Master Lease & Leaseback of Government Owned ... A Model for a Fixed Income Investment Product

Master Lease & Leaseback of Government Owned Real Estate: A Model for a Fixed Income Investment Product By Jeffrey E. Hutchinson Bachelor of Science, Engineering and Environmental Science Cornell University, 1992 Submitted to the Department of Urban Studies and Planning In Partial Fulfillment of the Requirements of the Degree of MASTER OF SCIENCE IN REAL ESTATE DEVELOPMENT at the MASSACHUSETTS INSTITUTE OF TECHNOLOGY September 2003 @2003 Jeffrey E. Hutchinson. All Rights Reserved. The author hereby grants to MIT permission to reproduce and to distribute publicly paper and electronic copies of this thesis document in whole or in part. Signature of Author: Je& F David Geltn Pr David Ge Cterdepartm ute son, Department of Urban Studies and Planning, August 4, 2003 Certified by: Real Estate F n Accepted by: in Real Estate Development MASSACHUSETTS INSTITUTE OF TECHNOLOGY AUG 2 9 2003 LIBRARIES ROTCH Master Lease & Leaseback of Government Owned Real Estate: A Model for a Fixed Income Investment Product By Jeffrey E. Hutchinson Bachelor of Science, Engineering and Environmental Science Cornell University, 1992 Submitted to the Department of Urban Studies and Planning In Partial Fulfillment of the Requirements of the Degree of MASTER OF SCIENCE IN REAL ESTATE DEVELOPMENT at the MASSACHUSETTS INSTITUTE OF TECHNOLOGY August 4, 2003 @2003 Jeffrey E. Hutchinson. All Rights Reserved. The author hereby grants to MIT permission to reproduce and to distribute publicly paper and electronic copies of this thesis document in whole or in part. Signature of Author: ffrof (Tionson,Department of Urban Studies and Planning, August 4, 2003 Certified by: David GefIe-r, Professor of Real Esta ce, August 4, 2003 Accepted by: David Geltner, Chairman, Interdepartmental Degree Program in Real Estate Development August 4, 2003 Master Lease & Leaseback of Government Owned Real Estate: A Model for a Fixed Income Investment Product By Jeffrey E. Hutchinson Submitted to the Department of Urban Studies and Planning on August 4, 2003 In Partial Fulfillment of the Requirements of the Degree of MASTER OF SCIENCE INREAL ESTATE DEVELOPMENT at the MASSACHUSETTS INSTITUTE OF TECHNOLOGY ABSTRACT: Throughout the United States, significant taxpayer capital is unnecessarily tied up in the ownership of state and municipal government buildings. Today, multiple state and municipal governments face record budget deficits, and are struggling to find ways to raise revenues and decrease annual operating costs in order to close these budget gaps. At the same time, substantial amounts of investor capital from both public and institutional funds, as well as private investors, sits idle, as there is a lack of opportunity for safe, moderate-return long-term investments in today's markets. This thesis investigates the benefits and drawbacks to an investment structure, similar to the commonly used corporate sale-leaseback, that can be used to free capital that is tied up in existing governmentowned real estate, while allowing governments to retain long-term ownership of these assets. It also presents the methodology for syndicating these investments into rate-able fixed income products, similar to municipal bonds or CMBS. These investments and the associated participation instruments create arbitrage opportunities for underwriters and syndicators of Government Lease Backed investments, and generate capital flows in the tens of billions of dollars. The models presented may be applied to federal, state and municipal government assets alike. However, this thesis focuses on the application of the models to assets owned by the State of California, as it currently has one of the most significant budget crises in the country, as well as the largest state-owned real estate portfolio. Thesis Supervisor: Professor David Geltner Title: Professor of Real Estate Finance Master Lease & Leaseback of Government Owned Real Estate: A Model for a Fixed Income Investment Product TABLE OF CONTENTS IN TROD U C TION .............................................................................................................................. 4 GOVERNM ENT-OW NED REAL ESTATE.......................................................................................................................4 CURRENT BUDGET DEFICITS.....................................................................................................................................4 CAPITAL M ARKET CONDITIONS ................................................................................................................................ THE M ASTER LEASE & LEASEBACK SOLUTION.........................................................................................................6 STATE OF CALIFORNIA .............................................................................................................................................. 5 . 7 STA TE OW NED RE A L E STA TE .................................................................................................... 8 OVERVIEW ................................................................................................................................................................ D OES THE PORTFOLIO FIT THE M ISSION? .................................................................................................................. A DVANTAGES OF STATE OWNERSHIP........................................................................................................................9 D ISADVANTAGES OF STATE OWNERSHIP...................................................................................................................9 KEY CONSIDERATIONS - SELL VS. HOLD VS. LEASE............................................................ 8 8 II. 10 THE CORPORATE SALE - LEASEBACK MODEL..............................................................13 III. OVERVIEW .............................................................................................................................................................. SELLER BENEFITS:...................................................................................................................................................15 SELLER D ISADVANTAGES........................................................................................................................................ BUYER A DVANTAGES.............................................................................................................................................. BUYER D ISADVANTAGES ........................................................................................................................................ M ASTER LEASE VERSUS SALE ................................................................................................................................. THE MASTER LEASE - LEASEBACK MODEL ................................................................... IV. 13 17 18 19 20 22 THE M ASTER LEASEHOLD INTEREST.......................................................................................................................22 THE GOVERNMENT LEASEBACK..............................................................................................................................23 VALUATION AND PROCEEDS....................................................................................................................................25 RATING THE LEASE INVESTM ENT ......................................................................................... V. CATEGORIZATION OF LEASES .................................................................................................................................. STATE CREDITWORTHINESS....................................................................................................................................28 ESSENTIALITY OF THE FACILITY..............................................................................................................................29 SECURITY FEATURES...............................................................................................................................................29 27 27 A SA MPLE TRA N SA C TION ..................................................................................................... 31 PROPOSED LEASE TERM S ........................................................................................................................................ V ALUATION.............................................................................................................................................................34 UNDERW RITING, SYNDICATION & ARBITRAGE.................................................................................................... ...................... SUM MARY ...................................................................................................................................... 31 V I. V II. T HE C A LIFORN IA MA RKET .................................................................................................. CALIFORNIA'S REAL ESTATE PORTFOLIO................................................................................................................38 H ISTORY OF SYNDICATION ..................................................................................................................................... OUTSTANDING ST ATE D EBT .................................................................................................................................... 35 36 38 38 39 VIII. C ON C LU SION ............................................................................................................................. 41 IX. A PPE ND ICE S .............................................................................................................................. 43 BIB LIO GR A PHY ............................................................................................................................. 51 X. INTRODUCTION INTRODUCTION CHAPTER1. CHAPTER I. I. INTRODUCTION GOVERNMENT-OWNED REAL ESTATE The US Federal Government, nearly all state governments, and hundreds of municipal governments collectively own and operate many millions of square feet of real estate throughout the country. The Federal Government, through the General Services Administration (GSA) owns 330 Million square feet in 1,700 buildings throughout the country '. The three most populated states; California, Texas and New York collectively own over 129 Million square feet of Space in more than 17,000 buildings, as outlined below: Table 1. - State-Owned Real Estate Portfolios California, Texas and New York Square Feet 102,085,726 9,955,213 17,700,000 +129,000,000 Buildings 16,955 70 126 +17,000 State California Texas New York Total: Does not include holdings associated with State University Systems. Sources: CA and NY Depts. of General Services, Texas Building and Procurement Division, July 2003. In many cases, it can be argued that the ownership and operation of these facilities is not critical to the mission of the various governments in providing services to their constituents, and that the ongoing cost of financing and operating these depreciating assets is not an advantageous use of taxpayer dollars. CURRENT BUDGET DEFICITS Currently the US Federal and many state governments are facing significant budgetary crises, as operating deficits exceed many billions of dollars: Table 2. Federal and State Budget Deficits Fiscal Year 2003-04 US Federal California New York Texas $307 Billion $38.0 Billion $9.3 Billion $3.6 Billion Sources: White House, CA, NY & TX State Government Web Sites. US General Services Administration, Public Buildings Service. PAGE 4 INTRODUCTION CHAPTER I. As illustrated, the State of California faces one of the largest budget gaps in the nation, with a projected shortfall exceeding $38 Billion for fiscal year 2003-2004. Issuing General Obligation (GO) bonds, to borrow money from the fixed income markets, has traditionally been a method that the State has employed to bridge budgetary shortfalls. However, with outstanding GO commitments of more than $25.0 Billion 2, the State is reaching its bonding capacity. To exacerbate this problem, California's GO bond rating was downgraded to BBB- by Standard & Poors during the week of July 2 1s', 2003, only one step above junk bond status. This not only hinders the State's ability to finance the deficit with GO bonds, but increases the cost of doing so substantially. As a result of these conditions, legislators face making significant cuts in government programs and services, as well as raising taxes and fees for services, placing further financial burdens their constituents. CAPITAL MARKET CONDITIONS While these enormous government-owned real estate portfolios remain un-leveraged and government budget deficits continue to hurt taxpayers, substantial investor capital remains sidelined, as there are few opportunities for secure, moderate-return, long-term investments. With the fallout in global stock markets since the spring of 2000, the current recession in the US, and continued recession in large foreign markets such as Japan, there has been a 'flight to quality' of investor capital. Seeking lower risk, investors have focused on more stable assets such as real estate or fixed income products such as treasuries and municipal bonds. However, fixed income investments have lust much of their luster. As the Federal Treasury has continually cut the Prime Lending Rate in an attempt to stimulate the faltering economy, yields on federal treasury and municipal bonds have correspondingly decreased to historic lows. Historic yields on various US Treasury securities are illustrated in the following figure. 2 California State Treasurer's Office, June 2003. PAGE 5 INTRODUCTION I. CHAPTER CHAPTER F.iu1THtiUTarYl Figure 1. - Historic US Treasury Yields Source: US Federal Treasury, July 2003. As we approach what many experts see as the 'bottom' of the yield curve, and interest rates seemingly have nowhere to go but up, investors face increasing interest rate risk in their fixed income portfolios. Additionally, competition for quality real estate investments is fierce. In the United States, which has one of the world's largest, most sophisticated and most transparent real estate investment markets, yields have been driven down by decreasing interest rates as well as a glut of capital investor capital. As many frustrated real estate investment experts have said, "There is too much money chasing too few good deals." THE MASTER LEASE & LEASEBACK SOLUTION As CFOs and treasurers of corporations, non-profits and NGO's have employed sale-leaseback structures to free-up capital for more mission critical uses, state and municipal governments can employ similar structures to leverage their existing real estate assets and generate revenues to finance critical government programs or new capital projects. The Master-Leaseback transaction closely follows the structure of the sale-leaseback. However, instead of purchasing the fee-simple interest in the property, the investor purchases a master leasehold interest, which corresponds to the term of a sublease of the property by the government. As described in detail throughout this thesis, this structure provides several benefits for taxpayers and investors alike: PAGE 6 CHAPTER 1. INTRODUCTION Benefits to Governments and Taxpayers: > Allows governments to leverage their credit rating to monetize their existing assets, freeing up capital to pay down previous obligations or fund ongoing programs; > Governments maintain ownership of structures that they have already financed; > Governments can continue to control and maintain facilities that are often critical to their identity and function; Benefits to Investors: > It represents a relatively safe long-term investment in a credit tenant; > Tax Exempt Status is granted at the federal level and at many state levels, on interest earned from these investments. > It provides an outlet for pent-up investment capital from pension and mutual funds, life insurance companies and private individuals; > The lease onligations of many state and municipal governments are rated by Moody's, Fitch's and Standard & Poors, providing an objective measure of risk to investors. In many cases investors can obtain a yield premium above the government's GO rating for essentially the same risk; > There is an opportunity for securitization and arbitrage of these investments by originators and syndicators. STATE OF CALIFORNIA Statutory conditions, including laws regarding municipal lease structures and annual appropriations, vary from state to state, making generalizations and universal methodologies difficult. However, the rationale and models investigated here can be adapted for application to many states and municipalities throughout the country. The analysis in this thesis focuses on the State of California, as it currently has one of the most significant budget crises in the country. In addition, California has the largest state-owned real estate portfolio, and a 20 year history of lease-backed and structured financings. PAGE 7 CHAPTER 11. CHAPTER II. II. STATE OWNED REAL ESTATE STATE OWNED REAL ESTATE STATE OWNED REAL ESTATE OVERVIEW As mentioned above and described in detail in Section V., the State of California currently owns over 102 Million square feet of real estate in more than 16,000 individual facilities. When including properties in the State university systems, this portfolio measures over 192 Million Square Feet in over 22,000 facilities. The development or purchase of many of these assets was financed directly with taxpayer dollars from State's General Fund or through State-Issued General Obligation (GO) bonds. In more recent cases, municipal lease obligation bonds have been issued to finance the development of State facilities, or provide a security interest to Landlords leasing space to various State agencies. Depending upon factors such as structure and timing of the bond issuance and the State's corresponding credit rating, the annual interest costs to taxpayers for these bonds is substantial. DOES THE PORTFOLIO FIT THE MISSION? What is the mission of the State Government? Is it to develop, invest or own and operate real estate? Many argue that, overwhelmingly, the answer is no. The general role of government is to provide support and services to promote and protect the security, health and well being of its constituents. Typical services include: > Fire Protection > Educational Services > Health Services > Utility Services > > > Communication Services Transportation Facilities and Services Security (Police, National, and Civil Defense) In some cases, such as civil or national defense, utilities or telecommunication, the ownership and control of certain facilities is considered necessary or critical to the government's mission. However, in many cases, the government's ownership of the physical facilities is not required in order for them to effectively provide resources or services to constituents. PAGE 8 STATE OWNED REAL ESTATE CHAPTER 11. As treasurers and CFO's of corporations, non-profits and NGO's alike have realized, ownership of real estate does not increase their ability to generate value for shareholders or enhance their ability to carry out their various missions. Recent market conditions and evolving transaction structures have allowed these organizations to carry out sale-leaseback and even synthetic lease transactions that have enabled them to re-deploy capital for mission critical uses, while maintaining occupancy and control of preferred facilities. These models can be applied to state and municipal governments as well. ADVANTAGES OF STATE OWNERSHIP From the perspective of corporations, state and municipal governments alike, one of the most significant advantages of real estate ownership is control. Historically, corporations and governments have desired to control the design and development of key facilities, such as headquarters, capitals and other landmark buildings that contribute to their identity and place in business or society. Additionally, having autonomy over configuration, maintenance and capital upgrades at their facilities enable these institutions to amend their operations and the use of their space to meet evolving needs or changes to their mission. However, there are a variety of lease structures available to corporate and government tenants that can provide them with a high degree of control over their facilities. As will be discussed in Chapter IV, Bond Lease or Triple Net (NNN) leases to a single tenant can be structured to provide the tenant with complete autonomy and control over the property. In exchange for such autonomy, tenants must also take substantial responsibility for property management and capital repairs, and for all costs associated with operating the property. In terms of enhancing or preserving the institution's identity, building naming or signage rights can often easily be negotiated for tenants who are sole or majority occupiers of the building. DISADVANTAGES OF STATE OWNERSHIP There are several disadvantages to the ownership of real property that are specific to state or municipal governments versus private individuals or corporations: > No Appreciation - Unlike private or corporate-owned, state owned real estate is primarily a cost rather than an investment. Since States are rarely sellers of properties, taxpayers do not receive the benefit of appreciation of these properties, essentially hindering the taxpayer's return on these financed assets. PAGE 9 1-1_1__1_-__,_'.__ 11 1- I -- - "itlj"j" CHAPTER 1I. CHAPTER II. - - - - - STATE OWNED REAL ESTATE STATE OWNED REAL ESTATE Increased OperatingExpenses - States are often required to hire more expensive union labor for landscape, operation and maintenance of its facilities. Therefore, taxpayers tend to carry a higher operating expense load than do owners and investors in privately held and operated facilities. > Asset Management - States with large real estate portfolios must carry substantial overhead associated with managing, maintaining and making improvements to their assets. Rarely does this ongoing expense translate into better facilities and services for the state's constituents. > Non-Optimal Use of Capital- When States own and operate substantial real estate portfolios, the taxpayers have made and investment in fixed depreciating assets versus, mission critical programs and operations. The credit worthiness (bond rating) of these institutions is better leveraged to fund programs that achieve their mission rather than to build or own real estate. KEY CONSIDERATIONS - SELL VS. HOLD VS. LEASE Today, government administrators face a diverse array of budgetary and operating challenges. Budgets and resources are reduced, and funding the immediate and long-term needs of the constituency has become more difficult. As states review their real estate portfolios and analyze methods to monetize their assets, they must weigh the advantages of ownership, disposal or leaseback on an asset-by-asset basis: Asset Attractiveness The attractiveness of different assets to different investors must be considered when conducting a sellhold-lease analysis. For example, a well-located and well-constructed office property may attract a variety of investors who will place a premium the asset's quality and location. This may provide an opportunity to for the state to obtain increased proceeds through a sale to investors who foresee asset appreciation, with relatively little asset or leasing risk. Selling and leasing back in such a scenario allows the state to obtain high proceeds while securing long-term use of a key facility. On the other hand, an office property that is not as well located or constructed will likely attract only those who wish to invest in the credit of the State. They will pay for the income over the lease term but are not interested in taking on any asset or leasing risk at the end of the lease obligation. In this case, a PAGE 10 , , -1 -1- I - _- STATE OWNED REAL ESTATE CHAPTER 11. Master Lease & Leaseback may be the best opportunity to leverage the state's credit, while retaining any benefits of future property ownership. Useful Life The age of a given asset is another key consideration in the analysis. An older property, which may be approaching the end of its useful life will be less likely to attract purchase investors, or will be discounted because of its age, reducing the potential proceeds from a sale. In the case of an older property, the only opportunity for monetization may be through a lase structure, where the investor is paying solely for the credit of the tenant over the term of the lease. However, proceeds available through this alternative may be limited, as investors will only agree to a lease term that does not exceed the expected useful life of the property. In many cases, the best option for the state is to continue to own and operate an older facility at the lower basis, as long as operating and improvement costs do not become prohibitive. Market Conditions Market conditions including prevailing rents and vacancy rates are a key factor in the analysis that the State must undertake. In a market characterized by high rents, the State may be better off either selling the asset, or continue to own it using traditional mortgage financing or even General Obligation (GO) bond financing, without bearing the additional costs of high lease payments. However, in a low rent environment, it may be advantageous for the state to enter a long-term lease, and secure the long-term use of key facilities at the lower rates, while using the proceeds to fund other facilities or programs. Table 3. Matrix of State Sell/Hold/Lease Considerations Sell Well Built & Located X X Newly Built Aging Asset High Rents Low Rents X X X Master Lease Hold/Own Less Competitive Market Conditions Asset Age Asset Characteristics Monetizing Strategy X X X X PAGE I I CHAPTER IL. STATE OWNED REAL ESTATE Strategic Implications In addition to the above-mentioned quantitative or monetary considerations, states must weigh more strategic implications when reviewing their real estate strategies. In many cases, states may desire the ownership of key facilities such as capital buildings or legislative offices, as symbols of their identity and sovereignty. Security, defense or critical communication and infrastructure nodes may also require the strict control and autonomy that comes with ownership. They may also wish to control property in a given neighborhood in order to preserve their option to expand. PAGE 12 THE CORPORATE SALE - LEASEBACK MODEL CHAPTER 1II. THE CORPORATE SALE CHAPTER III. - LEASEBACK MODEL THE CORPORATE SALE - LEASEBACK MODEL III. OVERVIEW Corporate ownership of real estate has been popular in the United States for much of the past century, and many U.S. companies still maintain real estate portfolios. However, as many treasurers and CFO's throughout the world have realized, ownership of real estate does not necessarily increase their ability to generate value for shareholders. Recent market conditions and evolving transaction structures have allowed corporations to carry out sale-leasebacks that have enabled them to re-deploy capital for mission critical uses, while maintaining long-term occupancy and control of preferred facilities. In a typical sale-leaseback transaction, a property owner sells real estate used in its business to an unrelated private investor or to an institutional investor. Simultaneously with the sale, the property is leased back to the seller for a mutually agreed-upon time period. Leases are usually longer-term in nature, and can run anywhere from 5 to 20 years, with the average lease term being 10 to 15 years, with renewal options 3. A schematic of a typical sale-leaseback transaction is provided in Figure 2. Key components of a Sale-Leaseback transaction include: > The property involved in a sale-leaseback may include either or both the land and the improvements. > Lease payments typically are fixed to provide for amortization of the purchase price over the term of the lease, plus a specified return rate on the buyer's investment. >0 The typical transaction usually involves a triple-net-lease (NNN) arrangement. > Sale-leasebacks often include an option for the seller to renew its lease, and on occasion, re-purchase the property. Key accounting and tax rules are applied differently to states then they are to corporations, and specific legislative or statutory restrictions can impact the applicability of the Corporate Sale-Leaseback model to an individual State or municipal government. In particular, it may require a vote or specific legislative authority for a State to actually sell a given property. However, several advantages and disadvantages to this structure do transfer to the Master Lease - Leaseback model, and are discussed here. 3 Barthell, 2001. PAGE 13 THE CORPORATE SALE - LEASEBACK MODEL THE CORPORATE SALE - LEASEBACK MODEL CHAPTER III. CHAPTER III. Figure 2. Schematic of Typical Sale-Leaseback Transaction Fee Interest in Land & Improvements vest TOO ~ nLegal Corporation Sale Transaction Costs: Brokerage Fees Fees Title & Escrow Costs Long Term Lease in Improvements Investor Benefits: * Large Transaction/Investment * Long-Term Credit Income; * Asset Appreciation; * Depreciation Deduction. Lease Transaction Costs: Legal Fees Recording Fees Corporate Benefits: * Cash Proceeds; * Better Balance Sheet Accounting; * Long-Term Lease Lock; * Control and Occupancy of Preferred Location; * Deductability of Rent Payments Investor Risks: * Lesee Default or Bankruptcy * Fire/Hazard Risk Corporate Risks: * Buyer Bankruptcy; * Loss of Inflation Hedge; * Market Rent Risk. PAGE 14 .......... CHAPTER 1II. CHAPTER III. THE CORPORATE SALE - LEASEBACK MODEL THE CORPORATE SALE - LEASEBACK MODEL SELLER BENEFITS: Free Up Capital- Sale-leaseback financing can enhance a company's financial performance by freeing up credit facilities needed for accounts receivable, inventory, growth, and expansion. It also indicates to the investment community the company's commitment to transform previously under-performing assets into cash for growth or other sound business reasons. The same can be said for freeing up capital in government-owned assets. Master lease proceeds can be used to fund or pay down GO bond obligations, or increase value to taxpayers by funding ongoing government service programs. Avoidance of Debt Restrictions - Businesses restricted from incurring additional debt by prior loan or bond agreements may be able to circumvent these limits by using a sale-leaseback. Rent payments under a sale-leaseback usually are not considered indebtedness for such purposes, thus a business can meet its cash needs through the sale-leaseback without violating any previous agreements 4. Similarly state governments that have approached their bonding limits, who do not want to impact their credit ratings, or bear the expense of further bond commitments can use these transactions to generate proceeds. In the case of California, GO bond issuance is subject to a super majority vote (2/3) of the electorate, and there are substantial administrative and time requirements to carry out Bond financings. Municipal leases and the issuance of associated Certificates of Participation (COPs) do not face the same regulatory or bureaucratic hurdles. Maintain Asset Control - As a single tenant signing a Bond or NNN lease, corporations are granted substantial control and effectively, possession of their facilities throughout the term of the lease. Under the Master Lease structure, the State continues to hold title to the property throughout the term of the lease, and reclaims all rights and opportunities of ownership at the end. Renewal Opportunity -A sale-leaseback also usually provides the corporate seller with renewal options at the end of the lease term, while conventional mortgage financing provides no guarantee for refinancing. In the case of a state Master Lease, states are unlikely to recommit to a lease without receipt of additional proceeds. This would require re-evaluation of the facility and the credit of the State, and a renegotiation of the lease and proceeds paid to the seller. 4 Barthell, 2001. PAGE 15 THE CORPORATE SALE - LEASEBACK MODEL CHAPTER III. Leveraging Credit - In a typical purchase transaction, investors may only be able to leverage 70% to 80% of a given assets income (credit) value at lower debt-like rates. However, in a longer-term leaseback transaction, the investor is taking little or no asset risk, and the cost of nearly all of the investment capital will be based on the tenant's credit rating. This will have the effect of reducing the rent that must be paid by the tenant, and/or increasing the proceeds paid for the ownership interest. Advantageous Market Conditions - As a result of the recent economic recession, which has been particularly acute in California, office and industrial vacancy rates are at recent historic highs throughout the State: Figure 3. Historic Office Vacancies in Major CA Markets 25.0 23.0 21.0 19.0 17.0 _ S15.0 S13.0 >. 11.0- 9.07.0 5.0 Q2/01 -+- Q3/01 Q4/01 Q1/02 Q2/02 Q3/02 Los Angeles - Sacramento -0- Q4/02 Q1/03 Q2/03 San Francisco Source: Grubb & Ellis Company, July 2003. Figure 4. Historic Industrial Vacancies in Major CA Markets 20.0 18.0 14.0 - 1600 12.0 - 10.0 8.0 4.0 2.0 ~:-u 0.0 Q1/01 Q2/01 Q3/01 Q4/01 Q1/02 Q2/02 Q3/02 Q4/02 Q1/03 Q2/03 -4- Sacramento --- Los Angeles -k Silicon Valley Source: Grubb & Ellis Company, July 2003. PAGE 16 CHAPTER 111. CHAPTER III. THE CORPORATE SALE - LEASEBACK MODEL THE CORPORATE SALE - LEASEBACK MODEL As a result of the glut of vacant space in the San Francisco and Sacramento office markets , and in the Sacramento and Silicon Valley industrial markets, market rents in these locations have correspondingly reached recent historic lows. Entering into long-term leases at this point in the market cycle allows sellers or master lessors who wish to become tenants, to negotiate from a point of strength and effectively 'lock in' valuable properties at lower rates. Obviously, lower rent levels will reduce the proceeds that credit investors will pay for the lease interest. However, treasury rates, and corresponding discount rates are also at historic lows (Figure 1.). Since discount rates are stronger levers of present value than incremental changes in income, the effect of lower rents should be offset, and substantial capital can be released through these transactions. Lower TransactionalCosts - In a Sale-Leaseback, the seller can often structure the initial lease term for a period that meets its needs without the burden of balloon payments, call provisions, refinancing, or the other issues of conventional financing. Moreover, the seller avoids the substantial costs of conventional financing such as points, appraisal fees, and some legal fees '. Improved Balance Sheet and Credit Standing - In a sale-leaseback, the seller replaces a fixed asset (the real estate) with a current asset (the cash proceeds from the sale). If the lease is classified as an operating lease, the seller's rent obligation is usually disclosed in a footnote to the balance sheet rather than as a liability. This results in an increase in the seller's ratio of current assets to current liabilities, which translates to a better ability to service short-term debt obligations 6. SELLER DISADVANTAGES Loss of Flexibility - The seller as the new lessee loses the flexibility associated with property ownership, such as changing or discontinuing the use of the property or substantially modifying a building. The saleleaseback often restricts the seller's right to transfer its lease interest. Generally it is more difficult to dispose of a leasehold interest than a fee-ownership interest. In the Master Lease model, the State retains title over the property, throughout and after the lease term. As long as the rentable square footage or income generated from the lease is not impacted, the State can maintain authority and control over configuration and improvements. 5 Valachi, 1999. 6 ibid. PAGE 17 CHAPTER 111. THE CORPORATE SALE - LEASEBACK MODEL Risk of Buyer Bankruptcy - If the buyer in a Sale-Leaseback files for bankruptcy, the bankruptcy trustee may reject any agreement to renew the leaseback or the seller's option to purchase the property. This is not a risk in the Master Lease structure, because the Master Lease interest holder is a bankruptcy-remote, single purpose entity or trust, whose sole reason for existence is to receive and redistribute income from the Master Lease. Higher Cost ofFinancing- The interest rate in a sale-leaseback arrangement generally is higher than what the owner would pay through conventional mortgage financing. The same hold true for a municipal Sale or Master Lease - Leaseback. As discusses in Chapter V the rating given to a State's lease obligations is generally H step below that of its General Obligations (GO) bonds. TransactionalCosts - The cost of negotiating a Sale-Leaseback may be higher, because substantial time and effort may be required to tailor the transaction to meet the seller's needs. In a Master Lease arrangement, there is no transfer of title or time required for escrow and closing formalities. As a result these transactions are often speedier and less costly BUYER ADVANTAGES Higher Return Rate - The investor can receive a higher rate of return in a sale-leaseback than in a conventional loan arrangement. In addition, at the end of the lease term, the buyer receives the benefit of any appreciation in the value of the property. Finally, the buyer can leverage the purchase with mortgage financing; this may further magnify the return rate on the cash invested. In the case of a state master lease transaction, the investor will likely receive a premium over the state's corresponding GO interest rate, for essentially the same risk. Predictableand Secure Return Rate - The long-term net lease enables the buyer to estimate accurately the expected future rate of return. Also, the extended term of the lease provides the buyer with protection from downturns in the real estate market and an inflation hedge, assuming that the property value appreciates over time. In the case of a master lease, this advantage is lost, because ownership and any asset appreciation remains with the State. Therefore, investors will have to consider interest rate risk as part of their analysis and valuation. PAGE 18 CHAPTER 111. THE CORPORATE SALE - LEASEBACK MODEL GreaterEase in Handling a Seller Default - In the event that the seller defaults under the lease in a SaleLeaseback, the buyer can simply terminate the lease and have the seller evicted. The buyer bears the risk of finding another tenant after the eviction process is completed. As discussed in Chapter V., this is not so straightforward in a master lease - leaseback, when the tenant is the owner. A different form of security interest is required for the seller to mitigate the state's default, which is usually caused by a non-appropriation of lease funds. Ownership of the Reversion - The buyer owns the reversionary interest in the property. If the seller has an option to purchase or an option to renew the lease, this may limit or postpone the time that the buyer actually realizes the profit potential. The buyer also bears the risk that the property value actually might decline over the lease term. In the case of a Master Lease, the buyer does not receive the benefit of a reversion or any associated property appreciation. BUYER DISADVANTAGES Possibilityof Seller Default - Perhaps the biggest risk that the buyer faces in a Sale-Leaseback is that the seller will default on the lease, which would leave the buyer without a tenant. If the seller files for bankruptcy, the buyer is considered a general creditor. If the arrangement were a conventional mortgage, the buyer would be considered a secured creditor. If the seller files bankruptcy in a soft real estate market, the buyer may have a difficult time finding a new tenant. In a state Master Lease and Leaseback, the risks are non-appropriation, or the Bankruptcy of the State. The municipal markets and key rating agencies closely monitor the fiscal health of state governments. Although possible, the risk of state bankruptcy is very remote. The more imminent risk to a state leaseholder is non-appropriations risk, and as discussed in Chapter V, this risk varies from state to state. In the case of California, State lease-backed obligations are backed by the full faith and credit of the state. Similar to traditional GO Bond financing, holders of the bonds are considered secured creditors in the event of Bankruptcy and do not typically face annual appropriations risk. Higher Administrative Costs - Because the typical sale-leaseback usually must be structured to meet the specific needs and requirements of both parties, it may require more time and increased administrative costs than a conventional loan transaction. PAGE 19 CHAPTER 1II. THE CORPORATE SALE - LEASEBACK MODEL RequiredPropertyManagement - In most cases, the seller assumes the responsibility and expense of dayto-day property management during the lease term. However, the buyer must make sure that the seller pays the property taxes on time and that tax assessments are reviewed and challenged when appropriate. The buyer also must periodically review the insurance coverage on the property and inspect it for proper maintenance. State and municipal properties are exempt from paying property taxes, so this obligation and administrative concern is removed from the purchaser of the Master Lease holder. In addition, the condition of the property throughout, and at the end of the lease term is not typically a liability of the Master Lease holder. FinancialAccounting Implications - Sale-leaseback accounting has its own GAAP authority. For the asset to be considered off-balance-sheet, the leaseback must be an operating lease, versus a capital lease. If the lease is classified as a capital lease, which means that the transaction is essentially a purchase by the lessee, the advantages of the sale-leaseback arrangement from an accounting perspective are altered considerably. Statement of Financial Accounting Standards No. 13 on accounting for leases requires that a capital lease be recorded as an asset and capitalized and requires the obligation to make future lease payments to be shown as a liability. Four key restrictions of FASB 13 determine operating versus capital lease designation: > PV of rental payments (including termination or non-renewal penalties) must be less than 90% of market value of property; > Primary lease term must be less than 75% of remaining useful life of property; > The Lease cannot transfer ownership to lessee during term; > The Lease cannot contain option to purchase option to purchase at discount. MASTER LEASE VERSUS SALE For economic purposes a properly structured master lease interest is nearly equivalent to a fee-simple ownership interest. By providing a master lease interest rather than a fee-simple interest to an investor, a given state or municipality can effectively go around legislative or statutory restrictions that would prohibit it from conducting a sale, while reaping much of the economic benefit. Other reasons that a master lease structure is more advantageous than an actual sale include: PAGE 20 CHAPTER 111. CHAPTER III. THE CORPORATE SALE - LEASEBACK MODEL THE CORPORATE SALE - LEASEBACK MODEL Lower Transactional Costs - Sellers of real property must pay brokerage commissions and legal fees, as well as their share of title, escrow and transfer taxes involved in the transaction, which can approach 3% to 5% of the sale value and reduce the amount of the proceeds actually received. Asset Quality - Typically, government owned properties are not of Class-A quality, and are often in less advantageous locations than competitive, privately owned properties, and investors will be investing more in the credit of the tenant than in the physical attributes of the real estate. A master Lease and leaseback will allow the government to maximize its credit value over the term of the lease, as it is unlikely that a discount will be applied for asset quality or risk. PAGE 21 CHAPTER IV. CHAPTER IV. IV. THE MASTER LEASE - LEASEBACK MODEL THE MASTER LEASE - LEASEBACK MODEL THE MASTER LEASE - LEASEBACK MODEL Economically, a Master Lease - Leaseback transaction is very similar to a Sale - Leaseback. However, structurally and contractually there are differences and characteristics specific to a Master Lease format that are advantageous for both government entities and investors alike. A schematic of the structure of this transaction is provided at the end of this chapter in Figure 5., and a discussion of its key components follows below. THE MASTER LEASEHOLD INTEREST The Entity In a Master Lease of a government facility, a single-purpose, bankruptcy-remote entity must be formed to hold the interest, collect and distribute income from the lease. The entity is typically a trust that is formed at Lease inception and dissolves at the conclusion of the term. This is necessary in order to prevent the leasehold interest, escrowed reserves other economic interests of the state from being claimed and transferred to another party through bankruptcy proceeds. Structure A typical master lease interest is an economic interest in the operations and income generated from the property. The interest is usually limited to the built improvements, and does not include the land. Title to the land and improvements of the property remains with the State, and the Master Leaseholder does not participate in any appreciation of the asset. Regulations vary from state to state regarding whether property taxes are payable on a leasehold interest in real property. However, in most states, state and municipalities are precluded from paying property taxes, and in structures where the state remains as the fee owner and title holder of the property, there is not a requirement for payment of property taxes. Term The term of the Master Lease typically runs concurrent with the associated sub-lease back to the state agency. This prevents exposure of the trust and its assignees to leasing risk or operating liabilities beyond the term of the agreement. PAGE 22 CHAPTER IV. THE MASTER LEASE - LEASEBACK MODEL Insurance The master lessee requires certain insurances to be in place to protect its economic interest in the asset. This includes protection from fire, hazard, and in the case of California, earthquakes. Since the State continues to be the sole occupier and operator of the property under the corresponding sublease agreement, they will typically carry these insurance policies and will indemnify the master leaseholder from any claims arising from loss or injury from such occurrences. Assignment Rights The Master Lease interest is held in a specially formed trust and is typically not assignable to other parties. As discussed later in Chapter VI, the trust may syndicate and issue Certificates of Participation (COP) to allow other investors participate in the lease income. THE GOVERNMENT LEASEBACK Although the Master Lease provides for the long-term 'ownership' rights of the investor, the terms and structure of the accompanying Leaseback or Sublease agreement, with the State agency as the tenant, is the key component that determines the value and security of the Master Leasehold investment. Leaseback Type There are three basic sublease structures that can be used in these transactions. A brief description of each of the three follows: Bond Lease - In a bond lease, the tenant (State) is wholly responsible for all aspects of the property and its operation throughout the lease term, including liability for casualty and/or condemnation events. All base rent is payable by tenant without any right of abatement or offset under any circumstance. The tenant typically indemnifies the landlord, or in this case, the Master Lease holder against all liabilities arising from its use or occupancy of the property. The tenant's only right to terminate the lease is based upon a condemnation, in which case tenant must purchase the Master Lease interest in the property for at least the un-amortized balance of its sublease payments. Triple Net (NNN) Lease - This lease is very similar to a bond lease, except the tenant has the right to terminate the lease or abate rent due to an event of casualty to or condemnation of a portion or all of the PAGE 23 CHAPTER IV. THE MASTER LEASE - LEASEBACK MODEL property. Lease enhancement policies, arranged at the borrower's expense, are required in such instances to insure over the risk of rent abatement or lease termination. Double Net (NN) Lease - This lease mimics a NNN lease, except the lessor will have certain ongoing obligations with respect to the property. The failure to perform the obligations could result in the tenant (State) having the right to abate rent or terminate the lease. Typically, such obligations include maintenance, repair and replacement obligations for roof, structure and parking. Additional debt service coverage and maintenance and repair reserves are required in such instances. Additionally, lease enhancement policies are required to insure over the casualty and/or condemnation risk. For the purposes of the model presented here, and in most leaseback transactions that have occurred in California, the preferred arrangement is a NNN lease. This provides the State with complete freedom of use for the property, and requires it to assume all real estate risks and obligations of ownership. However, since the State is not issuing a separate bond to guarantee payment of the lease, it is generally provided a rent abatement in the event of casualty or condemnation Term of Leaseback Key considerations in determining the appropriate length of the leaseback of the facility to a State agency include the age and condition of the property and historic tenancy of the property, as well as the mission, solvency and perceived longevity of the occupying agency. Investors must review the history of the facility, as well as the importance and historic funding of the occupying agency (tenant), and commit to a lease term which is appropriate to these conditions. In no case should the lease extend beyond the useable life of the property. Typically, lease terms average 10 to 15 years Security Interest The biggest risk to investors in government leases is non-payment of lease rent resulting from nonappropriation. Typically, states and municipal governments may enter into long-term leases for facilities, but the availability of funds to pay the lease rents is subject to approval in the agency's annual operating budgets. A holdback of investment proceeds is one method that is commonly employed to provide greater security from appropriation risks Proceeds Holdback - A reserve or holdback of a portion of the proceeds payable to the state for the lease is held in reserve as a security against default or non-appropriation. Typically, a reserve amounts to a 7 Valachi, 1999. PAGE 24 CHAPTER IV. THE MASTER LEASE - LEASEBACK MODEL percentage of the total proceeds that is enough to cover at least one years worth of rental payments from the state. This is usually held in an interest bearing escrow, with the interest either being credited against the rent due each year, or accruing for the benefit of the state and released at the end of the term. Sublease and Assignment Rights Over a 10 to 20 year period, state agencies may alter the way that they utilize their space. Granting the state or agency the right to sublease a portion or all of the space is not an issue, as long as the state maintains responsibility for the lease payments. Assignment rights are usually not as easily granted, and are typically only allowed in the case of one state agency assigning its lease to another. Insurance The lessee should agree to maintain the leased property in good repair and to insure it against loss or damage in an amount at least equal to the lease value. If lease payments are subject to abatement in the event the property is damaged, destroyed, or taken under a provision of eminent domain, the lessee must typically maintain business interruption insurance. VALUATION AND PROCEEDS Proceeds paid for the lease are derived using a typical present valuation methodology. The schedule of net lease income is discounted back over the term of the lease at a rate commensurate with the State's credit rating, plus a premium for any perceived appropriation or asset risks. Effectively, the discount rate applied equates to interest paid for borrowing against the State's future revenues. In some states, lease investments do not have the same "full faith and credit" backing as municipal General Obligation bonds. As described in Chapter V., these investments are rated at least one notch lower than a state's GO rating by rating agencies, and a risk premium is added to the discount rate. This results in more expensive 'borrowing' by the state. In California, where lease obligations are backed by the 'full faith and credit' of the State, they are generally rated % notch below the state's GO Bond rating, resulting in a less significant discount. PAGE 25 THE MASTER LEASE - LEASEBACK MODEL THE MASTER LEASE - LEASEBACK MODEL CHAPTER IV. CHAPTER IV. Figure 5. Schematic of Master Lease-Leaseback Transaction Master Lease Interest in Improvements State Government Lease Transaction Costs: Legal & Recording Fees Underwriting Fees Long Term Sub Lease in Improvements h-Yield Fixed Income Invest Mutual Funds Private Investors Lease Transaction Costs: Legal & Recording Fees Insurance Fees Government Benefits: * Cash Proceeds; * Long Term Lease Rate; * Control and Occupancy of Preferred Location; Undrrtr Investor Benefits: * Long-Term Credit Income; * Opportunity to Syndicate & Arbitrage Investor Risks: * Non-Appropriation * Fire/Hazard Risk Government Risks: * Loss of Inflation Hedge; * Market Rent Risk. PAGE 26 MI 11111OWM, - - - , IOW I i W , 111-,--_-_ -1 -1 __ -, ," " -,- , - - . - . 0, oil CHAPTER V. CHAPTER V. RATING THE LEASE INVESTMENT RATING THE LEASE INVESTMENT RATING THE LEASE INVESTMENT V. A key component to valuing the income stream from the lease investment and determining the proceeds that will be paid to the State in the transaction is the rating that the State's leaseback obligation is given by agencies such as Fitch Ratings, Moody's Investor Services and Standard & Poor's (S&P). These rating agencies have developed a thorough set of criteria for rating municipal leases and associated investment certificates. CATEGORIZATION OF LEASES The ratings these agencies apply to lease-backed securities can vary widely, depending on the credit strength of the tenant (State) and the structure and terms of the lease. Also, constitutional and statutory laws regarding the structure of leases differ amongst the states. However for rating purposes, municipal leases are categorized in one of two ways: > Leases resembling long-term debt, or > Higher-risk obligations requiring annual appropriations and having limited legal remedies. Debt-Like Leases Ratings for the first category reflect the long-term and binding nature of the lease. In cases where the lease is long term, and the legal recourse to leaseholders is similar to that of a long-term debt holder, ratings may be as high as the State's senior General Obligation (GO) debt rating. In the case of California, existing lease-purchase revenue bonds are generally backed by the 'full faith and credit' of the state, and are funded out of the appropriate State agency's operating budget. As a result, their credit rating is generally half a step below the GO bond rating. Leases with Appropriations Risk The second category involves leases that depend on budgetary appropriations by the State, and legal remedies are limited in the event of non-appropriation. Because of the risk that lease payments may be terminated before the end of the term, ratings on these transactions would be lower than the State's full faith and credit rating. Typically, the lease rating is one full category below 8. ' Standard & Poor's, 2000. PAGE 27 RATING THE LEASE INVESTMENT CHAPTER V. To rate a lease transaction requiring annual appropriations, Standard & Poor's evaluates the following: > General creditworthiness of the State; > Essentiality of the leased property; > Security features in the lease agreement. STATE CREDITWORTHINESS As a tenant, a state's general creditworthiness is reviewed in the same way as it's Credit Rating, or as if it were issuing General Obligation (GO) bonds. The State of California has historically maintained what is considered a high 'investment grade' credit rating. Investment Grade ratings are those that are rated A or above by the key rating agencies. The table below provides a summary of California's current credit rating by the various rating agencies. Table 4. State of California Credit Rating Rating Agency Fitch Ratings GO Bonds as of July 31, 2003 Best Attainable Rating CurrentRating AAA A Moody's Investors Service Standard & Poor's A2 Aaa BBB AAA Source: CA State Treasurers Office, July 28, 2003. The above ratings are on General Obligation (GO) bonds, which are the highest quality debt instruments issued by the State of California. The General Obligation (GO) bonds are backed by the full faith and credit of the State of California. Ratings on these bonds are what people usually refer to when speaking on the subject of a state or municipality's credit rating. It is worth noting that all three agencies lowered their ratings on California's GO Bonds in late 2002 and early 2003, citing the State's "inability to sufficiently address the 2003-04 fiscal year imbalance," and that the anticipated level of deficit would likely exceed the State's level of other borrow-able funds 9. Lower credit ratings not only hinder the State's ability to issue new bonds, but also increase the cost of doing so substantially. To further exacerbate the problem, Standard & Poor's downgraded California's GO bond rating three notches further to BBB during the week of July 2 1 ', 2003. This credit rating is just one step above 'junk' status. 9Califoria State Treasurers Office, July 2003. PAGE 28 .- 1-,&_1 -1-i---,,_ _ _- - - I ft , - -1- - - CHAPTER V. 9 4 11 -_ -1 RATING THE LEASE INVESTMENT ESSENTIALITY OF THE FACILITY The risk for non-appropriation is a key risk for the lessor/investor and, by assignment, any security or certificate holder of the lease investment. As investors pursue the leaseback and securitization of Stateowned assets, it is necessary to understand these risks as they apply to individual assets. Annual appropriation often depends on the importance of the leased property in providing essential governmental services. Services generally considered to be most essential by agencies such as S&P include police and fire protection, general government or courthouse facilities, or utility services. The rating rationale follows the idea that funding for facilities and services considered important to the state's operations are more likely to receive appropriations '0. While there is no precise formula to calculate a facility's importance, agencies like Standard & Poor's ask the following questions when evaluating lease issues: > Is the facility vital to the community, could the government function properly without it? > How does the facility tie into the government's total delivery system? > What would be the impact of not providing the facility or terminating the lease agreement before the end of the lease term? > Would it be practical, either financially or within time restrictions, for the government to accomplish its mission through or in another facility? After determining a facility's importance to the State, the length of the lease term also figures into the essentiality equation. In all cases, the lease obligation term should not exceed the estimated useful life of the asset(s). SECURITY FEATURES The history of legislative authorizations for lease financings, prior leasing experience, and the intent of the lessee are important in determining lease ratings. However, these factors are not substitutes for adequate legal protections. 10Standard & Poor's, 2000. PAGE 29 RATING THE LEASE INVESTMENT CHAPTER V. A lease contract's legal features, for the most part, must meet Standard & Poor's basic criteria to achieve an investment grade rating. Their absence, or their deviation from the basic criteria in a significant way, may adversely affect the rating Appropriation and Term The following lease appropriation features are viewed positively by Standard and Poors. Their absence or significant variation may adversely affect the rating: > The useful life of the leased property or project matches or exceeds the term of the lease contract. > The term of the lease contract matches the term of the bond issue or certificates of participation, avoiding exposure on renegotiation; if state law prohibits long-term leases, > The lease payments represent installments toward an equity buildup in the leased property. At the end of the lease and, all outstanding principal and interest should be repaid to the investor, allowing ownership of all interests in the property to revert to the lessee. > The lessee (State) agrees to request appropriations for lease payments in its annual budget. > For California lessees, the lessee covenants to appropriate lease payments, subject to abatement in the event the leased property is not available for use. Although Standard & Poor's also rates annual appropriation-style leases for California issuers, abatement leases are viewed favorably for their accruing characteristics 12 Security interest. Security interest is a common lease feature, in which the lessee grants the lessor - or the trustee collateral of security to protect the lessor in case of event of default or non-appropriation. In the case of such an event, the lessor, or its assignee, has the right to some form of possession of the leased asset, or receives refunds or deposit monies from its investment to compensate for its loss. A lack of security interest does not automatically mean that the transaction cannot achieve an investment grade rating. Rating agencies will evaluate the transaction within the context of the that state's laws and the government's specific circumstances, but this feature should be included if it is available. " Standard & Poor's, 2000. 12 ibid. PAGE 30 A SAMPLE TRANSACTION A SAMPLE TRANSACTION CHAPTER VI. CHAPTER VI. VI. A SAMPLE TRANSACTION This section investigates the application of the Master Lease - Leaseback transaction model to an existing State-owned office building in the Capital District of Sacramento, California. It will provide an example of methodologies for deriving key lease terms as well as the resulting valuations and syndication structures that are likely in the investment markets. An analysis of the benefits, drawbacks and fiscal impacts to the State is also provided. Urban office properties are typically given a high investment priority by institutions, as well as individual investors, and provide a good case to apply the model presented here. Details regarding key physical aspects of the asset, as well as operational and tenancy information are provided below: Table 5. CA State Office Property Details Address: Building Type: Mid-rise Office, Class-A Twenty Stories: Construction: Year 450 N Street, Sacramento, CA Built: Net Rentable Area: Current Tenant: Length of Tenancy: Use: (20) Concrete and Steel 1991 501,060 sq. ft. California Board of Equalization Twelve (12) Years Headquarter Office The office building at 450 N Street was funded and developed by the state's largest pension fund, the California Public Employees Retirement System (CALPERS) in 1991. Located in the heart of the State Capital District, the building was a build-to-suit for the State government. Within a few years of completion, the State issued GO bonds to purchased the property from CALPERS, and the State Board of Equalization (BOE) has remained as the sole tenant. PROPOSED LEASE TERMS The structure and terms of the Sub-lease to the BOE drive the value to the investors and the capital proceeds that will be made available to the State. A discussion of key terms of the proposed lease agreement follows. PAGE 31 A SAMPLE TRANSACTION CHAPTER VI. Type of Lease and Term Historic Tenancy - In considering the appropriate term of the lease, the history, mission and estimated longevity of the particular State agency or agencies occupying the building should be weighed. In this particular case, the State Board of Equalization (BOE) has been the sole tenant of the building since it was first put into service in 1991. DepartmentalMission - Established in 1879, the State Board of Equalization (BOE) is responsible for administration and collection of over $41.24 billion (2002) in annual sales and use taxes, property taxes and special taxes, as well as the State tax appellate program 13. 450 N Street has been the BOE's headquarters since 1991. Because of the agency's critical role in revenue generation and administration within the State government, its longevity is secured and it is anticipated that it will require full use of the facilities at 450 N Street for a long time. Useful Life - The property, which was constructed and put into service in 1991, is a modern, Class-A, 20story office building, built of concrete and steel, with a curtain wall facade. The State has maintained the property well over the past 12 years, and has carried out series of capital improvements to its systems and services. Based upon reports from engineers, architects and MEP contractors, the remaining useful life of the building is estimated to be at least 25 years. Based on these considerations above, a 20-Year, NNN Lease could easily be underwritten. However, for the sake of a simplistic example here, a 10-Year NNN Lease is underwritten. Lease Rent In order to derive a fair and equitable lease rent, the parties should have an understanding of the current economics associated with ownership and operation of the building, as well as comparable rents and expenses in the local office markets. Key parameters are outlined in the table below: Table 6. Sacramento Capital District Office Rent Analysis Rents and Expenses per Sq. Ft. per Month Low I High Range of Gross Rents Average Operating Expenses NNN Equivalent Rent $2.20 $0.63 $1.57 $2.45 $0.63 $1.82 Annual NNN Rent $18.84 $21.84 Source: Jim King, CB Richard Ellis, Sacramento "3California BOE, July 2003. PAGE 32 A SAMPLE TRANSACTION CHAPTER VI. A SAMPLE CHAPTER VI. TRANSACTION Comparable Market Rents - Currently, gross rents for office space in the Capitol District range from $26.00 to $29.00 per sq. ft. per year. Average expense loads on buildings of similar profile in the Capital District, including property taxes, is $7.50 per sq. ft. per year. From this market information, we can derive an equivalent NNN rent of $18.84 to $21.84 per sq. ft. In this sample transaction, a starting NNN rent of $19.00 per sq. ft. per year will be used. Rent Steps - Office and Industrial leases in California urban markets, especially longer-term leases, often include rent steps. Typically, Northern California office leases include a CPI adjustment every fifth year. For purposes of underwriting, CPI will be assumed to increase by 2.0% annually. Therefore, the rental agreement will include a NNN base rent increase of 10% at the beginning of the 6th year, as follows: Table 7. Proposed BOE Rent Schedule Year 1 " - 5 th NNN Rent per Sq. Ft. per Year $19.00 6 th - 0 th $20.90 Property Management Historically, the BOE has operated and maintained the facility, and under the terms of the proposed NNN Lease, all costs and responsibilities for doing so will continue to be born by the State and BOE. Security Interests Covenant to AppropriateFunds- The State will covenant in the lease agreement to take such action as may be necessary to include all rental payments due under the lease agreement as a separate line item in its annual budgets and to make the necessary annual appropriations. Security Reserve Fund - In addition to the State's covenant to appropriate for lease payments, a Security Reserve Fund will be established to withhold in an escrow an amount equal to the lesser of (i) 10% of the proceeds available from the investment, or (ii) 125% of the average amount of annual Base Rental Payments. The Security Reserve will be held in an interest bearing escrow, and released to the investors in the event of missed payments or default of the lease. As long as there is no default or other release of the security reserve, annual interest that accrues will be used to offset the State's annual rent payments. PAGE 33 CHAPTER VI. CHAPTER A SAMPLE TRANSACTION A SAMPLE TRANSACTION VI. VALUATION A spreadsheet illustrating the underwriting and valuation of this proposed lease transaction is provided in Table 9., at the end of this chapter. The first component of the underwriting is a projection of annual net income stream. As illustrated in Section I. of the analysis, the investment produces annual net rent payments of $95.2 Million in the first year, increasing to $104.7 Million in Year 6. Total net income to the investor over the ten-year lease is projected to be $999.6 Million. Credit Analysis and Bond Yields The required market yield on this income stream is projected based on an analysis of yields for similar municipal-backed fixed income securities. The following table provides an overview of market yields associated with various Treasury securities and differently-rated municipal bonds: Table 8. Yields on Municipal Bonds and US Treasuries UI.S. MNticipal Genteral Obligationt B3onds Mlaturity lY 2Y 3Y 5Y AAA 0.93 AA 0.96 A 1.19 BAA 1.55 Treasuiries 1.31 1.83 2.7 1.37 1.91 2.79 1.74 2.3 3.18 2.16 2.78 3.7 1.65 2.12 3.23 -- 7Y 3.42 3.54 3.98 4.42 -- toy 3.95 4.07 4.46 4.92 4.37 15Y 20Y 30Y 4.48 4.82 4.95 4.6 4.93 5.07 4.95 5.17 5.3 5.41 5.6 5.7 --- 5.27 As discussed previously in Chapter V., the State of California's GO Bond Rating is currently on the lower end of the 'Investment Grade' ratings. Blending the current ratings of S&P, Moody's & Fitch described in Chapter V., puts California GO bonds within the 'A' category above. However, as also discussed in Chapter V., California's lease obligations are usually rated one to one-half grade below the State's GO bond rating, putting it into the 'BAA' category above. Therefore an investor's expected yield in a 10Year lease to the State of California would be 4.92%, or 50 basis points above current 10-Year US Treasury yields. PAGE 34 CHAPTER VI. A SAMPLE TRANSACTION Market Investment Value As illustrated in Section III of the analysis, application of this 4.92% discount rate to the ten-year income stream from the lease results in a market investment value of approximately $770 Million. However, not all of these proceeds can be provided to the State. Structuring these agreements and investments is a substantial undertaking, requiring the resources and commitment of an underwriting and syndication team. UNDERWRITING, SYNDICATION & ARBITRAGE The Underwriter A large, well-capitalized institution such as an investment bank or municipal securities dealer is required to underwrite such substantial investments. Often, underwriters will solicit investment from other banks and dealers, forming a syndicate to share in the risk and opportunity of the investment. The underwriters typically charge a fee, ranging from 0.25% to 1.0% of the total investment for the direct costs of their services. In addition, and in exchange for committing to the investment in the lease, the underwriters are given the opportunity to remarket securities, commonly known as Certificates of Participation (COPs) in the lease, at a premium to their investment. This structure is illustrated in Table 9. Discount and Arbitrage As describe above, the required annual market yield on the lease investment is estimated to be 4.92%. Based on its knowledge of the market and risks associated with selling the lease securities, the underwriters will require a discount to this yield that allows them to profitably sell interests (COPs) in the lease in the open market. As illustrated in Section I. of the analysis, the underwriter's discount in this example is 30 basis points above the market yield. Applying the underwriter's discount rate of 5.22% to the projected income yields a total underwritten value of $759 Million, which represents the total gross proceeds available to the State. The 30 basis point discount granted for taking the underwriting and investment risk provides the syndicate with an arbitrage opportunity in the open municipal investment market. As illustrated in Section VI. of the analysis, potential arbitrage income from the successful sale of COPs associated with the lease investment is $11.38 Million. Adding this to the underwriter's fees provides a total potential income opportunity of $15.18 Million. PAGE 35 CHAPTER VI. A SAMPLE TRANSACTION Proceeds to the State Proceeds available to the State through this transaction are based on the underwritten value ($759 Million), less any underwriting and transaction costs. In this case, underwriting transaction costs total $11.38 Million, yielding total available proceeds of $747.7 Million. As described above, the lease agreement requires an escrow holdback of $74.7 Million, as security for the investors. Therefore Net Proceeds available to the State resulting from this transaction are $672.94 Million. Interest Accrual Based on yields of 2-year federal treasuries, the annual interest that will accrue to the $74.7 Million Security Reserve is approximately $1.23 Million. As outlined in Section VII. of the analysis, this amounts to 1.3% of annual rental payments owed by the State BOE. Unless there is a default or nonappropriation, this annual interest will be credited towards the State's annual rental payments. SUMMARY As described in this simplistic example, the State of California is able to leverage one of it's real estate assets to produce substantial proceeds for paying down existing debt, or funding State programs. In actual transactions involving longer-term leases, the investment can be tranched, much like a CMBS issuance and investors can be issued COPs for different periods and within that term. The structure of these arrangements is essentially borrowing against future revenues, with the repayment of the loan taking the form of lease payments. The borrowing outlined here comes at an interest cost that is 76 basis points above the State's GO borrowing rate of 4.46%. This amounts to a difference in available proceeds of $11.4 Million ($770.4 Million vs. $$759.0 Million) or 1.48%. However, in an environment where the State may be up against its GO borrowing limit, or where it may be difficult to obtain the votes required to issue new bonds, this may be an attractive alternative. Another benefit of this structure is the interest income on the Security Reserve, which essentially covers any transaction costs. As illustrated in Section V and VII of the analysis, the interest income of $12.3 Million exceeds the $11.4 Million on underwriting and transaction costs. PAGE 36 A SAMPLE TRANSACTION ASML VI. CHAPTER V1. CHAPTER RNATO Table 9. Underwriting & Analysis of BOE Lease at 450 N Street VII. Annual Interest/Rent Abatement I. Yield Analysis Yield on 10-YR Treasuries: Market Yield on 10-YR Muni Bonds: Market Yield on Lease Obligation: Underwriter's Discount: Underwriter's Yield on Obligation: |1. Lease Income Analysis Rentable Sauare Feet: NNN Rent per Sq. Ft.: Annual Net Income ($000's): 4.37% 4.46% 4.92% 0.30% 5.22% Yea~r: Spread to Treasury Escrowed Security Reserve: 2-YR Treasury Yield: Annual Interest Abatement: Ten Year Rent Abatement: 0.09% 0.55% $74,771 (from V.) 1.65% $1,234 $12,337 1.3% 1.2% 0.85% 9 1I 10 Total 501,060 $20.90 $20.90 $20.90 $19.00 $19.00 $19.00 $19.00 $19.00 $95,201 $95,201 $95,201 $95,201 $95,201 0.95 $90,737 0.91 $86,482 0.87 $82,427 0.83 $78,562 0.79 $74,878 0.75 $78,503 0.71 $74,822 0.68 $71,313 0.95 $90,478 0.90 $85,990 0.86 $81,724 0.82 $77,669 0.78 $73,816 0.74 $77,170 0.70 $73,341 0.67 $69,703 $104,722 $104,722 $104,722 $20.90 $20.90 $104,722 $104,722 $999,615 0.65 $67,969 0.62 $64,782 $770,474 0.63 $66,245 0.60 $62,958 $759,094 Ill. Market Valuation Market Yield/Discount Factor: Annual Present Value: Total Market Present Value: 4.92% $770,474 IV. Underwriter Valuation Underwriter Yield/Discount Factor: Annual Present Value: Total Underwritten Present Value: 5.22% $759,094 VI. Income to Underwriter V. Calculation of Proceeds to State Underwritten Present Value: Less Underwriter's Fees: Less Legal and Insurance Fees: Underwriting/Transaction Expenses: $759,094 ($3,795) ($7,591) ($11,386) Available Proceeds: Less Security Reserve/Holdback: Net Proceeds Distributed to State: $747,708 ($74,771) $672,937 0.5% 1.0% Market Value of Obligation: Underwriter Investment in Obliaation: Potential Difference Earned: $770,474 $759,094 $11,380 Plus Underwriting Fees: Income to Underwriter/Syndicator: $3,795 $15,176 10% PAGE 37 WWW" 11111~NM1 THE CALIFORNIA MARKET OPPORTUNITY THE CALIFORNIA MARKET OPPORTUNITY CHAPTER VII. CHAPTER VII. VII. THE CALIFORNIA MARKET CALIFORNIA'S REAL ESTATE PORTFOLIO California has the largest portfolio of State-owned real estate in the United States. Its holdings include over 2.6 Million acres of land on over 2,000 sites, and 195 Million square feet of built space in over 22,000 structures. Table 10. Summary of California State Owned Real Estate Controlling Agency Fee Properties Total Fee Acres Total Buildings Total Square Feet 2,023 2,559,977 17,151 105,794,077 Cal State University 32 19,130 1,321 50,476,272 University of California 14 85,293 4,026 39,046,153 2,069 2,664,400 22,498 195,316,502 Non University Agencies State Total: Source: California Department of General Services, July 2003. As illustrated in Appendix B, this property is administered and occupied by 43 State agencies in hundreds of communities in nearly all of the state's 29 counties. Amongst all of these properties, there will obviously be a wide variety of locations, tenants, and asset qualities. Only a portion will be attractive to investors and suitable for monetization through the lease structures described in this thesis. However, even if only ten percent of this built inventory gets monetized, it would represent over 19.0 Million square feet of State-backed leases for investors to participate in. HISTORY OF SYNDICATION The State California has a 20-year history of monetizing its real estate through lease-back structures and the issuance of Certificates of Participation (COPs). The impetus for these transactions was the passage of Proposition 13, in 1978, which among other tax changes, it required a two thirds majority of voters to approve any new State and County debts. Given the mood of the electorate at the time, it became nearly impossible to issue new debt obligations. Certificates of Participation (COPs) were authorized by the California legislature to allow municipalities to raise debt obligations without the issuance of bonds. PAGE 38 THE CALIFORNIA MARKET OPPORTUNITY CHAPTER VII. As utilized by California and other western states in recent years, COPs are certificates that entitle holders to receive a participation, or share, in the lease payments from a particular property. The lease payments are passed through the lessor to the certificate holders with the tax advantages intact. The lessor typically assigns the lease and lease payments to a trustee, which then distributes the lease payments to the certificate holders. Each Certificate represents a direct, fractional undivided interest in the Base Rental Payments to be made by the State due under the Lease Agreement. OUTSTANDING STATE DEBT Currently, the State of California has over $44.0 Billion in outstanding debt, including $25.4 Billion in GO Bonds and $6.7 Billion in lease obligation debt: Table 11. California's Outstanding Debt Outstanding Debt -General Obligation (GO) Lease Debt Revenue Anticipation Notes Total General Fund Supported Debt $25,358,627 $6,704,598 $12,000,000 $44,063,225 % of Total 58% 15% 27% 100% Source: California State Treasurer's Office, June 1, 2003 As lease debt represents over 15% of the State's outstanding obligations, California has historically undertaken the leveraging of its real estate holdings. However, as illustrated in the following table, lease backed obligations have accounted for only 5.3% of the State's most recent borrowing: Table 12. Historic State of California Bond Issues Year 2003 2002 2001 2000 1999 Total Bonds $5,197.3 $3,427.7 $9,516.3 $4,506.2 $4,647.4 Total: $27,295.0 Lease Obligation Bonds $0.0 $765.8 $204.5 $89.6 $395.7 $1,455.6 % Lease Obligation 0.0% 22.3% 2.1% 2.0% 8.5% 5.3% Source: California Department of the Treasury, July 2003. PAGE 39 CHAPTER VII. THE CALIFORNIA MARKET OPPORTUNITY Going forward, as California weighs options to fund its budget shortfalls, there is an opportunity to leverage its assets further and generate substantial proceeds for the state, as well as significant arbitrage and profit opportunities for underwriters and investors. It should be noted that there is a substantial difference between GO bond financing and leaseback financing; in that GO bonds are generally issued as a means to create a revenue-generating asset. Public buildings, schools, highways, and infrastructure are commonly funded with GO bonds, and their use or the jobs that they create can generate revenues to pay down the bonds, as well as fund other aspects of the state or municipal budget. Lease obligations on existing structures are essentially mechanisms to allow borrowing against assets that have previously been financed with General Fund monies or GO bonds. As such, it is deficit financing, and is not fiscally wise over the long term, unless there will be strong growth in tax receipts or other government revenues to pay down this more expensive debt over time. PAGE 40 CONCLUSION CONCLUSION CHAPTER VIII. CHAPTER VIII. VIII. CONCLUSION As described in this thesis, state and municipal governments own and operate substantial real estate portfolios throughout the country. In many cases, it can be argued that investing taxpayer capital in the ownership and operation of these assets is not necessary in order for these governments to effectively provide support and services to their taxpayers. The fact that government-controlled assets are rarely sold or provide the appreciation returns of privately owned assets, further fuels the argument against taxpayer ownership of real estate. While they own substantial real estate portfolios, many state and municipal governments simultaneously face record budget deficits. Politicians and government officials face making significant cuts in government programs and services, as well as raising taxes and fees for services in order to balance their budgets, placing further financial burdens their constituents. In addition to an outright sale, there are alternative transaction structures that governments may employ to leverage their existing asset base, and generate substantial revenues for meeting such budget shortfalls. One of these is a Master Lease and Leaseback of a property owned and occupied by a state or municipal agency. Much like a more common sale-leaseback transaction, the fundamental basis of this transaction is providing a lease investment opportunity to institutions and other municipal securities investors, effectively borrowing against future appropriations and lease rent payments. As illustrated in the simplistic example for the State of California in Chapter VI, the costs of funds to the states in these transactions is not substantially higher than GO financing, and depending on the particular legislative requirements of a given state, they may be easier to transact. In cases where a state or municipal government is up against its GO borrowing limit, or the legislative environment would preclude the approval of new GO bond issues, it can be an attractive borrowing alternative. When governments undertake these financings, they create substantial opportunities for investment banks and municipal underwriters, as well as for the syndicated investors who participate in the leaseback investment. In exchange for taking the underwriting risk and investing in the initial purchase of the lease interests, underwriters can earn substantial fees as well as arbitrage profits through the syndication and sale of lease interests in the open markets. Master Lease and Leaseback transactions of government facilities can provide investors with moderate return, long-term, tax-exempt returns. Participation in these lease obligations through a Certificate of PAGE 41 CONCLUSION CHAPTER VIII. Participation (COP) is an investment in a credit lease at returns that can range from 20 to 60 basis points higher than municipal bonds with equivalent maturities. In scenarios where the lease investment is in an agency with secured longevity or a state such as California that backs its lease obligations with its 'full faith and credit', investors can achieve these higher yields for essentially the same amount of risk as a GO Bond. Many consider this type of transaction to be the equivalent of more expensive deficit financing 14. As such, it makes more sense for states with growing populations, increasing employment or otherwise increasing tax receipts over the long term to undertake this method of borrowing than it does more mature or declining states '. For these reasons, these transactions are more prevalent and appropriate in states such as California and Arizona than states such as Massachusetts or New Jersey. The leveraging of real estate is just one of the many financing options available to meet the current budget shortfalls facing many state and municipal governments. Several factors must be weighed as governments analyze their real estate portfolios, and determine the best way to monetize these assets. As illustrated here, the Master Lease and Leaseback of real estate presents one of these opportunities, that can be tailored to meet evolving fiscal needs of state and municipal governments. "4Interview with Richard Marino. " Interview with Tom Lockard. PAGE 42 APPENDICES IX. APPENDICES APPENDIX A. LISTS OF TABLES AND FIGURES List of Tables: Page Table 1. - State-Owned Real Estate Portfolios - California, Texas and New York 4 Table 2. - Federal and State Budget Deficits Fiscal Year 2003-04 4 Table 3. - Matrix of State Sell/Hold/Lease Considerations 11 Table 4. - State of California Credit Rating 28 Table 5. - CA State Office Property Details 31 Table 6. - Sacramento Capital District Office Rent Analysis 32 Table 7. - Proposed BOE Rent Schedule 33 Table 8. - Yields on Municipal Bonds and US Treasuries 34 Table 9. - Underwriting & Analysis of BOE Lease at 450 N Street 37 Table 10. - Summary of California State Owned Real Estate 38 Table 11. - California's Outstanding Debt 38 Table 12. - Historic State of California Bond Issues 39 List of Figures: Figure 1. - Historic US Treasury Yields Paje 6 Figure 2. - Schematic of Typical Sale-Leaseback Transaction 14 Figure 3. - Historic Office Vacancies in Major CA Markets 16 Figure 4. - Historic Industrial Vacancies in Major CA Markets 16 Figure 5. - Schematic of Master Lease-Leaseback Transaction 26 PAGE 43 APPENDICES APPENDIX B. STATE-OWNED PROPERTY CALIFORNIA OF SCHEDULES STATEWIDE PROPERTY INVENTORY The Real Estate Services Division (RESD) maintains the Statewide Property Inventory (SPI), which is a centralized real estate management information system. This database consists of a comprehensive inventory of all leased facilities managed by the Department of General Services and all state proprietary land holdings except for the following: Department of Transportation (Caltrans) e Highway Operating Right-of-Way o Airspace and State Lands Commission listing for school lands only. General Information about the State's Inventory as of February 3, 2003 Leased Space Sacramento County Number of Leases Total Sq. Feet of Leased Office Space Total Sq. Feet of Leased Storage and "Other" Space Total Monthly Rent for all Leased Space Total Annual Rent for all Leased Space Total Rent Over 5 Years (non-escalated) 361 8,037,597 1,820,284 $ 14,810,616 $177,727,392 $888,636,960 Statewide Number of Leases Total Sq. Feet of Leased Office Space Total Sq. Feet of Leased Storage and "Other" Space Total Monthly Rent for all Leased Space Total Annual Rent for all Leased Space Total Rent Over 5 Years (non-escalated) 2,103 16,357,404 4,847,468 $ 33,080,490 $ 396,965,880 $1,984,829,400 State Owned Real Estate Total Fee* Sites/Facilities Total Fee Acreage Total Number of Structures Total Sq. Feet for Structures 2,042 2,608,114.10 22,305 192,523,658 *Note: "Fee" as used above refers to the state's ownership rights. A fee ownership is the most complete and unrestricted right of ownership of real property. PAGE 44 APPENDICES APPENDIX B. SCHEDULES OF CALIFORNIA STATE-OWNED PROPERTY DEPARTMENT NAME TOTAL SITES TOTAL FEE ACRES TOTAL STRUCTURES 2.25 22.34 19,130.21 2,121.30 2,907.16 153.17 0.26 2.51 24,029.15 3,065.15 3,059.03 169.91 49.74 854.64 549,336.26 78.83 74,892.92 1,932.80 2.43 81.61 652.88 10.51 587,570.45 1.55 2,717.22 5,896.54 241.76 1,153,332.20 3.20 760.83 5,259.65 152.49 12.50 8.90 6,157.49 52.32 2,105.40 85,293.46 2,403.35 1 54,000 54,000 1,321 5 27 1 1 3,164 569 1,267 120 31 46 748 120 2,234 126 1 7 129 4 1 1 367 388 95 5,799 4 44 9 2 1 50,476,272 17,237 68,690 2,000 9,251 36,379,243 5,826,748 7,272,032 964,288 587,869 1,072,092 1,107,845 467,226 3,893,070 16,339,796 34,000 426,841 1,139,033 91,731 3,325 237,000 4,594,026 5,091,309 1,853,362 6,739,268 42,278 38,299 499,223 267,280 137,275 38,211 TOTAL SQUARE Avg. Bldg. Size FEET AIR RESOURCES BOARD, STATE BOATING & WATERWAYS, DEPT OF CAL STATE UNIVERSITY COACHELLA VALLEY MOUNTAINS CONSERVA COASTAL CONSERVANCY, STATE CONSERVATION CORPS, CALIFORNIA CONSERVATION, DEPT OF CONSUMER AFFAIRS, DEPT OF CORRECTIONS DEVELOPMENTAL SERVICES DISTRICT AGRICULTURAL ASSOCIATIONS EDUCATION EMPLOYMENT DEVELOPMENT EXPOSITION & STATE FAIR, CALIF FISH AND GAME, DEPT OF FOOD AND AGRICULTURE, DEPT OF FORESTRY & FIRE PROTECTION, DEPT OF GENERAL SERVICES, DEPT OF HEALTH PLANNING & DEVEL, OFC STATEWIDI HEALTH SERVICES, DEPT OF HIGHWAY PATROL, DEPT OF THE CALIF JUSTICE, DEPT OF LANDS COMMISSION, STATE LEGISLATURE MENTAL HEALTH MILITARY, DEPT OF MOTOR VEHICLES, DEPT OF PARKS & RECREATION, DEPT OF REHABILITATION, DEPT OF SAN JOAQUIN RIVER CONSERVANCY SANTA MONICA MOUNTAINS CONSERVANCY SCIENCE CENTER, CALIF STATE LOTTERY COMMISSION, CALIF STEPHEN P. TEALE DATA CENTER TAHOE CONSERVANCY, CALIF TOXIC SUBSTANCES CONTROL, DEPT OF TRANSPORTATION, DEPT OF UNIVERSITY OF CALIFORNIA VETERANS AFFAIRS WATER RESOURCES CONTROL BOARD, STATE WATER RESOURCES RECLAMATION BOARD WATER RESOURCES, DEPT OF YOUTH AUTHORITY, DEPT OF THE TOTAL Non-University Total 1 3 32 6 22 3 2 1 40 5 45 5 32 1 364 12 258 104 1 4 108 6 57 1 5 78 97 275 1 1 56 1 1 1 2 1 323 14 9 - 3,447 2,544 2,000 9,251 11,498 10,240 5,740 8,036 18,964 23,306 1,481 3,894 1,743 129,681 34,000 60,977 8,830 22,933 3,325 237,000 12,518 13,122 19,509 1,162 10,570 870 55,469 133,640 137,275 -- 1,350 4,026 105 - 5,732,718 39,046,153 1,350,674 4,246 9,698 12,864 - 1 465.00 25 55 10 19,248.11 108,193.83 1,969.38 384 3,455,048 2,069 2,664,400.69 22,498 195,316,502 2,023 2,559,977 17,151 105,794,077 - 8,998 PAGE 45 APPENDICES APPENDIX C. HISTORY OF CALIFORNIA BOND ISSUANCES 4/24/2003 General Obligation State of California General Obligation Bonds $2,050.0 4/10/2003 General Obliga tion $1,400.0 3/27/2003 Revenue State of California General Obligation Bonds (Variable Rate) California Consumer Power and Conservation Financing Authority Energy Efficiency Master Trust 3/26/2003 2/24/2003 PWB Revenue 2/24/2003 Revenue 2/13/2003 1/9/2003 General Obligation Revenue Bonds Merrill Lynch Lehman Brothers $28.0 Goldman, Sachs & Co. $38.0 $329.9 Ramirez UBS Paine Webber Inc. $108.7 UBS Paine Webber Inc. $900.0 $342.7 Morgan Stanley Lehman Brothers Revenue Bonds, Series 2003A State Public Works Board - various Projects State of California Department of Water Resources Central Valley Project Water System Revenue Bonds Series Y State of California Department of Water Resources Central Valley Project Water System Revenue Bonds Series AA State of California General Obligation Bonds |CSU Systemwide Revenue Bonds, Series 2003 A Bond Total: Lease Obligation Total: $5,197.3 $0.0 0.0% 11/20/2002 Lease Revenue State Public Works Board Department of General Services 2002 Series A and Department of the Youth Authority 2002 Series B $405.0 11/7/2002 Revenue State of California Department of Water Resources $6,314.0 JP Morgan 11/7/2002 Revenue Power Supply Revenue Bonds, Series 2002A State of California Department of Water Resources Power Supply Revenue Bonds, Series 2002E $700.0 JP Morgan 10/29/2002 Revenue Anticipation State of California 2002-03 Revenue Anticipation $3,500.0 Lehman Brothers/Goldman Notes Notes 10/23/2002 10/23/2002 Lease Revenue Revenue State Public Works Board State of California Department of Water Resources Power Supply Revenue Bonds, Series 2002B and $173.0 $3,750.0 E. J.De La Rosa & Co., Inc. JP Morgan 10/23/2002 Revenue 10/9/2002 10/9/2002 General Obligation Revenue Anticipation State of California Department of Water Resources Power Supply Revenue Bonds, Series 2002D State of California General Obligation State of California 2002-03 Revenue Anticipation Morgan Stanley Sachs & Co. 2002C Notes Notes 10/1/2002 Revenue State of California Department of Water Resources Central Valley Project Water System Revenue Bonds 7/24/2002 Revenue 4/30/2002 Revenue 4/17/2002 4/11/2002 3/13/2002 General Obligation Revenue General Obligation Refunding Lease Revenue Bonds General Obligation $500.0 $800.0 $9,000.0 Lehman Brothers Merrill Lynch & Co. Lehman Brothers / Goldman, Sachs & Co. $171.0 UBS Paine Webber Inc. $300.0 Bear, Stearns & Co. Inc. $160.2 UBS Paine Webber Inc. $800.0 $174.7 $1,105.0 Lehman Brothers Lehman Brothers Salomon Smith Barney $187.8 $1,000.0 $3,427.70 $765.80 Goldman Sachs & Co. Merrill Lynch & Co. Series Z California Infrastructure and Economic Development Bank Clean Water State Revolving Fund Revenue Bonds Series 2002 2/27/2002 2/20/2002 Department of Water Resources Central Valley Project Revenue Bonds (Series 2002X ) State of California General Obligation CSU Systemwide Revenue Bonds State of California General Obligation Refunding Bonds State Public Works Board State of California General Obligation Bonds Bond Total: Lease Obligation Total: 22.3% PAGE 46 APPENDICES APPENDIX C. HISTORY OF CALIFORNIA BOND ISSUANCES 11/29/2001 Home Purchase Revenue 11/29/2001 Veterans General Department of Veterans Affairs, Home Purchase Revenue Bonds (2001 Series A) Department of Veterans Affairs, General Obligation Obligation Bonds Lease Revenue Bonds General Obligation Revenue Anticipation Notes General Obligation Veterans General Obligation Revenue and State Public Works Board State of California General Obligation Bonds State of California 2001-2002 Revenue Anticipation Notes State of California General Obligation Bonds Department of Veterans Affairs, General Obligation Bonds Department of Water Resources Refunding Bonds (Series W) 4/19/2001 Home Purchase Revenue 4/19/2001 Veterans General Obligation Lease Revenue RfnigBonds General Obligation Department of Veterans Affairs, Home Purchase Revenue Bonds (2001 Series A) Department of Veterans Affairs, General Obligation Bonds State Public Works Board 11/28/2001 10/30/2001 9/25/2001 6/12/2001 6/7/2001 5/1/2001 3/15/2001 2/27/2001 State of California General Obligation Bonds Bond Total: Lease Obligation Total: Veterans General Department of Veterans Affairs, General Obligation Obligation Bonds 11/29/2000 11/15/2000 10/11/2000 RevnBond s Lease Purchase Home Revenue General Obligation Lease Revenue Bonds Revenue 10/11/2000 10/17/2000 9/13/2000 6/20/2000 6/14/2000 Revenue General Obligation General Obligation General Obligation Lease Revenue Bonds BoardAffairs-Home Purchase State Pubiorks of Veterans Department Revenue Bonds (1997 Series C) State of California General Obligation Bonds State Public Works Board San Diego State University Parking System Revenue Bonds, SeriesB CSU Housing System Revenue Bonds, Series AZ State of California General Obligation Bonds State of California General Obligation Bonds State of California General Obligation Bonds State Public Works Board, Department of Corrections and Youth Authority Lease Revenue Bonds 4/19/2000 4/4/2000 General Obligation Revenue 3/28/2000 Veterans General Obligation Home Purchase State of California General Obligation Bonds California State University, Pomona Student Union Revenue Bonds Department of Veterans Affairs, General Obligation Bonds Department of Veterans Affairs-Home Purchase Revenue Revenue Bonds (Series A, B & C) General Obligation State of California General Obligation Bonds 12/6/2000 1/2000 12/6/2000 3/8/2000 2/23/2000 Bond Total: Lease Obligation Total: $117.2 Bear, Stears & Co. Inc. $111.3 Bear Steans & Co. Inc. $41.4 $1,000.0 $5,700.0 Redwood Securities Lehman Brothers Lehman Brothers $1,000.0 $42.0 Merrill Lynch & Co. Merrill Lynch & Co. $260.9 Lehman Brothers $39.8 Merrill Lynch & Co. $86.2 Merrill Lynch & Co. $163.1 Bear, Stearns & Co. Inc. $954.4 Salomon Smith Barney $9,516.3 $204.5 $230.4 $51.0 $97.1 2.1% Bear, Steamns & Co. Inc. s Da ndRauscerIc Brothers Lehman $648.0 $51.0 $14.1 Lehman Brothers Dain Rauscher, Inc. Salomon Smith Barney $12.8 $967.0 $850.0 $350.0 $38.6 PaineWebber Incorporated Merrill Lynch & Co. Merrill Lynch & Co. Lehman Brothers Salomon Smith Barney $500.0 $20.9 $66.5 Merrill Lynch & Co. Banc of America Securities LLC Merrill Lynch & Co. $159.8 Lehman Brothers $500.0 Goldman, Sachs & Co. $4,506.2 $89.6 2.0% PAGE 47 APPENDICES APPENDIX C. HISTORY OF CALIFORNIA BOND ISSUANCES 11/30/1999 Lease Revenue Bonds 11/18/1999 10/28/1999 10/20/1999 Lease Revenue Bonds Veteran General Obligation General Obligation 10/7/1999 Lease Revenue Bonds 9/29/1999 Lease Revenue Bonds Revenue Anticipation Notes General Obligation 9/22/1999 9/14/1999 6/15/1999 6/9/1999 4/14/1999 4/8/1999 4/7/1999 3/17/1999 2/23/1999 Lease Revenue Bonds General Obligation General Obligation Bonds Lease Revenue Refunding Bonds General Obligation Home Purchase Revenue Bonds General Obligation CaliforniaState Treasurer'sOffice UpdatedJune 20, 2003 California State University Housing System Revenue Bonds and Pomona Student Union Revenue Bonds State Public Works Board, Veterans Home in Chula Vista State of California Veterans General Obligation Bonds Series BJ 7/8 (AMT) State of California General Obligation Bonds State Public Works Board of the State of California, Lease Revenue Bonds (California Department of Health Services) 1999 Series A (Richmond Laboratory Project) Joint Powers Authority, Los Angeles State Office Building State of California 1999-2000 Revenue Anticipation Notes State of California General Obligation Bonds State Public Works Board (California Community Colleges) 1999 Series B (Various Community College Projects) State of California General Obligation Bonds $42.0 Merrill Lynch & Co./Salomon Smith Barne $16.0 Redwood Securities Group $60.0 $500.0 Lehman Brothers Merrill Lynch & Co. $179.1 Fleet Securities, Inc. $60.0 $1,000.0 $400.0 E. J.De La Rosa & Co. Lehman Brothers Merrill Lynch & Co. $45.7 $400.0 J.P. Morgan & Co. J.P. Morgan & Co. State of California Veterans General Obligation Bonds State Public Works Board (California Community Colleges) (Various Community College Projects) 1999 Series A State of California General Obligation Bonds $351.5 Bear, Stearns & Co. $52.9 $300.0 J.P. Morgan & Co. Morgan Stanley State of California Department of Veterans Affairs State of California General Obligation Bonds Bond Total: Lease Obligation Total: $240.2 $500.0 $4,647.4 Historic Bond Total: Historic Lease Obligation Total: Merrill Lynch & Co. Salomon Smith Barney $395.7 8.5% $27,295.0 $1,455.6 5.3% PAGE 48 APPENDICES APPENDIX D SUMMARY OF RECENT CALIFORNIA CREDIT RATINGS Fitch Date Rating 12/02 Moody's Investors Services Standard & Poor's Date Rating Date Rating 8/03 7/03 A3 12/02 BBB A 2/00 AA 2/03 10/97 AA- 11/01 Al 4/01 2/96 5/01 Aa3 9/00 AA 7/94 9/00 Aa2 8/99 AAA+ 9/92 AA 10/98 Aa3 7/96 2/92 AA+ 7/94 Al 7/94 7/86 AAA 7/92 Aa 7/92 A+ 10/82 AA 2/92 Aal 12/91 AA Prior 1982 AAA 10/89 Aaa 7/86 AAA 4/80 Aa 2/85 AA+ 9/72 Aaa 1/83 AA 11/40 Aa 1/80 AA+ 5/68 AAA 1/38 Source: California State Treasurer's Office, July 31, 2003 PAGE 49 APPENDICES APPENDIX E. LIST OF INTERVIEWEES Scott Miller, Principal Highland Net Lease, LLC Boston, MA M. Russell Feldman, Principal TBA Architects Waltham, MA Fred Pratt, Former CEO Lend Lease Corporation/Boston Financial Boston, MA Richard Marino, Senior Analyst Standard & Poor's, Inc. New York, NY Steve Zimmerman, Managing Director Standard & Poor's, Inc. San Francisco, CA John Campbell, Vice President Fixed Income Investments Lehman Brothers San Francisco, CA Tom Lockard, Managing Director Municipal Finance Stone & Youngberg, LLC San Francisco, CA Sameer Nayar, Director Large Loans & CMBS Credit Suisse First Boston New York, NY Jim King, Vice President CB Richard Ellis Sacramento, CA PAGE 50 BIBLIOGRAPHY X. BIBLIOGRAPHY Barthell, Jack, 'Companies Focus on Real Estate Strategiesfor the New Economy', Commercial Investment Real Estate Journal, January/February, 2001 Friedman, Steven M., 'Synthetic Leases: Benefit or Burden?',Commercial Investment Real Estate Journal, March/April 1998. Greene, John P., 'GenerateNew Capital by Leveraging Real Estate Assets', Trustee Magazine, pp.1416, February 1988. Marino, Richard & Colleen Woodell, 'PublicFinanceCriteria- PrisonFinancings',Standard & Poor's Ratings Services, June 15, 2001. Murphy, Steven & Colleen Woodell, 'PublicFinance Criteria- Securitization',Standard & Poor's Ratings Services, Nov. 13, 2002. Ralston, Gary M., 'Real Estate Sale-Leasebacks - What's the Attraction of the Net Lease Arrangement?', Commercial Investment Real Estate Journal, May/June 1997. Valachi, Donald J., 'Sale-LeasebackSolutions - Examine the Business and Tax Considerationsof These Transactions',Commercial Investment Real Estate Journal, May / June 1999 Bond Market Association, 'Investors Guide to High Yield Bonds', 2000. Bond Market Association, 'Investors Guide to Pass-Throughand CollateralizedMortgageSecurities', 2002. Bond Market Association, 'Investors Guide to CollateralizedMortgage Obligations',2002. Standard & Poor's, 'PublicFinance Criteria2002', Standard & Poor's Ratings Services, 2001. Standard & Poor's, 'StructuredFinance - Reverse Mortgage Criteria',Standard & Poor's Ratings Services, 1999. Standard & Poor's, 'Legal CriteriaforStructuredFinance Transactions',Standard & Poor's Ratings Services, April 2002. Standard & Poor's, 'US CMBS Legal and StructuredFinance Criteria',Standard & Poor's Ratings Services, May 2002. Stone & Youngberg, LLC., 'Weekly CaliforniaMunicipalMarket Report', July 25, 2003. PAGE 51

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