Using Lease Revenue Bonds for Capital Funding Needs

Large public and nonprofit entities are all too familiar with the challenges involved in developing new facilities. Traditional methods of building or modifying a facility can be a long and cumbersome journey that includes securing financing, hiring contractors, and dealing with the inevitable red tape and change orders.

Now institutions are discovering the advantages of lease structures as an alternative method of procurement that streamlines new building projects. For example, if a university wants to build new classroom space or a new healthcare facility for its medical school, it can enter into an arrangement with a developer and sign a long-term lease for that facility. The developer can then turn around and use the credit of the lease to finance the project with lease revenue bonds in the public finance market.

Government and nonprofit entities often have very specific and complicated procurement processes. "A leaseback is not about getting around those processes, it’s about streamlining them," says Nathan Flynn, Managing Director, Public Finance, with Fifth Third Securities.

"By using a leaseback structure, you can fulfill the established processes but not get caught up in all the rules that are meant to regulate a $50 million building versus a $50,000 change."

A lease transaction with lease revenue bonds is a financing method that uses lease payments to pay the principal and interest on bonds that fund the construction of a facility. The private entity that constructs the facility issues the bonds and retains ownership until the debt is paid off. The entity that leases the facility makes payments to the financing entity to cover the debt service on the bonds, essentially leveraging public market benefits for lease terms instead of loan terms.

Lease revenue bonds are well-received by the investment market, which has a big appetite for high-credit bonds. "Once you get it into the muni machine, it becomes a commodity similar to any other like-rated municipal product. That’s the beauty of it, because there’s such a huge demand, both on the institutional and also the individual side, for muni paper," says Flynn. "The value is getting this into a highly liquid, very vanilla structure that can be traded readily in the market."

When Is a Lease Revenue Bond a Good Fit?

Leases are ideally suited to specialized or critical facilities that are core to operations. The critical nature of the facility or specialized use removes some of the lease renewal risk for the bondholder because the occupier wants and needs to be in that facility or location over the long term. The investors who are buying the associated bonds place a premium on high-credit tenants versus a low-credit lessee where there is greater risk that it could walk away from the lease obligation in a few years. Other common criteria include:

• Leases that are structured with a minimum of 20-year terms
• Project size of $20 million and greater
• Leases structured with a specific start date that commences regardless of the status of the project

The responsibility of the lessee depends on the transaction and how a deal is negotiated. In some cases, the user is not directly responsible for any of the upkeep of the building, but the lease is structured such that any cost of building maintenance is automatically passed through to the tenant. "Anything that is done to maintain the building is passed along as part of the lease payment," says Aleks Granchalek, Managing Director, Public Finance, with Fifth Third Securities.

Argonne National Laboratory’s Innovative Project

Fifth Third Securities Inc. was the underwriter on $120 million in bonds that were issued through the Illinois Finance Authority to finance Argonne National Laboratory’s Theory and Computing Sciences Building near Chicago. The approximately 200,000-square-foot facility is home to the Aurora supercomputer, which is targeted to be the fastest computer in the U.S.

Fifth Third initially originated an approximately $80 million loan to Theory and Computing Sciences Building Trust, the conduit borrower, that was repaid with the proceeds of these latest bonds. In addition to repaying the loan, proceeds of the bonds are being used to fund capital improvements to the facility, fund a debt service reserve fund for the bonds, and pay the costs of issuing the bonds. UChicago Argonne LLC, whose sole member is the University of Chicago, leases and uses the facility.

One of the advantages for the lessee is that it allowed for faster delivery. Because the facility required many specialized improvements, the idea of taking the improvements through the federal appropriation process would have been very difficult. Every time a project change order would occur, it would require changing the appropriation. The lease structure gave UChicago Argonne LLC the flexibility to build the needed facility and react to new technology or changes in needs. Any additional costs related to change orders could be paid in cash or amortized over the term of the lease.

For investors buying bonds, there was confidence the lessee would remain a long-term tenant because of the specialized occupancy. The building shell is situated in the middle of a secure facility where the federal government has elected to put a valuable piece of technology, and the lease overlaps with a number of different operating factors that limit downside risk for the bondholders.

"Practically speaking, to cancel the lease, you would have to stop at least two large federal programs and pull substantial pieces of technology and improvements out of the building," says Granchalek. "So in that situation, you had a building that was pretty generic, but if you look at the use within it and the improvements they had to make, investors were protected in terms of lease renewal that they would appropriate every year."

Key Considerations for Lease Revenue Bonds

Key benefits for the occupiers or lessee are that it simplifies a complicated process and provides ease of execution and ease of procurement. Speed of delivery is an important consideration because large public infrastructure projects take a long time, regardless of the way they’re delivered. So, the ability to deliver something more quickly offers a number of advantages. Not only does it make that facility available to organizations sooner, but by shortening that time span, they can also take out some of the risks in terms of costs or other conflicts.

According to the U.S Bureau of Labor Statistics, the producer price index for construction materials, such as concrete and steel, has increased by 35% in recent years. Additionally, supply chain disruption or competition for materials with other large projects in a local market can contribute to delays and cost overruns. Opting for a more efficient procurement process that shrinks the development window can result in benefits such as reduced costs and faster delivery. Additionally, there can also be a benefit by transferring risk to the developer.

The two notable negatives are that the yield premium can be higher and the lessee begins paying rent at the predetermined lease start date regardless of the status of the project—even if the project is not completed. The yield can be higher because it’s a lease and not a direct obligation, even though the entity occupying the facility is responsible in the same way that they would be if they directly issued the debt. "Having that extra step from an investor standpoint does require a little bit of extra yield," notes Flynn.

Financing School Facilities

Lease revenue bonds have become a standard method of procuring new facilities for many institutions. Public schools within the state of Indiana, for example, have executed hundreds of lease revenue bond transactions for construction projects for its K–12 public schools. State rules and regulations forbid a school district from borrowing directly from the municipal bond market to fund major construction projects.

Rather, school districts form a building corporation whose sole purpose is to own the new building and lease it to the school district in exchange for a lease payment sufficient to pay principal and interest on the bonds that funded the construction project. One advantage for investors is that school leaseback bonds are typically rated "AA," because the state of Indiana has an intercept mechanism in place to pay the bondholder directly if the school district fails to. "As an investor, you have peace of mind that that money is there because, ultimately, it’s coming from state funds," says Flynn.

Consider Alternative Methods of Procurement

In an era of fast-paced change, moving away from old-school methods is no longer the same battle it once was. Innovation and looking for ways to improve on inefficient methods are now par for the course.

The traditional way to finance a new facility would be that an entity would need to follow very specific steps to achieve its end goal, from issuing general obligation debt to sending out requests for proposals and hiring contractors to do the work. Using lease structures can achieve a new facility, but improve the efficiency of the development, construction, and delivery mechanisms.

"At the end of the day, whether it’s a hospital, institution of higher learning, or some other type of facility, they’re still going to make that lease payment. So, that financing payment is still occurring—it’s more a matter of what’s the best way to arrange it," says Flynn.

The best approach for entities embarking on a new building project is to look at the bigger picture. It’s important to look at the structure of the debt in the procurement and not just the rate. Although the borrowing rate always matters, the cheapest option may not be the best option. Institutions can consider alternatives to traditional procurement methods and look for ways to do things differently, not just from a financing standpoint, but also from a procurement standpoint, and determine the most efficient route to getting the project built.

To learn more about leaseback bonds, contact Fifth Third Bank’s public finance experts.

Disclosure: This content is for informational purposes only and may have been derived, with permission, from a third party. While we believe it to be accurate as of the date of publication, it does not constitute the rendering of legal, accounting, tax, or investment advice or other professional services by Fifth Third Bank, National Association or any of its subsidiaries or affiliates, and it is being provided without any warranty whatsoever. Please consult with appropriate professionals related to your individual circumstances. Deposit and credit products provided by Fifth Third Bank, National Association. Member FDIC.

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