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Public-Private Partnerships: A Strategy to Minimize Public Subsidies


Public-Private Partnerships: A Strategy to Minimize Public Subsidies

By Hans Detlefsen
Jan 11, 2012

This article discusses why the cost of capital available to developers influences whether they will require subsidies. A strategy to minimize public subsidies involves seeking the most qualified developer who also has the lowest cost of capital.

Public-private partnerships can be an effective means to initiate economic development projects. Development types can include a range of properties including mixed-use developments, tourism attractions, conference centers, sports venues, hotels, and other real estate types. Public officials often rely on a competitive process, such as a Request for Proposals (RFP), to solicit proposals from private sector developers.

The aim of such an RFP process is often to identify a private-sector stakeholder to design, plan, construct, and own the physical real estate as part of a public-private partnership. The public sector’s role in a public-private partnership often includes providing some form of incentive to close a “feasibility gap”1 between the private sector developer’s total project cost and the estimated value of the completed development.

This article will focus on one key metric to determine which potential developers are likely to require the smallest and largest subsidies. This sometimes overlooked metric, the “cost of capital” to developers, can be a critical factor in determining the amount of public subsidies a given developer will need. A strategy to minimize public subsidies involves seeking the most qualified developer who also has the lowest cost of capital. Although such a strategy may be applicable to many development types, this article pertains specifically to the relevance of determining developers’ costs of capital in the context of developing hotels.

Hotel

Example
Let’s consider an example. For the sake of this article, we assume that a community is comparing two potential private-sector development partners as finalists for a desired hotel development. In general, we find that communities can compare development proposals on the following basic criteria, among others:

Knowledge and experience of developer
Development cost (or quality)2
Income potential
Cost of capital (or funding strategy)
For the purpose of this article, we assume both developer finalists have similar knowledge and experience pertaining to hotel developments. Furthermore, we assume they both agree on the hotel’s construction cost and have plans that indicate identical quality. Finally, we assume both developers forecast similar or identical income potential for the hotel.

The only difference between the two developers is their funding sources, which cause them to have different costs of capital. Hotel funding typically includes an equity component and a loan component. As different developers have access to different sources of equity and loan financing, the funding aspect of a hotel development can play a crucial role in determining a developer’s total project cost. This article will discuss the importance of identifying the developers’ costs of capital as a selection criterion for public-sector decision-makers running an RFP process of this type.

Measuring the Feasibility Gap
A feasibility gap can be defined as the difference between a project’s cost and its value. If a project’s value is greater than its cost, then it is feasible and no subsidies are required. However, this may not be the case for full-service hotels for which development costs often exceed the property’s value.

How can one determine whether a feasibility gap exists? And how can it be quantified? There are many methods developers and investors may use to estimate the feasibility gap of a hotel project. However, most methods essentially rely on quantifying two numbers for comparison: (1) the total development cost of the project and (2) the anticipated investment value of the project upon completion. If the project’s anticipated investment value is greater than its total development cost, then the project is feasible and would not require public-sector incentives. However, if the total project cost is greater than the investment value, then a feasibility gap exists. The size of the feasibility gap is measured by quantifying the difference between the project’s cost and its value.

Developers or cost estimators can provide detailed estimates of a hotel project’s cost. An experienced appraiser can estimate the proposed hotel’s value. The comparison of these two numbers allows one to quantify a project’s feasibility gap, if one exists.

There are three basic approaches used by appraisers to estimate value: (1) Income Approach; (2) Sales Comparison Approach; and (3) Cost Approach. The Income Approach is often the most appropriate approach to rely on when evaluating income-producing properties, such as hotels. Within the Income Approach, appraisers may consider several techniques for estimating value, but one of the simplest techniques is known as Direct Capitalization. This technique allows one to estimate a property’s value by dividing its net operating income by an appropriate overall capitalization rate. Although the Direct Capitalization technique is not always recommended for valuing a complex property, such as a hotel, the technique is useful in illustrating the importance of evaluating developers’ costs of capital. This simple technique can be expressed as the following formula, familiar to most appraisers:

I / R = V
In this formula:

I = net operating income
R = overall capitalization rate
V = value

This article focuses on the importance of capitalization rates used by potential developers. For the purpose of this article, a capitalization rate can be thought of as the overall “cost of capital”3 to the developer. Based on the preceding formula, then, one can see the relationship between a developer’s cost of capital (or required financial returns) and the resulting feasibility gap. The higher a developer’s cost of capital is, the lower the developer’s derived investment value will be. In other words, all else being equal, the higher a developer’s cost of capital is, the more subsidies this developer will need.

Comparison of Two Developers
Suppose a local government has issued an RFP for the development of a 400-room, full-service hotel. Then, assume two developers have been selected as finalists, based on their knowledge, experience, and other qualifications, as previously indicated. Assume both have estimated the total development cost for the proposed hotel to be $120,000,000. So, to determine whether a feasibility gap exists, we need to estimate the investment value of the project to each of the two finalists and compare these values to the development cost estimate.

Based on the formula shown earlier, we can estimate the investment value to each developer if we know the hotel’s expected net operating income (I) and the developer’s cost of capital (R). For illustration purposes, assume both developers are forecasting similar financial operating projections for the hotel, indicating a net operating income level of approximately $8,000,000 annually. We can divide this income figure by the cost of capital for each developer to estimate the investment values to these respective developers. We can then compare these values to the estimated development cost to quantify their respective feasibility gaps, or required subsidy levels.

Assume the following descriptions about the two developer finalists:

Developer #1 has an investment partner who is willing to provide equity for this project and requires a 15% return on any equity contribution invested. As a result of this developer’s current banking relationships, she also has a letter from a bank indicating she can obtain a loan for 70% of the project cost at an interest rate of 6.00%. Therefore, Developer #1’s weighted average cost of capital is 8.70%.

The following table summarizes this calculation and provides an estimate of Developer #1’s feasibility gap for the project.

Based on these assumptions, the indicated investment value of the completed hotel is about $92.0 million to Developer #1. This leaves a feasibility gap of approximately $28.0 million. The feasibility gap can be thought of as the required level of public-sector (or other) subsidies needed to allow Developer #1 to obtain funding for the hotel project. This incentive requirement represents roughly 23% of the estimated total project cost.

Developer #2 has an investment partner who will provide equity for the same project, but requires a 20% return on any equity investment. The developer’s bank has issued a letter indicating he can obtain a loan for 65% of the project cost at an interest rate of 6.00%. Note that this developer has access to a loan with a similar interest rate, but a lower loan-to-cost ratio, compared to the other developer. Based on these figures, Developer #2’s weighted average cost of capital is 10.90%.

The following table summarizes this calculation and provides an estimate of Developer #2’s feasibility gap for the project.

Based on these assumptions, the indicated investment value of the completed hotel is about $73.4 million to Developer #2. This leaves a feasibility gap of approximately $46.6 million. This feasibility gap can be thought of as the required level of public-sector (or other) subsidies needed to allow Developer #2 access to the funds required to develop the hotel. This incentive requirement represents roughly 39% of the estimated total project cost.

This article specifically highlights the importance of comparing parameters that influence the overall cost of capital. In the hotel example, there were two key differences. Firstly, the loan-to-cost ratio, or “leverage” available to the developers, affects how much of the total funds required can come in the form of debt, which is generally less expensive than equity. Secondly, the equity yield rate, or the required return on equity for the investors, reveals how expensive it will be for each developer to access the remaining portion of funds from equity capital sources.4

Concluding Remarks
The preceding example illustrates how differing capital costs can greatly affect feasibility. In this example, the two equally qualified developers would have very different requirements in terms of public subsidies needed to complete the same project. By evaluating the cost of capital available to potential developers, policy-makers may be able to gain important insights about the potential subsidies that will be required to complete various desired development projects.

As illustrated, the cost of capital can make a big difference in terms of whether a hotel project is feasible and to what extent developers may require public subsidies to complete projects. Developers can sometimes have significantly different costs of capital, depending on their funding sources. For this reason, public-sector decision-makers aiming to attract hotel developments to their communities may wish to evaluate these funding sources and any differences in capital costs when comparing developers.

Financing full-service hotels often requires some form of public subsidy. But investigating the financial capacity and funding sources available to potential private-sector development partners can help public-sector participants maximize the return on their public investments. More resources for evaluating development deals and public-private financing strategies can be found in the HVS library 5 or by contacting HVS6

1Economic Feasibility is defined as the “ability of a project…to provide a reasonable return on and recapture of the money invested”, The Dictionary of Real Estate Appraisal, 4th Edition, p. 91. This can also be thought of as the difference between the project’s cost and the project’s value to the developer.

2Variations of this criterion could include a project’s ability to generate economic impacts, jobs, or fiscal impacts.

3This cost of capital is typically a blended cost of various forms of debt and equity funding, which have required financial returns (i.e. interest rates and equity yield rate requirements).

4Based on our experience, the developers with the greatest access to financing often have the lowest cost of capital; moreover, such developers often have the greatest ability to complete a project according to the original terms negotiated, rather than a “downsized” or “revised” building program

About Hans Detlefsen
HANS DETLEFSEN is Managing Director of HVS Global Hospitality Services in Chicago. He holds a Masters Degree in Public Policy from the Harris School of Public Policy Studies at the University of Chicago, where he received the Harris Fellowship. He graduated magna cum laude from the University of Notre Dame with a Bachelor of Arts in Government and Economics.

3 Responses to Public-Private Partnerships: A Strategy to Minimize Public Subsidies

  1. Pressanykey Reply

    January 1, 2013 at 11:46 am

    When I think of these public/private projects the first thing that comes to mind is NEED, and whether there is a public consensus for that NEED.

    The next thing that comes to mind is the overall financial picture for the political subdivision/subdivisions that will be responsible for meeting the debt service for the project. The current amount of public debt, things like the annual collections for the local tax base, whether the local population is growing or declining, whether jobs are increasing or declining, the financial health of the top ten local taxpayers, any proposed capital projects by other political subdivisions in the county/city.

    So many times these projects, do to a well oiled PR campaign, take on a life of their own, usually well before any of the above mentioned concerns are ever discussed publicly. Certainly Earthcare Energy was a prime example.

    We have city and county councils for a reason. The council members are supposed to posses the ethics, intelligence, and experience to vet these projects and to be above any partisan shenanigans, outright cronyism, or quid pro quo.

    May 2013 actually be a “new beginning” for Evansville and Vanderburgh county.

    ____

  2. Pressanykey Reply

    January 2, 2013 at 8:48 am

    In today’s Courier&Press (1-2-13) in the legal section (section C) one will see from page C-1 to C-9 nine full pages of home foreclosure actions in Vanderburgh county.

    One can ill afford to ignore such economic indicators when considering the possibility of asking taxpayers to grant tax phase-in and abatement, and low interest or no interest loans to businesses.

    We are not out of the woods of the Great Recession by a long shot, plus, did we not read in today’s C&P a statement by Christy Gillenwater, incoming president of the Chamber of Commerce of Southwest Indiana, that “Businesses are sitting on a lot of cash.”

    ___

    • Zenarcher Reply

      January 2, 2013 at 10:28 am

      This article should be on the required reading list for all the City Council and County Council members. An excellant article, and I only hope the elected offical will read,understand, and abide by it.

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