SOMETHING TO TRY IN TRYING TIMES

A New Financing Tool for Municipalities

From the presentation made by D. J. Mosier at the 74th Annual Municipal Conference, October 16-19, 1987, Chicago, at the "Innovation in Penancing Municipal Government" seminar.

These are, indeed, times that try the souls of elected officials (with apologies to Revolutionary War hero, Tom Paine). Money to fund essential government services is harder than ever to come by — even in the most efficient, best run communities. It is for this reason that lease/purchase agreements offered by professional money sources, other than vendors, have become significant alternatives to bonds and cash wherever special pressures have put limitations on bonding. Its first great impetus was in California after the enactment of Proposition 13.

The recent passage of the Gramm-Rudman-Hollings bill, and to all intents and purposes, the end of federal revenue sharing, have made this alternative important throughout the United States. As the readers of this magazine know, the usual way municipalities have paid for capital acquisitions is with cash — from the "current" budget or from the proceeds of a bond issue. It has not been at all unusual that many pieces of equipment with a "useful life" of three to five years are purchased with proceeds from a ten to twenty year bond issue floated primarily to fund a much longer lasting capital improvement such as a village or city hall. This means, of course, that the taxpayers continue to pay for the "limited life" acquisition long after it is being used. This is not a situation elected officials enjoy because it creates an unnecessary cost for taxpayers.

But government bodies have not had too much choice in the past. One choice often used has been lease/purchase agreements offered through vendors. But the vendor who wished to sell a much needed word processor to a community, (for example, a word processor that will save time and money in the long run, costing in the neighborhood of $2,500) knows a great deal more about the word processor than sources of money. Usually, this results in a higher interest rate to the municipality. The State of Illinois, for example, will not approve lease/purchase agreements with vendors, though it does approve lease/purchase agreements with non-vendor investment sources. As beneficial as lease/purchase agreements may be, in many circumstances they certainly are not the only answer to funding. Each situation must be analyzed and the appropriate funding used to meet each specific need. Funding of a total project can include accumulated cash savings, bonds, and a lease/purchase agreement. Lease/purchase should be seen as an additional tool to help a community meet its financial needs, using it in addition to cash and bonds.

Lease/purchase agreements provide a number of advantages:

(1) They can be arranged in a much shorter period of time than a bond issue;

(2) They require much less time from elected officials, government employees and legal counsel;

(3) The agreement can be structured so that it does not impact on the government's debt limit;

(4) Most bond issues allow for early repayment, but at a substantial premium; a lease/purchase agreement provides for the exercise of a purchase option at any time without a substantial premium;

(5) The payment period can easily be tied to the useful life of the equipment;

(6) Lease/purchase agreements can be structured to fit the cash flow opportunities and needs of the government body; initial periods that require interest only payments or that provide for interest capitalization can be arranged;

(7) Lease/purchase agreements are not usually subject to referendum.

This acquisition method is currently being used for equipment as small as a single photocopy machine to projects costing hundreds of millions of dollars. Some typical examples: computer systems, telephone systems, fire trucks, library or city halls, trucks, school buses and police cars. With the exception of relatively small personal property acquisitions, there is no "standard" form for a lease/purchase agreement or contract. The agreement is negotiated to meet the specific needs of the governmental unit and the lessor; the form in each case reflects that special agreement. Lease/purchase agreements can be structured in which title passes to the government at the start of the agreement or at the end. It can provide for full amortization of cost over the agreed upon term or for a balloon or concluding payment at maturity. It can even be re-structured at maturity if the arrangement has not provided for full payment at that time.

Several questions are likely to come to mind. Following are some of the most frequently asked questions, with the answers:

December 1987 / Illinois Municipal Review / Page 23

WHAT IS THE COST? An exact interest rate cannot be quoted as a generality. Each situation is determined by the community's bond rating or financial position, the amount to be financed, the brand of the acquisition and the financial arrangements desired. To obtain the best results for the community at the time of closing, a lease/purchase supplier must have constant contact with a wide variety of investment sources. Having all this information at hand makes it possible to quote and lock in the best rates the day the agreement is signed. This is one of the ways vendor-sponsored agreements are likely to fall short.

WHAT ARE THE RESTRICTIONS? Very few. Lease/purchase financing can be used for any piece of equipment, new or used. It can be used to finance a new-facility or to rehabilitate an old one, providing in both cases they are owned by the municipality.

WHAT EXACTLY IS A MUNICIPAL LEASE? Whether an obligation is called a "municipal lease," a lease/purchase contract," a "financing agreement," or almost anything else, it is in essence an installment purchase contract used to finance the purchase of real or" personal property for a government unit.

HOW DOES A MUNICIPAL LEASE WORK? The typical municipal lease/purchase agreement is a short term obligation of three to seven years. It usually calls for level payments of principal and interest at a fixed interval — monthly, quarterly, semi-annually or annually. Although this is typical, longer terms and greater amounts of money for purchase of "big ticket" items can be used in lease/purchase agreements.

WHO PROVIDES THE FINANCING? A lease/purchase agreement starts with the government body's need for and purchase of a specific piece of equipment (or a group of different pieces of equipment) or facility. The lessor in the transaction acts as a financing agent or lender to the government unit. The lessor is usually a bank, insurance company or private investor — the same people who invest in municipal bonds. An organization such as D. J. Mosier brings to the municipality the best financing available at the moment the agreement is made. Lease/purchase agreements, and similar financing agreements, can provide all forms of governmental units with a useful tool to meet their capital needs. Both this type of financing, as well as traditional financing techniques can be used in tandem to achieve a balanced financing plan for governmental entities.

WHY USE LEASE/PURCHASE METHOD OF FINANCING? "We simply did not have the revenue to outright purchase it." Sound familiar? Yes it sounds like one of the reasons businessmen give for leasing rather than owning equipment: conservation of cash. but it doesn't have to be a businessman talking; it can be, and today it often is, a government official. This happens to be a reference to a major southern city which leased a $28 million phone system. The new system, it is from a well known supplier, and is being installed over 18 months, will carry voice, data and video and will manage energy use in the city offices. As with other municipal leases, this one is a lease purchase; after making ten annual payments, the city will own the hardware (and the software, too). In the past this city has either paid cash or floated bonds. Why are they leasing? Money, mainly. The recent slump caused a significant shortfall in their budget. They didn't have any money in their operating budget to pay for a $28 million phone system. Nor did they want to issue bonds, which might have depressed their credit rating. (Municipal leases generally don't count as debt.) The city was given an interest rate that was competitive with what the city figured it might have to pay by the time it had gone through the long and expensive process of bringing a bond issue to market. During the 18-month installation period, the city will pay only interest. After that, principal and interest will be due.

This experience with leasing is hardly unique. There are 80,000 units of state and local government in the U.S., most of them ground fine between voter demand for more municipal services — police, fire, garbage collection, etc. — and voter reluctance to pay higher taxes or approve more debt. For those who ask, "Why didn't they just do without?" the answer is that their system was antiquated and inefficient and the new-system, in the long run, would save time and money.

In summary, then, what are the benefits of lease/ purchase?

Bond issuance can be costly — smaller issues have high costs, medium and long term bonds arc often used to finance items with shorter lives than the term of the bonds, a substantial premium is charged for early call and excessive, costly legal and staff time is required. Bond issuance is inefficient and lengthy — issuing bonds is time consuming and requires inefficient use of elected officials' time. Bond issuance is restrictive — it usually requires voter referendum and restricts future government actions.

D. J. Mosier is the founder and president of DJM Municipal Services. Dee Mosier began her career in the investment world with Investors Diversified Services, Inc. (IDS) in 1971 as a Registered Representative, providing financial planning to individual and corporate clients. She moved through management at IDS (later purchased by Shearson/American Express) and in 1975 became Midwest Regional Training Manager. After joining Brook Investments as Partner and Vice President, Marketing, Mosier saw the need for special financial services for government and founded DJM Financial Services and D. J. Mosier Municipal Services, Inc.

Page 24 / Illinois Municipal Review / December 1987