MCTA Treasurer’s Manual

Chapter 10

Financing Capital Improvements

Overview

The need to improve the nation’s infrastructure has evolved into a major public policy concern at the federal, state, and local levels.  Like municipalities in other states, Massachusetts cities and towns have experienced impairments in their respective capacities to fulfill infrastructure needs, due to reductions in state and federal construction grants and to constraints in the local and state budgets.  The passage of Proposition 2½ (59:21C) has significantly exacerbated these problems .

Under Proposition 2½, cities and towns find it increasingly difficult to fund capital expenditure debt within tightened operat­ing budgets.  Accordingly, many local officials have deferred capital projects in order to sustain their operating budgets.  Moreover, as debt has been retired, municipalities have utilized “freed up” monies to pay operating expenses, thereby diminishing the capital expense portion of the budget.  This conduct has inevitably led to inadequate maintenance, repair, replacement and expansion of local infrastructure. 

Deferring infrastructure maintenance and improvement, of course, only compounds municipal financial woes, enormously increasing the cost of performing such work in the future.  Inescapably, such delay leads inevitably to a diminution in the scope and quality of public services.  Every city and town owes to the future the maintenance of its infrastructure in the present.

Capital Improvements Programs

Although not intrinsically responsible for capital planning, the treasurer, as a critical member of any community’s financial team, should play a central role in such planning. 

Every community should have a capital improvements program (CIP) [1] , coordinating the city or town’s planning, financial capacity and physical development.  Any community lacking such a program should move precipitously to develop one.  The process might commence with the community’s defining “capital asset” since no generally understood definition of this term exists.  Most would agree that a capital asset must be of significant value and have a useful life of several years.  Accordingly, CIP planning should establish working definitions for these terms.  Perhaps a capital asset would be defined as a tangible property with a value of at least $10,000 and a useful life of at least 5 years.

A capital improvements program should include both a capital “budget,” i.e., a spending plan for capital items for the upcoming year, and a capital “program,” i.e., a plan for capital expenditures that extends some number of years, perhaps 5, beyond the upcoming year.

Developing a sound CIP requires devoted and effective leadership and the amenable involvement and cooperation of all municipal departments.  Accordingly, with skilled leadership and broad cooperation critical to success, the com­munity’s chief executive officer should serve as chairperson.

The benefits of a successful capital improvement program include the following:

• Preservation of capital assets
• Coordination of capital needs and operating budgets.
• Soundness of municipal credit rating.
• Stabilization of tax rate and debt costs.
• Increase in federal and state aid.

Steps in Implementing a Capital Improvements Program  

In developing a capital improvements program, a city or town should undertake the following steps. (See also Developing a Capital Improvements Program: A Manual for Massachusetts Communities, prepared by the Municipal Data Management and Technical Assistance Bureau, on pages 10-12 through 10-37.)

1. Town meeting/city council adopt(s) a CIP bylaw.
2. Mayor/selectmen appoint(s) a CIP committee. 
3. CIP committee:
1. Prepares an inventory of facilities and equipment, specifying for each item its current condition.
2. Determines the status of previously approved projects, researching the funding situation of each.
3. Assesses the community’s capability to fund capital projects.
4. Solicits, compiles, and evaluates departmental requests for capital projects and equipment.
5. Establishes a priority for capital needs.
6. Develops a CIP financing plan that recommends a method of financing for each proposed project.
7. Submits proposed plan, including recommendations for the upcoming year’s capital budget and for capital expenditures for the several following years, to the mayor/ selectmen for consideration.
4. Mayor/selectmen consider(s) plan and forward(s) it, with any recommended amendments, to finance committee/city council.
5. Finance committee/city council reviews plan and makes recommendation on budget issues.
6. Town meeting/city council adopts plan.
7. Mayor/selectmen monitor(s) implementation of plan.
8. CIP committee initiates annual updating cycle by reviewing existing plan, making new recommendations and submitting recommendations to mayor/selectmen.

Role of the Treasurer —Identifying and Evaluating Financing Options

The treasurer’s role consists of contributing information about financing strategies to the CIP committee to assist in developing a plan to fund capital improvements.  In this role, the treasurer should acquaint the CIP committee with the following persons and agencies that can provide particular knowledge and expertise in municipal finance matters:

• Division of Local Services, Massachusetts Department of Revenue

This state governmental agency possesses statutory responsibility and authority to oversee and to provide assistance to cities and towns.  Its attorneys, in the Property Tax Bureau, and its local finance experts, in the Bureau of Accounts, are readily available to provide legal and financial information and advice on all aspects of municipal government. 

The Division also maintains a municipal data bank, which contains an extensive aggregate of information relating to cities and towns.  This resource can be assessed in a variety of ways, including via the Internet, and can be very useful in analyzing and comparing a city or town’s financial condition.

In addition, its Bureau of Accounts issues “state house notes,” debt instruments for cities and towns, certified by the Director of Accounts.  State house notes, payable annually, are usually limited to maturities of five years and principal amounts of $1,000,000.  The notes are generally less costly and easier to issue than conventional issues for borrowing.  They are commonly used for temporary loans and smaller long-term issues.

• Bond Counsel

These specialized law firms provide expertise in municipal borrowing matters.  Their attorneys guide cities and towns through the involved process of issuing long-term debt.  They also issue legal opinions to the purchasers of municipal bonds, advising them about the legal and tax status of such debt instruments.

• Financial Advisor

These finance experts possess particular expertise in municipal finance, municipal borrowing and the municipal securities market.  Financial advisors guide cities and towns through the planning, authorization and issuance of debt.

Debt Planning

As part of debt planning, a municipality must accomplish 3 things.  First, it must determine how it will pay debt costs.  Second, it must obtain authority to incur debt from the town meeting or city council.  Finally, it must carry out the actual issuance process.

Ability to Pay

Municipalities must choose from among three possible options in funding the debt service of a significant project.  These include:

• Paying the debt costs from the existing operating budget.
• Dedicating some specific revenue source, such as water and sewer receipts, to payment of the debt costs.
• Obtaining debt exclusion authority under Proposition 2½ and paying the debt costs from the additional levy capacity.

Absorbing the Debt Service within the Operating Budget

With most cities and towns levying at or near levy capacity, few municipalities can accommodate the payment of new debt costs from existing operational budgets without the necessity of making substantial cuts in existing programs.  For loans requiring repayment with annual principal payments, the interest due each year regularly declines, freeing up some additional money in each year’s budget during the term of the debt.  Presently, however, most loan repayments are structured with equal annual payments, combining interest and principal.  In these cases, only in years following the ultimate retirement of an existing debt issue can an operational budget generally absorb new debt costs. 

Designated Revenues

Municipalities sometimes incur debt to pay for capital projects of municipal departments that generate revenue from user fees, such as water and sewer departments.  In such an instance, a municipality, in cooperation with the rate-setting authority of the particular department, might decide to pay some or all of the debt costs from those fees.  Instead of issuing revenue bonds, however, municipalities in such instances generally issue general obligation debt upon the full faith and credit of the municipality because general obligation debt may be obtained at a substantially lower interest rate. 

In cases in which a municipality incurs debt to fund improvements for a limited and determinable area, the municipality might decide to pay debt costs from betterment assessments made upon property owners in those areas. (80:1) 

When municipalities incur debt for particular projects, such as school construction, library construction or water pollution abatement, they are entitled to receive partial reimbursement from a particular state grant.  School construction grants are awarded under Ch. 70B.  Under this grant program, the state reimburses communities a set percentage of the total debt cost, including both principal and interest, over the life of the school construction debt. (See Chapter 9 for additional information about the school building assistance program.)  Through its board of library commissioners, the state also provides grants to cities and towns for assistance in constructing facilities to be used as free public libraries (78:19H-19K) and for water pollution abatement projects (29C).

Proposition 2 ½ Debt Exclusions

In a community levying at or near capacity, and therefor unable to fund debt costs for a proposed project from its operating budget, the selectmen, or council, with the mayor’s approval, may vote, by a two-thirds vote, to seek voter approval at a regular or special election to exempt the debt payment from the Proposition 2½ levy limit. [59:21C(k)]  If the voters give approval, all debt costs for the project, both long and short-term, will be excluded from the city or town’s levy limit.  Once the debt costs have been fully paid, however, the exclusion authority lapses.  (See pages 10-38 through 10-50.)

Managing Debt

Municipalities must be diligent in planning and controlling the aggregate of their outstanding debt.  The impact of a community’s incurring unanticipated debt may be severe.  Even though the city or town may approve a Proposition 2½ debt exclusion, the attendant tax increase might very well diminish the taxpayers’ willingness to support future projects.  Therefore, as part of its capital planning process, every community should develop a strategy dealing with the issuance, timing and tax impact of current and future debt.  All finance officials, including the treasurer, selectmen or mayor, capital planning committee, and the community’s financial advisor, should collaborate in developing the strategy.  As part of their planing, these officers should constantly monitor the impact of state and federal legislation and administrative rulings on municipal finances.  They should also consider debt issuance practices of other relevant governmental agencies, such as regional school districts, counties, and water/sewer districts, and discuss these practices in their planning.

Formalizing planning about municipal debt should not result in necessary project’s not obtaining approval; rather, systematizing planning should, through its effect upon controlling a community’s borrowing costs and property tax rate growth, help ensure a financial environment which permits carrying out necessary projects, while minimizing taxpayer distress. 

Some communities, as part of their debt maintenance strategy, place all capital projects with a cost in excess of some established amount before the voters at a referendum for a Proposition 2½ exemption vote.  Others fund a base level of all capital debt within the general operating budget.  Still others set an amount that will be borrowed annually for capital projects within the general operating budget.  Communities possess broad discretion in their borrowing practices and strategies. 

Common Financing Options for Capital Improvement Projects

Prior to commencing a borrowing, municipal officials, in consultation with their financial advisor, should carefully determine the timing, size and category of borrowing that would best fulfill the community’s needs.  Their decisions should take into account the community’s credit status, the current and anticipated conditions of the bond market, and the capaci­ty of the community’s budget to accommodate increased debt service pay­ments.  Available debt options include the following debt instruments: 

1. General Obligation Bond  —  A written promise to pay a specified sum of money, called the face value (par value) or principal amount, at a specified date in the future, called the maturity date, together with periodic interest at a specified rate, issued by a municipality and backed by the full faith and credit of its taxing authority.  A bond requires an opinion by bond counsel on its legal aspects and tax status.

2. Note — A short-term loan, typically with a maturity date of a year or less.

3. Bond Anticipation Note (BAN) — A short-term note to provide cash for initial project costs issued in anticipation of bond proceeds.  BANs may be issued for a period not to exceed five years, provided principal repayment begins after two years (44:17).  The final maturity date of the project borrowing, beginning from the date the short-term note was issued, may not exceed the term specified by statute. (44:7 & 8)  BANs are full faith and credit obligations.

4. State House Notes — Debt instruments for cities, towns, counties and districts certified by the Director of Accounts.  State House Notes are payable annually and are usually limited to maturities of five years and principal amounts of $1,000,000.

5. State Aid Anticipation Note (SAAN) — A short-term loan issued in anticipation of a state grant or aid. (44:6A).

6. Federal Aid Anticipation Note (FAAN) — A short-term loan to be paid off at the time of receipt of a federal grant.  FAANs are full faith and credit obligations.

Summary of Short and Long-Term Options

The tables on the following pages summarize short and long-term options available.  Each of the options embodies both benefits and drawbacks and must be examined in the context of the financing needs of the particular project.

Comparison of Short Term Debt Financing Options
Criteria	Internal Borrowing	State House Loan Notes	Notes with Legal Opinion	Interim Loans – SRF
Issuer	City, Town or District	City, Town or District	City, Town or District	City, Town or District
Credit Quality	City, Town or District	City, Town or District	City, Town or District	City, Town or District
Reserve Fund	No	No	No	No
Administrative Requirements	Very Low	Low	Moderate	High to Start
Term (Maximum Feaseable)	Until 6/30	1 Year	1 Year	Until Bond Issue
Flexibility: Timing & Structure	Very High	High	High	High
Flexibility: Refinancing	Very High	High	High	High
How Marketed	Internally	Competitive	Competitive	Private Placement
Market	Local Treasury	Local	Local & National	State Agency
Costs: Issuance Costs	None	Low	Low to Moderate	Low
Costs: Interest Costs	Cash Investment Rate	Low to Moderate	Low	Very Low

Comparison of Long Term Debt Financing Options
Criteria	Bans & Paydowns	Lease Purchase	State House Serial Notes	Farmers Home Loans	State Revolving Fund Loans	Mini-Bonds	Municipal Bond Issue
Issuer	City, Town or District	City, Town or District	City, Town or District	City, Town or District	State Agency M.W.P.A.T.	City, Town or District	City, Town or District
Credit Quality	City, Town or District	City, Town or District	City, Town or District	City, Town or District	Municipalities, Local Aid Intercept & Reserves	City, Town or District	City, Town or District
Reserve Fund	No	No	No	No	Yes	No	No
Administrative Requirements	Very Low	Low	Low	Moderate	High	Very High	Moderate
Term (Maximum Feaseable)	5 Years	10 Years	10 Years	40 Years	30 Years	5 Years	20 Years
Flexibility: Timing & Structure	Very High	High	High	High	Very Low	Very Low	High
Flexibility: Refinancing	Very High	Depends	None	High	Limited	None	High
How Marketed	Competitive	Private Placement	Competitive	Private Placement	Negotiated	Over the Counter	Competitive
Market	Local	Limited Local	Limited Local	Federal Government	National	Private Citizens	Local & National
Costs: Issuance Costs	Very Low	Low	Low	Low	Low to Moderate	High	Moderate
Costs: Interest Costs	Low (Short Term)	Very High	High (Limited Market)	Moderate (Depends on Category)	Low (Subsidized)	Moderate	Moderate

Financing Capital Projects at the Best Interest Rate—How Bond Analysts Evaluate Municipalities

Bond analysts, such as Moody’s and Standard & Poor’s, closely review a number of indicators when evaluating a municipality’s credit risk.  Treasurers, therefore, should thoroughly understand these factors in order to assist them in securing the best credit rating  and interest rates for their municipalities.  The indicators fall within four, basic areas:

1. Debt structure and burden
• Long-term debt
• Long-term debt as a percent of full valuation
• Debt service as a percent of operating revenue
• Long-term debt per capita
• Yearly retirement schedules (i.e., the uniformity of annual debt costs)
• Debt authorized but not yet issued
• Over-lapping debt, such as the town’s portion of debt incurred by a regional school district.
• Short-term debt
2. Financial factors
• Unrestricted cash reserves
• Revenue sources
• Fixed costs as a percent of operating expenditures
• Actual vs. estimated local receipts
• Property tax levy vs. levy limits
• Property tax collections rate
• Operating deficit or surplus
• Liquidity
• User fees
3. Economic health
• Full valuation of real and personal property
• Location and natural resources
• Size and land use characteristics
• Population change and ages
• Income
• Housing characteristics
• Growth in residential/commercial tax base
• Unemployment
• Tax base
4. Management practices
• Professional management capability
• Accounting record-keeping and auditing
• Municipal services provided
• Intergovernmental relations
• Assessment of property
• Tax administration
• Legal and regulatory limitations
• Litigation cases and pending litigation

By monitoring these factors at least annually, treasurers and other financial officials can help their communities to improve, or at least maintain, their credit positions and to choose capital expense financing strategies most suited to their communities’ circumstances.