3.6.1 Financing Leases

Lease financing is the basic financing tool for “governmental” capital needs—acquisition of or improvements to real property or acquisition of personal property (e.g., equipment) for the payment of which no project, enterprise, or dedicated tax revenues are available. The public agency obtains financing by entering into a lease for which it makes rental payments from all lawfully available funds (i.e., from the lessee’s general fund). The public agency may lease the property to be acquired or improved, with the lessor acquiring or improving the financed property for lease to the public agency. In an alternative financing structure, known as an “asset transfer” or “equity strip,” the public agency leases out and leases back an existing unencumbered property. With an asset transfer, the lease out is for a lump sum rental payment that the public agency uses to pay the costs of capital improvements elsewhere. See Figure 3.4 Lease-Supported Debt.

With either approach, the public agency is generally permitted to substitute other property of comparable value for the leased property, and it is common for the public agency to substitute the new asset, upon its completion, for the initially leased asset. Public agencies may also be allowed to remove properties from a lease upon partial prepayment or if the remaining leased assets are of sufficient value. Although public agencies may select from a broad range of properties, lenders and investors generally prefer that the properties subject to a financing lease constitute “essential facilities”: facilities the public agency will have a strong incentive to retain, maintain and, if necessary, repair.

When, as is generally the case, the obligation to make rental payments under a financing lease is a general fund obligation of a local government entity subject to the limitations on indebtedness in California Constitution Article XVI, Section 18. The lease must fit within one of the debt limit exceptions. See Section 1.2, Constitutional Debt Limit.

The Annual Appropriation Exception, where the lessee has an annual option to terminate the lease, is a possible approach, but is not used much in California except for vendor direct lease equipment programs, such as equipment. The Offner-Dean Lease Exception exposes investors to less risk and is more common. The Special Fund Exception is also not often used when available, because revenue bond and installment sale agreements are preferable financing obligations. The discussion in this section, therefore, is focused on financing leases relying on the Offner Dean Lease Exception (generally referred to as “abatement leases”).

Satisfaction of the requirements of this exception, in particular the requirement that the lessee’s payment obligation be abated if the lessee does not have use and occupancy of the leased property, results in financing leases having a credit quality that is slightly below the public agency’s general credit standing.

PRINCIPAL USES – Lease financing is principally used for financing of non revenue generating governmental facilities. Asset transfer leases may, in limited circumstances, be used to obtain funds for other purposes.

PRINCIPAL USERS – Local government entities subject to the constitutional debt limit (cities, counties and school districts) are the principal users of lease financing, except with respect to financings for municipal enterprises such as water, sewer, power, or solid waste.

LEGAL AUTHORITY – The general statutory and city charter authority of public agencies to lease property covers lease financing. The leased property must be a leasable asset, which generally means land and depreciable property. Unless part of a larger project (e.g., a building or a parking lot), paint, windows and asphalt do not satisfy this requirement; dedicated public thoroughfares (i.e., bridges, highways, and streets) are questionable. The transaction must, absent another exception, be structured and documented in a manner satisfying the requirements of the Lease Exception to the constitutional debt limit. See Section 1.2.4.3, Lease Exception (the “Offner-Dean Lease Exception”).

APPROVAL PROCESS – The public agency’s governing board must approve the lease and the financing documents by resolution or, if required, by ordinance. Voter approval is generally not required and the procedural requirements for the disposition of property need not generally be followed if the property is leased back by the public agency.

STRUCTURES AND DOCUMENTATION – Documentation depends upon the answer to three basic structural questions:

Will the leased property be the financed property, or will the transaction be an asset transfer?
Will the vendor or other private lender provide financing, or will securities be publicly offered?
If securities will be publicly offered, will the securities be lease COPs or JPA lease revenue bonds?

The key documentation issues for financing leases are shaped by the constitutional requirements ensuring that the public agency’s rental payment obligation in each fiscal year is in consideration for the “use and occupancy” of the leased property in that year. See Section 1.2.4.3, Lease Exception (the “Offner-Dean Lease Exception”).

FAIR RENTAL VALUE – Fair rental value may be determined at the time the public agency enters into the lease, and the rent need not be reduced if the fair rental value of the facility declines. Because governmental facilities are generally not the type that are leased in a commercial context, fair rental value must usually be determined indirectly by reference to the value of the property. If the leased property is newly acquired or constructed, acquisition and construction cost can provide a reasonable proxy for value. If the leased property is an existing facility, however, value must be determined by a certification made by the public agency or, in some cases, by an appraisal.

A practical consequence of the fair rental value requirement is that the amortization period of leases for real property and improvements cannot be very short. To be amortized quickly, the principal payments would likely be unreasonably large and, thus, not reflective of fair rental values. In addition, variable-rate leases pose two significant challenges to the fair rental requirement. First, either because market rates rise, or because tendered securities cannot be remarketed and are held by the credit or liquidity provider and bear interest at a “bank rate,” interest rates can rise to levels which, if not limited, could cause rental payments for a fiscal year to exceed fair rental value. Second, the limits imposed by the fair rental value requirement may keep the public agency from being able to agree to immediately reimburse the credit or liquidity provider following a default, the inability to remarket a security, or the expiration of a credit or liquidity facility. Although these issues can be addressed (for example, with rent caps subject to carry forward), they can cause complications in negotiations with credit and liquidity providers, particularly in high interest rate environments.

NO ACCELERATION – Because acceleration would require prepayment of rent (paying during the current fiscal year for use and occupancy in future years) a financing lease may not allow the lessor, as a default remedy, to declare future rental payments immediately due and payable.

ABATEMENT – A public agency lessee may not have use and occupancy of a leased property if construction of the leased property is not completed on schedule (construction risk), if the property is seized by eminent domain (takings risk), or if the property suffers a casualty loss (casualty risk). In such cases, the lessee would not be obligated to make lease payments under an abatement clause.

Construction risk can be addressed by capitalizing interest to a date (generally 6 months) past the expected completion date, and by performance bonds and insurance. Construction risk can be avoided entirely by using an asset transfer structure in which the asset leased is a built facility. Takings risk is not generally a significant issue, as eminent domain proceedings against public property are rare, and condemnation proceeds are a source to prepay lease obligations. Casualty risk can be addressed by insurance, including business interruption insurance, but earthquake insurance is expensive and is not generally required. “Self insurance” in the sense of an independent and actuarially sound plan is generally permissible; “self-insurance” in the sense of absorbing the risk of being uninsured is not, because it undercuts the abatement requirement.

Debt service reserve funds address abatement as well as general lessee credit risk. Debt service reserves are therefore very common in publicly offered financing lease transactions and are more common in the financing lease context than for other municipal debt offerings with issuers of comparable credit standing.

Additional factors that may determine the structure of a financing lease include the following:

Will the trustee (acting on behalf of the bond or COP holders as assignee of the lessor) have as a default remedy the right to terminate the lease and take possession of the leased property? The alternative is to limit the trustee’s remedy to bring suit for each year of unpaid rent. A termination right is an encouragement to the lessee to make every effort to pay the rent. Repossession may not, however, be practicable and the repossession claim may, depending upon the circumstances, not be enforced if enforcement would have an adverse impact on public health and safety. The “essentiality” of the facility, of course, affects both the value of a termination remedy if enforceable and, in contrast, the likelihood that it would be enforced.
What will the value of the leased property be in relation to the aggregate principal component of the rent? The value of the leased property must be sufficiently high to support the rent level, but should/may it be significantly higher (often referred to as “over collateralization”)? If lease termination is a remedy, over collateralization provides lenders and investors greater security. Over collateralizing the lease may alter the economics of the transaction in such a way as to compel the lessee to meet the terms of the lease. The risk is that this may undermine the debt limit exception provided to lease financings. Leasing more property than necessary also reduces the amount of unencumbered property available to the public agency for other asset transfer leases.
Will a master lease structure be used? Master leases allow the public agency to add, in later transactions, additional properties and additional rent obligations. A master lease structure offers the public agency greater flexibility but reduces the level of comfort lenders and investors may receive from knowing what the leased property is. Liberal property substitution provisions in a lease involve the same trade off.

OTHER CONSIDERATIONS – When the lease itself is to be the tax exempt obligation it must be “debt” (an installment payment obligation) for federal income tax purposes and must have a separately stated interest component.

POST CLOSING ADMINISTRATION AND OVERSIGHT – A financing lease ties up property. Either lease restrictions or title or federal tax law considerations may limit to some extent the public agency’s flexibility in using the leased property or to sublease it or allow encumbrances. The maintenance and use of the property must therefore be monitored for the full term of the lease.