Breaking into the Ground Truth of Subdivision Bonds
Author: Suretypedia Team
Posted On: 09-10-2020
The Subdivision Bond is a tool used by local governments to guarantee the commitments made by land developers in their site plan. Often, developers are allowed by local statute to receive a Certificate of Occupancy (for commercial developments) and record their subdivision plat before completing all of the infrastructure improvements in their plan (street paving, storm drains, landscaping, etc). This provision allows developers to begin selling the subdivided lots to real estate buyers before completing the project in its entirety. To ensure that the improvements will eventually be completed as proposed, city and county development offices often require a surety bond establishing the surety carrier as a fiscally responsible guarantor who will pay for completion in the event that developers fail to build out their project from “soup to nuts”.
Nationwide, Subdivision Bonds have garnered a reputation among surety carriers as a high-risk category, citing high dollar value losses, albeit with low claim frequency. To evaluate this risk, underwriters commonly turn to conventional methods, looking for the usual telltale signs of financial reliability: the principal’s personal credit history and personal financial statements, and the business’s financial statements. While these methods are important, they are backward-looking criteria that may not provide the best representation of the risk at hand. In Suretypedia’s continued examination of the surety industry’s best underwriting practices, we take a closer look at the evaluation criteria for these bonds and ask, “Are we looking in the right place to understand the risk?”
How Do Subdivision Bonds Work?
Subdivision Bonds (which are often interchangeably termed as Land Improvement Bonds, Infrastructure Bonds, Land Disturbing Bonds, Site Improvement Bonds, etc.) provide a unique three-party advantage to land developers, their property buyers, and local governments. Bonds of this type allow developers to sell real estate before their project receives final inspection, thereby allowing them to realize revenue significantly earlier in the development process and reduce their financial risk. At the same time, the bonds provide a means by which a city or county government can financially guarantee the proper completion of all improvements in the subdivision’s scope. Finally, subdivision property buyers benefit from a community that is complete with all of the amenities as advertised in the glossy brochures available at the subdivision sales office.
Subdivision Bonds can guarantee a wide range of unfinished elements of a subdivision plan that are necessary to receive plat approval. They may include the construction of streets, potable water access, sanitary sewage, stormwater control devices, street lights, off-street parking, landscaping, and erosion control systems. Obligees sometimes require developers to post a bond early in the process as a final gating step in obtaining a building permit. More commonly though, the bond is only required if a developer wishes to receive a Certificate of Occupancy and record the subdivision plat prior to completing all improvements. The bond amount is typically determined by estimating the cost to complete all remaining improvements and applying an additional 25% as a contingency for cost overruns. Final approval for the bond amount generally comes from the obligee’s engineer, after reviewing the estimate submitted by the developer or their engineer.
Where Is the Risk in Subdivision Bonds?
Since Subdivision Bonds merely guarantee that a developer will build the project as they have planned, some exploration is required to uncover the real source of the bond’s risk. In the course of researching this question, the Suretypedia team polled dozens of obligees, speaking with the performance bond administrators at municipal governments ranging from small townships to metropolitan county offices. The prevailing report from bond administrators is that they very rarely pursue claims against Subdivision Bonds. In the vast majority of cases, developers complete their projects and pass final inspection, which stands to reason, considering the incentives motivating developers to deliver on their commitments. Developers need to maintain their reputation as competent builders. An abandoned, incomplete project would almost certainly be discovered in a potential investor’s or buyer's diligence, severely jeopardizing the potential for investment in future projects. Even independently funded developers need building permits to build future projects, and county development offices tend to have a long memory for abandoned projects. Developers who intend to stay in business cannot afford to invite a claim against their Subdivision Bond, especially if they are geographically bounded.
For this reason, the cumulative risk in Subdivision Bonds is the product of high-severity, but low-likelihood instances of abandonment by developers. When developers do suffer insolvency and are forced to abandon a project, the potential losses to the surety can be massive. Furthermore, there also looms the underlying risk of the real estate market. Large subdivision improvements can total hundreds of thousands of dollars and take several months to seize control and complete. Depending on the market cycle, the Surety may not be able to recover their entire loss with the sale of the property.
What Is the Value of the Developer’s Credit History?
As the Suretypedia Team explored in our article COVID Payment Deferrals: Should Sureties Ignore Credit Scores?, we continue questioning whether the personal credit score and credit history actually inform surety underwriters of the real risk posed by surety bond applicants. While the credit score and credit history tell underwriters a great deal about the applicant on an individual level, they are by their nature backward-looking and may fall short of helping underwriters accurately understand a developer’s’ likely performance on a future project.
Underwriters should also consider more acute aspects of the specific project when assessing the relative risk of a developer. The following factors would give underwriters a more complete picture of the risk:
Developer Experience - How many years of experience does the developer have? How many projects has the developer completed, and with what total budget? Has the developer ever failed to complete a project?
Project Scope - How similar are the proposed project’s improvements to the developer’s previous experience in scope and total cost to complete?
Project Source of Funding - How leveraged is the developer, and how leveraged is this project, as a function of total debt and equity in the land? How many months can the developer service the debt based on their liquid reserves? How does the total bond limit compare to the pro forma revenues of the project?
Business Financial Statements - How financially stable is the developer? Is the business profitable? Does the business have enough capital to operate and for how long? Are there existing lines of credit and how much has been used?
Operating Agreement for the Business - Who are the business owners and were they all included on the initial application? This is important in order to obtain the appropriate indemnity
Engineer’s Estimate - Is the estimate in line with the bond amount requested? Does the principal have the appropriate funding for a project of this size?
A holistic look at these criteria and details of the project itself greatly improves the assessment of the specific risk at hand. A precise look at the specific development gives an insight to the key question: What is the likelihood that the developer will complete this particular project, and what is the upper boundary of the downside risk if they do not?