The tiny town of Central Falls, Rhode Island,
celebrated its emergence from bankruptcy by
turning the exterior ring of lights back on
at its 109-year-old Cogswell Tower in Jenks Park.
City leaders had turned the lights off long ago
to trim electricity bills.
In the bankrupt central California port community of Stockton, most of the reduced municipal government staff still toils in a crumbling, rat-infested building because a bank repossessed the $40 million office complex that local officials had purchased earlier to convert into a new city hall—but then they failed to make the payments. Stockton’s myriad redevelopment projects, just a few years ago considered perhaps the most ambitious slate in the nation, have ground to a halt, and politicians have even pondered selling the city’s historic Bob Hope Theater to help pay overdue bills.

Until recently, officials in bankrupt Jefferson County, Alabama, were considering the sale or lease of Birmingham’s only hospital for the poor to a private health care company or real estate developer and use the proceeds to avoid even more cuts to police and fire departments. They instead decided to keep the facility open, but to eliminate in-patient care.

And in financially troubled Scranton, Pennsylvania, the mayor last summer temporarily reduced nearly all of the municipal employees’ pay to $7.25 an hour—the federal minimum wage—to save money while supporting a roughly 70 percent hike in property taxes over three years to help ease budget problems. A 22 percent hike has been incorporated into the city’s budget draft for 2013, but it could go even higher if the courts reject a proposed new levy on commuters who work in Scranton but do not live there.

Although most urban planners and real estate developers lament the sad financial state of government municipalities today, they’re also optimistic about the positive results that may eventually come from the wreckage.

“It’s sad that a lot of cities are going broke, but there’s a silver lining here,” says William Fulton, an urban planning expert and vice president of Smart Growth America in Washington, D.C. “Local governments are starting to rethink their previous growth plans, and that’s helping to open up a whole new world of investment prospects for developers and other real estate companies.”

Indeed, many of the growing number of municipalities that are pondering filing or have already filed for bankruptcy protection—from city and county governments to sewer agencies and road departments—are creating a fresh crop of opportunities for builders and realty investors.

Some municipalities are simply increasing the contracting out of vital services, such as road repair or building maintenance, to private firms that have smaller staffs and lower overhead. But others are starting to put well-located properties up for sale, using the proceeds to help fill their budget gaps. Still others are aggressively pursuing new, innovative public/private partnerships to cut costs and establish more reliable streams of revenue.

About 40 municipalities across the country filed for bankruptcy between the start of 2009 and the end of 2012, according to the Alexandria, Virginia–based American Bankruptcy Institute. That’s up significantly from 26 cumulatively in the previous four years (2005 through 2008).

Although financially troubled municipalities are pursuing different strategies to climb out of bankruptcy or avoid going into it, nearly all blame their current woes on a combination of factors that began to come together several years ago. The long-sluggish economy slowed job creation and kept the unemployment rate stubbornly high, which in turn curbed consumer spending and sent local sales tax revenue plummeting. A sharp drop in assistance from the federal government and state legislatures hurt, too.

Most cities and counties are also being smothered by debt owed to generous pension plans and long-term health care packages that were doled out to current and retired public employees when times were much better.

Yet, most experts say that the biggest culprit may be the prolonged drop in local property tax revenues that began after the nation’s housing bubble burst in 2007.

Revenue from local property taxes accounts for about 29 percent of a typical city’s annual income, making it the single largest source of cash to pay bills, according to the National League of Cities (NLC). The cash typically continues to rise for two years or more after a housing boom ends, though, because it takes a long time for most assessors to reappraise all the properties within their jurisdiction at their lowered values.

“This ‘lag time’ usually gives cities a bit of a [financial] cushion to avoid making big budget cuts immediately, because they assume that values will start rising again in a few years and tax revenue will pick up,” says Michael A. Pagano, a researcher for the nonprofit NLC and dean of the College of Urban Planning and Public Affairs at the University of Illinois at Chicago. “The problem now is that no one foresaw how long and how deep this housing recession would be,” Pagano says. “Traditional revenue models have gone out the window, and cities are suffering.”

For the first time in decades, the researcher adds, nationwide property tax revenue in 2010 fell by an inflation-adjusted 2 percent from the year before. It dropped a steeper 3.9 percent in 2011, about 2.1 percent in 2012, and Pagano says he expects it to essentially remain flat this year and next before slowly rising again in 2015. The same lag in reassessing properties at their new values on the way down also halts the rebound in tax revenues when values start to recover.

With no big economic pickup in sight and with operating costs continuing to rise, many experts say that even more municipal bankruptcies lie ahead.

“This is not the end. This is the beginning,” says economist Peter Navarro at the University of California at Irvine, shortly after three cities in the Golden State filed for bankruptcy in a span of just two weeks. As other cities “see it can be done and is being done, it will give them the idea” to file for bankruptcy, too, he says.

Few city council members or county supervisors relish the thought of filing for bankruptcy, says Marc Levinson, a lawyer who is representing the city of Stockton in its current bankruptcy proceedings. Levinson is a Sacramento, California–based partner in the restructuring group of Orrick, Herrington & Sutcliffe. “But cities don’t really have any choice if they have done their best to fix the problem by cutting costs or raising revenue—or by doing both—and still can’t meet their current or future obligations,” he adds. “Bankruptcy is not a good option until it’s the only option.”

Municipal governments that realize that bankruptcy is their only alternative should file sooner rather than later, some experts say. Prolonged dickering over the decision can often make matters worse rather than better; public anxiety grows and consumer spending falls (and local tax receipts along with it), while developers and other businesses reconsider new tax-generating ventures that have already been green-lighted by local officials.

In fact, it was a large real estate company—Hillwood Investment Properties, a division of Dallas-based Hillwood Development Co.—that helped pressure the city of San Bernardino into its bankruptcy filing last August.

Hillwood has been trying to market much of the undeveloped property surrounding the fledgling San Bernardino International Airport, a long-closed air force base that was reopened about two years ago as part of the city’s effort to attract more travel and freight business, but which so far has failed to garner a single commercial airline.

Officials had hoped that the redeveloped San Bernardino International Airport in southern California (above) would rejuvenate
the local economy, and real estate activity surrounding the facility appears to be gaining traction after a slow start.
Hillwood Investment Properties, one of the area’s biggest landowners, encouraged the city to file for bankruptcy last summer.

As city council representatives debated the pros and cons of filing for municipal bankruptcy last summer, John Magness, Hillwood senior vice president, appeared before the officials and essentially warned that there was no other choice.

“No responsible developer, including Hillwood, will risk its nationwide and worldwide relationships by getting its users to locate in a city with such dire financial challenges unless you take the next important step” by approving the bankruptcy filing, Magness told the council. The group started bankruptcy proceedings just days later.

While San Bernardino’s bankruptcy is still in its infancy, several other municipalities that have filed over the past year or two are already using their real estate assets to help work their way out of it. One of those is Jefferson County, Alabama, which filed in November 2011. Soon thereafter it sold more than $3 million in underused office space and raw land to help offset last year’s budget deficit, and the city plans to raise another $4.4 million through asset sales in fiscal 2013 to fund upgrades of its antiquated computer system and the sheriff’s department’s aging fleet of patrol cars.

Two views of the historic B&M Building in Stockton, one of dozens of
well-located properties that cash-strapped municipalities have been trying
to sell in order to make ends meet. Privately held Cort Cos. purchased
the vacant structure for less than half of what the city paid for it ten years ago
and plans to turn it into a mixed-use facility that includes a wine bar,
an upscale café, and office space.
“In the absence of any recurring revenue, we’ve had to think outside of the box in order to operate the county and have a positive impact on citizens,” says Jefferson County Commissioner Jimmie Stephens.

Many real estate investors are particularly attracted to the older buildings that some financially ailing cities are offering for sale in promising downtown areas—often at fire-sale prices.

One of those investors is Stockton-based Cort Cos., which in 2012 struck a deal to buy and renovate a historic three-story building in the heart of its bankrupt city’s downtown core for a reported $209,400 in cash. Stockton had purchased the edifice about 11 years earlier for $570,000 as part of its now-stalled redevelopment efforts.

Cort Cos. plans to renovate the vacant structure and place an upscale café, a wine bar, and a specialty grocery store on the street level. The Stockton Convention and Visitors Bureau plans to lease the second floor for at least ten years.

“Once projects like [this] happen, let’s open the floodgates,” Dan Cort, Cort president and CEO, said after Stockton’s city council approved the sale last October. “Let’s open our creative souls a little bit, and let’s start talking in positive terms.”

Asset sales, however, can go only so far, warns bankruptcy attorney Levinson. “It’s usually only a one-time fix,” he says. “Sooner or later, you’re going to run out of things to sell. It’s important for cities to also look for ways to establish new revenue streams that will generate longer-term, more reliable income and savings.”

Those efforts are already creating a new slew of public/private partnerships aimed at cutting cities’ ongoing costs and sometimes even creating new profit centers.

“We’re getting several calls a week now from municipalities across the nation that want to launch new projects with the private sector,” says Richard Norment, executive director of the National Council of Public-Private Partnerships in Arlington, Virginia. “There’s no question that the financial problems that most municipalities are facing has been a big factor in the increase.”

Nor is there any question that the dire financial conditions facing many cities have injected a new wave of creativity into the way those partnerships are structured. Although many municipalities still pursue the traditional format—a developer, say, might agree to build a new school at little to no cost in exchange for the right to erect a large sub­division—a small but growing number of deals are aimed at providing local officials with millions of dollars in upfront cash and a long-term revenue stream to help pay future bills. Norment says that municipal service agencies, especially public utilities, are among the leaders in such innovations.

One of the largest and most ambitious public/private partnerships is taking shape in Allentown, Pennsylvania, where local leaders have been reviewing proposals from a number of private firms and a local water and sewer authority that want to service and operate the city-owned water and sewer systems. Allentown—the state’s fastest-growing city—is not in bankruptcy, but it has been suffering severe financial pains.

Under a draft proposal that Allentown officials began circulating among potential partners late last year, the private firm that is selected would receive a 50-year lease to operate the systems. The winning bidder would pay the city an upfront fee—Gary Strathearn, the city’s finance director, says it could top $200 million—and an annual concession fee of about $4.5 million over the next half-century. A large chunk of the upfront charge would be used to begin paying down roughly $200 million in unfunded pension liability, Strathearn says, while the annual fees would be used to meet a variety of ongoing expenses in the coming decades. The private firm would make a profit by taking over a turnkey operation that will generate hundreds of millions of dollars during the lease term before the systems revert to the city.

In an effort to gain public and union support for the plan, the draft contract includes language that protects jobs, guarantees that all union contracts would be honored until they expire at the end of 2015, and limits any future rate hikes by linking them to the overall inflation rate. “We see this as a ‘win’ for everyone involved,” Strathearn says. “The city saves money and vastly improves its financial situation for years to come, the private lessee makes a solid profit, and our citizens won’t face huge rate increases in the future—while also getting service that is as good as or perhaps even better than [what] they receive now.”

While many cities and other types of municipalities will undoubtedly continue to struggle in the years ahead, some experts point to Central Falls, Rhode Island, to demonstrate the benefits that a well-executed bankruptcy can sometimes provide.

Central Falls, located about seven miles (11.2 km) north of Providence, has the distinction of being the smallest town in the nation’s smallest state: It’s barely ten blocks long by ten blocks wide. But its size didn’t make it immune from the same types of fiscal problems facing cities that are 100 or even 1,000 times larger, and it filed for bankruptcy in August 2011.

With remarkable speed, though, Central Falls leaders, union officials, and many of the town’s private citizens cobbled together a plan to get the city out of bankruptcy as soon as possible. Its emergence from bankruptcy was approved by a federal judge last September, just 13 months later—making it the fastest city to finish such proceedings in more than a decade.

The approved bankruptcy plan is already paying dividends, but they aren’t coming without some pain. Many of the city government’s 250 retired and current workers agreed to deep cuts in their pension plans and other benefits, after grudgingly acknowledging that it would be impossible for a town that brings in only $16 million in revenue each year to ever make up the $80 million it faced in underfunded pension promises.

Homeowners in Central Falls are feeling the sting, too. The city’s plan to emerge from bankruptcy calls for an increase of as much as 4 percent in property taxes every year through 2016.

On the upside, real estate developers are showing new interest in a city-run economic development program that gives tax breaks to companies that renovate older buildings, some of which are already being converted into residential or mixed-use projects that will further boost the community’s property tax base. Central Falls has also begun working with the neighboring city of Pawtucket, Rhode Island, on a multimillion-dollar plan to redevelop its share of the historic Blackstone River Corridor and the untapped potential of the riverfront.

And in a symbolic public celebration, the intricate ring of lights that encircles the town’s beloved 117-year-old Cogswell Tower—which had been turned off long ago to trim a bit off the city’s electricity bill—were switched back on just a few days after Central Falls’s bankruptcy plan was approved.

“Our official motto has always been ‘A City with a Bright Future,’ ” says Gayle Corrigan, the chief of staff for the state-appointed receiver in Central Falls who played a key role in the bankruptcy proceedings. “But now, it’s got a renewed meaning.”