How Much Subsidy Is Needed for Redevelopment?

Why do developers, lenders, investors and government agencies choose to participate in redevelopment projects? How important are public subsidies? Do redevelopers depend on them to get the job done? On these two pages, a state government official, a banker and a developer share their points of view.

These articles are a summary of the information presented during the “How Much Subsidy Is Enough (or Too Much)?” session at the Exploring Innovation in Community Development Finance conference. Presentations were given by Steve Trampe, president, Owen Development; Walker Gaffney, vice president, US Bank; and Mike Downing, co-director, division of business and community services, Missouri Department of Economic Development.

Mike Downing, with the Missouri Department of Economic Development, suggested that the public sector objective for redevelopment is removal of blight to stimulate private investment and to reduce crime and disinvestments. Likewise, local and state government agencies want to increase economic activity by creating jobs, reducing unemployment and increasing the tax base. Redevelopment also may slow urban sprawl.

The public sector may be of assistance with a redevelopment project, but there are considerations, including:

1. Does it conform to an area plan?
2. What is the impact on surrounding property?
3. How many jobs are created and what type?
4. What is the effect on competition (displacement)?
5. How much are public costs for the project?
6. What is the risk if it doesn’t work?
7. How much are net new tax revenues?
8. Will the project be successful?
9. Is the developer qualified?
10. Will the project stir up controversy?

Downing said additional considerations come into play when the public sector considers redevelopment incentives. For example, will the existing tax base and property decline continue if the area is not redeveloped? Will there be any net new taxes (new tax revenues from the project less incentives and “displaced” taxes) from the development? Will the developer get involved in the project without public sector incentives?

Public incentives are appropriate when the project passes the “but for” test, Downing said. For example, the project would not get done but for the incentives, perhaps because: the area has not attracted investment because it’s blighted or there are extraordinary project costs associated with things like hazardous waste.

Finally, a big factor in the “but for” test is whether the developer has a gap in project funding.

The method of funding will depend on the type of gap. The gap may be in the developer’s return on investment (ROI). For example, the market rate for the ROI on the project is 12 percent and the projected return without incentives is 7 percent, so the gap is 5 percent. Before deciding on whether the funding mechanism will include grants, tax credits, or tax abatement or diversion such as tax increment financing (TIF), several issues need to be addressed. Can costs be reduced? How accurate is the market ROI? How accurate is the developer’s projected ROI?

On the other hand, if the gap is due to a lack of funds to cover project costs, the funding method may be a subordinated direct loan, a guarantee of a portion of a bank loan, grants or tax credits.

The best use for diverted taxes, such as TIF, is to fill an ROI gap. There is little risk if the project fails, and upfront cash is not required. However, other taxing entities do not like their taxes diverted, Downing said.

Although tax credits can be used for either an ROI or a lack-of-funds gap, there is no repayment, and tax credits are not as efficient as cash, he said. Formula tax credits do not take into consideration whether there’s a gap and, if so, how much the gap is. However, both tax credits and grants have the benefit of being administered more easily than tax abatements and with more consistency.

Direct loans are best used to fill a gap caused by a lack of funds, Downing said. Although there are disadvantages to using loans—high risk of default, funding must be available and less consistency in amounts provided—there are also advantages. Repaid funds can be used for other projects, funds can be deferred in times of inadequate cash flow, and the loan can be repaid after the project is sold.

Downing suggests that government agencies have to decide whether it is more important to fund only the gap or to be more consistent. If they choose to fund only the gap, the public sector must be prepared to develop a consistent process for analysis and monitoring. His final recommendation is for priority projects: Consider providing funds for a portion of the developer’s pre-development costs.

Lender/Investor Educates Others on Tax Credits

Walker Gaffney with US Bank indicated that most lenders do not understand the complexities and costs of rehabs or census-tract-eligible subsidy deals involving New Market Tax Credits (NMTCs). They tend to think of them, perhaps understandably, in terms of the market-rate deals they see day in and day out.

For example, the typical lender has a problem with 20 percent developer fees. “Many lenders believe rehabbers are involved in a subsidy grab; and the second they are paid any developer fee, they will run for the hills,” Gaffney said.

As US Bank’s commercial real estate NMTC program manager nationally, Gaffney’s role is to educate the bank’s conventional lenders, introducing them to new markets and encouraging them to lend to projects located in subsidy niches available to real estate developers in various arenas.

Lenders who take the time to understand the disproportionately high upfront and ongoing costs of doing historic rehabs or deals with NMTCs quickly come to understand the importance of layering multiple subsidies. The synergies between the Historic Tax Credit (HTC) and NMTC programs make them very compatible. The recapture periods for the credits are similar—five and seven years for HTCs and NMTCs, respectively. Also, 70 percent to 75 percent of NMTC deals have been real estate deals.

However, while historic rehab credits are virtually unlimited, there are not enough NMTCs available each year. For developers interested in using NMTCs, Gaffney advises, “Have your deal teed up and ready to go when the next round of tax credits is available.”

For the lender or investor, what are some of the considerations when looking at a redevelopment deal?

1. What’s the developer’s track record and reputation?

a. Projects completed on timeand on budget
b. Subsidy-promised developer is truly committed

2. Is the entire team experienced and dependable?

a. Accountants
b. Legal representation
c. Other consultants (HTC, NMTC)

3. Do the projections make sense for this product in this market?

a. Basic underwriting should not get lost in the subsidy shuffle.
b. Getting it built and taking tax credits is only half the story.
c. Successful operation over many years is required to avoid recapture.

 

Developer Avoids Public Help

Steve Trampe with Owen Development said jokingly that he does developments in St. Louis County so he can afford to do deals in the City of St. Louis. Even though two-thirds of his projects in the city end up close to break-even or lose money, he is committed to historic redevelopment. Why?

“Because it creates a legacy,” he said. “I’m thinking more about how good buildings will last. If a building lasts 100 years, there’s a good chance it will last another 100. That is not true with most new buildings.”

Developers face challenges that run the gamut from time delays and unknown costs to the perception of crime in depreciating areas, the lack of adequate parking and typically higher taxes. On the plus side, redevelopment projects usually have lower acquisition prices, a central location, unique buildings and access to public sector incentives.

Trampe said he does not mess with subsidies if it can be avoided. Every time another component is added, the difficulty of the project goes up exponentially, he said. His advice: Keep it simple! The more subsidy sources, the less chance the project will get done. For example, if New Markets Tax Credits are used, that means the developer is prohibited from selling the property for seven years.

A developer may not get involved if he has to spend too much of his own money for a feasibility study on property he does not own. The level of architectural plans required by the public sector, in many cases before anybody else is even committed to the project, is time-intensive and costly. He indicated that, for some projects, a developer may have to incur $1 million in due diligence costs before the municipality or other local agencies commit to the deal.

It’s difficult to nail down construction costs on a complex historic rehab, he said. “It’s much easier to build a Walgreens … You know the construction costs because you do the same building over and over. But every different redevelopment project is unique and presents different challenges.

“In the city, there is no such thing as ‘virgin land’ or vacant property—there’s always something underground, even if above ground the building burned or was demolished. Forget about sampling. Get an excavator and see what’s there.”

In a city rehab deal, the developer worries about cash flow, equity, completion, personal guarantees and what can go wrong. Fees are needed to cover time, financial risk, losses—most cover a 20 percent flux. “The developer may get a $1 million fee, but most of it’s generally not profit. It needs to cover a lot of office overhead, in many cases from three to seven years of it.”

It’s all about risk and reward. Redeveloping historic properties is a hugely risky business. So how does a redeveloper judge success? In addition to an above-market-rate ROI that includes cash flow, appreciation at sale and tax benefits, the fewer hassles the better. If the project was done in a decent time period and on budget, if he didn’t lose too much sleep worrying about the unknowns and if he didn’t lose any friends (lenders, investors, public agencies), that’s a success, Trampe said.

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