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Ehlers Analysis of TIF Request Memo To: Adam Flaherty, City of Otsego From: Nick Anhut, Ehlers & Associates Date: August 24, 2017 Subject: Analysis of Riverbend North TIF Request The City has received a request for tax increment assistance for the Riverbend North development which consists of one initial phase of 164 market rate rental apartments units with supporting parking. The development will be situated on 7.4 acres of the 13.1-acre north site currently owned by Darkenwald’s Riverbend Wastewater Facility Company LLP. Potential second phases of development are currently envisioned to provide two 7,500 square foot commercial retail buildings and a commercial mini-storage facility on the remainder of the site. This memo is intended to discuss the following: ▪ Background describing the potential uses of tax increment financing (“TIF”) and TIF revenue created by the apartment development, ▪ A review of the underlying economics of the development and its “need” for assistance, and ▪ Options for the Council to consider if it moves forward. Background on TIF Tools and use Tax increment financing is a tool available for cities and counties to utilize for new developments that demonstrate a financial need for assistance. The underlying justification for the use of TIF is the “but for” test. This means that the Council must make a finding that the development project as proposed would not be feasible without the use of public resources. The TIF statutes (Minnesota Statutes, Section 469.174 to 469.179) do not dictate how such a finding is made, and this memo will discuss various approaches in more detail. There is also great flexibility in the “business deal” or negotiation on how much TIF can be directed to a project. If circumstances dictate, a project may not require all the available TIF. The Council has discretion to reject a request for TIF or it can cap a maximum amount of TIF based on any of the following: ▪ Reimbursement of public costs (infrastructure or grants) incurred for the project ▪ Reimbursement for certain extraordinary (site specific) private costs, ▪ Specific dollar amount designed to assist in securing private financing, or ▪ Ongoing operating assistance for a specified time period Because there is financial assistance negotiated within a contract, the Council also can make assistance conditional upon compliance with other factors such as construction completion by a 2 certain date, types of units or public amenities, and/or a higher level of quality in the exterior of buildings or landscaping than is required under the zoning code. The first step in evaluating a TIF request is to determine how much TIF is available. Our estimate assuming a $15,071,000 million estimated market value (provided by the Wright County Assessor) is that the annual TIF generated from the phase one apartment project will be approximately $212,345, as shown in the chart below. TIF does not capture the taxes attributable to the base (existing property) value nor does TIF capture certain other property taxes such as school district operating referenda. It does capture all other local jurisdiction’s share of the increased property taxes stemming from the new development, of which the portion of TIF attributable to the City’s tax rate is $70,438. WHAT IS EXCLUDED FROM TIF? Total Estimated Property Taxes 244,166 less State-wide Taxes 0 less Market Value Taxes (29,197) less Base Value Taxes (2,624) Annual Gross TIF 212,345 The developer has stated the proposed apartment development utilizes 7.1 acres of the larger site. Therefore, the base value assumption utilized in this analysis reflects 85% of the existing land value as currently defined within PID 118.50.026.2400. The City has options for ways it can utilize TIF for a particular assistance request. A PAYGO TIF Note structure offsets risk to the city. This approach is similar to the mechanism used with the Guardian Angels project and means the developer would privately finance the development costs and receive assistance payments to reimburse certain qualifying activities as TIF is generated from a newly created TIF District. Once the project incurs its qualifying costs, the City can issue a Note payable solely from an agreed upon portion of the TIF generated from the project. The developer can pledge the TIF Note revenue to help obtain the primary financing necessary for the development, along with its equity, to build the project. Or the developer can separately monetize the potential TIF Note revenue with a lender into a form of secondary financing. Upon completion of construction and after payment of taxes, the project would receive a semi-annual payment of the designated portion of TIF received by the City. If any year’s TIF decreases below expectations due to lower values or delays in project completion, the developer receives only what is generated. If the TIF increases above expectations, the City is only obligated to pay up to the agreed upon amount. Alternatively, the City could provide a direct grant or loan to the project to offset all or a portion of the connection cost with the TIF utilized to either reimburse the granted funds or supplement the loan repayment. This alternative places more risk to the city regarding the amount and timing of future TIF receipts. At the developer’s proposed financing interest rate, TIF payable from the full life of a TIF District could pay off the developer’s identified “gap” of $1.7 million within 14 years. 3 TIF Redevelopment Districts The developer has requested that Otsego establish either a redevelopment or housing TIF district to provide the assistance necessary to offset a “gap” in private financing for the proposed project. In order to qualify as a redevelopment district, 70% of the parcels comprising the area included in the district must be improved property and more than 50% of the buildings on that property must be substandard. In creating a redevelopment TIF District, Ehlers recommends the City contract to inspect the premises and provide a report documenting the required findings. We further recommend that the inspection and report be at the expense of the project and eligible for reimbursement from TIF. The TIF application states the findings may be met by the presence and remediation of the private wastewater treatment and older storage buildings located on the proposed site. TIF from redevelopment districts may be expended to reimburse various activities necessary to redevelop a site including but not limited to land acquisition, demolition, site improvements, remediation, utilities and public improvements. In a housing district, TIF must only be used to benefit a new rental development that has a portion of its units dedicated to persons with low to moderate incomes. The developer would be expected to comply with statutory requirements of having at least 20% of the units occupied by persons at or below 50% of median income, or at least 40% of units at 60% of median income. The affordability threshold is not an asset test, nor does it require restricted rent levels. These income restrictions will remain in effect for the term of the TIF assistance. The TIF application states that the cost of this affordability for 20% of units equates to $140,638 in reduced annual rental revenue corresponding to widening the financing “gap” by potentially another $1.7 million. If desirable the City can demand a higher percentage of units designated at affordable levels but doing so will increase the financial gap associated with the affordability. Economics of the Request We believe that it is important for a city council to understand the economics of a real estate development that is requesting assistance. Below is our understanding of the project’s sources and uses of funds with details on the project costs. The developer has indicated that it plans to construct the apartments in one phase starting in Spring of 2018 with completion in 2019. For purposes of the analysis below, we analyzed financial projections provided by the developer within the TIF Application. The development costs without connection to the city wastewater system total $21,546,000, equating to $131,378 per unit. Below are summaries of our understanding of project sources and uses adding in the connection and private waste water treatment plant decommissioning costs. 4 Riverbend North City of Otsego Summary Sources and Uses - Developer's TIF Application 164 Apartment Units SOURCES Amount Pct. Per Unit First Mortgage 18,610,746 80% 113,480 Equity - Developer 4,652,687 20% 28,370 TOTAL SOURCES 23,263,433 100% 141,850 USES Amount Pct. Per Unit Acquisition Costs 2,100,000 9% 12,805 Construction and Site Costs 19,655,213 84% 119,849 Professional Services 1,077,300 5% 6,569 Financing Costs 430,920 2% 2,628 TOTAL USES 23,263,433 100% 141,850 Analysis of Economics To help provide a basis for the evaluation of the “but for” test, we regularly review a developer’s projections for estimated costs, revenues, and expenditures (called a “pro forma”) when a city receives a TIF request. The pro forma review measures key factors in the developer’s assumptions to determine if the underlying assumptions are within industry standards. At times, a developer will show very conservative assumptions, which creates a gap in funding that the developer may argue creates a need for TIF. By altering some of the assumptions, a gap in funding may be reduced or eliminated. Below are six key factors we have reviewed for this project: 1. Land price and site costs 2. Revenues and operating expenses 3. Construction costs 4. Fees and the Total Project Budget 5. Financing assumptions and affordability 6. Potential investment returns 5 1. Land Price and Site Costs: We have been in situations with other cities where a council declined to offer TIF because the land price was too high and required too much subsidy. The proposed land cost to the apartment project price computes to $12,804 per unit or $2,100,000 total. Typically, a market development’s land prices fall in the range of $10,000 to $12,000 per unit for property acquisition. High acquisition costs drive up equity and debt requirements, which then creates lower debt service coverage and lower than market returns on equity. The budgeted cost is on the higher end of an acceptable range. The TIF Application budget does not separately disclose site cost like soil remediation, clearing, and demolition costs within this figure or the construction budget. 2. Revenues and Operating Expenses. The proposed annual revenue upon stabilization is anticipated to be $2.3 million and assumes a reasonable 93% occupancy. Operating expenses total $885,279 or $3,027 per unit, which is even on the low end of the typical $3,500 to $4,000 per unit cost. We have not conducted a market study to confirm the $1.30 average per square foot rents, but find the levels are in line with other market rate projects reviewed within the outer-ring metropolitan area. The developer provided a list of comparable apartment and their average rent levels at $1.34 psf. 3. Construction Costs. Construction costs of $119,849 per unit are on the low end of today’s construction market. It is unknown whether the amount includes a contingency figure and what portion contains site costs versus building construction. The estimates appear in line with expectations and are not creating an appearance of a greater need. If the Council is interested in requiring a higher level of exterior finish or higher level of amenity for this project, such a condition could be added to a TIF agreement. 4. Fees and Total Development Costs. The information within the TIF Application does not indicate whether a developer fee is included within the development costs. The total development costs to $141,850 per unit. A typical range for similar market rate apartment projects we have evaluated is between $150,000 and $200,000 per unit. The applicant does not appear to be padding the budget to convey a wider “gap.” 5. Private Financing. The assumption is the project will be financed with the combination of up front equity and a primary mortgage set at 80% of the development cost at a 4.75% interest rate with an amortization of 30 years. Without the proposed gap, equity requirement equates to $4.3 million. Net operating income upon stabilization provides 1.35x coverage of the anticipated annual mortgage payments which is strong. Additional financing would be needed to cover the gap which would either come from obtaining additional equity and mortgage proceeds, or secondary financing. Assuming the former, additional equity of $343,487 would be required and debt service coverage on the higher mortgage amount is 1.25x. Depending on credit profile, it is uncertain whether the additional financing could be obtained without the City’s assistance through TIF. 6. Returns. Return expectations vary by project type and investor. We suggest reviewing several different evaluation approaches to understand whether the need for assistance manifests itself in comparison to market driven projects. 6 Cash on Cost: As a percent of the total development cost, the stabilized net income of the project demonstrates an initial 6.3% return on cost. Cash on cost, the amount of income generated before debt payments, helps compare returns independent of equity and financing levels. Cash on cost returns exceeding 7-8% are typical private benchmarks. Cash on Cash: Assuming invested equity of $4.65 million (absorbing the gap), and all costs and rent levels as projected by the developer, the net income after debt service is an annual return on equity without TIF of approximately 6.4%. Given the level of risk involved in a new development, investment returns on equity are typically expected to exceed 10%. Internal Rate of Return (IRR): Comprehensive analysis of market returns also evaluate the potential value of the property, its cash flows, and potential sales. Stabilized cashflows and potential sales proceeds assuming no TIF anticipate 14.9% Internal Rate of Return through year 15. Typical benchmarks expect 15% to 20% IRR. Otsego Options Real estate is not an exact science. Different developers will have different tolerances for risk and different cities have various rationales for assistance. There are several economic questions raised in our analysis above. We provide the following considerations as options if the Council were to consider providing the assistance requested: A. Cap the assistance amount to only that level necessary to obtain financing for the gap as substantiated by qualifying redevelopment activities for the project. We recommend a pay-as-you-go form of TIF Note capped at the qualifying costs incurred, but payable over the full 26-year term of a new redevelopment district. As mentioned earlier, our TIF projection expects full payment to occur within 14 years. B. Additional Affordable Units. If the assistance qualifies for redevelopment district, the developer indicates a preference for 100% of units as market rate. However, if additional affordability is desired within the community the Council could explore negotiating to obtain some affordable units. Affordable rents are likely to expand the gap, so many communities offer assistance via TIF to offset the gap between market and affordable rents. Even though there is not a statutory necessity within a redevelopment TIF district, the Council could consider focusing additional assistance to obtain a specific number of units be designated as workforce or affordable housing. C. Additional TIF uses. The projected TIF revenue stream more than covers the full amount of the developer’s identified gap. A redevelopment district requires that at least 75% of the TIF expenditures going toward redevelopment activities within the boundaries of the TIF District. 15% may be used for pooling on redevelopment activity outside the TIF District boundaries and up to 10% for additional pooling or the City’s administrative costs. If there are redevelopment needs outside of the apartment parcel, up to 25% of the 7 TIF cashflow could conceivably be utilized for those purposes whether they include the adjacent mobile home park or other areas of the city. D. Ask for more information. The developer has provided adequate information to conduct the initial analysis, but the Council could request an appraisal of the property and/or a market study to establish the appropriate level of revenue expectations or community need. E. Reject the request for assistance. Please contact Ehlers with any clarifications or questions.