P3 Student Housing: Structuring for Certainty in an Uncertain World
While these uncertainties will likely not disappear overnight, it is likely that they will diminish as a synthesis of and balancing of supply and demand emerge in the near term, creating some semblance of a new normal.
Yet this new normal is likely to incorporate long-term trends that existed prior to the pandemic. One such trend is the fiscal challenges facing universities and colleges due to declining enrollment. The pandemic — and the resulting campus closures and shift to remote learning — exacerbated this trend as institutions faced a loss of housing and dining revenues as well as lawsuits seeking tuition refunds.
Although the vast majority of higher education schools are returning to in-person learning, the financial crunch continues. In addition, schools should be preparing to deal with another major driver of declining enrollment that is likely to materialize starting in 2025. That is when the number of high school graduates is expected to diminish as the effects of the 9% drop in birth rates during the Great Recession begin to take hold.
These economic and demographic uncertainties mean that universities and colleges will likely continue to look to public-private partnerships (P3s) to fund student housing needs off balance sheet. The purpose of this article is to draw on the lessons from defaulted student housing transactions to identify ways to structure new P3 transactions to mitigate the risk.
As discussed below, the key to structuring P3 student housing for success is to align financial incentives of all of the parties involved.
There have been three core drivers of student housing bond defaults. All three have been exacerbated by the pandemic.
The first is construction issues. Projects may run out of funds necessary to finish construction due to cost overruns or an unrealistic budget. The high cost of materials and labor shortages driven by the pandemic increase these risks. Insufficiency of construction funds may leave the bondholders with a project that is unfinished or delayed, and may be subject to mechanics’ liens. Unfinished projects do not generate revenues. Projects whose delivery is delayed miss the lease-up cycle and earn a troubled market reputation for having displaced their residents. Mechanics’ liens almost always constitute defaults under ground leases, which may lead to the loss of the project before the bonds are paid off.
Although bond documents often make the developer financially responsible for cost overruns, delays, and the costs of discharging mechanics’ liens, it may be difficult to hold developers responsible for practical reasons. Too often the developer is an undercapitalized single-purpose entity that has already collected all or nearly all of its development fee early on in the construction process. Under these circumstances, there may be limited practical recourse against a developer that shirks its contractual obligations.
The second issue is oversupply of student housing in the market, which depresses occupancy, rents, or both. This risk is managed by having a market study prepared that evaluates the economic feasibility of the project. However, nearly all, if not all, defaulted student housing projects we have encountered were accompanied by market studies that predicted success. Unfortunately, these studies can be too optimistic in their methodologies. Some also rely on faulty data that either resulted from inadequate due diligence or was supplied by a party that had the incentive to maximize the size of the project without any regard for its financial viability. The usual culprits behind data that is too optimistic or outright faulty are the sponsor institutions and developers.
The third issue is inadequate support from the sponsor institution. Given the off-balance-sheet nature of P3 projects, schools may not feel invested in the success of the project. Sometimes schools even feel that supporting a defaulted project may taint their own credit rating by association and for that reason take a hands-off approach. The resulting lack of institutional support can take different forms, including most commonly no financial support and no marketing support. In some cases, the University may see the P3 project as a competitor to its own student housing system and may seek to actively undermine it.
All three of these issues can be addressed and mitigated in the initial structuring of a P3 student housing bond transaction. The essential feature must be a proper alignment of interests and financial incentives.
First off, the sponsoring institution should have a financial stake in the success of the project. This can take a number of forms. The University could guaranty a 1.0 debt service coverage or could master lease a sufficient number of beds to get to a break-even occupancy. The school could backstop coverage until it meets a 1.20 level for two years in a row. The institution can also guaranty a minimum funding level in the debt service reserve fund. And lastly, the University could be required to own and hold 5-10% of the bonds. Owning the bonds provides an incentive for the University to work for the success of the project.
Another form of University support could be a contractual obligation to provide marketing support. Advertising the PPP student housing on the University website alongside University-owned housing is one form. Another would be sending advertising materials with University housing materials that are sent to students.
Where the P3 project represents the school’s first on-campus student housing facility, prohibiting the construction of additional student housing until the P3 project establishes a multi-year track record of success may be very helpful.
Secondly, developers should have an ongoing financial stake in the success of the project. They cannot be permitted to have an early financial exit. Otherwise, developers have little incentive to ensure that construction is completed on time, within budget, and lien-free, and that sufficient market demand exists given the project’s size and positioning in the market.
Most fundamentally, a significant portion of the development fee should be unearned until the project is delivered. In addition, development fees can be further deferred based on the performance of the project. Finally, the developer or a developer affiliate often becomes the initial manager of the project following its completion. In this event, a significant portion, if not the entirety, of management fees should be subordinated with proper incentives built into the management agreement. The management agreement should include financial performance benchmarks that must be met to avoid early termination, and should prevent the manager from recovering accrued but unpaid subordinated management fees in the event of termination for cause.
Lastly, the annual fee payable to the not-for-profit borrower should be tied to the success of the project.
The more the incentives of all P3 project parties are in alignment and the more parties have a clear financial stake in the success of the project, the more likely the project is to be successful.