There is a common misperception that a municipality's willingness to issue a so-called Developer Note on a pay-as-you-go basis is tantamount to providing equity to the redevelopment project.
Unfortunately, most Developer Notes have too much "hair" on them, thereby compromising their marketability. As a result, unless properly structured in the context of a negotiated Redevelopment Agreement, the utility of a Developer Note is not often maximized.
I have represented clients who have successfully monetized Developer Notes issued by a municipality. Working in tandem with underwriters, we have been able to finance and/or market for sale proposed Developer Notes.
As you structure the features of Developer Notes, the following principles may help you maximize their marketability. Keep these eight tips in mind.
- The Developer Note must be a negotiable instrument with defined principal and interest components.
- The Developer Note must have a defined amortization of principal.
- Upon issuance, the Developer Note should be "non-callable" for one-half the term of its life. Ideally, this means that a 20-year Note would have call protection for a period of 10 years. Call protection precludes the municipality from prepaying the Developer Note unless the lockout period restriction is formally waived by the holder of the Developer Note. Because of the already narrow range of prospective purchasers and interest holders in such a Developer Note, the anticipated income stream from the Developer Note must be protected for the benefit of the prospective purchasers and/or note holders.
- The Developer Note must be accompanied by an opinion of bond counsel that interest under the Developer Note is not includable in the gross income of the holder. The tax-exempt nature of such a Developer Note is critical to its marketability. Because of IRS private activity rules, in such an event, the underlying Redevelopment Agreement cannot, for example, preclude the developer from challenging real estate assessments, etc.
- There must be the option of assigning the Developer Note to a trustee for the benefit of certificate holders. The common structure is to assign to a trustee the interest in, and the right to receive payments under, the Developer Note. Therefore, the Redevelopment Agreement must authorize (preferably without the consent of the municipality) the assignment of the Developer Note to a so-called "qualified investor", meaning a qualified institutional buyer (QIB) or a registered investment company. The Redevelopment Agreement should define a qualified transfer to include the pledge of the Developer Note to a lender providing financing or the sale of the Developer Note to a "qualified investor" or to a trust where certificates of participation are sold to qualified investors.
- The original holder of the Developer Note will be required to provide a limited guarantee equal to 10 percent of the face amount of the Developer Note. That guarantee can be in the form of a letter of credit or cash. This 10 percent reserve will protect the purchaser(s) of interest(s) in the Developer Note from the consequences of unmet expectations due to increment projections which are not fully realized.
- In order for a Developer Note to be marketable, there can be no restrictions on the flow of increment to the holder. All restrictions must be removed or by their terms expired. Here is an example: in an instance where the municipality has remedies under the Redevelopment Agreement in the event the Developer fails to perform, breaches a covenant or fails to comply with other requirements,* then the remedies, if exercised by the municipality, cannot affect the requirement to make payments as and when required pursuant to the debt service schedule. Any remedies for events of default that threaten to interrupt the flow of such payments must be negotiated out of the Redevelopment Agreement. One alternative is to provide for a larger, tax-exempt note to be issued by the municipality and for a smaller, taxable note to be issued, against which the municipality has recourse and remedies under the terms of the Redevelopment Agreement. This structure is becoming increasingly popular in deals with the City of Chicago.
- The Developer Note should be issued on a parity basis. In order to retain maximum flexibility on the sale of a Developer Note, where multiple obligations are issued the Developer should have the ability to request that other obligations be subordinated to the primary, tax-exempt Developer Note. One benefit to this structuring is that additional coverage with respect to the primary, tax exempt Developer Note is built in.
The sale of Developer Notes at a relatively early stage in the development process can yield early and significant cash to supplement or replace a Developer's equity. In this way, the sale of Developer Notes can effectively produce the same results as take-out bonds issued during the course of the development process.
There are many pitfalls associated with successfully negotiating Redevelopment Agreements while not compromising the tax-exempt status or marketability of a Developer Note. Being aware of these pitfalls and structuring the terms of a Redevelopment Agreement around them is the key to successfully monetizing Developer Notes and to optimizing their value at an earlier stage in the development process.