Across the country, developers and large-scale builders use a variety of tools to raise capital for public spaces and infrastructure costs associated with the development of new residential communities. In recent years, the use of special benefit assessment districts has flourished as land prices escalated and developers sought out alternative funding for major infrastructure and amenity costs.

But many developers, who anticipated passing the district assessment costs on to homeowners are now stuck holding the bill. As if current economic conditions weren't stressful enough, add in that most special assessment funding is classified as first priority debt and it's no wonder that land sharks are speculating that many of these bonds are likely to be teetering on the edge of default.

During the recent heyday of quick sales and record-breaking absorption, builders and developers that could form a special district and issue tax-exempt bonds were able to install infrastructure and create highly amenitized communities, all by using what felt like free money. But with sales at a stall and land prices dropping, some projects may be worth less than the special debt they carry.

Known as Community Development Districts, or CDDs, in Florida and Mello-Roos Community Facilities Districts in California, developers initiate the formation of these entities by using engineers' reports to define the district boundaries. After a lien has been placed on the property defined within the district, bonds can be sold on the projected schedule of improvements, value creation, and anticipated sales rate modeled by the developer.

Under this structure, the land itself is used as security for the debt. Although the debt is non-recourse, it still carries its consequences. Failure to pay taxes results in a tax lien and potential foreclosure. That would result in ownership of the land by the district itself or, depending on structure and timing, the construction lender.

Factored into the income stream is an interest reserve–typically two years–that comes out of the bond proceeds and serves as a safety net while the developer works to get a community off the ground. "Hopefully that's something you never have to use and it sits there for the entire term of the bond issue," says Albert Praw, who, as CEO of Landstone and former corporate head of asset management and acquisitions for KB Home, has extensive development experience in both Florida and California. "But when you have to use it earlier, someone has to continue paying the tax. To the extent that a developer has not sold houses, that is who ends up paying."

According to Dr. Henry Fishkind, a Florida-based economic consultant with experience in CDD management, the structure has a historical track record of success through real estate downturns. "In our 30 years of business, we have only had two defaults," said Fishkind. "Will we have some stress in this downturn? You bet. But will we have significant defaults among districts? Absolutely not."

He credits the success to two factors: the fact that special districts are typically granted only to "A" locations, and the need for a 3:1 value-to-lien ratio to sell bonds.

"When we create real quality, these places do better, in both up and down markets; by accessing these public monies, our builder/developers can create quality places that outperform," says Fishkind.

Still, it's not a stretch to assume many bonds might be playing for time. Fishkind affirms that unlike bank debt, district debt cannot be renegotiated. "Everyone knows what the cost is going to be upfront."

In addition, a land acquisition source in Florida says that some financial players got aggressive when underwriting and selling bonds to investors. As a result, "they got handed out to weak developers, which diluted the equity."

Factor in the strain on absorption rates in many markets, and it's easy to imagine the interest reserves may be running out. At the height of the market in 2005 and 2006, a spike occurred in the number of bonds issued to take advantage of the newly entitled piece of property and the increased value of that land. "There was a much heavier concentration during that time," says a source at California Tax Data, who asked not to be identified. Today, he says there are roughly 125 of these districts in California. "Before 2005, they really weren't used very much at all."

Learn more about markets featured in this article: Dallas, TX.