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Mr. Kimball

Development & Construction

Public-Private Development Partnerships: Working with Municipalities on Tight Budgets

By Larry K. Kimball, Director of Hotel Development, C. W. Clark, Inc.

Public-private partnerships are a proven structure that often results in mutually-beneficial deals that incentivize new hotel developments for municipalities. Many of these deals are controversial because public or redevelopment funds are involved and sometimes the developer benefits more than the municipality over the long haul. In any case, this deal structure may be in jeopardy over the next few years. Municipalities throughout the U.S. are on the proverbial financial ropes and that is not good news for prospective hotel developers. We will discuss how we got here, where it is headed, and best practice strategies hoteliers can use to obtain financial incentives in future public-private partnerships.

Where Has All the Municipal Money Gone?

Higher Pension Costs

The influence of public sector unions is a primary reason municipalities face and will continue to face tough choices between providing or cutting existing services and imposing new tax increases. A recent University of Chicago and Northwestern University study estimated that states face a $3.92 trillion nationwide shortfall in unfunded pension liabilities for the period 2008-2023 (1). That is just the states, not the municipalities which are as follows:

"It is worth noting that the same issues also arise for the many municipal and county pension plans in the United States. According to the U.S. Census of Governments, local plans in aggregate held $0.56 trillion in assets as of June 2007, which is about 20 percent of what state pension plan assets were at the time. According to Pensions and Investments, as of September 2008 the largest of these local plans were New York City ($93 billion in assets), Los Angeles County ($35 billion in assets), and San Francisco County ($14 billion in assets). If local plans were as underfunded as state plans, underfunding would be $0.90 trillion using Treasury discount rates"(emphasis added) (2).

State "Loans"

As noted above and widely reported, states have their own financial problems. California legislators solved the current year state budget problem by "borrowing" about $2 billion dollars of redevelopment funds from municipalities. It was the ninth time since 1992. Sure the state is being sued by the California Redevelopment Association but it already happened. What state is next?

Lower Revenues from Sales and Property Taxes

The recession and residential housing market collapse has devastated the general funds and operating budgets for many municipalities. Operating reserves are being used to fund current year shortfalls. Sales tax receipts continue to be depressed as consumer's disposable income is tight from those who are cautions and/or underemployed. Assessors are revising downward the inflated residential and commercial property tax assessments and the adjustment to lower property tax receipts is significant and will be the new norm for many years.

Higher Borrowing Costs

The $2.8 trillion municipal bond market provides capital for redevelopment agencies. Municipalities' redevelopment agencies generally issue tax increment bonds to raise money to finance financial incentives for redevelopment projects. The source of bond repayment for hotel projects is generally a combination of future transient occupancy taxes, sales taxes, or special assessment taxes. Our new economic reality is prompting big revisions in the way major credit rating agencies evaluate municipality creditworthiness and combined with the capital markets the end result will be a change in a municipality's cost of bond financing.

In April 2009, Moody's Investors Service made an unprecedented announcement that it assigned a negative outlook for all US municipalities. Yes, Moody's and the other rating agencies are the same ones who got paid big fees to rate collateralized mortgage backed securities and other residential mortgage collateralized debt obligations. The law requires municipalities bond offerings to be rated by an approved credit rating agency. Moody's has used a distinct rating scale for U.S. municipal bonds since 1918 but is recalibrating to its global scale (3). Standard & Poors and Fitch Ratings are doing it too. While each firm's rating methodology is different, the basic concept will be to rate a municipal debt's likelihood of default on a scale similar to corporate debt. Do not expect the rating agencies changes to improve things across the board. The collective consensus is that for the next several years the capital markets risk appetite will result in higher borrowing costs for municipalities even if the credit rating is the same.

Given tight budgets and lack of construction financing for new hotels, how can hotel developers and municipalities move ahead together?

Jackpot! New Construction Financing

The problems are not all on the municipalities. If you haven't heard, in 2010 it is difficult to obtain construction and permanent financing for a new hotel project. Publicly traded hotel companies and REITs raised capital in late 2009 and 2010 with the intention of buying distressed hotels. It seems like everyone knows someone who has started a fund targeting distressed hotels. The industry is clearly in an era where it is cheaper to buy hotels in key markets than to build new ones.

Lodging Econometrics, a recognized authority on hotel real estate activity, reports the construction pipeline in Q1 2010 is down for the seventh quarter and off 49% by room count from the Q2 2008 peak (4). In 2011, they see new rooms supply increasing by 1.3%.

However, foreign and domestic private capital is available for new hotel development. Developers with flagged projects in primary and secondary markets are able to tap the private capital pool because those investors are seeking returns greater than those available on U.S. treasuries.

Best Practices for the New Reality

A version of the new reality is that state and local borrowing as a share of U.S. GDP rose from 15% in 2000 to an all time high of 22% in 2010 with projections it will reach 24% by 2012 (5).

The potential for a lower municipality credit rating from higher pension costs and lower sales/real property taxes will pressure city budgets even more. It will be tougher to get a city manager and their redevelopment staff to push a city council to approve a financial incentive to a public-private partnership. Such a request will be met with spirited discussions about the public benefit of reducing library hours and cutting public safety personnel or diversifying the tax base through new investment. Mayors and city councils must demonstrate political leadership and improve communication about project benefits with their constituents to get future deals done.

Tax increment bond financing, sharing of project generated sales and transient occupancy taxes, and abatement of the city's portion of real property taxes will still be the key tools of the trade. New federal sources created by the American Recovery and Reinvestment Act, passed by Congress in February 2009, are federal recovery zone facility bonds and Build America Bonds. Of course, New Market Tax Credits and an allocation of federal stimulus funds also create more options.

References:

(1) Washington Post; April 18, 2010; Page A18;
http://www.washingtonpost.com/wp-dyn/content/article/2010/04/10/AR2010041002762_pf.html
(2) Journal of Economic Perspectives-Volume 23, Number 4-Fall 2009-Page 208;
http://www.kellogg.northwestern.edu/faculty/rauh/research/JEP_Fall2009.pdf
(3) Moody's
http://v3.moodys.com/newsandevents/topics/us-municipal-rating-recalibration---gsrs/-/007016/-/-/0/0/-/0/rr
(4) http://www.lodging-econometrics.com/ExecutiveSums/USInd.pdf
(5) Wall Street Journal, June 14, 2010 page A17
http://online.wsj.com/article/SB10001424052748704269204575270802154485456.html?mod=ITP_opinion_0

Larry K. Kimball has over thirty years of hotel experience in development, finance, operations, and asset management at the corporate and operating unit levels. Mr. Kimball is currently Director of Hotel Development for C. W. Clark, Inc., a San Diego-based commercial real estate developer. In this capacity, he is responsible for the entitlement, design, financing, and asset management of several large public-private hotel and mixed-use projects totaling ~1,200 keys with combined development costs of $600+ million. Mr. Kimball can be contacted at 858-875-5146 or larryk@CWCLARKINC.com Extended Bio...

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