How Much Subsidy Is Needed for Redevelopment?

July 01, 2007

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.

Bridges is a regular review of regional community and economic development issues. Views expressed are not necessarily those of the St. Louis Fed or Federal Reserve System.

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