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All these difficlties considered, small wonder that a municipality may issue a developer note instead of a bond.






Sam Polsky is a principal of Polsky & Associates Ltd., a law firm based in Chicago.






or all their popularity — and at last count, there were 103 of them in Chicago alone — TIFs remain poorly understood, sometimes by the people who stand to benefit most by them. One part of the TIF puzzle is the difference between TIF bonds and developer notes, a difference that can go straight to a developer’s bottom line.
     Most states have adopted TIF legislation that gives municipalities the power to capture real estate taxes generated from new development in certain areas and apply those new tax revenues to help pay for eligible costs of development. Chicago and many municipalities elsewhere use TIFs extensively to kick-start commercial and industrial developments.
     The source for incentive payments under TIF is generally real estate taxes, while some municipalities also include sales tax incentives as part of the TIF. As a policy, Chicago limits its TIF assistance to incremental real estate taxes only and doesn’t pledge any new sales taxes as part of its TIF assistance.
     But what form of TIF assistance can a developer receive, and how do TIF dollars reach the commercial developer? The structure of a TIF deal will determine how a developer benefits from the economic incentive. Reaping the benefit of TIF dollars doesn’t have to mean receiving those TIF dollars immediately. There are basically two forms of TIF assistance: a TIF bond and a developer note (sometimes referred to as a "pay-as-you-go" deal).
     A TIF bond is issued by a municipality and sold through an underwriter, which results in immediate available proceeds to pay for eligible costs. But a common TIF structure involves issuing a developer note, which turns into an obligation for the developer, who is repaid over a negotiated term; that doesn’t usually produce immediate funds for the development.
     A bond seems to be a better vehicle, at least from the developer’s viewpoint, since it provides cash more quickly. But from the municipal perspective, bonds aren’t that easy to set up. To sell a TIF bond, underwriters generally want one of several assurances — a general obligation pledge from the municipality, a completely built project generating the new taxes that are the source of bond repayment, or a national credit tenant or user whose credibility assures performance and project completion.
     Except for major redevelopment initiatives with broad political support, general obligation bonds are usually not issued because of the financial and rating risk to the issuing authority. And except for a few highly credit-worthy national users, an underwriter won’t be able to sell bonds until a project is built to assure the new tax stream.

     In addition, issuing a TIF bond before completing the project and generating taxes is not an efficient way to utilize the new increment.
     Let’s say a redeveloper’s total budget is $24 million, with $6 million reimbursed from TIF for eligible costs. A municipality issuing a developer a TIF bond worth $6 million must sell a bond of about $8 million, since about $2 million of the bond proceeds will be used for such non-project related costs as capitalized interest, interest reserves and bond issuance costs.
     With a two-year gap between project commencement and collection of incremental taxes after reassessment, a bondholder will want proceeds from the bond put aside to pay interest on the bond (rather than merely accrue) until those new taxes are paid and funds are available to pay debt service.


Similarly, most bondholders will require an interest reserve of one year’s debt service to be put aside in case an interruption occurs while receiving tax payments resulting from delays in the tax collection process, legislative changes or a casualty.
     Also, selling an $8 million bond means having a new tax increment available to pay not only debt service on $8 million, but 110% to 115% of $8 million. Bondholders are risk-averse and want a cushion on the annual revenue projections. So on average, if the debt service is $640,000 for the $8 million bond (8% constant), you will need at least $704,000 in increment annually to satisfy the bondholders (1.1 x $640,000).
     With such difficulties considered, it’s a small wonder that a municipality may issue a developer note and not a bond. A developer note is merely an obligation to pay the developer a stated principal amount bearing interest at a negotiated rate. In essence, the developer "buys" his own bond but doesn’t come up with any dollars to buy the note. The note is issued to the developer to consider the eligible costs that the developer pays as part of its overall development costs. Payments under the note are reimbursed to the developer for certain eligible costs.
     In our example, the developer would receive a developer note for $6 million at, say, 8% interest. After the project is built and generates new taxes, the municipality begins paying interest and principal on the note, including interest that accrued before the new tax assessment and payment. Except for incidental costs, there are no major issuance costs and consequently no need to finance more than $6 million.
     It’s also not necessary to meet underwriter debt coverage ratios further eroding the amount of funds available for the project.
     Again using our example, only about $480,000 of increment (8% constant x $6 million) is needed to fund the annual obligation as opposed to about $704,000 under the bond structure. (For purposes of simplicity, ignore the effect of the interest rate differential for bonds versus notes).
     If the developer needs that $6 million at the time of construction, he or she will have to use the developer note as collateral for additional financing, since those funds represented by the note are payable over a possible 20-year term. However, once the project is completed and generates increment, it is then possible, as Chicago sometimes does, to redeem the note by issuing a TIF Bond.
     At that point the developer receives the full amount of his incentive, and the municipality usually doesn’t have to worry about capitalized interest or other significant reserves added to the amount of financing. Also, the interest rate on the bond is less than under the note, which is an incentive for the municipality to redeem the note, if possible.
     Negotiating a TIF incentive package involves analyzing the form of the obligation to be issued. Receiving bond proceeds may be the developer’s preferred structure, but might not be available. Understanding developer notes will allow a developer to capture TIF revenues more efficiently and enhance its project if the funds represented by the note can be financed for the short term without having to issue bonds.

September 2000

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