Landmark Brief: Charter School Facilities Finance Strategy Update 2013

What every charter school leadership team and board needs to know about current market and product
developments for charter school facilities financing in order to assess true costs, risks and opportunities.
BRIEF: Charter School Facilities Finance Strategy Update

June 27, 2013
Ted Fujimoto
Landmark Consulting Group BRIEF: Charter School Facilities Finance Strategy Update June 27, 2013
Overview
The charter school sector is over 20 years old and yet the majority of school leaders have not developed strategies to have reliable ways to obtain facilities and facilities financing. We believe the lack of facilities financing solutions has a larger negative impact on school quality and stability than realized. Implementing a high quality school design and operating system takes focused time and resources. Every minute taken away from implementing a strong school design and running effective school operations compromises the very thing that is supposed to enable charter schools to outperform. Every miscalculation of facilities timing and cost takes away precious resources needed to launch and operate the school. With these challenges, even the most experienced school teams struggle to create strong school launches due to the amount of time and resources spent on securing facilities. It is unacceptable that many charter schools secure facilities only months and sometimes days before opening caused by facilities financing fails to materialize at the last minute leaving only a few months to acquire, build and/or renovate a school building or by inexperienced and unsophisticated decision making on the schools part. As with any developing and emerging sector, the charter school facilities finance landscape is messy both on the buyer side (charter schools) and on the supplier side (financiers). On the financier side, early facilities financing solutions were not well designed to fit to the needs of charter schools and had limited amount of financing capacity (dollars available for financing.) On the buyer side, charter school leaders generally lacked sufficient commercial real estate development and financing experience. They also had a limited ability to understand the true risks and costs of these facilities finance solutions and financiers were not helpful enough to help them understand these risks and costs. Today, charter school leaders are more familiar with the various facilities financing products and tools such as bond financing, bank financing, credit enhancements, new markets tax credits, short-term leases, and long-term leases. Some larger charter school groups have been developing sophistication in the long-term facilities planning. However, we have found that many still have a limited understanding of the risks, true costs, and tradeoffs of each and how to create a comprehensive financing strategy that combines the use of a variety of solutions at the right time. Each solution of a particular type is not all created equal. Every one comes with features and risks. The purpose of this whitepaper for charter school leaders is to: 1. Be informed about facilities finance product and tool developmentsincluding features, market trends and risks. 2. Explore strategies to grow charter schools in a more controlled, deliberate and planned fashion leveraging the best combination of financing products and tools at the right time. We hope that this will help charter schools develop and execute strategic plans that create the highest quality charter schools at a quicker pacebenefitting more students and increasing their achievement. Copyright 2013 All Rights Reserved. Landmark Consulting Group, Inc. www.ConsultLandmark.org
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Market Developments
We believe that, overall, charter school leaders have had a tendency to underestimate timing, availability/capacity and cost risks of financing products. Some macro market developments to consider include: 1. Bond rates escalating from rising interest rates and accumulation of charter school bond defaults and downgrades. Implication: Actual cost of bond is a lot higher than what school leaders perceive. 2. Bond deals are collapsing at the eleventh hour even with schools that have successfully issued bonds in the past. Implication: Do not count on a successful bond issuance and have a backup plan. 3. Long-term lease financing solutions are maturing and their rates are declining - becoming competitive with the top 30% rates of the bond market. Implication: The flexibility and predictability of this capital may make this method more attractive than a bond.
4. New Market Tax Credits continue to be volatile and available to only certain schools. In 2013, there are some New Market Tax Credits available, as there were prior to 2012. This is in stark contrast to 2012 when there were almost no New Market Tax Credits available to charter schools. Implication: If New Market Tax Credits are available to your school, apply for them but look to other forms of financing as the primary plan and New Market Tax Credits as the secondary plan.
Copyright 2013 All Rights Reserved. Landmark Consulting Group, Inc. www.ConsultLandmark.org
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5. Bank loans are becoming more available. A number of banks have been aggressive in providing low interest loans with low equity requirements in certain regions but have a limited amount they are willing to lend to charters and within a concentrated geographic region. Most banks have high bar credit criteria and require substantial equity of 20-30%. Most bank loans are typically for a 5-7 year period. Implication: Evaluate the cost of bringing 20-30% equity to the table plus very high risk of higher interest rates after the loan term when you have to refinance. You may want to consider other long-term financing including long-term lease arrangements that may actually have a lower cost over the long-term and not have the equity requirements and associated costs. 6. Credit enhancement programs are useful across bank loans, bonds and long-term lease financing packages to lower the cost of financing, lower the equity requirement and/or qualify the school for financing it would otherwise not qualify for. Credit enhancement programs in the past have limited remaining capacity and some are attempting to rebuild this capacity. Implication: Make sure the provider has capacity for your deal and find out what their process and timing are. Check with the bank, bond, long-term lease financier to make sure the credit enhancement is acceptable early in the process as their criteria is getting more stringent.
Product Specific Considerations

School leaders should take the following factors in consideration in evaluating opportunities and risks using various financing products and tools:
Bonds Can be the lowest cost option when used at the right time
Cost Uncertainty Risk: Bond rates and costs are higher than expected. Schools have no control and no way to know ultimate cost of the bond until just before the bond offering. Currently, bonds costs are trending higher, driven by forecasted higher Federal Reserve interest rates and an escalated number of defaults and downgrades of existing charter school bonds. Timing Uncertainty Risk: Bond offerings may be aborted at the last minute due to lack of market. There are a number of recent bond deals that have fallen through at the eleventh hour even for some well-established charter schools. Financing Capacity Risk: Bond covenants will prevent flexibility of future growth and additional financing. A school is likely to be restricted on how much additional debt is allowed. This means that the school may have restricted ability to obtain other sources of financing at a later date without paying off the bond first. Another common restriction is that the bond takes priority over other creditorswhich are often not acceptable to other creditors. Qualification Risk: Schools must have sufficient credit capacity to be able to obtain bonds that are credit rated high enough to get reasonable rates. Building Cost Risk: Certain types of bonds may require that the charter school adhere to public 3|Page
school building codes which in some cases may be a 30-100% higher cost of construction than a similar building for a private school. True Cost: In addition to the coupon rate, a school must factor in fees and expenses (all in cost) PLUS the additional costs of capital incurred to finance reserve funds which can be between 10 to 15 percent. In other words, a school may need to borrow 10 to 15 percent more than it needs and is paying extra cost. Credit enhancements may be used to reduce the cost of a bond. Best Use: Bonds are best used when (a) the school or schools have been in operation for 10+ years, (b) there is a large enough portfolio of school buildings and/or sites to be financed, and (c) the school has no or very little additional expansion plans requiring future rounds of financing.
Bank Loans Medium priced option but only with credit and lots of equity
Cash Flow Risk: Bank loans usually require a significant amount of 20-30% of equity. This will potentially require a school to tie up its precious cash and grant money in a facility and away from operating and startup costs. Interest Rate Risk: Many loans are based on an adjustable interest rate. Interest rates are likely to go up significantly over time increasing the cost of the loan and decreasing the cash flow of the school. Timing Uncertainty Risk: Many bank loans may require a refinancing or balloon payment in the futuretypically 5-7 years. The charter school has no control of the financial markets and whether it will be able to refinance with favorable terms at that point in time. Financing Capacity Risk: Bank loan terms may prevent flexibility of future growth and additional financing. A school is likely to be restricted on how much additional debt is allowed. This means that the school may have restricted ability to obtain other sources of financing at a later date and may have to refinance each time. Another common restriction is that the bank loan takes priority over other creditorswhich may not be acceptable to other creditors. Qualification Risk: Schools must have sufficient credit capacity to be able to obtain bank loans that are rated high enough to get reasonable rates. True Cost: In addition to the interest rate, a school must factor in fees and expenses (All in cost) PLUS the additional costs of capital incurred to finance or obtain the 20-30 percent equity funds. Credit enhancements may be used to reduce the cost of the bank loan. Best Use: Bank loans are best used when (a) the school or schools have been in operation for 7+ years and (b) properties as smaller and/or at a lower cost, (c) the school readily has the ability to bring in low-cost equity, and (c) the school has no or very little additional expansion plans
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requiring future rounds of financing.
New Market Tax Credits One of the lowest cost of financing, if available
Timing Uncertainty Risk: New Market Tax Credits may not be available when the charter school needs it. Charter school leaders overestimate the availability of New Market Tax Credits and underestimate the volatility. Last year, very few - if any - New Market Tax Credits were available to the charter sector but this year they are available again. Financing Capacity Risk: Providers have only so many New Market Tax Credits available. Best Use: Use other forms of financing as the primary plan and New Market Tax Credits as the secondary plan.
Short Term Leases Great for small temporary spaces

Cost Uncertainty Risk: Costs may escalate at the renewal period of each lease. The amount of escalation is not necessarily known up front. Timing Uncertainty Risk: As the school grows, there may not be sufficient space to grow into when the school needs it. Occupancy Risk: There is no guarantee that the space will be available to the school at the new renewal. Building Cost Risk: Tenant improvements may not be allowed by the owner or buildings may need significant tenant improvements that are not recoverable when the school decides to move elsewhere. True Cost: In addition to lease rate, the cost of tenant improvements and the cost of capital for any required deposits should be factored in. Best Use: Short Term Leases are great for small schools, schools in their first year or two of existence or in facilities that are below market rents.
Long Term Leases Useful default financing for expanding and new schools
Cost Risk: Costs are actually aligned with the upper end of the bond market but without the restrictions of a bond or a bank loan. Lease agreements often escalated their rates to mirror interest rates. Long Term leases are offered by some providers to be structured as a mortgage to reduce or eliminate property tax costs. Timing Uncertainty Risk: Some leases may require a refinancing/buyout after Year 7. The
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school has no assurances that it can qualify for other forms of financing. It is important to have terms that the school (not the financier) has the option to refinance or do a buyout after 5+ years. True Cost: In addition to the lease rate, the cost of any equity needed should be factored in as well as cost of property taxes and maintenance. In addition, the cost of a buyout should be considered. Some leases have an escalating buyout premium over the length of the lease based on fair market value or cap rate. Other leases have a declining buyout premium over the length of the lease. Best Use: Long Term Leases are great to provide a baseline financing program for any quality charter school group that has expansion plans for one or more schools until a large portfolio can be refinanced using bonds and/or New Market Tax Credits. This is the most predictable and stable capital available with the largest capacity.
Credit Enhancement Useful in conjunction with bonds and mortgages to lower costs of financing
Financing Capacity Risk: Providers have a limited amount of credit enhancement capacity available at a given time. Best Use: Use it in conjunction with bonds, long-term leases, especially bank loans to lower financing costs. Always have a backup plan if the credit enhancement provider does not have enough capacity.
Free or Low Cost Buildings Great option if they are appropriate buildings in the right location
Timing Risk: The charter school has no control of the availability of these buildings. This may cause the charter school to have to delay opening. Cost Risk: Free or low cost buildings are not necessarily cost-free or even low cost. Costs to consider include extra maintenance for ill-maintained and older buildings, utilities, transportation and costs of renovation, etc. Operating Risk: The building design may not fit the needs of the charter school or have operating restrictions if it is shared with other tenants that have operational impact on the charter school. Recruitment and enrollment of students may be more difficult if not located properly. Best Use: Use in conjunction with district school conversions or serving neighborhoods where districts or private schools have shut down schools within. 6|Page
Potential Strategic Options

Charter school teams develop a school design, acquire authorization, raise funds, launch a school, implement the design and operate the school all a huge effort. To add the uncertainty of the ability to secure school facilities on top of these issues often becomes the last straw. A solid strategy accomplishes the following: 1. Creates a path with a high degree of confidence that a charter school is able to obtain the facilities it requires both at the start and when it expands. 2. The financing strategy optimizes the cost of capital to the lowest cost over time without creating constraints that prevent a school from growing as planned. 3. Financing is sensitive to cash flow constraints for the first few years of a startup school until they reach full enrollment. 4. Requires very little equity or no equity to be tied up in facilities that would negatively impact the operating cash flow and reserves of the school. 5. Allows for schools to refinance within reasonable time periods at a given price with the schools (not the financiers) option.
Formal Layered Program Approach

The Formal Layered Program approach is for charter and education management organizations that have ambitious plans for continuous expansion. Layer 1 establishes the baseline foundation method of financing facilities. Each higher layer may have greater risks of execution but with lower costs of capital payoffs which, if successfully obtained, can be used in replacement of the baseline financing method. Layer 1 Long-Term Lease Establish a long-term lease program as the default method of financing for new projects. In partnership with the right real estate development firm and real estate fund, the equity requirement may be 0% to 10%. Layer 2 New Market Tax Credits Pursue available New Market Tax Credits to see if any of the school facilities projects could be financed using this method in replacement of the Long-Term Lease program. This is more useful for smaller projects. Layer 3 Bank Loans with Credit Enhancements Identify any potential special bank loans with credit enhancements and low equity requirements that could be at a lower cost of capital than the long-term lease program. Copyright 2013 All Rights Reserved. Landmark Consulting Group, Inc. www.ConsultLandmark.org
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Layer 4 Bonds Work on large issue bonds to take out seasoned properties (7 to 12 years) from the long-term lease program and any bank-financed properties that have higher capital costs. To optimize facilities costs per pupil, schools should ramp up to full capacity within 2 years, no more than 4 years. It is also possible to expedite the fill-up of a building by launching multiple schools on the same campus and in the future by either adding on new buildings to that campus if there is sufficient land space or building new campuses at a different location.
Build-Out Program Approach

The Build-Out Program approach is designed for single schools or schools with limited expansion ambitions. The basic idea is to mirror the facilities Build-Out to match as closely as possible the needs of the school each year as they add new grade levels. This approach works best when a school is able to reach full enrollment within 2-3 years of opening. Stage 1 Property Acquisition and First Building Using long-term lease financing, acquire a reasonably priced property. A building must either be built or may be remodeled that is sufficient to house the first year or two of enrollment but not more. The first payment of the long-term lease should be delayed until January of the first school year of operation thus cutting the first year capital costs in half. Stage 2 Expansion Building In Year 2, another building is constructed to house the remaining schoolalso using long-term lease capital. Stage 3 Refinance After the buildings have been seasoned (5-12 years), the school identifies any lower cost sources of capital (loans, bonds, New Market Tax Credits) to refinance out of the long-term lease without compromising and depleting operating cash reserves.
Deferred Slow Growth Approach

The Deferred Slow Growth approach is designed for single schools or schools with limited multi-site expansion ambitions and slow enrollment growth. Stage 1 Short-Term Temporary Lease Identify temporary short-term lease facilities sufficient to accommodate the first few years of enrollment. Copyright 2013 All Rights Reserved. Landmark Consulting Group, Inc. www.ConsultLandmark.org
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Stage 2 Long-Term Lease or Credit Enhanced Bank Loans Once the school reaches 75% full enrollment, start acquisition and building of permanent long-term facilities using long-term lease capital or credit-enhanced bank loans. Stage 3 Refinance After the buildings have been seasoned (5-12 years), the school identifies any lower cost sources of capital (loans, bonds, New Market Tax Credits) to refinance out of the long-term lease without compromising any needed operating cash reserves.
Conclusion
The most important thing a charter school can do to establish a coherent growth plan is to have a welldefined facilities strategy that is mostly in the direct control of the school. Facility delays create enormous opportunity and organizational cost both on school quality and financially. Each year the school is not able to meet enrollment goals, revenues are left on the table. Each school that didnt open in the specified timeframe delays reaching the financial cash flow breakeven and sustainability point. Considering these potential consequences, finding facilities financing solutions that remove this uncertainty even if it costs a little more can be worthwhile. For example, many charter management groups run a negative $500K to $1M in cash flow per year until they have enough schools with sufficient enrollment to reach their breakeven pointe.g. 12-15 schools. Every year of delay in reaching this breakeven point can be costing the organization nearly a million dollars cash flow. Paying a 0.5% to 2% more for financing that removes the facilities uncertainty and enables the organization to execute as scheduled may more than pay for itself. We recommend that charter school leaders take a layered or staged approach to financingalways starting with the most predictable form of capital and facilities options (e.g. long-term lease) and then simultaneously pursuing other reasonable secondary lower cost options. If one of these secondary options is viable, then the school always has an option to replace the long-term lease option with the lower cost option.
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About Landmark Consulting Group, Inc.

Founded in 1988, Landmark Consulting Group helps create, launch and grow high impact education organizations, projects and programs that are quality, innovative, sustainable, and scalable. Our clients have created or transformed 1,100 schools, impacted the lives of over 360,000 students and raised over $150 million in philanthropy support. We have worked and supported more high performance school models and school networks than anyone in the country. For school organizations, we can help you codify your school or program model, design and implement an effective replication system, plan for quality growth that is sustainable, and/or help you improve the fidelity and quality of implementation across schools. Partnering with our team will help you launch smoothly and with quality. For communities, local foundations, intermediaries, cities, states and local school districts, we can provide assessment services of existing conditions, help draft supportive policies and cultivate support for high performance schools.
For Information Contact:

Ted Fujimoto President tedf@consultlandmark.org 916-769-2417
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Ted Fujimoto - Founder/President

Ted Fujimoto is an experienced entrepreneur and consultant in organizational performance, development, scaling and business planning. He has helped develop business strategies for many education organizations including Bay Area Coalition for Essential Schools, Big Picture Learning, New Technology Foundation, Alliance for College-Ready Public Schools, Partnerships for Uplifting Communities, Linking Education & Economic Development, California Charter Schools Association and the New York Charter Schools Association - representing more than $150 million in funding. As a freshman in college, Ted founded and operated for eleven years a management and technology consulting company serving a range of customers including AirTouch Communications, Bank One, Chandon Estates, California Chamber of Commerce, GM, IBM, New York Times and Remy Martin. He was an equity partner in the consulting firm that developed the retail concept for Saturn Auto Company and re-engineered the retail networks of 11 automotive and hospitality brands. As a community business leader, Ted helped to design and found the highly regarded Napa New Technology High School and the New Technology Foundation which was acquired by KnowledgeWorks and as New Tech Network, is creating schools across the country. He also managed the Bill & Melinda Gates Foundation and Carnegie Foundation grants for education reform initiatives in the Sacramento region. He served on the California Education Technology Advisory Committee and received the 2002 Center for Digital Government "In the Arena" award for education leadership in transforming vision to reality. In Converge Magazines, "1999 Year in Review," Ted was named one of "Educations Dreamers, Leaders and Innovators." He currently serves as Chairman of the Supervisory Committee at the California Credit Union, a $1.4 billion credit union serving the education community. He co-founded and is on the board of the Right To Succeed Foundation and the Muzart World Foundation.
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What every charter school leadership team and board needs to know about current market and product

BRIEF: Charter School Facilities Finance Strategy Update

Product Specific Considerations

requiring future rounds of financing.

Short Term Leases Great for small temporary spaces

Potential Strategic Options

Formal Layered Program Approach

Build-Out Program Approach

Deferred Slow Growth Approach

About Landmark Consulting Group, Inc.

For Information Contact:

Ted Fujimoto - Founder/President

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