It's one of the most popular financing techniques in a locality's toolbox: tax increment financing (TIF), a low-cost way to pay for economic development projects. But TIFs are also dependent on rising real estate values since they use future gains in property taxes to finance current improvements. Does the recent decline in real estate values signal tough times ahead for TIFs?

I put that question to an expert in the world of TIF: Toby Rittner, the president and CEO of the Council of Development Finance Agencies. Here is an edited version of my conversation with him.

Let's start with the basics. How does tax increment financing work?

It's unlike any other tool. A locality is able to direct specific tax dollars from the development itself to pay for that development. The premise is that if you take an underutilized piece of property that is not returning much tax revenue and put a better facility on there, it will be assessed at a higher level and bring in a higher tax return. TIFs are used predominantly for redevelopment, regeneration and reinvestment in underserved or underutilized markets.

How widespread is its use?

Forty-nine states plus the District of Columbia have TIF legislation in place. There are very active states, such as Illinois, California, Florida and Texas; and there are those like New York and North Carolina that have done nothing or very little with TIFs. But once state legislation enables the use of TIFs, there is almost no input at the state level. TIFs are a local redevelopment tool.

What happens if real estate values fall?

There are some situations where TIFs are struggling. But the large majority of TIF projects did not allocate the full increment [of increased property taxes] to the project -- only 50 to 70 percent of the increment. They created debt reserve funds to protect the investment, and they often have underlying letters of credit or a guarantee of some sort. The majority of projects are doing okay even without huge increases in property assessments. It's a vindication of sorts for the use of TIFs because even in difficult economic times, they've still done pretty well.

Beyond real estate value, what sort of risks are there with TIFs?

You have to have a lot of faith and comfort with the developer. If the developer flakes out or bails out on a project where you used TIF to extend the infrastructure -- that's a primary risk. It happens rarely, but it does happen. Other risks are that a project doesn't return what you expected it to -- you were supposed to see, say, $10 million in tax returns and you only get $2 million. That happens rarely because most TIFs are very conservative.

A lot of projects today are no longer tapping general funds to finance TIF projects. They seem to be issuing TIF bonds to pay upfront for improvements. Why is that?

If you had asked me 10 years ago, I might have said it was 50-50 on bonds vs. use of general funds. In today's current market, we are seeing most TIF transactions using bonds. It's easier than any other form.

A locality uses TIF money to pay for eligible parts of the development -- infrastructure and other items approved within the state statute. It can pay for roads, sewer upgrades, intersection and transportation elements, maybe a parking garage -- things that have a public use. It doesn't pay for private uses. Ten years ago, cities were more flush with tax revenue so they just appropriated general funds toward the improvements and paid themselves back from increased property values. Now, they are more likely to float a bond. That will probably stay. Bond money is pretty affordable and abundant right now.

Some tremors ran through the TIF world recently when a judge issued a foreclosure decree on a Cleveland TIF project, the Arcade. It is scheduled to be sold, and the holder of the TIF bonds has asked the judge to require that the future owner of the project continue to make debt payments under the original TIF financing agreement. Is this something localities that use TIFs should be worried about?

Cleveland is a member of our organization so I wouldn't be comfortable saying too much about that project. But the way Cleveland structures its TIF deals is a little unique. There are a variety of ways to structure a deal, and Cleveland uses the mortgage-type structure. Should there be a foreclosure or default, it reflects on the company balance sheet as default on a mortgage. The Arcade project is underperforming and the owner is not able to make payments. In this situation, if they don't pay, it shows as a fall down on mortgage. But there are no implications for TIFs in general. TIF bonds have performed very well despite the current recession. I have seen very few defaults around the country -- just some restructurings for the sake of getting lower-term debt. Right now TIFs are making a resurgence. Communities realize they have to invest in the best urban infill and revitalization projects. The logical tool to use is TIF.

Looking at the array of tax incentives available to localities to attract development, how would you rate TIFs?

There's no question that TIF is an incentive for the developer. But this is not corporate welfare. The only way the developer gets access to TIF funds is to do the development. Unlike abatements or other incentives -- even tax credits -- you really have to do the project to get the tools.