibility is up to 75 percent, but no grants are awarded until the minimum target user fee is reached and the actual loan and grant eligibility is determined by reasonableness of estimated user charges and MHI. A municipal guaranty may not be required, and issuance costs are generally low. RUS will provide commitment for permanent financing prior to authorizing design, but interest rate and grants are not established until time of settlement. A trustee is not required.
RUS's project involvement from funding through design and construction can add significant delays to project progress. RUS must approve the project scope, bid specifications, costs, etc. Interim construction financing is generally required but may be waived in certain cases. Future borrowing and expansion are subject to RUS approval and so are rate adjustments. A reserve fund equal to the annual debt service must be built-up over 10 years, and the possibility of a future loan call exists if the financial condition of the authority improves.
Public Bond Issue
Public bond issues are perhaps the most traditional method of funding for infrastructure projects in Pennsylvania . Municipal authorities can borrow at tax exempt interest rates for purely public projects for up to 30 or 35 years, depending upon the size and credit worthiness of the authority, the size of the issue, and the general economic conditions at the time of issuance. Interest rates may be fixed or variable, and security is generally the pledge of the system revenues. A municipal guarantee may be required under some circumstances. Bond insurance is often used to achieve a lower interest rate. A debt service reserve fund equal to 100 percent of the average annual debt service is usually required, but special circumstances may prevent its establishment. The services of a bond counsel are critical to the transaction. A trustee is also required, which is typically a bank having corporate trust powers or a trust company.
The bond market may be accessed in a number of ways but the two principle methods are 1) direct issuance by the authority utilizing the services of a bond underwriting firm or 2) the authority's participation in a bond pool.
The first method requires an authority to select an underwriter and sometimes a financial advisor to structure the bond issue and sell the bonds. The underwriter, financial advisor, bond counsel, authority solicitor, and engineer will structure financing specifically tailored to the authority's needs. The financing plan will take into consideration the authority's cash flow and revenue stream, length of the construction period, any existing indebtedness, and the need for future borrowing. Typically, revenue bond financing can be accomplished in a relatively short period of time compared to financings through state or federal agencies, and there is generally no third party review of the project scope, plans or specifications. Revenue bonds provide the most flexible financing option available to municipality authorities.
Generally, there are higher costs associated with the issuance of revenue bonds. The project team will consist of a bond underwriter, a bond counsel, and the services of a trustee bank or trust company. An independent financial advisor may also be retained, and additional work by both the authority's solicitor and consulting engineer is generally necessary. However, these latter costs may not be any greater than those that might be incurred in satisfying the state or federal requirements associated with financing provided through a governmental program. The need to establish and fund a debt service reserve account will also generate some additional costs; however, these funds may be invested, so the additional cost should be minimal when viewed over the life of the bond issue.
The second method by which municipal authorities can access the public finance market is through a bond pool. Bond pools, like the one established by the Pennsylvania Local Government Investment Trust (PLGIT) issue large amounts of debt for the purpose of lending the proceeds to eligible borrowers. Bonds are generally issued by a tax exempt body such as the Emmaus General Authority which issued the bonds for the PLGIT program. Other bond pools are available in Pennsylvania , but participation may be limited to specific types of borrowers or for specific purposes.
Generally bond pools will help lower the cost of issuance. Typically, they provide standardized documents to help reduce the legal cost associated with a bond issue, and there is no need for the authority to retain a bond underwriter. The authority may or may not choose to retain a financial advisor, depending upon the complexity of the transaction. There is usually no need to fund a debt service reserve account.
Not all potential borrowers are eligible to borrow from a particular bond pool. In addition, each participant in the pool must meet the minimum credit standards for the pool. Often, bond pools will offer only variable rates—although some pools provide an option for both fixed and variable. Bond insurance may be required. A portion of the loan proceeds may be used to currently refund outstanding debt, but advance refunding is generally not permitted.
Although bond pools offer attractive interest rates and typically lower costs of issuance, they may not serve the needs of all authorities or be advantageous for all projects. They deserve to be evaluated like all other financing alternatives available to authorities, but should not be pursued to the exclusion of other available options.
Financial Assistance Options for Homeowners
The ability of property owners to pay a tapping fee in addition to the cost of installing the building sewer is always a concern. Many families find these costs to be extremely burdensome. However, in some communities, the imposition of such fees lowers the overall cost of the system by lowering the long-term borrowing requirements and avoiding the interest cost associated with debt. While these fees may be burdensome for many, their imposition is quite commonplace. For those households where the payment of such fees in addition to the other costs associated with the installation of the sewer system constitute a genuine hardship, there are programs available to help. One of the most popular is a program administered by the U.S. Department of Agriculture's RUS.
Rural Utility Service - U.S. Department of Agriculture
Rural Housing Loans and Grants Program
RUS provides low interest loans and grants to eligible applicants living in rural areas to make improvements to their property. Among these improvements is the cost to install public sewers (including the payment of a reasonable tapping fee). The cost of constructing bathroom facilities or installing the building sewer from the lateral to the household plumbing also qualifies for RUS funding. Loans or grants are made directly to the property owner and are based upon their ability to repay the obligation. Grants may be made to those applicants 62 years of age or older with incomes that are insufficient to repay any portion of the loan. In each instance, the borrower must be the owner of the property. The cumulative maximum loan amount to an individual is $15,000, the maximum cumulative grant amount to any one individual is $5,000, and the maximum loan term is 20 years. The interest rate is 1 percent.
This program offers several advantages.
- Individual home owners, not the authority, apply directly to RUS for assistance.
- Interest rates are 1 percent and, in some instances, grants are available where household incomes are too low to repay the loan.
- The Township is able to impose a reasonable tapping fee on all connections with some assurance that funds will be available to the most needy households in order to pay them.
As with any government financed program, timing is often a problem for the receipt of funds. A lien is placed against the improved property until the loan has been repaid. Applications must be made directly to the county office of RUS.
PENNVEST's Loan/Grant Program
Another program that may be useful for individual homeowners is the loan/grant program offered by PENNVEST to repair or replace on-lot septic systems. Although most authorities operate centralized sewage collection and treatment systems, some have become the responsible agency for administering municipal on-lot management districts. Other authorities operate a pump and haul type of system or provide similar services that require homeowners to have and maintain their own on-lot facilities. The PENNVEST program is administered through local banks but is underwritten by PENNVEST. Lending amounts are subject to a maximum threshold, and maximum household income criteria must be met in order to participate in the program. Due to the difficulty in administering the program, PENNVEST has been reconsidering its usefulness. If your authority provides services to individual households that must maintain their own on-lot sewage facilities, up-to-date information on this program may be obtained directly from PENNVEST.
Grant Programs
A wide variety of grant programs are available to municipal authorities. However, many of these programs have only limited funds, and they seldom offer grant amounts sufficient to make substantial reductions in project cost and user charges. In addition, most grants are directed toward achieving a specific purpose such as economic development, community revitalization, housing rehabilitation, or reduction of cost for low/moderate income households. The principle source of grants is the Pennsylvania Department of Community and Economic Development (DCED).
The DCED administers a Community Development Block Grant Program for the U.S. Department of Housing and Urban Development for a variety of qualified projects, including the construction of water and wastewater facilities. The program has two segments. Approximately 50 percent of the money allocated to Pennsylvania is reallocated to various entitlement communities. Each county in Pennsylvania is an entitlement community as are most major cities. The remaining funds are allocated through a statewide competitive program. Request for funding for county entitlement funds is made through the county's planning commission, which acts as a screening agency for the county commissioners. Applications for funding through the statewide competitive grant process are submitted directly to DCED. The basic eligibility criteria established by DCED requires that 51 percent of the project benefit low and moderate income households in the project area.
The advantages of this program are many:
- It is easy to apply.
- You are able to discuss project merits with the decision makers.
- Multiple-year funding is possible once the project is qualified.
However, the program also has its disadvantages:
- The grants are typically small relative to project size. (Grants through the county entitlement program seldom exceed $20,000 - $30,000, and the maximum grant available through the statewide program is $350,000.)
- As a condition of the grant, tapping fees for low/moderate income households must be eliminated to recognize the impact of the grant.
- Administration is sometimes cumbersome.
- It is often difficult to establish the exact percentage of low/moderate income households in a project area without conducting a house-to-house income survey.
- Separate accounting of all CDBG funds must be maintained.
Additional programs may be available if your project helps local industries create and keep new jobs or is needed to facilitate the location of a new employer to your area. In both instances, additional grant funds may be successfully incorporated into your project's financing package if the Governor's Response Team can provide guidance to your authority on how to access these funds. Many of these programs require the assistance of your municipal officials since grants are made to the municipal body that is responsible for grant administration.
The Role of Your Professional Advisory Team
In order for an authority to undertake a successful financing, outside advisors are frequently needed.
The Solicitor
One of the most important members of the authority's financing team is its solicitor. This is particularly the case if the financing involves a loan from a local lending institution that does not need the guarantee of the authority's sponsoring municipality. However, each solicitor will have had different degrees of experience in identifying potential lenders, negotiating the terms of the loan, and securing all of the opinions and certifications needed to complete the closing.
Bond Counsel
The solicitor is frequently assisted in these endeavors by special counsel referred to as bond counsel. The role of the bond counsel is to ensure that the debt issued by the authority is in full compliance with all federal and state laws governing the issuance of tax exempt debt. Bond counsel has typically had a great deal of experience with these matters and issues an opinion to the lender or debt holder that none of the relevant statutes have been violated. In instances where a municipal guarantee is needed, he will often coordinate the authority's efforts with the solicitor for the municipality and the elected officials. He will also be involved with the preparation or review of the submittal to DCED when their approval is required.
Consulting Engineer
Your consulting engineer will also play an important role in advising legal counsel of the amount and timing of expenditures related to the proposed project. He often must prepare the overall project schedule and an estimate of the project's cost. He is frequently called upon to provide certifications concerning the adequacy of rates and charges to repay indebtedness and other certifications concerning the useful life of the facilities being constructed. He will often be asked to calculate or recalculate user charges for those connecting to a water or sewer system or those using the services provided by the authority.
Bond Underwriting Firm
If the authority issues debt in the public market, short-term project notes or long-term revenue bonds, a bond underwriting firm is necessary. There are several in Pennsylvania that have public finance departments specializing in the issuance of debt by municipalities and municipal authorities. The underwriter will provide an analysis to the authority of the marketability of its debt, the interest rate that it will likely pay, and advice and guidance to the authority on how to go about issuing the debt. The underwriter will then proceed through his organization to sell the authority's securities to the investing public at large or to large institutional investors or banks. There are some who feel that the financial advisory role offered by the underwriting firm and its role as the marketer of the authority's securities represents a conflict of interest, however the practice is fairly widespread here in Pennsylvania .
Independent Financial Advisor
Often, authorities will retain the services of an independent financial advisor who will review the fundamental economics of the project, determine the authority's financing needs, and provide an impartial analysis of the types of financing that are best suited to the authority's repayment ability. They are also helpful in determining the estimated impacts on customers through the calculation of user charges, and they frequently can provide all of the necessary certifications to government agencies concerning the adequacy of revenues and other financial matters. Like the bond counsel, they typically have had extensive experience in a wide variety of municipal borrowing situations and are prepared to quickly identify the most cost-effective source of funds. They do not replace any individual or firm who would otherwise be involved in the transaction but will frequently provide assistance to them that helps reduce the costs. However, their true value is in the ability to secure improved interest rates and other borrowing terms that have a profound impact on the overall cost to the user. Even a small difference in the average interest rate over a 20 or 25-year period can result in a substantial dollar impact.
As you can see, the world of municipal finance can be complex and involve numerous individuals and interest. Obviously, authorities will always want to pursue those financing alternatives that result in the lowest net overall cost, while other professionals must pursue different goals (including the overall legality of the transaction or the creation of a favorable market environment). It is important that each authority member review the transactions very carefully and make certain that the overall financing makes sense in light of the authority's needs. From time-to-time, "gimmicks", "scenarios", and "innovative financing schemes" will be touted as too good a deal to pass up. Indeed, some of these alternatives can be immensely beneficial to an authority, but great care should be taken before choosing one of these alternatives since there is often some element of risk that must be assumed in order to achieve the reward. When a deal looks too good to be true, perhaps it is. If in doubt about a particular transaction or aspect of one, a second opinion is often useful.
For more information on the financial decisions that face municipal authorities, contact Russ McIntosh. For information on water and wastewater engineering, contact Chuck Wunz. |
