On April 2, 2018, S&P Global Ratings published its "Special Assessment Debt" criteria on RatingsDirect. In fourth-quarter 2019, S&P Global Ratings completed its implementation of the same, reviewing all existing issuances under the new methodology.

Of the existing public issue ratings reviewed, we raised 56%, lowered 3%, and affirmed 41%. We have added 43 special assessment rating issues since the criteria was released (for a total of 365 public ratings, after accounting for issues defeased during the implementation period). Chart 1 details the rating distribution for the public issuers falling in scope of the criteria.

Chart 1

We took 179 positive rating actions on ratings that we reviewed under the revised methodology. Of these, 30% were one-notch, 30% were two-notch, and 40% were three-notch or more (with the majority being three-notch). Eleven reviews resulted in one-notch negative rating actions, while 131 reviews resulted in affirmations.

Following the criteria implementation, the modal rating remains 'A-'. However, the overall distribution has taken a more normal shape, skewing slightly positive. Overall, the direction of rating actions met our expectations, with more positive rating actions than negative, though the magnitude of positive actions slightly exceeded our initial expectations.

This is partly due to the share of rated special assessment debt issuers within California, which, as anticipated, experienced the bulk of the multinotch positive rating actions under the revised methodology for a variety of reasons, as discussed below. California accounted for the majority of the public ratings at 54%, followed by Florida at 37%, with the remainder spread across 12 states.

For additional detail on California-based special-assessment-secured obligations and legal structures (such as community facilities districts/Mello-Roos districts, public financing authorities /Marks-Roos districts, assessment districts), see our report "Why California Special Assessment Ratings Are Bolstered By New Criteria," published Feb. 5, 2019.

Chart 2

Table 1

Observation On Criteria Implementation

As noted in the criteria, when fiscal stress does occur, we've observed two main patterns of delinquency and default among bonds backed by special assessments. The first occurs as the result of high concentration of property among several developers or even a singular property developer, typically when districts are in an early stage of development. During this phase, project success and the ability to collect assessments largely depend on the operating environment and the viability of only a few owner-developers, concentrating credit risk and magnifying the exposure to real estate market dynamics. The second typically occurs during a significant downturn in the real estate market itself, pressuring assessment collections regardless of concentration or development status. An example of this would be a major market correction such as the one that occurred in 2007 to 2011, or a more localized decline in prices, which could signal a softening market for real estate. In general, we believe a built-out district with strong taxpayer diversity is more likely to be able to withstand some market stress, including the simultaneous delinquency of multiple property owners.

As we rate only upon request, the special-assessment-backed debt we do rate tends be self-selecting in a certain respect. That is, it consists almost exclusively of fully or highly developed districts with minimal developer or vacant lot/unplatted exposure. The revised methodology captures these strengths of the rated universe in a variety of areas that we believe accurately reflects credit quality.

The methodology explicitly assesses development status (which we define based on vertical construction completion), top assessment payer concentration, and other nuances related to the nature of assessment payers. While these attributes were assessed in our prior criteria, in practice, many of them were captured in assessing overall value-to-lien (VTL) ratios. For instance, the prior criteria included guidance stipulating that special assessment bonds in the 'A' category would generally have overall VTL ratios of greater than 20 to 1. Although this metric remains important, we've generally de-emphasized it in our revised criteria because of low historical correlation between value and tax liens, and special assessment/special tax default, particularly after VTL ratios exceed 5 to 1 or after development is completed. This is explainable, in our view, as the value of the asset relative to the tax lien provides an incentive for current owners, prospective lien holders (through a tax certificate sale or foreclosure process), or mortgage holders to pay taxes and assessments in a timely manner for this class of land-secured debt. As a result of the criteria change, many issues, particularly in California, that did not meet this 20-to-1 threshold but were fully developed, could withstand relatively high cash flow stress, and are in relatively strong economies realized positive rating actions.

Additionally, the majority of special-assessment-backed issues receiving positive rating actions can withstand high cash flow stress over the life of the bonds, as captured by the maximum-loss-to-maturity (MLTM) stress metric used in the Financial Profile section of the criteria. This metric incorporates performing revenue and available excess liquidity without considering recovery. It's useful on a stand-alone basis, but also when compared against taxpayer concentration, developer concentration, or undeveloped or other "high-risk" parcels. In general, among rated issuers, this ability to withstand high stress is exhibited by assessment areas with little to no property developer exposure, limited undeveloped parcel exposure, and relatively low overall taxpayer concentration. The majority of rated special assessment issues that experienced a positive rating action exhibit excess debt service coverage, moderate to high annual revenue (assessment) flexibility, and adequately funded reserves (typically equal to 100% of maximum annual debt service or the lowest of maximum annual debt service, 10% of principal, or 125% of average annual debt service).

California's High Revenue Flexibility Puts It Ahead Of Florida In Positive Rating Actions

Issues in California have experienced a higher share of positive rating actions and a higher overall distribution under our criteria than those in Florida have (see chart 2 and table 1). In general, the dichotomy between the two states under the application of the methodology to date is summarized by the credit factors detailed in table 2.

Table 2

Based on publicly rated issues and the data highlighted above, we observe that:

• Issuers and structures in California have significantly higher revenue flexibility to cover delinquencies or are structured to maintain excess cash flow coverage. As a result, issuers in California have a higher ability to withstand long-term stress prior to a debt service default occurring, as measured the MLTM. This translates into higher financial profile scores across California versus Florida. This is predominantly related to Mello-Roos and Marks-Roos-enabled structures in California, which allow for varying degrees of special tax flexibility, in contrast to traditional assessment districts. Most rated community development districts in Florida, in contrast, are structured for 1x debt service coverage and maintain no effective revenue-raising flexibility--a general exception being senior-subordinate collateralized bonds whereby the senior lien benefits from excess debt service coverage.
• Our view of district/assessment area characteristics across rated California issuers is slightly stronger than that for Florida, resulting in higher district characteristic scores. While rated areas across both states tend to be highly developed, buildout and concentration metrics are slightly stronger in California among rated issues. In addition, assessment areas in California tend to be significantly larger on average than in Florida, contributing to diversification.
• Furthermore, despite the lack of availability of market value information in California and despite Proposition 13 limitations that constrict assessed value, the median overall VTL ratio in California is higher than in Florida. We note that property is assessed at 100% of market value in Florida, providing an accurate picture of property values. The information from tax rolls in California includes deflated assessed values, as limited by Prop 13.
• Our view of local economies across rated California issuers is generally slightly stronger than that across Florida. Relative to Florida, local economies in California are generally defined by higher incomes and significantly lower mortgage foreclosure and pre-foreclosure rates. However, local economies in California are also characterized by widespread housing affordability issues and lagging population growth relative to Florida, possibly leading to some convergence in economic fundamental scores over time.

Special Assessment Financings May Proliferate Outside Of California

Over the past two years, we've observed an increase in the use of special assessment financing by general-purpose local government entities to finance a variety of projects, including fire services, undergrounding utilities, and commercial redevelopment. We'll continue to observe these trends and how the credit characteristics differ from those of more traditional infrastructure-related special assessment districts.

In the face of rising ad valorem property tax burdens and the proliferation of legislative changes to limit annual growth in revenue, special assessment financing may appear increasingly attractive for development or redevelopment. This may be particularly true in states such as Texas, whose Property Tax Reform and Transparency Act of 2019 reduced the maximum rate by which the operating property tax levy for local governments may increase from year to year to 3.5% from 8.0% without voter overrides. Special assessment debt in Texas is enabled through public improvements districts. Additionally, special assessment financing was recently authorized in North Carolina. As the state's population continues to grow (driven by net domestic migration trends that rank third among all states over the past five and 10 years), we think special assessment financing may be an attractive tool for counties and local governments--though we have yet to rate any North Carolina special assessment obligations.

Additionally, we'll continue to monitor insurance markets and uptake rates in places such as California and Florida amid a seemingly growing prevalence of climate-related natural disasters.

S&P Global Economics predicts the likelihood of a recession occurring on a 12-month rolling cycle to be moderate at 25% to 30% (see "U.S. Business Cycle Barometer: Walk The Line," Nov. 25, 2019). Despite prospects for modest growth, a deceleration in certain economic variables affecting real estate markets has taken hold. Following a strong recovery from the latest recession, property value appreciation has begun to slow in most major real estate markets. Furthermore, distress metrics, including foreclosure and pre-foreclosure rates, have inched up year over year. However, we believe that real estate demand remains comparatively strong given that existing and new home supply remains significantly lower than pre-recession figures, particularly around major metro areas. With a tight labor market and volatility in interest rates, certain property developers may begin to experience growing financial pressures that could reverberate to "dirt" or "development" bonds over the next several years, though we anticipate that mature districts will remain resilient, as demonstrated in prior economic cycles.