Building for the Future:
A Guide to Facilities Loan Funds for Community-Based Child and Family Services
January 5, 2000
Prepared for
Carl Sussman is the principal of Sussman Associates, a Boston-based management and community development consulting practice. Mr. Sussman has over 30 years of community development experience, including 15 years as the founding executive director of a state quasi-public corporation, the Massachusetts Community Economic Development Assistance Corporation. He also managed and played a critical role in designing and implementing Massachusetts’ Child Care Capital Investment Fund. For the past ten years, he has been a leader in the child care facilities development and financing field and has written, spoken, and consulted widely on the topic.
INTRODUCTION
Entering the school through a side door, you descend a short flight of stairs. Insulated pipes cling to the ceiling like stalactites. The masonry walls wear a dull standard-issue uniform of pea-green paint. A room halfway down the hall houses the family support center, sporting a high ceiling, four small basement windows high on the wall, a couch, toys, and a collection of desks, tables, chairs, and shelves. Is this a "welcoming" environment, a place parents might gravitate to and spend time at? Is this even very functional for the meetings, training sessions, consultations, and socializing that happens here? Probably not. The site’s one virtue is its minimal cost. This one overriding economic consideration profoundly limits the ability of child and family service programs to meet the needs of those they are intended to serve. Recognizing the poor quality and scarcity of physical space currently dedicated to community-based child and family services, forward- thinking nonprofit leaders, government officials, foundation executives, and business leaders increasingly have begun to explore and, in some cases, to establish specially designed loan programs to supply capital to providers of these services, who may not be able to access credit from any other source.
Are facilities financing programs a logical response to these problems? Can the organizations or individuals providing community-based child and family services support debt? What kind of impact can a lender have on the capital problems of child and family service programs? Can a targeted lender affect programs in other ways, contributing to better management or even program quality improvement? How complicated is it to create and operate a loan program? How difficult is it to raise loan capital? This guide is designed to answer these and other questions that potential loan fund sponsors might ask themselves. This is not a "how to" operating manual that describes the procedures for underwriting, closing, and monitoring loans; rather it is a guide for policymakers, funders, program directors, and opinion leaders trying to expand and strengthen the system of supports and services for children and families. It tries to provide information, based on a growing experience from around the country, upon which to assess the feasibility and potential impact a specialized lending program might have on addressing the capital needs of those who deliver supports and services to children and families.
A TIME OF OPPORTUNITY
Why now? Why have loan funds gained currency as a policy strategy for improving the quality and supply of community-based child and family services? The answer is two-fold. First, there is a growing demand for child and family service facilities. Child care and pre-kindergarten funding has exploded:
All of these trends stimulate demand for center-based early care and education programs and translate into the need for more facilities. Similar trends are fueling the expansion of family support services, albeit on a smaller scale.
Second, while these factors stimulate demand for more or different facilities, it is increasingly feasible to raise the capital needed to operate a facilities loan program.
These factors have combined to create a moment in history when the capital needs of community-based child and family support services have risen on the agendas of many individuals and institutions. It is also a time when the creation of loan funds is more feasible than at any time in decades. In short, a unique opportunity exists.
But how significant is the problem of facilities for community-based child and family services, and how effective are loan programs at addressing their capital needs? These are the first critical questions this Guide addresses.
WHY FACILITIES MATTER
Let’s start with child care, where the role of facilities has received somewhat more attention and is therefore better documented. There is a growing shortage of child care facilities. Unlikely as it would be, one can imagine this topic in the hands of a late-night comedian like David Letterman, asking rhetorically, "Why aren’t there more child care centers?" The punch-line, of course, is, "All the church basements are already in use."
Dark humor to be sure, but humor that perhaps reveals a deeper truth: that it is common practice to locate child care centers in facilities designed for some other use, especially church basements. There is a deeper irony as well; as a society, we have come to think that the type of space we reserve in our homes for the furnace, laundry room, storage, and sawdust-filled workshop is somehow a logical environment for young children to spend much of the day when it is under a religious structure or public building. Of course, the reason so many child care centers locate in church basements is because there is no other use for the space. So it is cheap, perhaps even free, and available.
In addition to child care centers being in short supply, the quality of community-based child and family service facilities is frequently fair to poor. This impacts on the quality of these important community services. To be sure, a very substantial part of the facilities problem is economic; programs, especially governmentally and philanthropically supported ones serving lower-income communities, lack the revenue to pay the full cost of well-located and appropriately designed physical facilities. Well-situated street-level quarters constructed or renovated to meet the specialized programmatic needs of a family resource or child care center would be out of the question. The underlying fiscal problem is also evident in the notoriously low wages and paltry benefits offered to caregivers and the frequently inadequate level of administrative staffing evident in these programs; the prevalence of poorly located, low-cost "as-is" child care and family resource facilities is simply another manifestation of society’s frequent unwillingness or inability to pay the admittedly high cost of delivering quality early childhood and family support services.
The underlying economic realities that created and sustain the facilities crisis have spawned some dysfunctional adaptations that have compounded the problem. For example, not only have parents come to accept basement-level child care space, many providers no longer aspire to better facilities. Basil J. Whiting has noted:
…that nonprofits…are concerned about "diverting" scarce funds from services to facilities that could be criticized by the community. In addition,…many boards and staffs of nonprofits have an often unspoken "hair shirt" mentality that they "should" be in poor facilities because they serve poor communities, that it is "normal" to have "cruddy" facilities, furniture, and equipment, even if their inadequacy impairs service delivery. Perversely or not, some see it as a kind of "badge of honor," something to [tolerate] with both resignation and pride for devoting themselves to the good works they do.
One might add to Whiting’s list, a reluctance to invest in facilities when the staff remains so grossly underpaid.
Regardless of the causes, a facilities crisis exists in the family support and early care and education fields, and this crisis profoundly affects the supply and quality of these services in lower-income communities. These are the two critical dimensions of that crisis.
Supply
Recent empirical studies have demonstrated that child care supply correlates with income; the supply of both family day care and center-based care is greater in more affluent communities as compared with less affluent ones. The discrepancy is most pronounced for center-based care.
A recent U.S. General Accounting Office report, Welfare Reform: Implications of Increased Work Participation for Child Care, (May, 1997) concluded that the supply of center-based care is already insufficient, especially in poorer neighborhoods, and will grow worse as welfare reform proceeds. This is especially true because the federal block grants that accompanied welfare reform’s enactment have allowed the states to subsidize more children than ever before, but limit the use of block grant funds for facilities. Many states have also begun to fund pre-kindergarten programs, often delivered by nonprofit child care providers. All of this expansionary pressure is occurring in a strong economy where the demand for real estate is strong, and therefore its price is especially high. With a limited supply of low-cost/ no-cost space – church basements and public facilities – in most communities, the relative shortage of child care, especially center-based child care, can be expected to grow more severe.
That shortage creates a very serious quality problem as well; parents will have fewer choices and will have to resort to either inferior-quality or higher-price care. Others simply won’t be able to find care at all. According to the GAO, in Chicago, the supply of child care is only sufficient to accommodate 14% of the demand for infant care. The increased demand has presumably made the problem worse.
Studies demonstrate that quality early care and education stimulate important developmental gains for low-income at-risk children. Mediocre or poor quality care does not produce those benefits. In fact, such programs may even be detrimental to at-risk children. Thus, the shortage of center-based care often forces parents to cobble together less stable and lower quality services for precisely the group of children most in need of high-quality care. Thus, the shortage of supply has serious quality implications for children and compounds the challenges parents face trying to enter and stay in the workforce.
Quality
Two characteristics of physical space affect child care quality: Inherent characteristics of space and the level of rehabilitation.
Inherent Characteristics
The inherent characteristics of space are hard to change. Basement locations with minimal natural light or locations inconvenient to public transportation are inherently undesirable characteristics for child care. Sometimes child care centers locate in residential structures, including apartments. Residential buildings are constructed around a relatively small grid of rooms. This is fine for the average family. But when it becomes child care space, too much of the space is devoted to circulation—"pathways" through these rooms. The many rooms make supervision difficult. Finally, the size and proportions of the rooms make it hard to design appropriately scaled activity areas around the periphery. The basic structure of a residential building does not lend itself to adaptation to such a radically different use.
PROBLEMS WITH SPACE |
Inherent Characteristics |
Level of Rehabilitation |
Level of Rehabilitation
The level of rehabilitation undertaken by most human service programs when they rent or buy a new facility is minimal. Programs tend to take space "as is." Yet to operate optimally, most programs need to reconfigure the space and change fittings and finishes to meet their unique requirements. It is common for new commercial tenants to rehabilitate, a process referred to as "tenant build-out." A family support center, for example, might want to create a generous common area just inside the entrance designed to be welcoming, a place where parents would feel comfortable lingering. It might be designed like a playground in a public park, with play equipment and toys for children and park benches for adults. Or perhaps it might look more like an oversized living room. One of the most costly yet desirable adaptations a child care program might make is to create bathrooms immediately adjacent to each classroom.
The shortcomings of most facilities can be attributed to the cost-driven process of selecting only among buildings that are available at low cost or no cost; this process yields facilities that are inherently less desirable and dictates that the provider will use it substantially as-is.
The Programmatic Impact of Facilities
The quality of a facility cannot make a poor program good, but it can greatly enhance the quality of any center or even a family day care home striving to implement a strong, "developmentally appropriate" program. Facility quality impacts parents, staff, and children.
Parents
Research suggests that unstable child care arrangements, the stress arising from the demanding logistics of drop-off and pick-up, and dissatisfaction with other aspects of their child care arrangements decrease the likelihood that the parent will secure and hold a job. Capital for facilities addresses these problems in several important ways.
Staff
There are numerous and profound ways in which facilities affect staff. "Burn-out" is a well-documented problem for poorly compensated front-line human service workers, contributing to high staff turnover. This undermines stable attachment for the children and leaves the industry with too few experienced teachers.
An important factor in this turnover is the greater physical and emotional demands placed on staff working in low-quality facilities. For example, sometimes child care and Head Start teachers have to "break down" their classrooms each Friday and set them up again the following Monday to accommodate weekend Sunday school classes. An almost universal complaint among child care teachers is the grossly inadequate supply of classroom storage space and running water. Both require frequent trips in and out of the classroom for set-up and clean-up activities. These are just some of the tasks that require extra physical labor, either because the program cannot afford exclusive use of the space or because the facility has never been reconfigured to make the job of teaching easier.
Even more demanding is the classroom management burden created by bathrooms located outside of the classroom area. Bathrooms should be adjacent and directly accessible to the classroom.
Children
Youngsters who participate in high-quality programs benefit intellectually, physically, and emotionally. Most child care classrooms are divided into activity areas: dramatic play space, blocks, quiet reading area, etc. To achieve the optimal arrangement, the space needs to be big enough, well proportioned (not too long and narrow, for example), and set up to provide visual separation between activity areas. Scaling bathroom fixtures, window placement, and other features to a child’s size helps to foster a sense of competence. But, by far, the greatest benefit to children arises from parents and staff feeling greater satisfaction with the facility and program.
Family resource programs are a newer phenomenon, so it is harder to document the impact of inadequate facilities. Yet central to the principles of the family support movement is a consumer-centered approach to service delivery. Location is obviously key. The space needs to be inviting and be designed to accommodate both parents and children, spanning many age groups. Meeting rooms and office space designed to support access to a blend of services and the wide variety of users are essential. Just like child care, these requirements are impossible to satisfy without a budget that can support the cost of real estate and access to enough capital to reconfigure the space to meet programmatic requirements.
THE TWO-DIMENSIONAL PROBLEM
Capital expenses are fundamentally different from most other program expenses. Unlike pencils, food for snacks, utilities bills, and staff salaries, capital expenditures are made infrequently and have a useful life that spans years or even decades. In the normal course of things, no enterprise would borrow money to pay for services and supplies that are used within weeks. But debt is the ideal method for making capital investments; a loan spreads the cost over the investment’s useful life. In effect, with each year’s monthly loan payments, the borrower is only paying for that proportion of the investment being used to deliver that year’s services.
From an economic perspective, the problem facing providers has two dimensions:
Facilities loan funds are designed to directly address the second dimension of the problem by creating a lender with the financial and institutional ability to make these loans. However, this Guide also maintains that facilities loan funds often stimulate broader systemic changes that affect operating income and the willingness of providers to assume debt, leverage new sources of capital and in other ways stimulate higher levels of capital investments in community-based child and family support facilities. These are the indirect benefits of a specialized facilities loan program.
The following section begins by describing how facilities loan funds directly improve access to credit. Then it explores the mechanisms through which they can have broader indirect impact on the level of capital investment in community programs.
WHAT IS A FACILITIES LOAN FUND?
As described in the previous section, part of the facilities crisis in community-based family and child services is caused by the lack of capital to invest in physical improvements and capital purchases. These programs are often unable to satisfy conventional bank underwriting criteria. Facilities funds are banking institutions, too; they make loans. But unlike conventional banking institutions that line Main Street or occupy the most prominent skyscrapers in every big city, facilities funds are specialized nonprofit lending institutions. They are one of a broader class of lenders known as "development lenders" or CDFIs that are designed and capitalized to enable them to make some types of loans that commercial lenders find unattractive. The loans might be too small to be profitable. The borrower or project might be too risky for a variety of reasons. There may be insufficient collateral to secure the loan. The borrower may be unable to make a sufficiently large down payment. Perhaps there simply is not enough revenue to pay commercial rates of interest.
How do Providers Use Loans? So if child care centers are so financially marginal, how can they use debt? The answer is that debt is used to fill critical gaps. Here are three examples of loans made by the Child Care Capital Investment Fund in Massachusetts, although the names and some of the identifying details have been changed: See Appendix D for fuller descriptions of two other projects. |
Access to Debt Many community-based organizations cannot qualify for bank loans. Facilities funds provide access to credit (loan capital) for those organizations that for one of a variety of reasons cannot qualify for a bank loan: An ability and motivation to shoulder these "transaction costs" and "lending risks" are the chief reasons why facilities funds can provide access to debt that conventional banking institutions might avoid. |
Most nonprofit development lenders are neither regulated nor capitalized like conventional lenders. As depository institutions, banks are strictly regulated by either state or federal agencies to protect depositors and the public’s confidence in the soundness of the banking system. Moreover, as profit-making business ventures, commercial lenders are profit maximizers; they seek to minimize the risk of incurring losses and to secure the most competitive return. For such institutions, some potential borrowers are unattractive.
Pressures do exist to open bank lending to borrowers that are sometimes denied credit. The Community Reinvestment Act has succeeded in getting banks to look more closely at potential loans they might once have rejected out of hand. The Small Business Administration and the U.S. Department of Agriculture offer loan guarantees and other enhancements to certain types of borrowers to reduce a bank’s exposure enough to meet the institution’s underwriting standards. But in the final analysis, safety and soundness requirements dictate that conventional lenders reject many socially worthwhile ventures because they cannot meet their or their regulators’ credit standards.
Where do these rejected borrowers go? In most cases, these borrowers forego whatever investment they had sought to make. Certainly, many of those borrowers were well served by the denial; the proposed project may indeed have been too likely to fail. Under these circumstances, individuals and for-profit businesses might borrow from friends, family, or very high-cost lenders. For nonprofit organizations, there is a growing number of nonprofit development lenders that extend credit to otherwise "unbankable" human service organizations. These development lenders include:
Development economist Albert O. Hirschman has observed that development institutions fall into two categories: demand-following and supply-leading. A demand-following development lender provides capital in a market where demand is strong. For example, emergency loan funds exist in some locales to make short-term working capital loans to nonprofit human service agencies that face periods of temporary lagging cash-flow between fiscal years on state contracts. These nonprofits seek and need these short-term loans to survive, but they may not be conventionally bankable because of lack of consistent profitability, inability to secure personal guarantees, or loan size. But a development lender familiar with state human services contracting may find this an attractive opportunity. If there is sufficient demand for these loans, then by entering this market, the lender is exhibiting demand-following behavior.
Supply-leading behavior is usually the result of miscalculation. In this case, the lender observes that there is a need for debt, creates a loan product, and then discovers that access to capital is only one of the problems preventing investment activity. Fortunately, the existence of loan capital creates the conditions where the other barriers get addressed, eventually leading to investments, although often not without problems. Hirschman sees the tendency to underestimate the obstacles to development as a benevolent process and coined the term the hiding hand to describe it. According to Hirshman,
since we necessarily underestimate our creativity, it is desirable that we underestimate to a roughly similar extent the difficulties of the tasks we face so as to be tricked by these two offsetting underestimates into undertaking tasks that we can, but otherwise would not dare, tackle.
The work of the hiding hand can be seen in the experience of many development finance institutions and products. It was certainly the case with Massachusetts Child Care Capital Investment Fund’s creation. The loan fund’s sponsors realized that the philanthropic sector could not satisfy the demand for capital grants from expanding child care agencies. They felt that debt ought to be a viable alternative. The Fund’s board and staff quickly learned that there is a significant difference between the need for capital and the demand for loans. To the profound unease of the Fund’s founders and managers, loan demand lagged far behind projections. Money raised with dramatic documentation of the need sat in the bank while the Fund scrambled to understand the barriers and develop responses that would stimulate demand.
The barriers to lending were many and formidable, including the economics of child care, a culture prevalent in the industry that was averse to both loans and making capital investments, and the limited capacity of child care providers to plan and execute capital improvement projects. As Hirschman’s hiding hand postulates, if these problems were known, neither the Fund nor its eventual success would have been possible. Some of the barriers could not be overcome. But some could. After eight years, loan demand exhausted the original capital, enabling the Fund to raise and borrow additional capital. There are indications that the culture has begun to change, albeit gradually. More dramatic has been the effect of technical assistance. As providers confronted inevitable crises— a fire marshal’s order to relocate, a state license revocation threat, or an expired lease— providers gradually began working with and increasingly relying on the Fund to help them plan and finance facilities improvement projects.
The Fund’s experience is fairly typical of facilities loan funds. So are its services. While these funds make loans, they also provide important technical assistance, and often engage in various systems change activities.
Subsidizing Loans If a community-based child or family services program needs to make capital improvements but lacks the ability to pay annual principal and interest payments within its tight budget, a loan is simply unaffordable. End of story? Not necessarily. Two ways a lender can make a loan more affordable are to find resources with which to decrease the interest rate, or increase the repayment period. For those community-based organizations operating at or near break-even year in and year out, for whom manipulations of the rate and term still do not make a loan affordable, the lender will need to identify a source of deep subsidy. One way to achieve that is through debt service support: annual grants that help the organization make its loan payments. Just as spreading the cost of a project over time with a loan makes a capital project more affordable to a borrower, spreading the cost of grants over a period of years can benefit some funders. Facilities funds can help design and administer such programs. Example Recognizing that many nonprofit child care centers could not afford to repay loans for capital expansion projects, the City of San Francisco not only raised $10 million to capitalize a facilities fund (see box in capitalization strategies), it pledged general funds to subsidize up to 80% of the cost of principal and interest. Thus, for example, instead of paying $20,500 a year in principal and interest on a 7-year 10%, $100,000 loan, the borrower might pay as little as $4,100. That type of deep subsidy, while simultaneously making the cost more affordable by spreading the community organization’s cost over 7 years, also subsidizes the principal – the capital – as well as the interest expense. |
Lending
Facilities funds make loans. Nonprofit human service organizations seldom borrow funds. When they do, however, it is usually for working capital lines of credit or for the purchase of or improvements to a major capital asset such as a building.
Facilities funds specialize in extending credit for the purchase and renovation of facilities. Such loans are used for three purposes:
Sometimes a loan can involve all three of these uses.
Land and buildings are typically quite expensive assets with a very long useful life. Buildings and their components, such as the roof and the mechanical systems, do wear out and require additional investments from time to time. But the economic life of a facility is relatively long. Indeed, real estate tends to appreciate in value (although this may not be the case in neighborhoods suffering from disinvestment). Because of its long life and expense, financing real estate generally involves large loans and a long repayment period (known as the loan term), typically 15 to 20 years and sometimes even longer.
Renovation projects can be modest, involving just a few thousand dollars, or substantial, involving a "gut" rehabilitation of the structure. In addition, renovations fall into two categories: those done to buildings owned by the borrower and those done to leased properties. The latter are known as leasehold improvements. In most industries, it is rare for a commercial tenant to lease a space without making some level of investment to customize the space for its specialized needs. These "leasehold improvements" are also referred to as "tenant build-outs" or "tenant fit-outs." In some cases, the landlord will make and finance these improvements as part of the rental agreement. In such cases, the landlord serves as the developer, a role that includes financing the improvements and hiring and supervising the contractor. The costs of those improvements and development services are built into the rent. Bringing the building up to current building codes and most mechanical systems improvements— electrical, plumbing, heating, and ventilation— are generally the landlord’s responsibility. Otherwise, the tenant build-out is the tenant’s financial responsibility.
Loans for leasehold improvements are generally harder to secure and are available for fewer years than a loan to purchase real estate. With a purchase, the borrower gives the lender a mortgage as security. If the borrower fails to repay the loan, the lender forecloses and recovers the amount owed to it. The security available on a leasehold improvement loan is unattractive. The landlord may grant the leasee the right to assign the lease to the lender in the event of foreclosure. However, unless the lease is unusually attractive— a great site or favorable rent— assuming the obligation to pay the rent would strike most lenders as a burden, not loan security. Moreover, the loan term for leasehold improvements cannot exceed the term of the lease, excluding renewal options. So the leasees, even when they secure a loan to make leasehold improvements, are unable to spread the cost of the improvements over as many years as a purchaser. On the other hand, since they are not actually buying the real estate, their need for capital is also less than a purchaser’s.
Renovation loans are often used to reconfigure space by removing non-load-bearing partition walls to create more or differently sized rooms, or built-in units, or make a facility handicapped-accessible. Equipment loans are generally shorter still, perhaps for three years. Computer systems, buses and vans, and outdoor play equipment are just some examples of the assets financed with equipment loans.
Technical Assistance
Although making loans is a lender’s most obvious function, development lenders generally do more. Most provide technical assistance. Self-Help’s community facilities loan program published an excellent guide to understanding a child care program, The Business Side of Child Care: A Reference Manual for Child Care Advocates and Lenders (September 1997). The Nonprofit Facilities Fund of New York produces materials and offers training in facilities management. The Local Initiatives Support Corporation and its affiliate, the Community Investment Collaborative for Kids (CICK), make recoverable grants that enable providers to pay architectural, legal, and consulting fees to the members of the development team who plan the facilities project. The Child Care Capital Investment Fund has made grants to pay for an architect and a child care program consultant to jointly assess a provider’s space and make recommendations for how to improve it. The Ohio Community Development Finance Fund trains Head Start grantees in how to plan and finance new facilities.
These are just some of the technical assistance initiatives sponsored by community facilities lenders. Training and information dissemination is one strategy frequently used either to build the capacity of providers to undertake and manage facilities projects, or to stimulate demand indirectly by influencing attitudes about debt and facilities investments. Project-specific technical assistance is a more direct technique for supporting loan demand. Most small and medium-size human service agencies need assistance to undertake a facilities investment project. These organizations lack the staff and board members who can devote months, or in some cases, years to the process of identifying a site, negotiating site control, supervising a design team, overseeing zoning and other site-approval processes, raising the financing, and completing the many other development tasks associated with such a project. The leadership of these organizations is usually unfamiliar with the development process; they need ongoing advice from people with development and finance expertise.
Finally, there are the costs. Optioning land and paying for architectural and legal services are just a few of the out-of-pocket costs of planning a facilities project. Smaller human service organizations generally lack the net worth to pay for these services. Development lenders address these bottlenecks with staff-provided technical assistance, and grants and loans to pay for third-party expertise. Most of these latter costs are routinely treated as costs of developing the project and are recovered by the lender if and when the project is successfully completed.
These lenders also provide business, management, and child care programming technical assistance. In many cases, lenders help providers to improve their financial bookkeeping and to better understand their financial conditions. Many of these lenders hire child care experts to assist providers to make better use of their facilities. Sometimes the lender helps with marketing strategies and other business advice.
Technical assistance is a set of complementary services required to translate capital needs into loan demand and into new and improved facilities. Provision of technical assistance services is a factor that dramatically differentiates the nonprofit institutions that dominate the development lending field from conventional lenders.
Systems Change
Many facilities lenders also participate in the longer-term process of altering the underlying conditions that contribute to the facilities crisis in human services. A group of 16 nonprofit facilities lenders formed the National Children’s Facilities Network in 1993. (See Appendix G for a list of organizations belonging to the Network, along with contact information.) The Network advocates to remove federal funding and regulatory obstacles to child care and Head Start facilities development, offers advice and testimony concerning proposed legislation, and has formulated other legislative proposals.
Independently, these lenders have worked at the state policy level as well. The Illinois Facilities Fund designed and, with the state, helped implement a revenue bond financing program that led to the development of seven child care and family support centers. The Local Initiatives Support Corporation worked with legislative leaders in Connecticut to draft and enact a more ambitious revenue bonding program. The Development Corporation for Children, until recently a development organization, not a lender, has been tapped to operate a facilities loan program for the state of Minnesota.
These public policy and system change initiatives, while not at the core of what these lenders do, like technical assistance, are part of their larger mission of creating more and better facilities for community-based child and family services.
The Market
Despite the budgetary constraints that prevent so many programs from locating and either constructing or renovating a quality facility, some programs nonetheless have, or manage to assemble, the resources they need. To do so, however, usually requires two types of financial resource: (1) a reliable income stream with which to pay a healthy rent and/or to make monthly principal and interest payments on a loan, and (2) equity— such as a capital grant or retained net worth— with which to make a down-payment or other front-end payments to purchase a building or make improvements. Obviously, the more cash (equity) you have in hand to pay for construction or renovation costs, the less cash you need to borrow. In the nonprofit sector, especially among small and medium-sized organizations, the overwhelming preference is to secure philanthropic and government capital grants to cover purchase and construction costs; there is very little understanding of or comfort with debt as a financial tool to spread capital costs over an asset’s useful life. However, relatively few foundations and government agencies make capital grants. It generally takes fundraising sophistication and extraordinary leadership to succeed in raising such funds. Larger and more sophisticated organizations that have developed a donor base of individuals can sometimes launch a successful capital campaign. But once again, this is not common among community-based child and family service programs.
The one arena where some progress has been made in recent years is Head Start. Faced with mounting evidence that restrictive federal regulations making it difficult to use federal funds to purchase, construct, or renovate facilities had slowed the pace of Head Start expansion, the 1992 Head Start Reauthorization Act sought to solve some of the problems by allowing federal grant funds to be used to make interest payments. As a result, Head Start grantees are increasingly willing and able to assume debt to expand capacity. A small number of grantees have used the new regulatory flexibility to cobble together the resources necessary to create model Head Start centers. For many other Head Start grantees located in tight real estate markets, federal capital and annual operating grants are still insufficient to enable them to overcome the low-cost/no-cost, as-is facilities formula.
The demand side of the community-based child and family services facilities debt market is complicated. For-profit child care is more plentiful in higher income communities and in employer-sponsored child care. Some of these are well-capitalized chains that can raise both debt and equity. Some also are "hosted" by real estate development firms or employers who provide space at subsidized rates. Smaller for-profit child care businesses have a more difficult time borrowing money, although they qualify for Small Business Administration loan programs that are not available to not-for-profit organizations. A number of states, including Maryland and Connecticut, also offer loan guarantees designed to induce conventional lenders to extend credit by reducing their risk.
The nonprofit portion of the market is more prevalent in lower-income communities. Such programs can partially offset low public-sector subsidies with grant revenue from foundations, private donors, and workplace fundraising organizations like United Way. On the other hand, many providers argue that the cost of providing care to at-risk children is higher; they often have higher staff-child ratios, as well as needs to provide other services.
In general, the nonprofit child and family services market can be divided into two categories: smaller, usually single-site programs, and larger multi-site and often multi-service agencies. The latter achieve economies of scale and benefit from more diversified funding sources. While smaller agencies tend to be administratively lean, with the program director forced to wear many hats, larger providers can support more specialized middle managers. Directors of larger programs are also more likely to have management experience, whereas smaller programs are more likely to recruit their directors from the teaching ranks. For the larger providers, these differences translate into a greater interest in making capital investments, greater comfort with the notion of using debt, and greater staff capacity to devote time and energy to the complexities of purchasing and/or rehabilitating a facility.
Another factor that contributes to differences among providers is funding streams. In general, Head Start grantees have more stable and adequate levels of funding than child care programs, which rely on state-subsidized vouchers and parent co-payments. Organizations that deliver entitlement-funded services like early intervention programs—especially those funded through the medical insurance system, such as Medicaid— are compensated more adequately and are therefore more able to make facilities-related investments and to use debt as a tool to do so.
One would expect the same type of market segmentation among family support programs. Larger multi-service organizations are better able to cross-subsidize programs and to access philanthropic dollars to augment public funding streams. Such agencies also have the management depth and professional skills to carry out capital planning and to manage a physical development project. However, the family support movement is still young, with few sources of deep operating subsidies and very little experience with the physical dimension of program planning.
The need for capital among human services providers is quite significant. One study places the capital need among existing child care providers at $2.28 billion, and another $16 billion if the system could expand to serve unserved and underserved populations. But capital needs and effective demands are very different. Loan demand among nonprofit agencies is predictably low, constrained by:
While loan demand is low, so is the supply of debt capital. Banks are the main source of conventional commercial debt. While commercial lending is an important line of business for most banks, the child care market is unattractive to most banking institutions. The child care market generally suffers from:
Most of these problems would apply to family support programs as well.
Filling the gap between the modest demand for community-based child and family service facilities loans and the scarcity of available loan capital has created a niche market opportunity for nonprofit development lenders. These organizations have successfully made facilities loans by absorbing the high transaction costs, shouldering greater risk, offering technical assistance, developing specialized knowledge of the industry or sector, raising a pool of capital to collateralize loans, and adopting alternative underwriting methodologies. Many of these lenders have also sought to stimulate demand by attracting equity and lower-cost capital, and offering educational programs. Guided by their missions, development lenders often find themselves in the paradoxical situation of having capital but weak demand; their job includes the complicated tasks of removing barriers, solving problems, and stimulating systemic changes that will both create demand and produce important social investments in the community.
Types of Loan Funds
The development lending industry has grown dramatically over the past 20 to 30 years. There are even a few for-profit community development banks, most notably Shore Bank in Chicago. This guide focuses on the nonprofit institutions that have been most active in facilities lending.
Development lenders serving child care and family support programs vary by level of specialization, whether they are regulated depository institutions and their capital structure. These characteristics strongly influence institutional behavior.
Specialization
Broadly speaking, categorizing development lenders by their specialization in family support or child care lending produces three groups:
The trend in development lending is increasingly toward institutions that serve multiple markets. However, it is extremely difficult to address the credit needs of the child care and family support organizations without creating a dedicated source of capital and specialized staff, because the market for loans is extremely weak. The challenge is to use a supply-leading strategy and technical assistance to develop a market.
One of the keys to success in development lending is a thorough knowledge of markets that appear to be fraught with risk to conventional lenders. That is one reason for industry-specific lending. Many community development lenders started as affordable housing lenders before branching out into micro-business lending, business lending, and other fields. Child care loan funds are a relatively new form of industry-specific lender. The Child Care Capital Investment Fund lends primarily for child care, early intervention, and Head Start centers. The Development Corporation for Children in Minnesota recently launched a loan fund affiliate, First Children’s Trust.
A fundamental principle for managing and limiting financial risk is diversification. Specialization concentrates risk, leaving a lender vulnerable to unexpected changes in market conditions that might place the lender’s entire loan portfolio at risk. This risk is partially offset by the greater knowledge of a market that comes with specialization. Specialization enables the lender to be better equipped to assess these risks and to craft strategies for mitigating them. For example, Head Start and state-subsidized child care rely on very different income streams. An early childhood facilities lender can diversify by funding different types of early childhood programs.
In undeveloped markets, such as child care and family resource lending, failure to specialize will almost certainly limit the potential borrowing. For example, during its first few years of operation, the Child Care Capital Investment Fund experienced unexpectedly low loan demand. In response, the Fund briefly considered expanding its market by becoming a nonprofit facilities fund that would serve a much broader array of human service organizations. Since these organizations face facilities financing needs that are similar to those in child care, serving their needs as well would have the effect of expanding the market for the Fund’s capital. This option of becoming less specialized was rejected. Had it been adopted, loan demand probably would have increased. However, the market the Fund eventually developed among child care agencies probably would not have materialized, because staff would have pursued the path of least resistance rather than nurturing the child care market. Thus, specialization is essential in the common development lending circumstance where loan demand is weak.
Somewhat less specialized are the nonprofit facilities funds. These lenders address the credit needs of nonprofit human service organizations. Best known of the facilities funds are the Illinois Facilities Fund and the Nonprofit Facilities Fund of New York. Far more common are more diversified community development lenders. The current term of art for such institutions, including the more specialized ones described above, is "Community Development Finance Institutions" (CDFI), a term popularized after Congress passed the Community Development Financial Institutions Act in 1994. The community loan funds, community development corporations, and community development credit unions often make an occasional child or family service facilities loan as part of their normal business and commercial lending.
A growing number of CDFIs have created specialized lending programs either targeted to community facilities or child care lending. Coastal Enterprises, for example, a statewide community development corporation in Maine, established a separate child care lending program with its own dedicated capital source, lending staff, and technical assistance providers. Such programs benefit from the economies of scale that larger financial intermediaries can achieve, while retaining the specialization and focus on the unique challenges and needs of a niche market like child care. Similarly, Self-Help, a community development credit union and loan fund serving North Carolina, has operated a child care lending program for a number of years. It recently enlarged that activity into a broader community facilities lending program.
The trend in the industry seems to be to promote specialization, but to do so through corporate structures that allow them to achieve economies of scale. For instance, after its pilot phase, the Child Care Capital Investment Fund merged with a state quasi-public agency, the Community Economic Development Assistance Corporation (CEDAC), as a controlled affiliate with its own board of directors and loan officers, but shared loan servicing. In other cases, the child care or facilities lending is organized as a program or profit center for a more diversified community development lender.
These hybrid structures combine the best of both worlds: specialization that enables them to meet the market development challenges of lending to a particular sector of human service providers, with the multiple advantages of doing so within a corporate entity with the economies of scale, managerial systems, diversification, and lending expertise to ease start-up, minimize costs, and manage risk.
Regulatory Environment
Most depository institutions are subject to either state or federal regulations. These regulations are designed to assure depositors that their money is safe and the general public that the banking industry is sound. Regulated financial institutions have much less flexibility in the type of loans they can make than unregulated lenders. So, for example, a regulated lender may have to reject a loan request because the borrower cannot provide sufficient collateral, whereas an unregulated lender might feel that the borrower’s fundamental creditworthiness mitigates the need for the level of collateral required by regulators. The unregulated lender has the operating flexibility to make such loan judgments. Depository institutions, such as Shore Bank in Chicago, and community development credit unions, such as Self-Help in North Carolina, are regulated. Nonprofit facility loan funds, like Illinois Facilities Fund, and community development loan funds, like Delaware Valley Reinvestment Corporation, are unregulated because they do not accept conventional deposits. Unlike depository institutions, in order to raise their temporary capital, unregulated financial institutions create temporary investment instruments or borrow funds. Although more highly regulated, depository institutions have the advantage of being able to raise far more capital through the depository mechanism.
Capital Structure
Belden Daniels, a development finance consultant, is fond of observing that financial institutions "are what they eat"; in other words, the characteristics of their capital largely dictate lending behavior. For example, a bank with short-term deposits will be limited in its ability to make long-term loans. Similarly, an institution that pays its depositors or investors a high rate of interest must charge its borrowers an even higher rate.
There are three characteristics of a lender’s capital structure:
Lenders derive their loan capital from two sources. Temporary capital is, as the name suggests, temporary. A savings deposit is temporary capital. The depositor will eventually withdraw the funds. In effect, these are funds that are loaned to a bank or lending institution. That institution, in turn, pays the depositor interest. Development banking institutions raise temporary capital from depositors as well as from other types of temporary investments, including borrowing funds that they re-lend, usually at a slightly higher interest rate than they pay to their lender.
Permanent capital, on the other hand, is net worth. It is money a bank owns free and clear. Net worth or equity is the banking institution’s own savings, its nest-egg. The combination of permanent and temporary capital represents a lender’s total "capitalization."
Length of Temporary Capital Investments
The great advantage of loans is that they enable a borrower to spread the cost of an asset over its useful life; you may not have the $12,000 you need to buy a car, but you can afford $300 per month in interest and principal payments on a 3-year auto loan. Since most of the money lent by financial institutions is money they have borrowed from other people and institutions, lenders have to match their assets (the loans they make) and their liabilities (the loans made to them). Remember Jimmy Stewart’s predicament in "It’s A Wonderful Life": faced with a "run" on the saving and loan association he operated, he implored his neighbors not to withdraw their deposits. As he explained it to his panic-stricken depositors, the little community-based lender did not have the cash available; instead, the money was working in the community, funding home mortgages for others in the town.
That is the predicament of some lenders. If a lender derives its temporary capital from short-term sources such as checking accounts, they are more likely to make short-term loans such as working capital lines of credit and construction loans. But with more long-term investments, like 5-year certificates of deposit, a lender can manage to make longer- term loans.
In trying to fund the purchase or renovation of a building, or even leasehold improvements, family support and child care programs generally need the longest possible loan terms. A $10,000 loan for 5 years at 8% requires $2,500 a year in debt service (principal and interest). But the same loan written for 10 years costs less than $1,500 a year: a 40% savings on annual debt service payments. Admittedly, the total interest paid over the course of the repayment period will be higher with the longer loan. The advantage for the borrower, however, is that the lower annual costs are affordable with the longer amortization period.
So the length of temporary capital investments in a lending institution influences the length or term of the loans it can make, and therefore also determines the type of lending it does. An institution with short-term temporary capital is more likely to do construction lending, which has loan terms of less than a year and a half, than permanent mortgage lending, which has terms in excess of 10 years. From the perspective of a borrower taking a loan to pay for a capital improvement with a long useful life, borrowing from a lender with long- term temporary capital improves the likelihood of securing a loan with a longer term, which, in turn, will have more affordable monthly payments.
Ratio of Permanent to Temporary Capital
Another related feature of capital structure is the proportion of the lenders, total capital that is "equity" (also known as "net worth," "net assets," or "permanent capital"). These terms refer to the lending institution’s own savings. Unlike temporary capital, permanent capital cannot be redeemed (although operating losses will reduce the institution’s savings). However, assuming that the lender operates on a break-even basis, the permanent capital is just that: permanent. So, with more permanent capital, a lender has the ability to make longer-term loans.
Permanent capital also has a favorable effect on interest rates. Lenders pay for the use of temporary capital. This is a cost passed on to borrowers in the form of interest payments. The higher the institutions’ cost of money, the higher the interest rate they charge borrowers. But since permanent capital has no cost (other than opportunity cost), a lender with a lot of equity relative to its temporary capital, has a lower cost of money: hence the ability, at least among nonprofit lenders, to make lower-cost loans.
Development loans are believed to entail more risk than conventional loans. If the lenders are responsible for repaying temporary capital, they will likely be more risk-averse with such funds. Though it is an extremely valuable resource, a lender can assume more risk with its permanent capital than with its temporary capital. So, in addition to having lower costs, a lender blessed with a high proportion of permanent capital can shoulder more risk.
Finally, permanent capital is like an endowment. It generates interest income for the lender. Part of this is devoted to fund a loan loss reserve and other operating costs. But the spread (the difference between the cost of money and the amount of interest paid to the lender on money it lends) is obviously much larger on permanent capital; the difference is frequently used to fund technical assistance services that are central to a development lender’s mission.
Cost of Money
The use of temporary capital comes at a price to the lender. Banks pay interest to their depositors, and so do community development lenders. The community development lender’s temporary capital comes in the form of loans, or "equity equivalent investments." These too bear interest, although in some cases these loans are made by philanthropically oriented individuals and institutions who forego a market rate of return on their funds in order to further the lender’s mission. For example, some foundations make "program related investments" (PRIs) in order to enable a development lender to make more loans. The Ford Foundation made PRIs in Coastal Enterprises’ child care loan program and in the Child Care Capital Investment Fund. The foundation charged 1% interest, an extremely favorable rate. This made the Fund’s cost of money very low. With the approval of the Ford Foundation, the Child Care Capital Investment Fund charged child care providers 5% on its loans. The Fund’s 4% markup enabled it to absorb the high transaction cost involved in making these loans and allowed it to provide a great deal of technical assistance to its borrowers. After seven years, the Fund made the first of four annual payments to retire the Ford investment. To replace the capital and expand its lending, it has since negotiated two new loans, one for $1 million, the other for $3 million, with a consortia of banks and with an insurance company. These new loans are also at a favorable interest rate: 5%. But this is five times the cost of the Foundation’s PRI and has forced the Fund to raise the rate of interest on its child care facilities loans to 7.5%.
Because it is less costly, permanent capital affects a lender’s average cost of funds. A fund with $1 million in permanent capital and a $1 million, 5% investment in temporary capital has an average 2.5% cost of money. If the same institution had $3 million in permanent capital instead of $1 million, its average cost of money would be half as much, 1.25%. However, such proportions are hard to achieve in the real world.
Facilities funds with the high cost of money not only must charge higher interest rates, they are under pressure to minimize operating costs. Such a fund would be forced to pursue higher-quality, less risky credits and would be less likely to provide technical assistance. Thus, capital structure is a critical consideration in designing a development finance institution. The capitalization must follow from the needs in the market.
In general, development lenders that are capitalized with a high proportion of equity, pay substantially below-market rates for their temporary capital, have long-term sources of temporary capital, and are unregulated have greater flexibility to offer products and services tailored to the needs of young and undeveloped markets for debt. On the other hand, the regulated financial institutions tend to be larger and realize significant economies of scale. These institutions are better positioned to do the type of volume lending that is possible where loan demand is high.