When two hijacked aircraft crashed into the World Trade Center, the attack not only claimed approximately 2,800 lives, but also destroyed much of the commercial and residential infrastructure of downtown Manhattan.
An estimated 13 million square feet of office, retail and residential space was lost, an amount greater than all of the office space in the City of Seattle. Estimates of the cost to rebuild lower Manhattan range from $20 billion to $50 billion, with the cost to rebuild the World Trade Center alone estimated at over $7 billion. Compounding both the tragedy and the enormity of the rebuilding costs is the difficulty in obtaining financing to rebuild. Commercial loans (if they can be obtained at all) have prohibitively high interest rates. Equity is likely inadequate or unavailable. Tax-exempt bonds offer significantly lower interest rates than commercial loans and are more feasible than equity, but numerous limitations exist to financing privately-owned property. However, as discussed below, Congress recently enacted legislation to minimize the limitations on tax-exempt bonds, making their issuance much more attractive.
Tax-Exempt Financing Limits
In general, only a limited category of privately-owned facilities may be financed with tax-exempt bonds. These bonds, known as "private activity bonds," may be issued only for select facilities specifically authorized in the Internal Revenue Code, such as airports, docks and wharves, power generation facilities and manufacturing facilities. Excluded from the list of permissible projects is commercial office and retail space. Although some flexibility exists in financing commercial facilities in certain specially-designated "enterprise zones," no such enterprise zones are located in lower Manhattan.
Tax-exempt private activity bonds may also be issued to finance residential housing, but federal tax law requires that a certain percentage of the units financed be set aside for low-income tenants, resulting in lower revenues.
In addition, regardless of the type of project, the amount of private activity bonds that may be issued in the State of New York is subject to an annual "volume" limitation of just under $2 billion, which is far less than the amount of financing needed to rebuild the World Trade Center alone, and projects must compete for an allocation of the volume limitation.
Finally, the interest received by holders of private activity bonds, although exempt from regular income taxes, is subject to the federal alternative minimum tax of 28% for high income individuals and 20% for corporations. To compensate for the application of the alternative minimum tax, such bonds have to be marketed to bondholders at interest rates higher than tax-exempt bonds issued for governmental projects (although still lower than commercial rates).
Without an act of Congress, tax-exempt municipal bonds would not play a significant role in the rebuilding of lower Manhattan.
Liberty Bonds
In the aftermath of the terrorist attacks, Congress passed the Job Creation and Worker Assistance Act of 2002, which contains a number of provisions to help rebuild parts of lower Manhattan. Chief among these is a provision removing many of the limitations on the use of private activity bonds to finance commercial and residential facilities in Manhattan. The Act created a new type of private activity bond called a "Liberty Bond" to help finance the reconstruction of commercial and residential property in New York City, but primarily lower Manhattan. Pillsbury Winthrop LLP took an active role in the preparation of the Act, presenting the sponsors of the legislation with various proposals permitting the issuance of tax-exempt bonds to finance such projects.
Liberty Bonds have some special benefits designed to minimize the limitations of private activity bonds so as to make tax-exempt financing available to rebuild lower Manhattan. First, the amount of Liberty Bonds issued is not restricted by New York State's annual volume limitation and no one has to compete for an allocation of the private activity volume limitation. In addition, the interest accruing on Liberty Bonds is not subject to the alternative minimum tax, which means that Liberty Bonds can be marketed at lower interest rates than traditional private activity bonds. Finally, Liberty Bonds used for construction may benefit from the preferential rules afforded to construction financing, so net earnings from investment of bond proceeds during a project's construction period do not have to be rebated to the Treasury Department if the bond proceeds are spent within two years of the issuance of the bonds.
In order to qualify as a Liberty Bond, a bond must be issued prior to January 1, 2005, and must be designated a Liberty Bond by either the Governor of New York State or the Mayor of New York City. In addition, at least 95% of the proceeds must be used for qualified project costs, which are the costs to acquire, construct, reconstruct or renovate nonresidential real property, residential rental property or public utility property. Bond proceeds can also be used to acquire existing buildings; however, in that case, the bonds must also finance rehabilitation costs equal to not less than 50% of the financed acquisition cost. This rehabilitation requirement is well above the normal requirement for tax-exempt bonds that rehabilitation costs equal at least 15% of the building acquisition cost. This 50% rehabilitation requirement is likely to ensure that the bond proceeds are used to rehabilitate property damaged by the terrorist attacks of September 11, rather than as a financing tool for private parties to acquire property.
Liberty Bonds may also be issued for residential rental housing. Unlike traditional tax-exempt multifamily housing bonds, no low-income set aside of units or other income limit on the tenants of the building is required.
Liberty Bonds are limited to an aggregate amount of $8 billion, all but $2 billion of which must be used in the "Liberty Zone" consisting of the portion of lower Manhattan located on or south of Canal Street (which is in Chinatown), East Broadway (east of its intersection with Canal Street) or Grand Street (east of its intersection with East Broadway). Other general limitations include a $1.6 billion limit on residential rental property and an $800 million limit on retail sales property. The Governor and the Mayor each have a 50% approval authority; hence, each may designate up to $800 million in bonds for residential rental property, up to $400 million in bonds for retail sales property, and up to $1 billion in bonds outside the Liberty Zone (subject to an overall $4 billion designation cap).
Additional rules apply to non-Liberty Zone property. For example, the use of bond proceeds outside the Liberty Zone is limited to nonresidential real property in New York City which is part of a project consisting of at least 100,000 square feet of office space (although the project may consist of space in multiple buildings).
A Unique Opportunity
Liberty Bonds present a unique opportunity to apply tax-exempt financing to rebuild lower Manhattan. Recently, Liberty Bonds in the amount of $100 million were sold by the New York State Housing Finance Agency to finance the construction of new residential rental housing in the Liberty Zone. These bonds are variable rate bonds backed by a letter of credit, with the initial interest rate for the first weekly period priced at 1.8%.
In addition, Liberty Bonds, in the approximate amount of $100 million, have been proposed for a large commercial office building in Brooklyn by the New York City Industrial Development Agency, and Liberty Bonds for two residential rental projects in lower Manhattan, in the approximate amount of $240 million, have been proposed and are under review by the New York State Public Authorities Control Board.
When New York City issued its first series of bonds dedicated to rebuilding City-owned infrastructure shortly after September 11 of last year, the issue was greatly oversubscribed and resulted in very low borrowing rates. Based on the market's reception to those bonds, as well as to the first issue of Liberty Bonds, it appears investors desire to participate in the reconstruction of New York City. While the rebuilding tasks remain daunting, perhaps obtaining the funds to complete those tasks won't be as difficult as first imagined.
Edward J. Rojas is Counsel in the New York office and may be contacted via e-mail at erojas@pillsburywinthrop.com or by phone at (212) 858-1180.
Heather Bridgid Conoboy is an associate in the New York office and may be contacted via e-mail at hconoboy@pillsburywinthrop.com or by phone at (212) 858-1506.
Pillsbury Winthrop LLP is a global law firm with power and presence on both U.S. coasts and abroad, with core practice areas in: real estate, litigation, technology and intellectual property, energy, capital markets and finance. The firm has 17 offices and approximately 800 attorneys worldwide. For further information on the firm's real estate practice, please contact Jim Rishwain at jrishwain@pillsburywinthrop.com or (310) 203-1111.