Battling Over Limited Water Rights : Construction: Many developers can’t finish costly projects because officials say there is not enough water for existing neighborhoods--let alone new ones.

Home builders and local governments in California are at odds over water-use restrictions imposed because of the drought, with some developers contending they face financial ruin and may default on bonds used to finance their projects if water limits aren’t lifted soon.

Developers need permits from municipalities to use water during construction and hook up homes to main water supplies. Without those permits, developers can’t complete their projects and thus can’t sell homes. Although new homes often use water more efficiently than older ones, developers are meeting resistance from local officials who say there is not enough water to go around to existing neighborhoods--let alone new ones.

Such a dispute has surfaced in Riverside County, where Elsinore Valley Municipal Water District officials voted March 6 to turn off the tap on new development. That decision threatens the repayment of nearly $40 million in development bond financing and will delay construction of more than 4,000 apartment units and single-family homes in the area.

“It’s a very difficult situation, but our priority is our current users,” said Gary F. Kelley, president of the board of the Elsinore Valley Municipal Water District, who notes that the district is already requiring existing users to conserve water.

The latest rains have brought hope that California’s five-year drought may soon ease. And water district officials such as Kelley believe that developers can survive a temporary moratorium on new construction until water supplies are replenished. But the state’s water shortage is far from over. Officials continue to adopt stringent water conservation measures to head off shortages later this spring when drenching rains normally subside.

Twenty-three water districts in the San Diego area are considering proposals that could slow new building construction by requiring builders to pay to retrofit older homes with water-saving devices that would conserve enough water to allow new construction. And construction bans are on the books in Santa Barbara and some Northern California communities.

Yet the move by the Elsinore Valley Water District has astounded construction industry officials and further soured investors on development bond financing, which had already been viewed as risky because of the recession and housing slump. Some investment firms, such as Capital Insight Brokerage in Beverly Hills, have even stopped buying California development district bonds out of fear of possible defaults.

“To the extent there is a housing slowdown you are going to see defaults, no question about it,” said David Hitchcock, a bond expert with the New York-based Standard & Poor’s bond rating agency. “Most of these (development bonds) would be in the junk bond category if they were rated” by independent agencies. Junk bonds are speculative financial IOUs mostly offered by institutions that don’t have long track records.

“I just hope to God the water district comes to its senses,” said Chris Taylor, director of planning and engineering for Homestead Land Development Corp., which plans a 2,000-home project in Lake Elsinore. Taylor said his company has invested $100 million in the project so far but has built only 65 homes. Those homes would bring in only about $10 million if sold--not nearly enough to pay the company’s huge costs on its investment.

The concern in California recalls the widely publicized problems in Colorado, where at least 12 development districts have filed for bankruptcy in the past year. Scores of Colorado residents face the prospect of losing their homes because developers have defaulted on more than $500 million in special district bond financing.

Yet in California, bond financing remains very popular. Since the Mello-Roos Community Facilities Act of 1982 was passed to give local officials the authority to create development districts, nearly $3 billion has been raised. Mello-Roos type financing has also taken hold in several other states, including Texas, Florida and Arizona.

Any city council, school board or other governmental body can establish a development district. But at least two-thirds of the district’s voters must approve a bond issue that is paid back through a tax on property owners. If there are fewer than 12 residents, the land owners vote.

That latter feature makes Mello-Roos districts particularly easy to create on undeveloped land and attractive to debt-wary municipalities. That’s because the burden of financing new infrastructure costs are borne first by developers, who pay interest on the development bonds during the initial stages of construction, and later by new home buyers and other land owners who move into the community.

In places such as Lake Elsinore, however, the water shortage is washing away some enthusiasm for Mello-Roos financing.

“It’s really upsetting,” said Taylor of Homestead Land Development. “If the moratorium were to go on to next year, we would really suffer. If the decision of the district drives us out of business, then we start defaulting on our (Mello-Roos) taxes.”

“We haven’t put the brakes on the Mello-Roos (financing) but we are worried,” added Todd Schermerhorn, project manager for Friedman Homes, which is due to break ground April 1 on an 800-unit housing development in Lake Elsinore that will rely, in part, on $15-million worth of Mello-Roos bonds due to be sold over the next few weeks. “Without water meters we could be crushed” financially, Schermerhorn said.

Another builder in Lake Elsinore, Presley Corp., expressed its displeasure with the water district by filing a lawsuit seeking a temporary restraining order to reverse the ban on new water meters.

However, the request was denied by a Riverside County Superior Court commissioner at a March 7 hearing. Although water district officials have let Presley obtain water meter permits for the 33 houses currently being completed, the district is maintaining its ban on water meters for the more than 1,000 homes that Presley has planned for the site.

“Our agency has to be concerned for the health, safety and welfare of our citizenry,” explained Elsinore Water District spokesman Mark Dennis. “Water for construction purposes is a non-essential use. Unfortunately, these builders were caught by this moratorium and construction will slow to a halt because they won’t be issued water meters.”

Accountants and lawyers who handle Mello-Roos bond issues argue that defaults are unlikely because of various financial safeguards, such as setting up reserve funds to pay bond interest in case a project is delayed.

Investors are also said to be protected because bonds are usually issued for no more than 33% of the appraised value of the property. That’s to cushion against any unforeseen decline in value if construction is delayed or not completed. So theoretically, the unimproved land could be sold to satisfy any outstanding debt.

But assessing vacant land is a tricky affair, experts say. Because appraisers set the value of undeveloped property based on an intended use--whether an office building or residential neighborhood--the value of raw land can change if projects don’t proceed as planned, especially if a developer walks away or is barred from turning on the tap to a completed community.

“With this credit crunch, we’ve seen the value of raw land go down in value just like any other real estate,” said Marilyn M. Cohen, president of Capital Insight. “That’s why I haven’t sold any Mello-Roos bonds for more than a year now. There’s been a deterioration in the economic environment and when you extrapolate that out, you see the problems that could develop with unrated bonds” like the Mello-Roos variety.

Dean Misczynski, who works for the California Senate Office of Research and helped draft the Mello-Roos legislation, believes that the measure offers more benefits than drawbacks. But even he has become concerned that problems could develop as the economy slows housing construction and as local officials move to curtail water use.

“I’ve become somewhat pessimistic,” said Misczynski. “I’m sure there is some unwise Mello-Roos financing out there.”

In light of his concerns, Misczynski has been advising local officials that they should tread carefully. “Mello-Roos gives you enough rope to hang yourself,” Misczynski told an audience of local officials last year during a San Francisco conference. “What you must do, as a public finance official, is to create a sense of integrity and fairness.”

Bond Financing Amount of development bond financing in California authorized under the Mello-RoosCommunity Facilities Act of 1982, which gave local officials the authority to createhousing development districts and finance them through bond issues. in millions of dollars 1983: 8.5 ‘84: 19.8 ‘85: 91.5 ‘86: 147.2 ‘87: 240.1 ‘88: 570.3 ‘89: 751.2 ‘90: 977.1 Source: California Debt Advisory Board