If the school bond referendum passes, the City’s credit rating will be crucial to the cost and even ability to issue $120 million in bonds for a new GMHS and to finance other approved CIP items. Because of the historically large debt contemplated, credit rating agencies will focus intensely on the City’s ability to meet future debt service obligations and its flexibility to manage future revenue or expenditure shocks. The strength of the City’s financial position and outlook is even more critical in light of a recent finding that Virginia is in a relatively weak position to withstand financial shocks from a national recession, which could result in cutbacks in state grants and transfers.

Program assumptions underlying the bond referendum and the lack of actions to assess properly and mitigate the many risks involved raise serious doubts about the City’s ability to avoid a credit downgrade.

In their most recent assessments, bond rating agencies have focused on the current financial position and recent history of Falls Church financial management but have not carefully assessed details of the referendum program. They have highlighted the following factors in making these assessments:

• Adequate reserves accompanied by adherence to formal financial policies
• A relatively moderate level of fixed costs (i.e, debt service, pension obligations and Other Post-employment benefits (OPEB)) as a percent of government spending
• A historical practice of paying off a high percentage of debt principal (75% to 80%) within 10 years.
• Maintenance of long term City debt at about 5% of personal income
• Continued growth in real estate valuations given heavy dependence of City revenues on real estate taxes
• A past history of cutting nonfixed cost expenditures, when necessary, to maintain budget balance

November referendum plans would negatively affect these rating factors in the following ways:

1. Reduction in Reserves. The remaining $10 million in capital reserves from the water system sale would be fully drawn down and a negative gap between the unassigned fund balance target of 17% of expenditures and projected future fund balances will steadily increase for at least 5 years. In contrast, to protect its credit rating, the City’s Financial Advisor has recommended increasing the unassigned Fund balance to 20% and dedicating a specified portion of tax revenue each year to increase capital reserves to meet unanticipated capital needs.

2.  The City would violate several financial policies recently approved by the City Council including:

a.  Allowing the unassigned Fund balance to fall increasingly below the 17% of expenditures, notwithstanding the policy requirement to restore an unexpected drawdown below the 17% level within 5 years. This planned violation of policy would reduce the financial capacity to manage budgetary shocks.

b.  A debt ratio potentially as high as 17% of total expenditures would breach the stipulated policy limit of 12%. A higher ratio would increase fixed costs and limit flexibility to meet future city and school operating costs and new infrastructure needs and would compound risks associated with lower fund balance ratios and the use of capital reserves.

c.  The contemplated structure of the $120 million bond issuance would be a major departure from past practice of paying off 75-80% of debt principal within 10 years and would breach the debt policy payout minimum of 25% within 5 years and 50% within 10 years. Specifically, the plan calls for issuing bonds for 30 years with level debt service instead of the usual policy of 20 year maturities with a level payment of principal. Thus, debt service would remain above the historical percentage of expenditures for a longer period of time, further constraining the City’s flexibility to meet future operating expenditures and to issue new debt for infrastructure.

d.  The ratio of debt to assessed real estate values would be very close to the City’s financial policy cap of 5%. Failure of some key assumptions could easily raise this ratio. For example, (i) the projected $40-$45 million net revenue from the sale or lease of land at the GMHS site may not be realized, (ii) real estate valuation growth is likely to slow or even decline with a recession or (iii) more debt may be required to meet school construction cost overruns or finance additional infrastructure not paid for by developers.

3.  The referendum plan would triple per capita debt to about $14,000, or 21% of per capita income (2015). Servicing this city debt will fall most heavily on homeowners, who account for only slightly more than half of total households, but pay over 70% of real estate tax revenues, the most important revenue source for the City. (Owners of apartments only pay about 10% of the total real estate tax.) But over 80% of homeowners also have mortgage obligations not to mention other types of personal debts.

4.   Past history shows that real estate valuations decline in a recession, the probability of which is rising rapidly. Valuations declined by over 9% during 2008-10. Demographic outmigration in the adjoining jurisdictions of Fairfax and Arlington counties in recent years, following decades of high population growth, may well dampen future demand for new housing in the region, including Falls Church. Weaker housing demand on top of already apparent weak demand for new commercial development (offices, retail and hotels) does not bode well for real estate valuations. A slowing or decline in real estate values before real estate tax yields from development at the GMHS site are fully stabilized (in 2033) would hit the City’s finances at a particularly vulnerable period, i.e., with debt service at a historic high as a percentage of expenditures and reduced reserves

5.  Recent stress-testing by Moody’s Analytics shows that Virginia ranks near the bottom among the 50 states in terms of its preparedness for a financial shock from recession. Thus, in addition to the negative factors discussed above, the City could well face reduced grants and transfers from the State of Virginia if an increasingly likely recession were to occur in the next 3-4 years.

The Davenport Report and the School Bond Referendum

The City’s Financial Advisor in a late 2016 report emphasized that the high level of borrowing for the total CIP if the bond referendum passes would leave little flexibility to accommodate major cost changes or budgetary shocks. The Advisor warned that an adverse credit rating action would likely result if inadequate coordination and cost overruns in connection with a new GMHS lead to unplanned borrowing, or if other items are added to the CIP.

Accordingly, the Advisor stressed the need for a carefully thought out and publicly discussed comprehensive plan of finance for the GMHS project with a thorough assessment of risks and employment of risk mitigating strategies to protect the City’s credit rating. In addition to recommending an increase in the unassigned fund balance ratio and rebuilding capital reserves, the Advisor (a) warned against risks such as heavy reliance on land proceeds, (b) underlined the importance of a clear and well understood plan for rapid budgetary rebalancing in the event of revenue shortfalls or higher than anticipated interest costs and (c) strongly recommended that the City make cost comparisons with similarly situated localities.

The information made available to the public to date makes clear that the City Council and School Board have flagrantly ignored the Advisor’s recommendations and warnings. Specifically:

1. Instead of building up reserves, the referendum plan would deplete capital reserves and create a growing negative gap between the assigned fund balance and the 17% of expenditures policy target.
2. The plan is heavily reliant on highly uncertain land lease proceeds, which are estimated at far above recent market transaction values.
3. Although certain risks have been publicly listed, no efforts have been made to conduct stress tests to quantify the range of potential costs if key assumptions are not met.
4. In the absence of stress testing of risks, no strategy has been developed to address budgetary shocks that would emerge if key assumptions are not met. Although the City Manager has produced a skeleton projection of revenues and City and School Division operating expenditures, none of the basic underlying assumptions and relevant policy actions has been provided nor have any alternative scenarios been evaluated.
5. No comparisons of costs for building recent or planned high schools in the region have been made.

In sum, passage of the referendum and the underlying program entails numerous actions or inactions that would threaten the City’s credit rating at a highly vulnerable time. Moreover, City officials have flagrantly ignored the advice of the City’s financial advisor for addressing risks inherent in the referendum program and aimed at protecting the City’s credit rating. Thus, the lack of attention to actions required to maintain the City’s credit rating under the referendum program poses an even greater threat to its future financial stability and will make the prospect for astronomical tax increases almost inevitable.