Many developers struggle to deal with the cost of debt for ambitious real estate projects. But partnering with public and private entities can help reduce the loan required from the bank, allowing the developer to leverage its equity more effectively.
“The projects that require public and private partnerships, a combination of private conventional bank debt supported by quasi-public sources, are typically deals that wouldn’t happen without those subsidies,” says Michael K. Dostal, Senior Vice President and Commercial Real Estate Manager with FirstMerit Bank. “It harkens back to the 1980s, when many urban projects were required to meet the ‘but for’ test for low-interest government loans, or else the project wouldn’t happen.”
Smart Business spoke with Dostal about how large-scale development projects are made possible by public and private funding.
Why would companies want to involve public or private parties in real estate projects?
Because of the economic challenges facing some of these difficult projects, they just can’t work conventionally. The Flats East development project in Cleveland is a good example, because a public subsidy was needed to deal with the physical challenges of that site. A site may need to be heavily engineered to support development. Perhaps the roadways need to be expanded to improve physical access to the site, or utility infrastructure upgrades (water, sewer, electric) are needed.
When you deal with all those elements, you add costs you wouldn’t find in a simple greenfield development in a suburban location. The necessary upgrades increase the cost of the project, and if you tried to finance in a conventional fashion at, say, 75 percent of the total budget cost, it wouldn’t work. The cost of the debt would make the project unfeasible.
What types of projects are usually financed in this manner?
It’s not always a new site; it could be a redevelopment site. If you’re renovating an 80- to 100-year-old commercial property, you typically have to deal with out-of-date core infrastructure and mechanical systems, and inability to support modern telecommunications. Those are added costs that you wouldn’t have if you were building new. But there is a lot of energy in urban areas to revive our commercial core rather than demolish and build anew.
The cost of a 100,000-square-foot new development is not comparable to an urban redevelopment, but rent is still driving the market. You have to find a way to make the bottom line work because the rents are fixed in the marketplace. So you then have to deal with the cost of debt. That is the overriding challenge.
How do these difficult projects happen?
There is a need for multiple layers of financing. The Flats East project had 37 funding sources, led by two major banks. Another project in the University Circle area of Cleveland had 11 sources of financing. Developing these projects is not for the faint of heart. It requires a lot of cooperation with the many financing sources. The bank, as the lead lender, has to balance being in control without ignoring the issues, concerns, rights and privileges of the other subordinate financing sources.
What are typical sources of financing that can be secured for real estate projects?
Traditional public infrastructure support includes typical municipal bonds and infrastructure or general obligation bonds that go toward public improvements that support the site, like roadway access and public parking garages. Also, there are truly subordinate sources that generate equity for commercial redevelopment projects. There are two particularly prominent funding sources of this type. First, historic tax credits, offered by the U.S. government and available through the IRS, provide tax credit for the eligible amount of investment directed toward upgrading eligible properties. Second, the New Market Tax Credit, another federally designated program, was established to support job creation.
These tax credits are typically earned by the developers and syndicated to an investor, usually institutions such as banks and corporations. Developers could use the credits themselves, but usually the developer is not generating enough income to take advantage of them. So they are sold to corporations, which contribute much-needed equity to projects.
In addition to federally designated tax credits, the state of Ohio now offers historic and New Market tax credits as well. Another source of funding is local foundations, such as the Cleveland Foundation, the Greater Cleveland Partnership and the Columbus Foundation, that support historic or urban redevelopments and job creation.
Typically the final piece in these communities is the urban governments themselves — the cities of Akron, Cleveland and Columbus all offer either redevelopment or economic development grants and low-interest financing sources.
Why are these partnerships becoming more prevalent?
Their increased prevalence is a reflection of the economic times. The last time that significant public/private partnerships were required was the late ’80s and early ’90s, when a lot of our urban cores were redeveloped. Projects like the Short North area in Columbus and Tower City in Cleveland received significant tax credits for historic renovation.
Help was required because economic times were such that market rents wouldn’t support private capital doing it alone, and there was a scarcity of capital. We’re going through that again, as many large-scale projects were stopped when the financial markets crashed in 2008. Slowly, developers have dusted themselves off and government and foundation sources have stepped up in creative ways to support development. In turn, the banking industry has been nudged back to the table.
When times are tough and capital is scarce, everyone needs to come to the table to get these deals done, or else nothing happens in the marketplace.
Michael K. Dostal is a Senior Vice President and Commercial Real Estate Manager with FirstMerit Bank. Reach him at (216) 694-5654 or Mike.Dostal@firstmerit.com.