While much of the price declines among high-grade bonds have been recouped this year, that has not been the case with another segment of the market, Community Development District bonds. For our thoughts on the potential opportunity presented by these bonds, click here.

Fast-growing states like Florida, Colorado and Texas have all adopted legislation allowing the use of “special districts” to help meet the infrastructure needs of residential and industrial growth. In each case, a local unit of government is created that has as its primary purpose the issuance of bonds to fund the roads, water, wastewater plants and other projects needed to build homes, retail centers and industrial parks.

Here’s how they work: A real estate developer identifies a piece of land to develop into a new housing project. To build this project, including the roads, water service, clubhouse and other amenities, the developer needs to find a source of funding for all the things that make the housing project a community. The city or county in which the development is to be built doesn’t want to increase taxes or fees on existing residents since they wouldn’t benefit from the new infrastructure. If existing residents were to bear the costs of these improvements, they would likely reject the project.

Another choice the developer could make would be to build the cost of the common infrastructure into the prices of the homes that will be built. However, this approach could make the cost of housing too high for the targeted potential home buyer, i.e., first-time purchasers or retirees, while making the cost of housing uncompetitive with rival housing developments.

Instead, the more popular approach since the late 1970s has been to create a governmental district whose boundaries are coterminous with the housing project to be built. This special district serves as the entity to issue debt for, build, and then own the infrastructure necessary for development of the housing project. The bonds are repaid by the residents who directly benefit from the infrastructure improvements, and not by those who live in other neighborhoods. Further, by spreading the bond payments over many years, subsequent homeowners who will benefit from the project’s roads and wastewater system also share in paying the cost for the benefits they receive as well.

Florida’s Community Development Districts

Florida currently has 1,628 special districts, of which 574 are community development districts (CDD). Other districts include business improvement districts, downtown redevelopment districts and similar special-purpose units of local government.

CDDs have certain common characteristics. They are governed by a board that is initially appointed, but once the community is built out, is elected by residents. Bonds are typically issued in sufficient amount to cover the cost of improvements needed to support housing and/or commercial construction. A specialized engineering firm determines how much the “special assessment” needs to be on an annual basis for each living unit or commercial space, sufficient to meet annual debt service on the bonds. Finally, a maintenance assessment is also set for each parcel to provide for on-going maintenance of the financed infrastructure.

In Florida, once the land within a CDD is platted, the annual special assessments for each home site are recorded by the county tax collector on the county tax rolls and are collected alongside property taxes due on each property. Unlike property taxes, special assessments are fixed in amount and cannot change. They are set at the amount necessary to retire their associated debt. Like property taxes, special assessments must be paid in full and rank in priority with property taxes, ahead of all other debts, including any outstanding mortgage. Special assessments and property taxes are levied against the property itself, not the property’s owner. Therefore, the remedies for unpaid taxes and assessments are the same and look to eventual satisfaction through a foreclosure sale of the home, if all other measures fail.

Typically, both property taxes and special assessments are levied in November each year and are due by the following April 1. Delinquent taxes and assessments are recouped later that spring through a sale of “tax certificates” by the county tax collector.  A bidding process begins at an interest rate of 18% and is bid down to the level necessary for the sale to take place. The sale results in a winning bidder paying the overdue taxes and assessments, and eventually collecting interest for “loaning” the overdue taxes and assessments to the county. After two years – and before seven years have passed – the  property will be put up for auction by the county to repay tax certificate holders the amounts they lent the county, plus interest. At any point prior to an auction, the homeowner can redeem the property by paying off the tax certificates outstanding plus interest due.

The attractiveness of bonds issued by community development districts is exemplified by the strong legal process outlined above that serves to protect the security granted to bondholders. Since delinquent special assessments, needed to pay debt service, are recouped in a timely fashion by the sale of tax certificates, bonds backed by special assessments on built out (or nearly built out) communities rarely default. Both the high rate of interest borne by tax certificates and the possibility of property foreclosure together makes the market for tax certificates attractive in itself. Today, CDD bonds, upon build out, are receiving ratings in the “A” category by Standard & Poor’s, reflecting the strong payment track record they have enjoyed.

Jay Abrams is the Chief Municipal Credit Analyst of FMSbonds, Inc. Email the Author02/26/2009