Financing Hotels with Tax-Exempt Bonds: What is a 63-20 Corporation?
|
Financing Hotels with Tax-Exempt Bonds: What is a 63-20 Corporation?
|
Category: Worldwide - Industry economy
- Figures / Studies
This is a press release selected by our editorial committee and published online for free on 2008-12-10
As the credit markets continue to constrict and hotel development costs remain near historic highs, it has become increasingly difficult to finance hotel projects using the conventional mortgage-equity approach to financing. This is especially true for more costly, full-service hotel developments. The use of general obligation bonds or revenue bonds to finance hotels can provide a substantially lower cost of capital compared to using a mortgage lender and equity investor. The lower cost of capital associated with bond financing, especially tax-exempt bond financing, can make some hotel projects feasible that otherwise would not be. This article discusses the potential benefits and risks associated with using a so-called “63-20” corporation to finance hotels with tax-exempt bonds.
What is a "63-20" Corporation?
Projected Cash Flows
Traditional Financing
Bond Financing
Discount
Discount
Factor
Discounted
Factor
Discounted
Year
@ 12.5%
Cash Flow
@ 7.0%
Cash Flow
2011
2,897,000
0.88897
2,575,334
0.93458
2,707,477
2012
2,861,000
0.79026
2,260,935
0.87344
2,498,908
2013
2,820,000
0.70251
1,981,092
0.8163
2,301,960
2014
2,905,000
0.62451
1,814,206
0.7629
2,216,211
2015
2,992,000
0.55517
1,661,068
0.71299
2,133,255
2016
3,081,000
0.49353
1,520,557
0.66634
2,053,000
2017
3,174,000
0.43873
1,392,525
0.62275
1,976,608
2018
3,269,000
0.39001
1,274,959
0.58201
1,902,588
2019
3,367,000
0.34671
1,167,372
0.54393
1,831,425
2020
3,468,000
0.30821
1,068,884
0.50835
1,762,955
Reversion
36,660,000
0.30821
11,299,101
0.50835
18,636,085
NPV of Discounted Cash Flows
28,016,033
40,020,471
A so-called “63-20” corporation is a nonprofit entity formed under general state corporation law. The term “63-20” comes from a ruling by the Department of Treasury, which first authorized this type of tax-exempt financing in 1963, as published in Revenue Ruling 63-20 of the I.R.S. code. The ruling was updated in Revenue Procedure 82-26. Under these rulings, states and political subdivisions are authorized to issue obligations, the interest on which is exempt from federal income taxation.
These 63-20 nonprofit corporations must be sponsored by a local or state government entity. To qualify, each of the following requirements must be satisfied:
* The corporation must engage in activities which are essentially public in nature;
* The corporation must be one which is not organized for profit;
* The corporate income must not inure to any private persons;
* The state or political subdivision thereof must have a beneficial interest in the corporation while the indebtedness remains outstanding and it must obtain full legal title to the property of the corporation with respect to which the indebtedness was incurred upon retirement of such indebtedness; and
* The corporation must have been approved by the state or political subdivision thereof.
Benefits of Using “63-20” Financing
By sponsoring the creation of a nonprofit corporation to issue these tax-exempt bonds, a community can maintain financial and legal independence from a hotel development project, while still allowing the project to be financed by raising capital through the tax-exempt bond markets. Due to the tax-exempt status of these bonds, a project’s cost of capital may be substantially lower than if funds were being raised from the conventional capital markets. Cities such as Austin, Texas and Overland Park, Kansas have recently used “63-20” corporations to issue tax-exempt bonds for hotel projects.
The ability to issue tax-exempt bonds, which generally represent a lower cost of funds than traditional hotel financing, is one of the main advantages of using a “63-20” corporation to develop a hotel project. The following example illustrates how tax-exempt bond financing can affect considerations of a project’s feasibility.
Suppose a community is seeking to attract the development of a 200-room, full-service hotel with a major national brand and 20,000 square feet of net rentable conference space. Further suppose that detailed estimates indicate a total project cost of US$40,000,000. Finally, suppose a credible market study provides cash flow forecasts from net income and a reversion, beginning in 2011, similar to those shown in the following table.
Under current market conditions, using a traditional financing scheme, we might assume a loan-to-value ratio of 60%, an interest rate of 7.5% on the mortgage, a yield of 18% on the equity, a terminal capitalization rate of 9.5%, a 25-year amortization and a 10-year holding period, depending on numerous project-specific considerations. These valuation parameters would allow us to derive a discount rate of about 12.5% to apply to future cash flow expectations. The net present value of the cash flows, discounted at 12.5%, in this example, is approximately US$28,000,000. This leaves a financing gap for the project of about US$12,000,000.
Using tax-exempt revenue bonds to finance 100% of the project, however, it would be reasonable to assume a much lower cost of capital. Based on input from investment banks and trading firms, we assume 7.0% for this example. In this case, the net present value of the same cash flows would be approximately US$40,000,000, thereby eliminating the financing gap and making the project feasible. This is possible because the cost of capital under the bond-financing scenario is much lower than under the traditional-financing scenario.
In this example, we assume a single tier of unrated debt. However, there are numerous possible capital structures that could be considered, some of which would involve multiple tiers of debt, some of which could be rated investment grade.
Tax-exempt revenue bonds and general obligation bonds can also be issued by government entities, rather than nonprofit corporations, to support hotel or convention center projects. A recent example is the 500-room Renaissance by Marriott in Schaumburg, Illinois, which is connected to a convention center and owned by the Village of Schaumburg. Although similar capital cost savings may apply to these alternative forms of financing, this article focuses specifically on the use of “63-20” corporations for hotel financing.
Potential Risks of Using “63-20” Financing
Although the benefits of using tax-exempt bond financing for hotel projects are compelling, there may be several potential reasons not to embark on such a strategy. There are important risks to consider when evaluating whether tax-exempt bonds should be used to finance a hotel project. These risks can be both political and financial in nature.
Political risks may arise if the existing hotel community opposes the development of a proposed project. Existing hoteliers may view the use of tax-exempt bond financing as an unfair incentive provided to a project that will compete with their existing hotels. One way to address this political risk is to place requirements on the proposed development to include amenities, such as conference space, that will induce new hotel demand to the market. By developing an over-sized conference space relative to the proposed number of guestrooms, the project may be able to generate substantial overflow room night demand that will benefit other hotels in the community.
Financial risks may arise if the new hotel does not meet performance expectations and if the project revenues are insufficient to make scheduled debt payments to bond holders. The financial risk to the sponsoring government entity may be limited at the outset by defining to what extent it is willing to consider appropriating funds to the nonprofit corporation that issued the bonds in the event of a shortfall. The degree to which the sponsoring government is willing to provide some security will generally affect the perceived risk of the bonds and, therefore, the price investors are willing to pay for them.
Although a “63-20” corporation is not a government entity, and the local sponsoring government may not have any requirement to appropriate funds in the event of a shortfall in revenue to pay bond holders, the local government may not want to see the project fail. Therefore, the local sponsoring government may feel the need to provide financial assistance to prevent a potentially embarrassing default or damage to the community’s image. One way to address this risk is to plan for potential market downturns or other unforeseen factors by creating adequate contingency funds. In fact, reserve funds are typically required for bond financing. This could result in the need to borrow more money than would be needed for projects using traditional financing. Alternatively, or additionally, planners may wish to consider purchasing an insurance policy to guarantee the bonds; however, this may not be cost effective under current market conditions.
Concluding Remarks
One way to gauge the potential risk of a project is to retain a qualified, independent feasibility consultant to provide an unbiased projection of likely cash flows. These cash flows should be considered in light of credible project cost estimates based on design plans that are complete or nearly complete and supported by a guaranteed maximum price provided by a general contractor or a member of the development team.
Tax-exempt bond financing can make an otherwise infeasible project possible in some communities, but the appropriateness of such a strategy needs to be determined at the local level by responsible stewards of the community. Local decision-makers must weigh the potential risks and benefits of using such a strategy. More resources for evaluating the use of a “63-20” corporation and other types of public-private financing strategies can be found in the HVS library or by contacting HVS.
|
|
