Missouri Lease Financing
Projects to be Considered
Lease financing is an appropriate financing vehicle for any project in which (i) the project could serve as collateral (e.g. a mortgage could be placed on all or part of the assets being financed), (ii) the facilities are essential to providing basic governmental services and (iii) the issuer has sufficient revenues to pay debt service without any future tax increase.
The following are a few examples of the types of projects suitable for this form of financing:
Water and Sewer System Projects
Essential equipment (e.g. fire trucks)
Forms of Lease Financing
There are three methods by which Missouri governmental entities may finance equipment and facility acquisitions using lease financing. The methods are direct financing through a leasing company or bank, Certificates of Participation (COPs) or Leasehold Revenue Bonds.
Some leasing companies and banks act as lessor and provide direct lease financing. The leasing company or bank purchases the property and then leases the property back to the governmental unit. Direct financing by the lessor is essentially a private placement and, consequently, interest rates tend to be significantly higher than those available on either publicly sold COPs or lease revenue bonds. Rates for privately placed securities typically range from 1/4% to over 1% higher than rates on publicly sold securities.
Certificates of Participation
As an alternative, lease financing can be arranged through the public sale of certificates of participation, sometimes referred to as COPs. Each certificate holder owns a beneficial interest in the lease. Certificate holders, in the aggregate, essentially constitute the lessor. Certificates of Participation are a newer form of lease financing that are gaining popularity with issuers and have gained acceptance by investors. Although the documentation is significantly different than for revenue or general obligation bonds, the sale of the securities involves a process that is essentially the same.
Leasehold Revenue Bonds
The third method of lease financing is through the sale of bonds secured by lease payments ("lease revenue bonds"). This method requires that the property and/or equipment be purchased by a not-for-profit corporation or governmental agency. The not-for-profit corporation or governmental agency issues bonds secured by the lease and serves as lessor of the property.
Just as cities establish industrial revenue bond authorities to serve as a conduit issuer of industrial revenue bonds, governmental entities can establish not-for-profit-corporations to serve as a conduit issuer for lease financing. The Corporation would be formed under Chapter 355 of the Missouri Statutes (the General Not-For-Profit Corporation Law of Missouri) and would serve as the financing vehicle for the governmental entity. The governmental entity would be responsible for determining the purposes of the Corporation and the composition of its Board of Directors.
Once established, the not-for-profit corporation can issue bonds for a specific project or serve as an ongoing financing vehicle for the governmental entity (e.g. annual equipment financings). Unlike an industrial revenue bond authority, a not-for-profit corporation has no ongoing decision making power. It can only issue bonds when directed to do so by the governmental entity. Its investment and spending powers are assigned to a Trustee (a Missouri Bank) who performs these functions solely as directed by the governmental entity.
Bond proceeds are used by the Corporation to acquire capital assets as directed by the governmental entity. The capital assets are then leased to the governmental entity through a one year lease with annual renewal terms and a final maturity corresponding to the term of the bonds.
Terms of the Financing
The terms of the financing are set forth in a lease-purchase agreement between the governmental entity and the lessor. The governmental entity makes payments in an amount sufficient to cover debt service. In addition, the governmental entity has the responsibility for the operation and maintenance of the leased facilities and the costs associated therewith.
In Missouri, lease payments are subject to annual appropriation by the governmental entity. The lease is automatically renewed as long as the governmental entity continues to make annual appropriations. Because the governmental entity is not obligated to make lease payments beyond any current fiscal year, the lease obligations are not considered debt for purposes of any constitutional or statutory debt limitation and do not require voter approval.
For federal income tax purposes, the lease agreement is deemed to be a conditional sale agreement, with the result that the interest component of the "rental" payments made by the governmental entity are generally exempt from federal income taxes under the Internal Revenue Code.
Marketability and Interest Cost
The marketability of lease obligations and, consequently, interest rates are affected primarily by the government's
Ability and Willingness to Pay
Ability to Pay
Ability to pay is an assessment of the current creditworthiness of the governmental entity as well as the probability that the entity will have sufficient funds to make lease payments in the future without any future voter approved tax increases. In addition to an analysis of the current and projected revenues available to pay debt service, creditworthiness takes into account numerous factors including a governmental entity's financial, management, economic and demographic condition since each of these factors could affect the governments future ability to pay.
Willingness to Pay
Marketability of lease obligations is highly affected by the likelihood of nonappropriation. The major variable in this analysis is a determination as to the importance of the leased property in providing essential services by the government entity.
As previously indicated, rental payments are contingent on the governmental entity making annual appropriations to the lessor. In the event rental payments are not made, the governmental entity losses the use of the leased facilities. Accordingly, willingness to pay is affected by the importance of the leased capital asset to the government in providing basic government services.
From a market perspective, leased property is generally classified in one of two categories which are "essential" and "non-essential". Essential facilities are used for basic government services such as police or fire protection properties or equipment. Non-essential facilities are used for services the government could forego such as recreation activities. A government entity is more likely to continue making annual appropriations on lease obligations for essential facilities.
Similarly, an event of nonappropriation is more likely to occur for a computer system which may become obsolete than a building with a useful life of twenty to forty years. An event of nonappropriation is also more likely to occur if the property or equipment can be rapidly substituted.
Most Missouri lease obligations are sold as unrated securities. When lease obligations are rated, the rating assigned is typically at least one rating grade lower than the governmental entity would receive on its general obligation bonds. Some lease obligations are qualified to obtain a municipal bond insurance policy from a "Aaa" insurer. The feasibility of acquiring insurance must be measured in terms of the cost of insurance acquisition against the reduction in interest rates and total interest cost.
Interest rates are largely affected by bond rating. Since the lease obligations will have a lower rating than an issuer's general obligation bonds, interest rates will be correspondingly higher. If we assume that an issuer could obtain insurance and that both the issuer's general obligation bonds and lease obligations would have a "Aaa" rating, then the rate differential between general obligations bonds and lease obligations would be in the range of 1/8% to 1/4%.
Sale of Lease Obligations
The governmental entity may sell the lease obligations by competitive sale, negotiated sale, or private placement. Each of these methods is discussed herein.
Competitive Sale: In a competitive sale, the obligations are advertised for sale. Any broker dealer or dealer bank may bid on the obligations at the designated date and time of the sale. The obligations are awarded to the bidder offering the lowest net interest cost. For general obligation bonds, the primary advantage of a competitive sale is that it assures the receipt of the lowest possible interest cost at the time of the bond sale. However, in the case of lease obligations, the market is more limited than with general obligation bonds and other methods of sale are often more appropriate.
Negotiated Sale: In a negotiated sale an underwriter is selected to purchase the bonds. The underwriter, in turn, sells the bonds to the public. The terms of the bonds are tailored to meet the demands of the underwriter's clients. A negotiated sale assures the governmental entity of having a bond purchaser. This method of sale is desirable when the market for the bonds is strongly dependent upon the bond terms and structure or when the governmental entity lacks strong credit features.
The method of sale is known as a negotiated sale because the terms of the bonds and the terms of the sale are negotiated by the issuer and the bond purchaser. Sale of bonds in this fashion, however, does not preclude competition. WM Financial Strategies would prepare a request for proposals for distribution to several prospective underwriters. The request for proposals would include the bond terms desired by the governmental entity and would enable prospective underwriters to indicate which terms must be modified as a condition to their purchase. Additionally, the underwriter's response would include their fees and an indication of interest rates. At the time of the sale, WM Financial Strategies would represent the governmental entity in negotiating the final terms and interest rates to assure that they are consistent with prevailing market conditions.
Private Placement: A private placement is handled in an identical fashion as a negotiated sale except that the bonds are not reoffered to the public. A private placement is typically used when a public market does not exist for the bonds. This can occur in instances where the credit of the issuer is weak, the bond issue is too small to market publicly, or the terms of the issue are so unusual that the public would not be interested in purchasing the bonds. Although costs of issuance are often less than for a negotiated or competitive sale, the total interest cost is typically higher in a private placement with interest rates generally in the range of 1/4 of 1% to 1% higher than in a public sale.
As with a negotiated sale, a private placement does not preclude competition. WM Financial Strategies would solicit proposals from prospective purchasers and negotiate the terms of sale on behalf of the governmental entity.
Risks and Rewards of Lease Purchase Financing
Lease purchase financing is often used to avoid a bond referendum or to finance items traditionally financed on a pay-as-you-go basis. Lease purchase financing is gaining market acceptance. Issuers are now able to market leased obligations with rates only slightly higher than comparable maturities of general obligation bonds.
The primary advantage of lease financing is that it provides a viable source of tax-exempt financing and eliminates the necessity of costly pay-as-you-go approaches when voter approval is unlikely.
The primary drawback of lease financing is that no income stream is attached to debt payment. In contrast to lease obligations, voter approved bonds authorize an income stream. General obligation bonds permit an issuer to levy taxes and revenue bonds permit an issuer to pledge revenues from user charges. Accordingly, an issuer can find itself cash strapped in future years by virtue of lease payments. Before undertaking a lease purchase financing, a careful analysis should be made of projected revenues, expenses, and community economic and demographic factors which may affect future income trends.
For capital projects, WM Financial Strategies can assist in identifying the most appropriate financing vehicle. When lease financing is appropriate, WM Financial Strategies works with the governmental entity in analyzing the feasibility of each alternative leasing method and in determining the most cost effective approach.
DISCLAIMER: The material contained at www.Munibondadvisor.com is for informational purposes only and is not an offer to sell or a solicitation to buy any security. Nothing contained herein should be viewed as investment advice or as constituting a recommendation to buy, hold or sell the obligations referred to herein. WM Financial Strategies is an independent financial advisor serving government entities exclusively and is not a broker dealer. Nothing contained herein should be considered as advice to any governmental entity. WM Financial Strategies makes recommendations to its governmental clients only after a complete review of their particular financial needs and circumstances and such circumstances and needs often require the additional assistance of nationally recognized bond counsel or other legal representative. Links to any external websites are intended for information purposes only and are not an endorsement or concurrence with any opinion, service or product referenced at the site.
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