This article is reproduced in The Tax Exempt Leasing Letter with permission of Standard & Poor’s Ratings Services, a division of The McGraw-Hill Companies, Inc. - “Securitized Federal Leases Revisited”, by Colleen Woodell and Richard Marino, dated March 4, 2002 - Further reproduction or distribution is prohibited without the express written consent of Standard & Poor’s Ratings Services.

Securitized Federal Leases Revisited
March 4,2002 (Acrobat PDF version)

Richard J Marino, New York (1) 212-438-2058; Colleen Woodell, New York (1) 212-438-2118

Private developers continue to show a strong interest in using the capital markets to finance construction or refinance existing mortgages by using federal lease payments as security. However, credit quality on these transactions can vary widely depending on the contractual and structural provisions of the lease. Standard & Poor’s has public ratings on over 30 transactions that are backed by lease rental payments from several different U.S. agencies. Although all of these structures are secured by lease rentals paid by the U.S. government, some transactions carry more risk. Reflecting this risk differential, the rating distribution on these issues ranges from ‘AAA’ to ‘BBB’, with the preponderance occurring at the ‘AA’ level.

Most federal lease agreements are not structured with a public debt financing in mind. There are risks that are not usually associated with municipal lease transactions that investors will need to evaluate before purchasing the security. Each federal lease has different features and needs to be evaluated on a case-by-case basis. Most prominent in many of the federal lease transactions is the risk associated with the involvement of an unrated developer as lessor. To mitigate the developer risk, Standard & Poor’s requires that the lessor be a single-purpose corporation or limited partnership (SPE) with restrictions on future indebtedness and its operations limited to the leased property. In addition, Standard & Poor’s will require a non-consolidation opinion between the SPE and its principals. However, significant developer risk exists with the construction and operation of the facility.

Four key areas that should be carefully evaluated are:

1. Appropriation risk;
2. Structural risks;
3. Cash flow risks; and
4. Construction risk.

Appropriation risk

As with municipal leases, the most important factor in determining credit quality is the government’s obligation to make lease payments subject to the government’s access to the facility as well as the lessor’s successful performance of all of its obligations under the lease. This is defined as the appropriation risk. Certain government leases do not carry the appropriation risk in that the government’s obligation is absolute and unconditional subject to the terms of the lease. If this is the case, an opinion will be required from the agency’s general counsel’s office stating that the lease rental payments are general obligations of the U.S. government backed by its full faith and credit. Most General Service Administration leases fall into this category. Typically, such obligations carry a rating at the ‘AA’ level or higher, depending on the structural risk and cash flow risks associated with the contract.

There are two other types of appropriation risk that federal leases carry. In some instances, the obligation to make lease payments is subject to Congress making an appropriation to the agency for a specific function, such as military housing. Under this scenario, the military department is obligated to make the lease payment if Congress appropriates any funds to the agency for housing military personnel. The only way the military department would not be obligated to pay is if Congress appropriated the funds for military housing and included specific language stating that the specific lease or class of leases were not to be paid. As with other types of appropriation risk, the essentiality of the function to the government is important. Funding for certain less-essential government programs may be more tenuous and therefore would receive a lower rating than a program such as military housing that could be viewed as being important to the nation’s strategic interests. While the government may change the way it houses its military personnel, it will still appropriate funds for this purpose and the military is obligated to make lease payments.

The second type of appropriation risk is that of the congressional line item. This type of appropriation is more visible and would undergo a very stringent analysis of essentiality. Risks associated with the congressional line item appropriation involve not only the funding of specific governmental programs but also the importance of a single site to the delivery of services provided by the program. Since demographics and cost structures change over time, it could have an impact on where and how the government wants to provide services.

Structural risk

The lease structure governs the environment under which the government’s lease payments are made. There are four basic elements that could have an impact on credit quality:

1. The match of the lease term to the term of the debt obligation;
2. Lessor obligations under the lease;
3. Rent off-set rights by the government; and
4. The government’s termination rights under the lease.

Typically the term of a federal lease will match the term of the debt obligation; however, a securitization can receive an investment-grade rating even if the term of the lease is not equal to the debt maturity. Some federal leases are structured with a limited term but give the government the option of renewing the lease one or more times over a fixed period. Developers have securitized the government’s lease payments over the entire period rather than for the current lease term. However, there is a risk that the government will not exercise its option to renew the lease if circumstances change, such as finding a lower-cost facility or a program is not renewed. In these instances, a full real estate analysis risk assessment will be performed. This analysis along with the essentiality of the leased asset and any factors present that may mitigate the renewal risk will be the key factors in determining whether the securitization receives an investment grade rating. (See “Sidebar: Mitigating the Renewal Risk,” below.)

In general, rated municipal leases are triple net with the government responsible for maintenance, taxes, and utilities. However, most federal leases do not carry this feature and the lessor can be responsible for one or all of these obligations. Federal lease payments are structured in one of two ways with each based on the amount of space leased: either the government pays a single rent payment that takes care of both debt service and operations or lease payments are bifurcated into two separate streams. These two rent streams are base rental payments—typically used to pay debt service—and operations and maintenance rent. If the lessor defaults on his obligations under the lease, the government’s remedies can range from rental off-set to termination of the lease. The cash-flow analysis plays an important part in evaluating this risk. However, if the government has the right of termination, it could have severe rating implications. Strong cash flows, coupled with a sufficient cure period, could partially mitigate this risk, given that the lessor will have an incentive to operate and maintain the facility properly. However Standard & Poor’s reserves the right of analytical judgment. When the government’s rights for lessor non-performance are limited to rent offset, credit quality is also severely impaired if the off-set rights could impact base rental payments—the portion of the lease rental payment used for debt service. If the off-set rights only impact the operating rent, there are two scenarios that could enable the transaction to achieve an investment grade:

1. The government has the right to off-set operating rents and perform the obligation itself; or
2. The government has the right to off-set operating rents but cash flow coverage is deemed to be sufficiently strong enough to mitigate risk.

Some federal leases will contain clauses that allow the government to vacate portions of the leased space and off-set rent proportionately. Whether the government will exercise its right to vacate is speculative and, as such, would make any transaction that contained the clause speculative.

Another risk prominent in federal leases is that of damage and destruction. The government usually will have the right to abate rents during periods of non-occupancy. In some cases, although not all, the government may have the right to terminate the lease. To achieve an investment grade rating, the lease must contain several features that minimize the risks associated with damage and destruction:

1. The lease must require that the government gives the lessor ample time to repair or replace the facility;
2. The government will continue to occupy and pay rent on the useable portion of the facility; and
3. The government will resume the entire contracted rent payments when restoration is complete.

To mitigate the lessor’s liability and costs associated with damage and destruction, Standard & Poor’s requires the lessor to have rental interruption insurance for a period in excess of the time it would take to rebuild the facility, as well as casualty insurance at replacement value but not less than the par amount of the indebtedness outstanding. The insurance provider must carry a rating on its claims-paying ability that is no less than one category below the rating on the transaction and, at minimum, is investment grade. In addition, Standard & Poor’s requires at a minimum a debt service reserve fund equivalent to at least two months’ base rent payment for the insurance claim process to finalize.

Termination rights are by far the most problematic elements to achieving an investment grade rating for a federal lease transaction. Termination with respect to damage or destruction and non-performance of lessor obligations may be mitigated by either insurance and other restrictions on the government or strong cash flows, respectively. However, some leases contain a termination-for-convenience clause that gives the government the right to end the lease and its obligations at any time. Similar to the government’s right to vacate space, in most cases this clause adds a speculative element to the continuance of the government’s rent payments and the transaction would therefore receive a speculative rating. However, in some cases the government has stated that it will pay off any outstanding indebtedness if it exercises its rights under the convenience clause. This allows the developer to achieve an investment-grade rating on the transaction.

Cash-flow risk

The cash-flow analysis evaluates the lessor’s ability to fulfill all of its financial obligations under the lease and make timely payments to the bondholders. Given that each federal lease transaction has different characteristics with respect to the lessor’s obligations and the government’s remedies, Standard & Poor’s has not established a coverage test for its cash-flow analysis. In determining cash-flow adequacy, it is important to make sure that government lease payments will match debt service due dates. Most federal leases are structured with monthly lease payments made in arrears. Most federal leases are also structured with a base rent component and an operating rent component. To achieve an investment-grade rating, base lease payments will need to equal or exceed debt service requirements. If the lessor has operating or maintenance responsibilities, Standard & Poor’s evaluates the operating rents under very conservative expenditure estimates with reliance on historical costs for similar buildings in the area. In addition, an operating reserve equivalent to a minimum of one month’s rent is required.

Standard & Poor’s also evaluates the ability of the lessor to make the required capital repairs on the facility during the life of the bonds. To do this, an independent engineer’s report is required. If annual cash flows are not sufficient to make the required capital repairs in each year, Standard & Poor’s will require a capital reserve fund that can either be funded upfront or from excess cash flow over the life of the bonds.

Construction risk

Construction risk occurs when the government’s lease rental payment is dependent on the completion of the project to its specification. If construction risk is present, Standard & Poor’s requires either of the following:

1. Interest to be capitalized for a period extending beyond the construction timeline. The capitalize interest requirement will depend on the time schedule and complexity of the construction. As a result, Standard & Poor’s rating will be provisional (p) until the project is accepted by the government, or
2. A construction risk analysis be performed (see Standard & Poor’s project finance criteria).

Standard & Poor’s does not give weight to payment and performance bonds given the historical lack of timeliness and sufficiency of such payouts.

The Next Generation of Federal Leases

Standard and Poor’s has recently placed an investment-grade rating on a transaction whereby a private developer was selling bonds to finance the design, construction, completion, and development of office and research facilities used and occupied by a management and operation (M&O) contractor in connection with its ongoing activities at a federal facility pursuant to its management and operating contract with the United States of America, acting by and through a department of the federal government. Unlike previously rated federal leases, these bonds are secured by a pledge of the rent payments under a lease between the M&O contractor and the developer and not between the federal government and the developer. The credit risks associated with this type of transaction could include:

1. The private nature of the projects being financed;
2. The initial term of the lease not extending to the life of the bonds; and
3. The lack of a marketability of the project.

To achieve rating separation from the private developer and an investment-grade rating for this type of structure the following elements must be present.

Strong legal structure

1. The term of the lease has sufficient renewal options to extend to the life of the bonds;
2. There must be an executed contract between the federal government and the M&O contractor to manage the facility which may or may not extend to the term of the lease;
3. The financed facilities should be owned by a single-purpose, bankruptcy-remote entity. The facilities may than be leased back to the private operator. Such lease must meet Standard & Poor's published criteria for lease purchase agreements;
4. The obligation to make debt service payment on bonds sold to finance these projects should be a special obligation of the issuing entity and payable solely from the revenues of the trust estate;
5. The contract with the federal government, along with the revenues associated with those contracts, should be assigned to the single-purpose, bankruptcy-remote entity and, in turn, pledged to a third-party collateral agent as part of the collateral security for the bonds;
6. Confirmation that the contract revenues supporting the transactions would not be property of the bankruptcy estate of the private operator or subject to the automatic stay provisions were the private operator has to file for bankruptcy;
7. Payments from the contract revenues should, in the first instance, be used to pay debt service on the bonds; second, to make any required property tax or insurance premiums; third, to replenish all required reserve accounts and, last, to flow back to the operator for prison facility operations; and
8. Confirmation that the operator can be terminated and replaced in the event of a default by the operator under any of the contracts with the federal government.
9. Moreover, the single-purpose, bankruptcy-remote issuer should be owned by an independent not-for-profit-corporation having no affiliation with the private prison owner, preferably a not-for-profit that has as a charter commitment to aid government in the providing of essential services.

Strong project essentiality

The project facility should be of an essential nature meeting the stated mission of the contracting federal department.

Strong lease revenue stream

The lease payments should originate from rental reimbursement payments due the M&O contractor from the federal government under the M&O contract. The contracting federal department, as part of its consent to and acceptance of the lease, must acknowledge that the rent under the lease, together with other operating expenses are allowable reimbursable expenses under the M&O contract.

Rent payments

Rent payments should be paid directly to the Trustee by the contracting federal department thru the Federal Assignment of Claims Act.

Requirement to renew

If the M&O contract does not extend for the term of the lease, the M&O contractor must provide that as long as its M&O contract with the contracting federal department remains in force and effect, the M&O contractor will exercise each of the extension options which should match the extension options of the lease.

Operator substitution

If the private operator fails to meet the requirements of the M&O contract with the contracting federal department, that contract may be terminated. The transaction should be able to rely on the government department or a number of other private operators being available to assume the role of operator. The M&O contractor should agree under the lease that any replacement operator responsible for the management of the facility enters into a replacement lease for the property with the same terms and conditions as set forth in the lease. As such, the payments from the contracting federal department in support of the debt service payments on the bonds will continue regardless of who the M&O contractor is.

Strong monitoring of the facility

Details surrounding the procedures and requirements of the facilities will also be evaluated. The contracting government department should regularly monitor the facilities and have measures in place that will rapidly address any contract violations.

Sidebar: Mitigating the Renewal Risk

An example of a federal lease whose term did not extend to the debt maturity was a recently presented transaction with a private developer who was selected to develop and build a new headquarters facility for a U.S. government agency with the GSA acting as lessee. While Standard and Poor’s did not issue a public rating on the transaction, it did ascertain that despite the term of the lease falling short of debt maturity, an investment grade rating was warranted.

Like other GSA leases, the lease was a full-faith-and-credit obligation of the United States of America for its initial term and the obligations of the GSA under the lease were not subject to availability of appropriated funds. Unlike other GSA leases, the term of the lease fell short of the maturity schedule of the bonds being issued. The bonds that were being issued had a repayment schedule in excess of 30 years while the GSA only has congressional authority to enter a lease for a period of no more than 20 years.

The GSA does have a renewal option that, if exercised, would extend rental payments beyond the life of the bonds. However, there is an inherent risk that the lease will not be renewed due to real estate market considerations. As such, a full real estate analysis risk assessment was performed. The results of that analysis determined that the rating for this facility would be deeply speculative grade at the agreed upon rental rate.

However, the following factors were present that mitigated these negative credit factors by reducing the lease renewal risk, and thus elevated the rating to investment grade. They are:

Strong project essentiality

The office complex being considered was extremely essential as it consolidated the agency’s personnel into one complex and provide for improved efficiencies and operational savings.

Significant renewal notification

The GSA and the federal government agency had been evaluating the consolidation and move of the agency over a period of many years . Given the significant renewal notification period that the GSA must give if it is not going to renew they would have to start planning their next move during the middle of the initial lease term.

Location

The location of the complex was a factor. Given the limited availability of sites sufficient to meet the agency’s needs it would have been unlikely adequate space would be available to the agency for any future relocations.

Renewal rates are likely to be competitive

The lease was awarded because it was the lowest cost to the GSA including the renewal options. The relocation of the agency’s headquarters required a significant upfront cost to the government agency due to the specific requirements of that agency, which are above the expenses allowed by the GSA. If the agency were to seek relocation at the renewal option date and a similar relocation cost were to be required and amortized over a 20-year lease, the projected rental amount would be above their present renewal rate.

Other GSA options

Even if the government agency desires not to renew the lease, the GSA has the option to renew and replace the agency with another federal government tenant(s).