For the most part, public agencies own their public facilities and equipment. However, leasing is becoming a popular alternative to outright purchase or issuing bonds to finance capital assets over a period of several years. Any agency authorized to acquire or dispose of real or personal property can enter into a lease. Counties, cities, school districts, and redevelopment agencies use this method of financing relatively commonly. For convenience, we will sometimes refer to all these local agencies as jurisdictions.
Lease financing is based upon a jurisdiction's authority to acquire and dispose of property rather than on its authority to incur debt. As a result, under state law, a properly constructed lease is not considered a public debt.
"Lease-purchase" agreements (in which the agency leases a facility while purchasing it) and "sale-leaseback" agreements (in which the agency sells a facility to a lessor and then immediately leases it back) offer several advantages over other financing methods. First, an agency can obtain a facility without a large initial investment. Second, the agency can obtain quick cash for a facility (although the cost of repaying the lease will exceed the sale price). Third, a lease can be used to spread the cost of a facility over a long period of time. Fourth, lease agreements do not contribute to a jurisdiction's Gann spending limit. Fifth, voter approval is not a requirement as it would be with special taxes and some types of bonds.
Using lease financing is not without its drawbacks. The agreements necessary to finance large capital facilities are complicated and involve numerous players such as bond counsel, underwriter, and trustee. Leasing, because of the uncertainties of the market and annual allocation of payments, may require higher debt payment than bonds in order to attract investors. Additionally, because leases are designed to be tax-exempt investments, their popularity and marketability is susceptible to changes in federal or state tax law. Also, it may be difficult to find single investors for some leases. Unlike special assessments or taxes, a lease does not generate funds on its own and requires another source of income to pay it off.
When a local agency enters into a lease arrangement (thereby becoming the leasee), it may lease a facility from another public agency, a nonprofit corporation set up for that purpose, a bank or private leasing company or a joint powers authority. This lessor assigns all its rights in the leased property or equipment to the lessee or trustee and acts as an intermediary between the local agency and the investors. The trick to leasing is finding someone who is willing to invest in the return from the agency's lease payments. This may be a single investor or, more frequently, a group of investors who have purchased undivided shares of the lease obligation (these shares are called "certificates of participation").
When a single investor is involved, that investor will generally be the lessor. The municipality leases a facility or equipment from the investor. As lessor, the investor then receives a portion of each rental payment as tax-exempt interest.
Certificates of participation (COPs) are securities designed to make municipal leases accessible to the small investor by dividing the lease obligation into small parts. Each COP is an undivided share of the total lease obligation. The lessor assigns the lease to a trustee who then sells COPs in the lease. Purchasing a COP entitles the investor to a portion of the jurisdiction's lease payments. COPs are generally available in denominations of $5000 and marketed by firms specializing in municipal securities. Investors buy COPs as a source of tax-free interest income, so it is extremely important to be sure that the lease is structured in accordance with federal and state tax laws. Bond counsel and qualified financial advisors should be consulted when giving serious consideration to a COP issue.
Some examples of COPs include:
Local agencies with projects that are too small to attract investors or to otherwise be feasible for lease financing have recently discovered the advantages of pooled COP issues. By pooling the COPs for several projects, several agencies can work together to minimize the costs of initiation and issuance. Economies of scale allow each local agency to minimize its costs of issuing a COP and may reduce the interest that must be paid on the lease. Because the use of COPs allows the project to be financed by many small investors rather than one large one, it increases the pool of potential investors.
Pooled COPS are offered through a Joint Powers Authority (JPA) created by the entities involved. Once the JPA is formed, it can be used repeatedly for additional COPs. However, all the leases being offered through each issuance of COPs must be entered into simultaneously. The economies of scale involved in pooled leasing are directly related to the size of the anticipated lease.
Here are two examples of pooled COPs. Los Angeles County schools issued pooled COPs worth $23 million in June 1987. In 1982, the cities of Arcata, Cloverdale, Healdsburg, Sebastopol, and Sonoma, acting as the Redwood Empire Financing Authority, issued COPs for over $1.54 million to finance fire station renovation and expansion, storm drain improvements, street lighting, and other utility improvements. See The Use of Pool Financing Techniques in California, published by the California Debt and Investment Advisory Commission, for detailed information on pooled COPs.
California law allows certain public entities to issue lease revenue bonds to finance capital improvements that are then leased to a public agency. The bonds' debt service is repaid from lease payments received from a public agency other than the issuer of the bonds. Again, this financing tool is designed to avoid classification as a debt and to be exempt from both Proposition 13 and Gann limit restrictions.
Lease revenue bonds may be issued by a nonprofit corporation under the Nonprofit Public Benefit Corporation Law (Corporations Code sections 5110 et seq.) and the Public Leaseback Act (Gov. Code sections 54240 et seq.), a parking authority created under the Parking Law of 1949 (Streets and Highways Code sections 32500 et seq.), a redevelopment agency (Health and Safety Code sections 33000 et seq.), or a joint powers authority under the Joint Exercise of Powers Act (Gov. Code sections 6500 et seq.). In general, lease revenue bonds may be more expensive to issue than general obligation bonds. Their advantages include the lack of a public vote requirement.
In some ways, a sale-leaseback arrangement resembles the refinancing of a home. It allows a local agency to get money out of an existing facility or equipment and to pay the money back over time. Briefly, a sale-leaseback works like this: the municipality sells a facility or equipment to an entity such as a non-profit organization, an investor or a group of investors. The municipality then leases the facility or equipment for the period of time and at the rate of payment necessary to eventually buy it back, with interest.
Sale-leaseback has advantages for both investors and the municipality involved. The investor receives a stream of payments and interest from the local agency. If properly structured, these will be non-taxable. The local agency receives an infusion of cash which it may pay back in installments, while still being able to use the facility or equipment.
This type of lease arrangement is a bit like leasing an automobile. It works like this: under agreement with a local agency, an investor or investors will construct a facility or obtain equipment for that agency. The agency then leases the facility or equipment from the investor at a rate sufficient to eventually pay for the cost of the facility or equipment, with interest. Upon completion of the payment schedule, the facility or equipment will become the local agency's property. Like the sale-leaseback agreement, investors are attracted to this arrangement by its tax-free return. Municipalities like it because it allows them to obtain property without a large initial investment and to pay it off in installments.
Whether any lease arrangement will be economical for the local agency depends upon a variety of factors including market conditions, the current tax laws, the structure of the lease, and the relative costs of other methods of financing. Local agencies should carefully evaluate these factors and compare their costs to other financing methods before entering into lease financing.
Two fine general sources of information on lease financing are the California
Debt and Investment Advisory Commission's California Debt Issuance Primer
and Guidelines for Leases and Certificates of Participation (CDAC 93-8),
available from the Commission.