Private Capital for Public Schools

Districts overcome cultural barriers to find non-public building partners by John M. McLaughlin and G. William Bavin
The problems are legion. There is not a school leader in the country unaware of the dilapidated condition of many of America’s public schools.

A study in 2000 by the National Education Association estimated that $268 billion is needed to bring the nation’s schools up to acceptable standards for basic issues such as plumbing, roof integrity, lighting and safety. The Government Accounting Office stated that 60 percent of school buildings suffer at least one major structural problem. In schools built in the 1920s and ’30s, the lye tends to leach from the mortar leaving the bricks held together only by sand.

In addition to the pressing renovation needs, new schools are in demand across the country. Florida adds almost 60,000 public school students a year while New York City’s enrollment grows by 25,000 annually, according to “Financing School Facilities,” published by the Association for School Business Officials. Clark County, Nev., which is one of the nation’s fastest growing school districts, opened 16 new facilities in 2001 and 13 in 2002 and has 25 school projects in the pipeline for opening in the next two years. Nationally, tens of billions of dollars are needed for the construction of new facilities.

The enormity of the school infrastructure problem is overwhelming the capacity of school districts and states to address it effectively. Financing school improvements, expansions and new construction by traditional means such as general obligation bonds or equalized funding formulas is limited. One solution to the infrastructure crisis beginning to take shape is the entrance of private capital into the public school facilities market. While still in the early stages, public-private partnerships increasingly are providing a viable alternative to address the need for extensive renovation and development of public school facilities.

Cultural Issues
The Association of School Business Officials offered one of the more comprehensive looks at the problem and some forward-thinking remedies in its 1999 report, “Financing School Facilities: A Report Prepared by ASBO International’s Facilities Project Team.” ASBO criticized general obligation bonding and equalized funding as limited in terms of adequacy and resulting in significant accumulated deferred maintenance.

In its report, ASBO highlighted innovative financing strategies and recommended policy and statutory changes. Among its recommendations: changing state and federal laws to allow the capital markets to receive a tax-exempt return for investments made in the renovation and construction of school facilities.

That recommendation was partially addressed when President Bush signed into law the Economic Growth and Tax Relief Act of 2001. Section 422 of that act extends the privilege of using tax-exempt private activity bonds to qualified education facilities. Previously, the ability to issue bonds that earn interest exempt from federal taxation was largely limited to state and local government.

Section 422 joins the Qualified Zone Academy Bond program, launched in 1997, in the federal government’s effort to assist public education’s facilities crunch. While Section 422 and QZAB are steps in the right direction, funds are limited and far exceeded by demand. Section 422 is capped at $3 billion annually, yet spending on new facilities, expansions and renovations was more than $20.3 billion in 2001, according to School Management and Planning’s Seventh Annual School Construction Report.

Michael Sullivan, vice president of business affairs at the University of St. Thomas in St. Paul, Minn., and a contributing author of the ASBO report, believes not enough has happened to address the facilities problem. Experienced as a financial officer in both higher education and K-12 education, Sullivan reports that private financial participation in facilities development is common among universities but still a rarity in public schooling. In particular, he bemoans the sealed bid process used in Minnesota and many other states in which the low bid wins the contract.

Sullivan wants to see more design-build projects in the public school arena. At his university, he says, “design-build is worth about 10 percent in time and cost. We build 10 percent faster and 10 percent less expensively.”

Design-build now encompasses about one-third of all non-residential construction according to Richard Belle, editor of Design-Build Dateline, a trade publication. Its use, he says, “clearly has quadrupled in the last 20 years” and should command about 50 percent of the market in the next 10 years.

As a private institution, St. Thomas can use design-build for facility development, but public schools and public universities in Minnesota, with the exception of the University of Minnesota, which pre-dates the state’s constitution, are prohibited from its use. “Instead of a closed economic system, we need to get the market working to provide a more efficient and economical system and more competitive pricing,” Sullivan concludes.

Others point to the cultural aspect of change that has made the use of private capital slower to take root in the K-12 market. Tom Daly, a senior vice president with the investment firm Legg Mason Wood Walker in Baltimore, has engaged in numerous public-private postsecondary financings. He says, “There is a lot of difference between dealing with one institution when compared to dealing with a school board and local politics.”

In higher education, investors deal with the institution itself and not with elected officials. “People don’t think of the chief financial officer at the University of Maryland in the same way they think of an administrator in the Fairfax County Public Schools,” he notes.

Many potential financiers see negative perceptions commonly associated with the use of private capital in public education. Privatization is still a loaded word that stirs the emotions. “I don’t like that word at all,” Daly says.

He views the increasing use of private capital for a variety of public projects as public-private partnerships that can yield major benefits, drastically reducing the time required from concept to completion and saving significant money for the public. Nonetheless, he acknowledges the cultural barrier that must be cleared for school leaders to look to the private markets for help in building and upgrading facilities. “This is a substantial change for the public school sector and it’s hard for people to let go,” Daly concedes.

Pulling the Ripcord
Letting go is what has happened in Natomas, Calif., but it took an innovative superintendent and a hard-working, business-savvy board to find a way to build new facilities and maintain existing schools without breaking the bank. Natomas is a first-ring suburb of Sacramento.

Historically an agricultural area on a flood plain, the Natomas Unified School District enrolled only 200 pupils in 1980. When flood control levies were re-worked in the area, Natomas’ pace of development escalated. Superintendent David Tooker’s growth plan had scenarios for slow, moderate and fast growth based respectively upon 250, 500 and 1,000 new homes annually. But even his fast-growth projection underestimated the district’s current rate of 2,500 new homes a year in Natomas. The district now has some 32,000 homes and apartments and 7,900 students in K-12.

With such rapid growth, Natomas will be facing facilities development challenges for the foreseeable future. For Tooker, the question is, “How do we build schools that are there and ready when the kids get here, and the district does not have to go through an overcrowded stage?” Voters in the district passed almost $46 million of local bonds and Tooker projects that Natomas will draw down on that amount about $15 million every other year to upgrade existing facilities and satisfy districtwide needs, such as a centralized kitchen.

The desire for a second high school in the district posed a problem—either spend most of the bonding capacity on the new high school and defer the upgrades in the other facilities or come up with an innovative way to fund a second high school facility. While pursuing a two-track system that examined both traditional financing and a build-lease arrangement, the board settled upon a build-lease arrangement with The Eastridge Companies. Natomas now is constructing a $58 million education complex, which will include not only a new high school but also a satellite center for an area community college and branch of the community public library. The facility will open in August 2004.

While the school district has a 20-year lease, it negotiated an early buyback right. Tooker says the district plans to buy the facility in 2006 using a combination of local and state bonds and developer fees—$3 per square foot of new construction, which currently nets the district some $18 million annually.

Entering into a build-lease agreement wasn’t easy, Tooker says. “We couldn’t find anyone in California who had done this so we were out there on a little bit of faith. … These types of arrangements are do-able but you have to understand that until it becomes more commonplace, you have to work yourself through the details.”

Phil Geiger, president of the Eastridge Companies, collaborated with Tooker and the Natomas community. Geiger, a former superintendent with an education doctorate from Columbia and an MBA from the Wharton School at University of Pennsylvania, served as executive director of the Arizona School Facilities Board before joining Eastridge. Geiger has seen many school districts put off a $50,000 maintenance problem and wind up with a multimillion dollar nightmare.

The tough economic times the states are experiencing are forcing districts to think along new lines. Geiger believes that private capital is going to be used much more frequently for school construction and renovation. “This is really no different than senior housing,” he says. “The reliability of the revenue stream is the key question.”

But the cultural readiness of schools to use private capital sources is still a question. “Schools don’t tend to be pioneers,” Geiger adds. “They stick with the tried and true. … People are more likely to do something different if they have run out of options.”

Mother of Invention
Out of options is how one might have characterized the Niagara Falls, N.Y., Public Schools. In the late 1990s, Niagara Falls had a shrinking tax base and many decrepit public school buildings. After a year and a half of evaluation and public input, the board of education determined it needed to build one new facility to replace the 100-year-old Niagara Falls High School and the rapidly aging LaSalle High School.

To accomplish this goal without a tax levy, Niagara Falls obtained special state legislation allowing the district to partner with a private developer to manage the high school project. Honeywell, which had a strong relationship with the district after completing energy retrofit work on 18 of the district’s schools, was selected as the program manager. Niagara Falls High School became the first privately financed, privately managed public school construction project in New York state.

Honeywell selected J.P. Morgan to find private capital to finance the construction. One incentive for investors in the deal is the fact that the interest portion of the lease payments is exempt from federal tax. Because Honeywell is not in the real estate business, a special purpose entity was established as the financing and ownership vehicle for the project.

The school district now leases this $80 million state-of-the-art high school, which opened in September 2000, for $4.8 million a year. In 27 years, ownership of the 400,000-square foot facility transfers to the school district. Superintendent Carmen Granto calls the project “a revolution in school financing, partnership, programming, leadership and technology.”

The innovative financing of Niagara Falls High School bought the district something that traditional financing methods could not—time. The district would have had to go through the entire lengthy bond election process and faced an uncertain outcome with voters. The agreement with Honeywell allowed the district to open its facility much sooner than it would have with the traditional method of financing.

Efficiency Mechanism
For decades, businesses have used innovative financial structures to manage their real estate needs and exposure. Based on the experiences of the Natomas and Niagara Falls school districts, other public schools might benefit from similar mechanisms.

A recent study by the Center on Reinventing Public Education focused upon national trends in education and the effects these trends will have on facility development in public schooling. The study identifies six criteria as important for the leadership of school districts to consider. One is economic efficiency. A section of the study titled “The Future of School Facilities” states: “In education, efficiency means focusing spending on productive activity, i.e., instruction. Through innovative partnerships and other arrangements, districts may be able to redirect resources away from inefficient facilities toward instruction. Districts should also ask themselves if the potential exists for improving the quality of facilities without increasing public spending, or if it is possible to provide the same quality of facilities at a lesser cost to the taxpayers.”

If necessity is the mother of invention, the current fiscal crisis facing state and local education budgets bodes well for a rapid expansion of the use of private capital in public school development and renovation. It seems reasonable to expect that progress on this front will be measured in miles, not inches, in the not too distant future.

John McLaughlin, an education consultant on finance and strategic planning, is president of the John McLaughlin Co., 1524 S. Summit Ave., Sioux Falls, S.D. 57105. E-mail: john@mclaughlincompany.com. William Bavin is the founder of Education Capital Markets, an investment bank and financial advisory firm in Alexandria, Va.