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Filling the Private Sector Economic Gap

Is the Economy Coming Back?

Are we seeing an uptick in new private commercial development? Are retailers beginning to make commitments for store openings over the next two years? More so than we have seen in a number of years, indicators are pointing in the direction of greater private activity, specifically for the balance of 2012 and for 2013. The trend is upwards, from much higher hotel room revenues, to retailers cutting deals with developers to anchor new projects, and office occupancy getting to the point where there is now demand for new space!

In a March 19, 2012 press release, Pannell Kerr Forster Consultants, one of the nation’s leading hotel economists, projected strong growth in hotel room revenues through 2016. They stated that “with nearly two years of momentum,” room revenues will rise 5.8 percent in 2012 based on a 1.6 percent increase in occupancy and a 4.1 percent gain in average daily room rates. An April 2012 publication by the International Council of Shopping Centers (ICSC) reports “a tally of 22 major retailers found that industry chains collectively posted a 4.1 percent year-over-year comparable store gain in March which matches the 4.6 percent pace for the 2011 fiscal year. March performance showed widespread gains with some acceleration in the apparel and department store segments.” According to the March 2012 UCLA Anderson Forecast report on national activity, office vacancy rates continue to decline, particularly in the Central Business Districts, with vacancies down to 12.7 percent at the end of 2011. The Coldwell Banker Richard Ellis (CBRE) February 2012 US ViewPoint report, which covers all sectors of the commercial real estate market, shows a 254 percent increase in overall activity during the last two years.

There has been very little activity by developers and retailers over the last three to four years due to the economic downturn. With the turn around that we are seeing, we should be preparing for increased activity in the coming year and thinking about how best to assist those projects that clearly need some level of public assistance to be economically feasible.

Is There a Need for Public Assistance for Private Projects?

While we expect developers to select sites where the economics make sense (i.e., where the rents achieved will support the debt and equity investment), that may be a difficult hurdle for projects in urban infill sites, redevelopment projects, closed manufacturing plants, abandoned landfills, and brownfield sites. In these cases the costs for acquisition, relocation, demolition, site remediation, and offsite infrastructure, when added to the normal development and construction costs, can make the projects infeasible. Also, where parking structures are required to create the density desired by the local jurisdiction, the structure costs may be too expensive to be supported solely by private debt and equity. It is rare that a developer can achieve the incremental rental income necessary to offset the premium cost for structures compared to surface parking, which may be upwards of 500 percent on a per-parking-space basis. Many transit-oriented development (TOD) sites fall into this situation. In cases like these, developers must look to other funding sources to create a viable project.

When is Public Assistance Warranted?

There are many ways to evaluate the economics of a private development project, especially given that the results change based on the level of equity in the project and the terms of the private debt. Analyzing the need for public assistance to the private sector, often referred to as the “economic gap,” generates its own vocabulary, and a few definitions are in order before discussing:

  • Gross Income: the total income from rents, leases and other sources, such as common area maintenance (CAM) charges.

  • Net Operating Income (NOI): the net income after expenses, but before debt service.

  • Net Income: the income after the payment of debt service.

  • Return on Cost (ROC): the NOI divided by the total project costs.

  • Return on Investment (ROI): the net income divided by the equity.

  • Cap Rate: The percentage number applied to the NOI to determine the project value.

The most widely used metric to measure the strength of a project is ROC, which compares the total project costs to the NOI. If the rents from a project do not represent a reasonable percentage of the project costs—typically at least nine percent—the project is not viable. And because the NOI does not include debt service costs, the level of debt or equity in the project is not part of the ROC analysis. Therefore, the ROC can be applied to almost any project.

When extraordinary development costs are necessary, such as demolition or site remediation, the ROC ends up being dramatically below levels that are acceptable to lenders and investors.

The example in Box 1 is a redevelopment project on a brownfield site in which the demolition and site remediation costs total $12.5 million. Box 1 illustrates the effect of public support.

Without public assistance the project incurs an annual loss of $63,000 and therefore cannot even cover the debt service on the construction loan that is required for the project. The ROC is seven percent and the ROI is negative because of the losses. The loan to value ratio is a very high at 89 percent, and the debt coverage ratio is 0.98, demonstrating to potential lenders that the developer is unlikely to be able to repay the loan. Clearly this is a project that is not economically viable.

However, when the local jurisdiction recognizes the importance of bringing this brownfield site back into productive use, and supports the project with $12.5 million in public financing to cover the remediation costs, the outlook changes. With the jurisdiction providing assistance, the project achieves a 10 percent ROC and a 12 percent ROI. This reduces the loan to value ratio to 63 percent and brings the debt coverage ratio up to 1.31. These metrics would be attractive to both lenders and equity investors, making the project possible.

The Role of Public Policy

Virtually every state constitution prohibits financing that constitutes a “gift of public funds.” Generally, this refers to the act of public dollars being used in a way that does not fulfill a legal public purpose. If the analysis demonstrates that the public assistance is the minimum amount necessary for the project to be economically viable, then the constitutional test is met. In the example provided, the level of public assistance improves the project economics to the point where the developer can secure the debt and equity necessary for the project to move forward, thus helping to fulfill the local jurisdiction’s economic development goals.

In addition to evaluating projects to determine if there is an economic gap, local jurisdictions will consider other public policy factors in determining whether to provide public assistance for a project. These factors include:

  • Locations in minority areas or areas of high poverty or unemployment;

  • Designated redevelopment areas;

  • Identified blighted areas;

  • Plant closures and abandoned landfills;

  • Projects that generate significant new jobs;

  • Projects that diversify the jurisdiction’s economic base;

  • Projects that strengthen the jurisdiction’s tax base;

  • Historic restoration areas and structures; and

  • Transit-oriented development (TOD) sites.

 

Successful Examples of Closing the Economic Gap

Nashville, Tennessee

 

 

The following examples provide successful solutions for developer/investors and cities that sought public support structures to make the projects possible.

The 80-acre Bellevue Shopping Center site is virtually abandoned, with only a small Sears store remaining, which is doing limited business. The site has topographic challenges, and the only viable option is to demolish the buildings and re-grade the site so that new development can occur. The site has very high demolition and grading costs.

The proposed project is a major mixed-use development with 600,000 square feet of retail that includes major anchor retailers, a multiplex theater, health club, sports retailer, shops, and restaurants. The site includes multifamily residential and senior housing along with a hotel and office space. The project will also provide a permanent home for the local community theater. Two parking decks with 1,000 spaces are required to allow the density desired for the project. At total buildout, the project is estimated to cost $223 million.

Our analysis for the developer demonstrated that the project would require $30 million in public financing to achieve a 9.25 percent ROC, even with the owner of the project writing down the land value to less than half the 2007 purchase price. The public financing plan recommended that this be achieved by issuing public debt supported through tax increment financing and through an assessment district (see EFR article Value Capture Strategies within theU.S. in Volume 5, Issue 2).1 

Huntington Beach, California

The City of Huntington Beach, California is a good example of a city choosing to assist in a redevelopment project to redefine and renew blighted areas. Through the use of public financing, an abandoned motel that had been a source of ongoing law enforcement problems for many years was transformed into the Hyatt Regency Resort.

The project site, located just south of the famed downtown shopping district and historic “Surf City” also had a series of environmental remediation issues with extensive soil and water contamination. The effort also included relocating the residents of a trailer park with 1950s-era coaches into safe and sanitary housing. The condition of the coaches was so bad that many literally fell apart when the construction company attempted to relocate them.

The new hotel has 517 rooms and is the only beachfront hotel facing the Pacific Ocean for a 10 mile stretch, both north and south. In addition to eliminating the blighted conditions at the site, the City requested quality conference space for civic events. The hotel provided over 100,000 square feet of indoor and outdoor function space, including three ballrooms and 14,000 square feet of conference facilities.

The project received $26 million in public financing, which enabled the project to go forward.

The funding amount was provided through the combined use of a tax increment bond and a US Department of Housing and Urban Development Section 108 loan and Brownfields Economic Development Initiative grant.2

Conclusion

With an improving economy, the private sector can be expected to become much more active. The need for public assistance for urban infill, redevelopment, brownfields and TOD sites will remain, as the extraordinary costs associated with those projects will adversely affect the private sector’s ability to secure the required debt and equity.

 

Notes:

  1. Parsons Brinckerhoff represented the private owner and fee developer in negotiating the public assistance. The author of this article led the negotiations.
  2. The author of this article, and now Director of Finance and Investment for Parsons Brinckerhoff, negotiated the public assistance prior to joining Parsons Brinckerhoff.

 

Image Header Source: Chris Yunker (Creative Commons)