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Supplemental Borrowings for Rising Construction Costs

By Kent Cashell posted 05-11-2022 04:49 PM

  

Co-authored by Andrew Laskey.

Many districts that have undertaken facilities improvement projects over the last two years are finding themselves in the difficult position of needing additional funds in order to complete their building programs. Even with the best plans that included adequate contingencies, rising costs on everything from fuel to materials to labor are hitting budgets hard. Design and construction firms are reporting year-over-year cost increases of 15% to 20% on a cost-per-square-foot basis. When districts opt for a bond issue to undertake a major facilities program, they vote to do so months before the election. If successful on the ballot, the bonds issued to fund the project will generally be sold a few months later. Then the construction begins. It’s easy to see how a district can get caught in a difficult situation in a rising-cost environment. 

So what to do? Obviously, one answer is to value engineer your project downward to live within the original estimated cost. Unfortunately, this may not only be painful, but, in many cases, impractical. There’s only so much you can downsize when faced with dramatic cost increases. At some point, you start to impact the integrity of the commitment made to residents on the final project. For many districts, the solution is to combine these cost-saving efforts with additional borrowing to supplement the voted bond issue. There are a few options districts have in order to realize these additional resources for the projects.

Issuing bonds, which generally provides the lowest cost of borrowing, is limited to very specific situations. Obviously, this can be done with voter approval. In addition, under certain circumstances, bonds may be permitted for energy conservation projects, technology, and transportation-related spending. But usually, these circumstances don’t apply to general construction projects that need additional funds simply due to inflation. Rarely, if ever, would a district want to go back on the ballot to request additional funds for a project already approved by voters. In these cases, if a supplemental loan is required, it will usually need to be in the form of a lease obligation or Certificates of Participation (COPs). COPs are issued not as a debt, but rather under a capital lease structure that requires the district to appropriate funds annually for the repayment. As such, these obligations are not subject to debt limitations; however, unlike a voted bond issue, without an additional levy of some kind, the annual payment must come from existing district resources. So, the ultimate question isn’t how, but rather how much - meaning, what will the district’s annual payment be, and can it handle that out of currently available funds?

The process for borrowing additional funds in this manner is very straightforward. These supplemental loans can be issued through a public offering, like traditional bonds, or through a direct loan with a financial institution. Generally, if the size of the loan would allow for repayment within a shorter time frame - say 15 years, then a direct loan may be a good option. That said, since the ultimate limiting factor may be the annual payment coming out of existing resources, a district may wish to borrow over a longer-term if the asset being financed warrants that (a building, for example, certainly would). While it entails a higher interest cost overall, the longer the borrowing term the lower the annual payments will be.

From a public policy standpoint, borrowing over the life of an asset is generally considered appropriate. If a public offering is desired (or indeed required, because a direct loan option isn’t feasible), then the traditional process will be followed. An offering document will need to be produced, credit rating(s) obtained, and sale process undertaken. If exploring a direct loan, it can be beneficial to run a competitive process to solicit loan proposals from the financial institutions that are active in the direct loan market. The district can engage financial professionals to assist with this. Your financing professionals can assist in structuring the repayment term, as well as drafting a term sheet that lays out all of the applicable parameters of the loan. This can include (but is not limited to) the following: the borrowing amount, the security of the loan, the repayment schedule, optional redemption provisions, tax status, bank qualified (BQ) status, relevant financials, and any fees the district may be responsible for, relevant proposal deadlines and transaction timelines. This process ensures the responding financial institutions understand the terms of the loan and provide proposals that can be compared on an “apples-to-apples” basis. These direct loan proposals can then be compared against each other and to a comparable capital markets issue before accepting a proposal or declining all and pursuing an issue in the capital markets. Again, the how is easy, the difficult part is fully analyzing the impact that the annual payment (which usually is going to come out of currently available resources) will have on the aggregate operation of the district.

Repayment on a supplemental loan can be made from any source allowable under law, but generally will be from general funds or permanent improvement funds. One option would be to request voter approval for an increase in either general fund or permanent improvement fund millage to offset the cost of repayment on the supplemental loans. In this way, the district can avoid impacting current operations and may actually gain resources over time as the loan is repaid. However, voter approval is difficult, and often the district will need to analyze current operations to determine the amount of repayment that can be handled without undue stress on the forecasted financial picture. Approaching the problem from this direction may actually determine the amount of supplemental loan that can be handled, thereby outlining the amount of project that can be covered. In other words, the question may not be how can I borrow enough to cover the total shortfall, but rather, the district determines the amount of supplemental loan that can be handled within the budget, which then determines the value engineering that needs to be done.

In this time of rising costs, the need to include design and construction contingency budgets is more important than ever. Even with that careful planning, it is commonplace to end up needing additional funds for a large-scale facilities improvement project. Borrowing to fill this gap is often required, and the process for doing so by using COPs (or some form of lease obligation) is often the answer. If you find your district in this situation, take heart. You are not alone. Numerous districts are currently going through this very scenario. While not ideal, usually there is a way to reach a good compromise between value engineering the project to save costs and supplementing the original budget with additional funds.


Kent Cashell is Managing Director at RBC Capital Markets, an OASBO Gold Sponsor. He can be reached at kent.cashell@rbccm.com or 513.826.0551.

Andrew Laskey is Director at RBC Capital Markets, an OASBO Gold Sponsor. He can be reached at andrew.laskey@rbccm.com or 513.826.0582.

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10 days ago

Excellent insights Kent! Exploring all options for cost-savings and added value for school districts will go a long way with community members who will appreciate the district's due diligence.  Thank you for your thought leadership and the work you and Andrew do to help your customers!