Across the country, municipalities are focusing on tax-exempt lease purchase financings and installment sale agreements as alternatives to traditional bonds. As a reflection of diverse needs of cities, these transactions range in size from $100,000 to $100 Million and we’re seeing more of them all the time. In fact, the private placement investment market is estimated at over $20 Billion annually and growing. One of the reasons for this expanding market is that tax- exempt capital leases and installment sale agreements offer simplicity, flexibility, speed, and attractive rates. Consider the differences between private placements and traditional bonds:
- Single Investor
- Transactions up to $100 Mil.
- Payment Flexibility
- Minimal Transaction Fees
- Competitive Rates
- Financing Terms up to 20 Yr.
- Low Interest Rate Risk
- Quick Funding
- Multiple Investors
- Transactions $10 Mil. plus
- Less Payment Flexibility
- High Transactional Fees
- Competitive Rates
- Financing Terms up to 30 Yr.
- Higher Interest Rate Risk
- Longer Funding Cycle
When considering a private placement, cities have two main options: Lease Purchase Financing and Installment Sale Agreements.
Lease Purchase Financing
Lease purchase financing allows the borrower to acquire essential purchase assets or refinance existing obligations and spread the payments over the asset’s useful life. This strategy preserves valuable cash and enables the municipality to do more with its resources. There are two types of lease purchase financing structures:
- Appropriation Based Lease: Under this structure, the municipal governing body appropriates the payment due to the investor each fiscal year. In the event of non-appropriation, the lessee must return the asset back to the investor and pay any remaining funds that have been appropriated, but have not been paid for the current fiscal year. The risk is mitigated through funding projects with high essentiality and good underlying financial fundamentals.
- Abatement Lease (used only in California and Indiana): With this style of financing, the municipality has an unconditional obligation to make the scheduled payment(s) to the Investor during the financing period as long as it has use of the asset. This structure is primarily used for real property transactions, but is applicable to equipment financings. The lease payments are abated provided that the municipality has substantial interference or loss of use of the asset.
With an abatement lease, the investor reduces risk by requiring the lessee to maintain rental interruption insurance during the term of the financing, which will require the third-party insurance carrier to make payments during the asset rehabilitation period. Once the building is rehabilitated or the equipment is operational again, the municipality must resume making the remaining payments. Most importantly, the payment stream is not interrupted.
Installment Sale Agreements
Installment sale agreements are similar to lease purchase financing in that they allow the borrower to finance equipment, infrastructure, or real property over the useful life of the asset. Whereas lease purchase financing is secured by the underlying collateral, installment sale agreements are secured by the municipality’s enterprise fund, such as water, sewer, or electricity. The borrower will covenant to raise rates, fees, and use all legally available funds to maintain a specified debt service coverage ratio.
Private Placements Considerations
A few things to consider with private placements are payment flexibility, asset ownership, default risk, investors, improved municipal purchasing power deriving from lower tax exempt rates, and budget optimization.
Private placement financing can be structured with monthly, quarterly, semi-annual, or annual payments to match the seasonal fluctuation of revenues. Through making more frequent payments, such as quarterly, the municipality can lower its overall interest cost, which flows directly to the bottom line.
Title to the equipment, facilities, or infrastructure is typically held by the borrower. The investor is secured by a UCC filing or leasehold interest in the asset. Upon completion of the scheduled payments, the lien is released and the municipality owns the asset free and clear.
Banks, insurance companies and funds are the primary investors. Each institution has their own unique investment criteria with some focusing on specific assets while others may emphasize longer financing terms, or a specific region of the country. Interest rates are determined by the asset type, financing term, and underlying financial strength of the municipality.
Lower Tax Exempt Rates
Section 103 of the Internal Revenue Code allows interest expense to the investor to become exempt from federal taxation. Overall, municipal governments are able to reduce their interest expense by approximately 1/3 while providing the investor with an attractive after-tax return. Additionally, most states exempt the interest income on debt and capital leases originated by municipalities within their states. This translates into even lower borrowing rates, which enables the municipality to have more purchasing power.
Optimizing Your Budget
Municipalities can maximize their project funding options by combining their federal & state grants and cash reserves with lease purchase financing or installment sale agreements to acquire more essential purpose assets such as vehicles, computers, energy conservation projects etc.
Consider a municipality in the Unites States that is looking to acquire five fire trucks. Though the city recognizes the need for the equipment, the council does not want to deplete its budget reserves. The municipality can finance the fire truck acquisition with a tax-exempt lease purchase financing, while funding personnel, maintenance, and insurance expenses from its cash reserves. By doing so, the municipality aligns the fire truck’s economic useful life with an equivalent financing term of 10-15 years to lower its payment and still have ample funds for its operating expenses. The rainy day fund is safe and sound, while employee productivity and morale remain high.
Transaction Process Management
In order to deliver capital quickly and efficiently, it is important to streamline the necessary steps of project discovery, credit review, and documentation. The right financing partner will guide the city through the process, drawing from their experience to deliver the financing package that is right for them. Always complete your due diligence to pick the right partner.
Municipalities are uniquely positioned to take advantage of private placements to acquire essential assets. Lease purchase financing and installment sale agreements allow the borrower to fund new acquisitions and refinance existing assets for general fund and enterprise fund operations. They both offer competitive rates, payment flexibility, low cost of issuance, and quick funding. Overall, lease purchase financing and installment sale agreements are valuable tools for municipalities to expand their resources and meet its strategic objectives with greater ease and simplicity.
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