• Roadways and Parking

• Water Systems

• Sewer Systems

• Parks and Open Space

• Pedestrian Walkways

• Hiking, Biking and Pedestrian Trails

• Landscaping

• Drainage Systems

• Public Lighting

• Public Buildings

• Schools

• Fire Protection

• Public Facilities

• Traffic Safety

• Equipment, Furnishing and Vehicles

The following identifies a typical CFD structure (though each transaction and CFD is somewhat unique):  Developer owns real property, which it intends to develop as a master planned community or other significant residential or commercial development.  Developer files an application with the municipality to form a CFD.  Once formed, the CFD issues bonds.  Typically, the bonds are either special assessment (a land-based financing) or general obligation bonds (more of a hybrid credit/land-based financing).  The proceeds from the sale of the bonds to third parties are deposited into a trust account and released by the trustee, either to reimburse the developer for public infrastructure previously paid or directly to the contractors constructing the public infrastructure.  The bond holders are then repaid by the landowner (whether it be developer or a purchaser of developer) either by an additional property tax or by a special assessment against the property.  The CFD concept is attractive for many developers because the interest rate paid to bond holders often is lower than what is available from conventional financing and developers can pass the obligation to repay the bond holders to future property owners, thus resulting in a lower sales price for the improved property.

Over the last decade, the use of CFDs has increased as a means of financing the costs of providing and maintaining public infrastructure.  The following statistics show the trend of CFDs:

 

Formations

Bond Issues

Source:  RBC Dain Rauscher

III.            Formation of the CFD.

a.                  Petition for Formation/Joinder of Landowners.

The statutory process for the formation a CFD is simple, provided that all of the landowners within the proposed CFD support its formation and join in signing the formation documents.  Typically, a developer of a master planned community or other significant residential or commercial development will initiate the formation of a CFD upon property it owns, prior to sale to others.  If there are multiple owners and not all of the owners join in the request to form the CFD, then the municipality will consider a petition for formation at the request of the owner(s) of 25% of the property within the proposed district.  If the owner(s) of 25% of the property within the proposed district request formation, then the municipality will hold a hearing.  After the hearing, if the municipality approves the formation, it will cause an election to be held, and if a majority of votes (by acreage, not by person) at the election support the formation, then the CFD will be formed.  As a practical matter, without the support of all of the landowners, a developer will have difficulty financing any of the public infrastructure, even after the CFD has been formed.  More detail is provided below in the process for issuing special assessment and general obligation bonds.

            b.            Consent of Others Having a Lien or Option Interest.

In addition to the support of the landowners, a developer must also have the consent of any party having a lien or option on property within the proposed CFD.  Lenders have taken different positions on the benefit they perceive from formation of the CFD.  Some lenders take the position that the lien of the additional property taxes or special assessments, which by statute would be prior to their lien, are unacceptable, as they essentially remove the lender from first position.  Other lenders recognize that any funds raised through a CFD must be spent on actual public infrastructure costs, and thus, approve the CFD formation based on the improved value of their collateral after construction of the public infrastructure.

As a developer considers the formation of a CFD, it should consider who must consent in the short term and in the long term to the formation of the CFD and to any finance activities of the CFD.  For example, consider if a developer has an option to purchase 640 acres of property, 160 acres per year for 4 years. With each purchase from the current landowner, the landowner pays a portion of a note (and deed of trust), so that the current landowner can release the property to the developer free and clear.  If the developer decides it would like to form a CFD, it must have the approval of the current owner, and the current owner's lienholder before formation can be effective.  The developer's transactional attorneys should consult the attorney representing the developer in the CFD formation during the time the option agreement is being negotiated to ensure that the developer maximizes its ability to compel cooperation from the current landowner and its lienholder.

            c.            Municipal Application Process.

Although the statutory formation process is not document intensive, most municipalities will have application procedures and certain policies to be followed prior to allowing the actual formation of the CFD.  Attached to these materials as Exhibit "A" is a sample of the "Town of Buckeye, Arizona Policy Guidelines and Application Procedures for Community Facilities Districts" and attached as Exhibit "B" is the "City of Goodyear, Arizona Policy Guidelines and Application Procedures for the Establishment of Community Facilities Districts."  As an example, the Town of Buckeye provides for the consideration and analysis by the Town of the plan of finance for the proposed CFD and requires the Developer to front certain costs and fees that the Town expects to incur to perform such analysis, whether or not the CFD ever is formed.  It is critical that the developer have appropriate legal and financial representation at an early stage to ensure that the formation process does not stall because of the developer's failure to comply with the municipality policies or failure to compile information sufficient to provide to the municipality to support its application.

d.            CFD Development Agreement.

Typically, the landowners within the CFD, the municipality and the district will execute a Development, Financing Participation and Intergovernmental Agreement ("CFD Development Agreement") concurrent with or shortly after formation of the CFD and will record the CFD Development Agreement against all of the property within the CFD.  Although not required to be recorded immediately following formation, it is prudent for the developer to do so because the CFD Development Agreement provides the basic parameters of the CFD and the rules for reimbursement.  The CFD Development Agreement provides the contractual cap of the amount of assessment for parcels of property within the CFD and the contractual cap for the tax rate for the CFD.  The CFD Development Agreement also provides for indemnifications of the CFD and the district board.  The CFD Development Agreement usually contains numerous recitations and disclaimers that the municipality and the CFD are not required to sell bonds, and if they fail to sell bonds shall have no obligation to reimburse the developer or any of the other owners for amounts paid for public infrastructure.

e.            Election.

Shortly after formation of the CFD, the CFD will hold an election to authorize the general obligation bonded indebtedness.  A majority of all of the qualified electors within the CFD, as described in A.R.S. €48-3043, will need to vote in favor of the authorization.  Generally, the qualified electors will need to go to the polling place on election day to cast a ballot.

IV.       Types of Bonds Sold to Finance Public Infrastructure.

a.      Special Assessment Bonds.

1.            Overview.  Once a CFD has been formed, the developer can finance certain public infrastructure in accordance with the terms of the CFD Development Agreement.  One mechanism of financing public infrastructure is through the sale of special assessment bonds, which become a lien against the real estate owned by the developer and/or the owners.  The public infrastructure to be financed with the special assessment bonds may benefit either the entire community or a specific segment of the community.  The following is a general description of the process for issuing special assessment bonds:  First, the developer, in consultation with its legal and financial advisors, its engineers and the representative of the CFD determines what infrastructure is intended to be financed with the special assessment.  An assessment engineer is then hired by the CFD to determine what property within the CFD is benefited by the infrastructure to be financed, as only the property benefited may be assessed and all of the property benefited within the CFD must be assessed.  Once the preliminary report of the assessment engineer is circulated, the developer will learn what property the assessment engineer believes should be included within the assessment district (which often is a subsection of the entire CFD).  The CFD will then procure an appraisal of the benefited property (which typically assumes completion of public infrastructure to be financed with the special assessments).  Through a series of meetings and negotiations, the parties will either broaden or narrow the scope of the public infrastructure to be completed and financed through the assessment to enable a widening or a narrowing of the assessment area.  The developer and the municipality will have negotiated, and the CFD Development Agreement will provide, that the value of the property assessed must be some multiple of the amount of the assessment on the property.  Depending upon the results of the appraisal, at the closing of the special assessment bond sale, the developer and/or owners may be required to pay down the assessments to a reduced level to be consistent with the ratio described in the previous sentence (see discussion of "Paydowns Prior to Closing" below).

2.            Documents.  The developer and all other owners, option holders or lienholders of all real property within the assessment area will be required, as a condition to the special assessment bond issue, to execute a Waiver and Development Agreement (which waives such parties rights to protest the assessment, and generally, commits such parties (excluding lienholders) on a joint and several basis to indemnify the CFD from any securities fraud liability in connection with the bond issue).  It is the execution of this document that makes it extremely difficult to pursue a special assessment bond issue after the sale of any portion of the property to end users.  The end user likely will view the public infrastructure as a developer obligation and will not vote to, and will strongly object to reimbursement of the developer for such costs.  Without the execution of the Waiver and Development Agreement by all of the above parties, a significantly more difficult public process is necessary.

In addition to the Waiver and Development Agreement, the developer and possibly other owners of the property within the assessment area will be required to prepare and issue indemnity letters, indemnifying the CFD and the underwriter of the bonds from a number of items including misrepresentations or omissions in the offering document used to sell bonds.  The developer and possibly the other owners will be required to obtain an opinion of counsel in connection with the bond sale.  An official statement must be prepared, which is a lengthy document disclosing all known facts about the property and risks associated with the development and the sale of the bonds.  Finally, for those owning property that is subject to more than 20% of the value of the assessments, a continuing disclosure undertaking must be signed and the obligations for continuing disclosure of material information about the owner to the bondholders must be fulfilled on an annual basis.

                  3.            Assessment Equalization.  The likely result of the report of the assessment engineer is that there will be unequal assessments against much of the property within the assessment area. If the property has not been platted at the time of the special assessment bond issue, than the assessments will be by parcel rather than by lot, and upon recording of the final plat, the CFD will go through an administrative process where the assessment on the entire parcel will be apportioned as against each lot. The unequal assessment of lots may be a consideration for a homebuilder purchasing lots subject to the special assessment, as the homebuilder may want uniform assessments on lots of equal size.  Accordingly, the homebuilder may need to prepay some of the assessments to a uniform level, which may impact their cash flow.

                  4.            Paydowns Prior to Closing.  To the extent that the assessment attributed to a particular parcel is inconsistent with the maximum ratio allowed by the CFD Development Agreement, the developer and possibly the other owners will be required to "paydown" the assessment such that the value of the property is consistent with the ratio described in the CFD Development Agreement.  For example, if the CFD Development Agreement allows a four to one value to lien ration, and the property to be assessed is appraised at $100,000, and the portion of the total assessment to be allocated to such property (as determined by the assessment engineer) is $33,000, a condition of the special assessment bond closing would be the developer's cash "paydown" of $8,000 of the assessment, such that the resulting assessment is no more than 25% of the value of the property.  The amount of such paydowns is impossible to determine until the developer receives the report of the appraiser and the assessment engineer.

                 5.            FHA/VA Approval.  If the developer has plans to sell all or a portion of the property to homebuilders who market to individuals who may apply for FHA insured and VA guaranteed home loans, the developer should recognize a few issues unique to such loans.  For FHA insured and VA guaranteed home loans, the statutes and regulations relating to such loans provide that the loan must be a first lien on the property.  By imposing an assessment against the property (which has a statutory priority over other liens), there is an argument that the assessment is now the first lien and the homebuyer's FHA or VA mortgage is a second lien.  If so, the assessment may disqualify the property from receiving an FHA or VA loan.  It is prudent for developer's counsel to discuss this issue with the developer and determine whether the developer has sufficient information to obtain letters from FHA and VA acknowledging that the assessments would be disregarded for purposes of determining whether the FHA or VA mortgage was a first lien against the property.

                        b.                        General Obligation Bonds.  The public infrastructure to be financed with the general obligation bonds must benefit the entire community and not a specific segment of the community.  Once improvements are identified, the developer begins negotiating the terms of the Standby Contribution Agreement and other related documents (see below).  Once those agreements are negotiated, general obligation bonds can be sold and an additional tax levied against the property subject to the maximum amounts described in the CFD Development Agreement.

1.            Documents.  The parties will need to prepare the official statement, which would be similar in form to the official statement described above for the special assessment bonds.  The developer and possibly other owners will need to provide an indemnity letter and an opinion of counsel similar to those required for the special assessment bonds.  Finally, the developer will need to execute a Standby Contribution Agreement ("SCA"). Essentially, the SCA provides the guaranty of the those signing the SCA that such parties will pay any shortfall between the additional tax revenue from the increased property tax and the principal and interest payment then due for the bonds.  Typically, the SCA remains effective until the additional tax paid equals or exceeds the principal and interest payment on the bonds for two full tax years.  The length of the SCA is a negotiated item.

 2.            Standby Contribution Agreements.  If general obligation bonds are to be issued early in the development of the project, the municipality and the CFD likely will require greater financial strength of the party to the SCA or greater collateral supporting the SCA.  CFDs have some flexibility in the financial criteria of the party to the SCA.  With appropriate financial strength, the CFD may simply accept the financial statement of the party to the SCA.  Absent sufficient financial strength, the CFD may require a letter of credit or a cash deposit, the amount of which would be negotiated.

If general obligation bonds are to be issued after the project has a documented track record of success, the municipality and the CFD likely may not require the same level of financial strength of the party to the SCA or collateral supporting the SCA.  Once there are homes and/or improvements to the property, the secondary assessed value of the property increases and thus the additional tax revenue produced by such property increases.  Accordingly, there is less risk to the CFD that the tax revenue will not be sufficient to make any necessary principal and interest payments on the bonds. Unlike special assessment bonds, once the election to authorize general obligation bonded indebtedness is held, the developer does not need further consent of or cooperation of property owners (provided such owners are not parties to the SCA (i.e., with joint venture partners or other significant landowners)).

V.            Related CFD Issues to Consider.

a.                  Timing of Bond Issues and Payment Obligations.  The developer must understand that the timing of bond issues may change depending on the motivation of the municipality and current climate for CFD financing.  When preparing pro formas and projections, the developer should provide for unforeseen delays that may impact the timing of bond issues, and any payments or prepayments required in connection with any bond issue.

b.                  Development Obstacles.  Prior to allowing the consummation of any bond transaction, a municipality often will require that certain development milestones be completed or satisfied.  For example, a municipality likely will not allow the CFD to consummate the sale of any bonds until the developer can demonstrate that there is adequate sewer and water capacity to serve the property.  The developer and its counsel should analyze and discuss with the municipality whether there will be any significant obstacles in the future, at the earliest possible time.  Minor issues may simply impact the underwriter's ability to market the bonds, but major issues may impact the municipality's decision to issue bonds.

c.                  Municipality/CFD Recovery of Operational Shortfalls.  The statutes provide for the collection of an additional tax for the operation and maintenance of the public infrastructure financed through a CFD.  Often, the CFD will require in the CFD Development Agreement that the developer bear the cost of any maintenance obligations in excess of the operations and maintenance tax collected.  In practice, municipalities often require at the time of conveyance of public infrastructure, that the developer sign an agreement conveying the public infrastructure free and clear of liens, and obligating the developer to pay any shortfall or operational deficit for such public infrastructure.

d.                  Compliance with Title 34.  The CFD statutes require that any public infrastructure constructed pursuant to the CFD Development Agreement or which are eligible for reimbursement from the CFD be publicly bid pursuant to Title 34 of the Arizona Revised Statutes.  The developer should recognize this may inhibit their ability to select contractors of choice.

e.                  Sales of Bonds.  The developer should discuss the current state of the bond market with the underwriter early in the process.

f.                   Plats and Dedications.  Although not necessary as a due diligence item, it is critical that prior to dedicating property to the municipality by way of plat or map of dedication, that certain language be included on the plat that preserves the right to reimbursement from bond proceeds for the conveyance of such public infrastructure.  If property or improvements are dedicated without preserving the right to reimbursement, a developer may lose the ability to be reimbursed in the future.

VI.       Special Issues for Homebuilders Purchasing Property with CFDs.

Among other important issues to be considered, a homebuilder should specifically consider two issues when purchasing property within a CFD. 

If special assessments have been levied against the property, homebuilders should examine the amount of assessment on each lot, and if unequal, determine whether it will affect the marketing of the lots.  If the difference in assessment will affect the marketing of the lots, the homebuilder should determine, and include in its pro formas and profit analysis, the amount necessary to pay down the assessments on the lots to a uniform level (and the homebuilder should make sure to include any prepayment penalty associated with early payment of the assessment). 

If the property is subject to additional tax resulting from general obligation bonds, the homebuilder should recognize that the tax rate is unlimited.  The developer selling the property to the homebuilder may have contractually agreed to a limitation, and is probably a party to the SCA, which provides recourse to the developer by the CFD if the tax revenue is not sufficient to pay the debt service of the general obligation bonds.  However, the law states that taxes must be assessed regardless of the resulting rate, in an amount sufficient to pay the debt service.  Again, there generally is significant protection by way of reserve funds and SCAs, but there is no guarantee that a homeowner will not receive a significantly higher tax bill, if the developer defaults.

VI.       Other Issues Not Discussed Here. 

One of the most important points to understand is that there are a number of other issues that will be raised in the process, but that are not addressed in this article or are not addressed in detail in this article. Examples of such topics are payment of operational shortfalls, reserve funds (the need for, and amounts of), Revenue Bonds (seldom used alternative to special assessment and general obligation bonds), the nature of disclosure required to future homeowners or property owners or reference, a copy of a disclosure used in a residential development in Scottsdale is attached as Exhibit "C") and other topics.

VIII.            Conclusion. 

When counseling your clients, please remember the three most significant points that a developer's attorney should understand after reviewing this article: (i) when used properly, CFDs can be an effective and flexible tool to finance infrastructure at interest rates significantly lower than conventional financing; (ii) the developer's counsel must manage client expectations, as to timing, expense and the required financial strength; and (iii) the developer's counsel should consult qualified legal and financial professionals early in the transaction.