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Debt Dynamics

Institutions partnering on residential housing projects with third-party developers must evaluate critical credit components of such transactions.

By Apryl Motley

A room of their own? In decades past, most higher education students did not have this expectation of their housing on or off campus. Times certainly have changed. In fact, one of the most popular types of new campus housing is suite-style, which includes several bedrooms with private baths, along with generous common space for kitchen, living room, and more.

"We didn't have the kind of housing students wanted," says Dana Keith, associate vice president, financial affairs, at the University of Alabama (UA), Tuscaloosa. "They like having their own rooms; suite-style housing is what they wanted."

At the same time, says Sara Russell, director, municipal finance, for RBC Capital Markets: "A lot of institutions are faced with tightening constraints on their budgets, and it's difficult to go to state legislatures for money to build housing."

Student demand coupled with increased enrollment led the university to consider funding models that would make new housing available quickly, but cost-effectively—"a challenge that can be hard to overcome when you need to rely on state appropriations, the legislative process, and public sector unions," notes Bob Shea, NACUBO's senior fellow, finance and campus management.

The need to finance student housing projects is evident, but the question is who will pay—when and how—and in what manner will this decision affect an institution's balance sheet? According to a September 2014 report from Standard & Poor's Rating Services, during the past three years, the number of its rated privatized student housing transactions has more than tripled.

"We have seen a huge increase in these kinds of transactions, where universities outsource housing to private developers," says Jessica Wood, director, U.S. public finance, for Standard & Poor's. "And we expect this trend to continue."

Neither institution wanted to undertake any agreement or partnership that had the potential to negatively impact its debt capacity and overall credit rating.

For example, the University of Alabama, in 2008, opted to establish Ridgecrest Student Housing LLC, a nonprofit corporation, under the university's 1831 Foundation, formed to transact business associated with providing housing at or near the UA campus.

Similar concerns led to the University System of Georgia's decision to enter into a public-private partnership (P3) with Corvias Campus Living. Under the agreement, Corvias plans to construct more than 3,753 new beds across seven of USG's nine privatized campuses, and will be responsible for managing the operations of both the new beds and the 6,195 beds on these campuses.

"Many universities have a lot of capital constraints, combined with short- and long-term capital needs," says Kurt Ehlers, managing director of Corvias Campus Living. "This creates a significant challenge for them, but a great opportunity to leverage the experience and financial resources of the private sector."

While dealing with myriad challenges on the financial front, institutions like UA and the University System of Georgia are almost simultaneously faced with modernizing aging student housing facilities or constructing new ones to remain competitive in the marketplace. According to the National Center for Education Statistics, "college enrollment is expected to set new records from fall 2012 through fall 2021. Between fall 2011 and fall 2021, enrollment is expected to increase by 13 percent."

Six Key Characteristics

Rating agencies evaluate the following credit characteristics when determining the strength of a student housing project. The most highly rated projects address these areas.

1. Project location. Projects located on institution-owned property are viewed as having less risk.

2. Project management. The highest-rated projects are managed by the institution itself, implying a greater degree of control.

3. Support from underlying institution. Those projects demonstrating direct financial backing or vacancy guarantees from the host institution have been the highest rated.

4. Project demand and occupancy. Both strong demand for on-campus housing and positively trending enrollment levels are considered.

5. Break-even occupancy levels. Cash-flow projections incorporate a reasonable allowance for flexibility within projected occupancy, vacancies, and expense growth. Higher-rated transactions usually have a break-even occupancy much lower than 95 percent.

6. Rate covenant and debt service coverage. In more highly rated transactions, debt service covenants generally include debt service and all operating expenses, with minimal subordinated expenses. A typical covenant might set rates at a minimum level of 1.2 times the next year's debt service and all operating expenses.

Source: Living on Campus: Rating Factors for Privatized Student Housing Bonds (Standard & Poor's, September 2014)

Read on to learn more about two prevalent models for funding, and essentially privatizing, new student housing: forming a nonprofit corporation or entering into a public-private partnership, both of which are considered off balance sheet transactions. Institutions should keep in mind, however, that rating agencies generally continue to consider such debt when evaluating the institutions' overall ratings, cautions Shea. "Agencies look at the cash flows associated with student occupants, occupancy rates, and the projected housing demand now and in the future. They also consider relationships between and among the university, the foundation, the developer, and the property manager."

Catalysts for Coming to the Table

A series of factors usually prompts higher education institutions to consider off balance sheet transactions for housing construction. Chief among them, reiterates Keith, is the desire "to bring housing online as soon as possible." For UA, that meant keeping up with enrollment that increased by more than 8,400 students, from fall 2003 to fall 2009. During this same period, the university issued debt to build two new on-campus residential facilities in 2005 and 2006. These were followed by the privatized student housing projects Ridgecrest East and West, in 2007, and Ridgecrest South, in 2009—all of which offer four-bedroom suites with private bedrooms.

While the need for more housing had been evident, the university had already issued debt for deferred maintenance and the expansion of academic, residential, parking, and athletic facilities. Keith notes that establishing the 1831 Foundation was identified as the optimal funding option for getting the best credit rating without adding another obligation to the university's balance sheet.

In the case of USG, Ehlers says "a confluence of factors" led the administration to pursue a public-private partnership to fund construction of new student housing. One of those factors was the state's limitation on the amount of debt institutions can undertake.

While state support of institutions has decreased, Ehlers notes: "Increasing tuition was not a viable funding model." Further, in the past, "housing had been a lower priority for higher education institutions, when compared to academic or athletic facilities that support recruitment. "As a result, the trend had been towards [constructing] one-off housing projects that would be underfunded, without programs for maintenance and modernization."

All these factors have served as catalysts for higher education institutions to pursue alternative funding models to fulfill their housing needs.

Details of the Deal

The manner in which such funding models would be structured was of great concern to both UA and USG. Neither institution wanted to undertake any agreement or partnership that had the potential to negatively impact its debt capacity and overall credit rating. Following are some of the institutions' concerns and considerations:

Credit criteria. Ehlers acknowledges that the USG Board of Governors expressed concern about how the partnership would affect the institution's credit rating and, ultimately, the kind of credit that can be raised in the future. According to Ehlers, Corvias was able to address these concerns by keeping the debt off the balance sheet, using GASB Statement No. 34 accounting rules, and entering into a concessionaire agreement with USG. The arrangement allows USG to "exercise lots of controls in terms of what the housing will look like and how it will be managed-while we [Corvias] provide management and maintenance services and continue to raise capital for the project."

Revenue model. The P3 into which Corvias and USG have entered is different from some other models, where the developer takes as payment a portion of the proceeds from rents. Instead, since Corvias is a fee-based company, "we earn developer, construction, and management fees, which are negotiated upfront to ensure that the cash flow from our P3s stays with the institutions," Ehlers explains.

"Under our model and approach, we have programmed out a plan over 65 years to replace all of the housing constructed as part of our partnerships," he continues. "At the end of our partnerships, the average age of existing assets is 15 years. There's always funding in place to replace, repair, and modernize the housing. At the end of the ground lease, the asset goes back to the university in great shape."

Another difference in Corvias' approach to typical P3s is that there are no break-even occupancy rates or guarantees built into their agreements. "We're confident in our ability to build the right product for students and keep the housing full," Ehlers says. "We believe that we can do that in a cost-effective way, and we worked with USG to set rents to keep units affordable."

Debt perception. At UA, while the affordability of the rental rates for its privatized dorms was carefully considered, "our biggest concern was how the debt would be perceived by the rating agencies," Keith says. UA conducted a demand study, which included compiling rental comparisons for the area and analyzing the local off-campus housing market. "We used the study to guide us," Keith explains. According to her, overall occupancy in the university's student housing, inclusive of the privatized dorms, ranges from 96 to 98 percent. However, there is no first-fill provision (in which students are assigned first to specific residence halls before other housing), as is sometimes the case when using this funding model.

RBC's Russell explains that student demand is quite important on the financing side as well. "Investors are interested in where the draw for students will come from; what do students say they want and need versus what's being constructed?"

Pointers for Privatization

Here are some key steps you might want to take as your institution considers the overall financial feasibility of privatizing student housing.

  • Don't be afraid to approach a ratings agency. "Do your homework, and don't be afraid to ask different questions," RBC's Russell says. "Sit down with the rating agencies and discuss different scenarios."
  • Evaluate your long-term goals for housing. "Ask yourself, what do I need my housing to look like? How are we going to raise the bar for all of our housing across the institution, new and existing?" Corvias' Ehlers advises. "Also consider whether there's a way to leverage the private sector without giving up things critical to your institution's approach to educating students."
  • Conduct a cost-benefit analysis to get the right team in place. The University of Alabama's Keith says, "You have to have good people on your staff who can help you work through the deal." For example, there are legal costs, and an institution may not have the right "conduit" in place to issue revenue bonds for the project. Construction personnel could be another concern. Can you do it in-house, or do you need to outsource? "Develop a team of people who have done this kind of deal and understand the rating agencies' expectations," Keith advises. "Be mindful of the players needed to make transactions successful.

Project control. Another concern was how much control UA would have over the management and design of the new housing. Russell notes that "a lot of institutions have concern about maintaining control. There's a balancing act that has to happen between their desire to have control over the materials and design of the facilities as well as their enforcement of standard residential life policies and their goal of preserving their future borrowing capacity. The question becomes, how do we have control, but it's not our debt?"

At UA, administration of the privatized facilities is handled in-house. "We serve as the manager for these residence halls," Keith says. The university's housing/facilities division manages operations for these new dorms, and UA charges the foundation a management fee for these services. From Keith's perspective, this arrangement was a means of getting the best debt rating, because the debt issued for the new housing was an obligation of the foundation rather than of the university. UA's current private student housing bond has an A- rating from S&P.

By the same token, Russell notes that, while there's generally concern about the debt being part of the institution's credit profile, "you have to go into the process knowing that the rating agencies are going to put the debt on your credit, which doesn't have to be a bad thing."

Credit Concerns

"Just because a transaction is off balance sheet doesn't mean we consider it off-credit," says Jessica A. Matsumori, a senior director at Standard & Poor's.

This is the case, because for those privatized student-housing bonds that are rated, support from the underlying institution is one of the key credit characteristics that are evaluated in determining the rating. "While transactions may be off the university's balance sheet, the transaction could receive an uplift in rating based on its relationship or connectivity with an underlying institution," Standard & Poor's Wood says. "If the housing wasn't on, or associated with a campus, and benefitting from competitive advantage in terms of marketing and filling beds, those transactions wouldn't be rated as highly."

S&P provides ratings that are reviewed annually, and the rating agency's outlook period looks forward for two years. Certainly, evaluation of risks for the short- and long-term is part of what goes into the ratings.

For privatized student housing bonds, there's always new construction risk and timing risk of a building not opening on time. "We look to see what contingency plans are in place for construction or budget delays, and for housing these students," Wood says.

"In general, our rated universities have A/A+ credit ratings, while these transactions are typically rated in the BBB category (if they have a solid link to the sponsor institution), because there is considerable startup and construction risk," Matsumori explains. Another key area of risk is cash flow based on projected rental income and occupancy rates, which are also among the key credit characteristics that go into ratings. "Expectations about occupancy and rental rates might not come to fruition," Matsumori notes.

"Typically, the security of the bond is nonrecourse to the sponsor institution, made up of net revenue [cash flow]," Wood says. "Revenue comes down to occupancy and rental rates, and the biggest pressure area is rental rates if students are not willing to pay a premium for newer, more modern housing. Further, if enrollment declines and there's no first-fill provision, there could be pressure on occupancy." However, from Wood's perspective: "Another unknown is the relationship between the institution and the private developer. It could change."

For instance, the pricing strategy is a key piece. According to Wood, "over the long-term, they could disagree on pricing strategies and levels of investment in deferred maintenance," which is one of the areas reviewed when evaluating the financial projections for these transactions.

Despite the risks and credit concerns, Matsumori acknowledges: "Privatized student housing bonds could be the best option for some public institutions to complete projects quickly.

"It's so difficult for them to do these kinds of projects on their own. They almost have to find other ways to do these projects; while private institutions often have more flexibility."

As this funding option may continue to be the most viable, are there concerns about the long-term impact of privatized student housing bonds? RBC's Russell doesn't think so. "It's not of great concern," she says. "As long as certain budget controls are in place and institutions meet the ratings agencies' threshold for debt coverage, these housing projects can be self-supporting assets. Most business officers understand that these are revenue-producing assets, and can be viable, ongoing self-supporting enterprises."

APRYL MOTLEY, Columbia, Md., covers higher education business issues for Business Officer.

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The Privatization of Campus Facilities

In November 2014, the University System of Georgia (USG) announced that it is embarking on a course to become one of the nation's largest experiments in an emerging trend with dramatic implications: the privatization of noneducational campus facilities, such as housing, parking, and power plants.

Under the Georgia plan, the state university system will lease to Corvias Campus Living, a private company selected through a formal public bidding process, the future revenue streams from the housing that comes to the school in the form of student rent payments. In exchange, the private company will oversee the new construction of more than 3,700 beds, and the maintenance of the entire portfolio of approximately 9,950 beds. It will also invest in renovations over the life of the program—some 40-plus years.

Of course, P3 projects (public-private partnerships) are nothing new to the higher education community. In the past, however, these projects have typically revolved around a single building: carve out a residence hall, form a private sector partnership, and move on to the next capital project. The difference now is that colleges and universities nationwide have quietly begun exploring the possible strategy of turning to private investors for the packaging and sale of a portfolio of noneducational university assets—such as residential housing facilities. Clearly, a goal is to renew aging facilities or to raise new capital in the face of declining funding.

This new strategy creates greater scale that can mitigate risk for investors and increase the return for campuses. These nontraditional partnerships have the potential to release great value buried on university balance sheets, but will require schools to reinvent the historical model for the way noneducational campus facilities are built and maintained.

As campuses evaluate the potential of such an approach, they may find value in the experiences of other nonprofit sectors. Kurt Ehlers, managing director of Corvias Campus Living, a Corvias Group subsidiary, believes the industry can benefit from the lessons learned by the federal government's privatization of military housing—arguably one of the most successful P3 efforts to date.

"We worked with the U.S. Army to literally reinvent the definition of a public-private partnership," says Ehlers, "and it has allowed privatized military housing providers to revolutionize the quality of housing nationwide over the past 13 years. That wouldn't have been possible in a traditional P3 model, because of the inability to balance reinvestment in the asset with a return to the investor, when everything is tied to cash flow. This revised approach is similar to the way campuses have monetized existing parking assets or power plants. Therefore, we believe that higher education institutions that are considering privatizing a portfolio of assets should understand how this different portfolio-based P3 model works to dramatically improve student housing."

In this context, campuses are also seeking to understand if monetizing parking, housing, power plants, or other noncore facilities is right for them. Several items are needed to create the right environment for an effective third-party arrangement to monetize a campus's nonacademic assets, manage the facilities, support the program, and ensure effective reinvestment in the facilities. Based on our company's experience, campus administrators must understand five core areas in order to make a well-informed decision.

1. Relevant data. Basic information on your systems and facilities is absolutely needed in order to strike an effective deal. Items such as building square footage, occupancy rates, historical annual expenditures, and the estimated capital needs must be well-documented and disclosed as part of the deal process.

2. Asset valuation. The valuation of campus assets will be tied to future cash flows, because there is limited information on market profiles for resale. Therefore, a realistic assessment of the revenue generated by the facility is needed to determine cash flow. Additionally, the potential revenue generated for the facilities will need to be divided between reinvestment (both to the buildings and cash to the campus) and the return for the investors.

3. Program alignment. Campuses need to have strict control over the programming of space to ensure integration with the university mission, academic goals, and residential objectives. Additionally, campus administrators need to understand how other departments may be effected by the change. If housing moved to a private partnership model and the facilities employees moved to the third party, then there might be a significant impact to the existing facilities, HR, accounting, and other campus departments. The biggest impact could be the inadvertent reduction in scale that would likely drive up costs. With a sale of assets, which are likely to be maintained by the third party, the facilities organization might reach a tipping point where its costs to the rest of the campus might grow unnecessarily.

4. Transition transparency. Transparency of the deal's details is extremely important in order to balance the many needs and wants across the campus. As with any negotiation that has the potential to provide additional resources to many constituencies, those entities will need to understand the financial terms, the reinvestment needs, and the operating implications of the deal. This knowledge by all involved parties helps ensure that there is no confusion, nor perception of "free" capital. In addition, issues such as how debt is cross-collateralized to other income sources will need to be unwound. The reduced debt expense and corresponding impact on the campus income statement, balance sheet and credit rating, will need to be understood upfront.

5. Management monitoring. Once the university team has specified how the transaction proceeds will be used, and set the expectations and impact of the monetization, the program needs to be independently validated over time so the team is assured that the use of the proceeds is consistent with the original plan's requirements.

The bottom line is that—as in any major financial deal—a clear understanding of the implications of privatization is needed before proceeding down any P3 path. Most campuses are dependent on revenue streams from auxiliary buildings, but seldom are the full costs of maintaining and upgrading these facilities properly documented. This significant omission can make it difficult to determine whether an asset sale is a good deal or not, by conducting only a superficial assessment.

In order to truly analyze the potential value of privatizing noneducational facilities, these five points give rise to important questions that all university business officers need to ask regarding their cost basis on auxiliary building maintenance and development. If the answers to those questions support the case for privatization, the financial upside to the campus can be significant.

DAVID KADAMUS is founder and chairman of Sightlines, a consulting firm that advises higher education leaders on facilities and capital investment strategies.

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