Memorandum

City of Lawrence

City Manager’s Office

 

TO:

David L. Corliss, City Manager

 

FROM:

Diane Stoddard, Assistant City Manager

Roger Zalneraitis, Economic Development Coordinator/Planner

 

CC:

Cynthia Boecker, Assistant City Manager

 

Date:

 

November 10, 2009

RE:

Response to McClure Letter and Questions about 4950 Research Parkway

 

On Monday, November 9, the City Commission received a letter from Kirk McClure regarding the proposed City-County acquisition of the West Lawrence Labs facility at 4950 Research Parkway for utilization, lease and sublease by the Lawrence Douglas County Bioscience Authority (LDCBA) as a graduation bioscience incubator facility. This memorandum will respond to the issues and questions posed in the letter. 

 

At the macro level, it is very important to understand that bioscience is a key economic strategy for Kansas, and an important trend for Lawrence and Douglas County to embrace.  Kansas ranks thirty-second in the nation in terms of economy, yet Kansas has recently moved up to #9 on Business Facilities’ Top 10 list of states in the nation for biotechnology strength. In order to take advantage of current and future opportunities, the community must position itself effectively to have the proper availability of lab space for companies to incubate, grow and prosper. 

 

Professor McClure raises several questions in his letter.  These are good questions, which are important to pose, and we are pleased to respond to the questions.  However, it is important to address a few overall concerns with Professor McClure’s points.  Professor McClure states that there are “flaws and misrepresentations” in the proposal for the City/County acquisition of the facility.  We respectfully disagree with that statement.  We believe that the proposal has been carefully considered, and that the assumptions utilized are reasonable.  Further, there are no “misrepresentations” in the proposal.  One may disagree with the lease rate assumptions utilized in the projections, but there certainly has been no intent to misrepresent any aspect of the proposal.  To the contrary, it is vital for the City and Douglas County to fully understand the proposal and the assumptions utilized.  City staff, County staff and LDCBA officials stand ready to ensure that any questions are appropriately answered and full information is provided. 

 

Additionally, Professor McClure states that “the financial projections for the property anticipate that it would not generate sufficient income to cover the costs of operation and that the taxpayers of Lawrence and Douglas County would subsidize the property to cover the losses.” In fact, the financial projection for the facility, which assumes a gradual build up to an 89% occupancy rate over four years, demonstrates a positive net cash flow every year with the exception of the first year.  LDCBA has taken this into account in its projections and has cash flow on hand to cover this very modest planned loss.  

 

It is accurate that the proposal provides that the City and County would subsidize the interest payment on the bond.  This subsidization would be very modest.  The Sample Bond Amortization Schedule demonstrates this directly.  The average annual interest subsidization over the term of the 25-year bond issue would be $18,570 each for the City and the County.  This amount is slightly higher in the first five years during the time that the payment from the LDCBA is fixed at $25,000 and the facility occupancy is increasing to the 89% projected level.  It is important to note that the proposal calls for the establishment of a building fund that would equalize gains and losses over time.  

 

If occupancy projections are not met, or projections are off for any significant length of time in the future, it would be anticipated that the LDCBA, the City and the County would need to visit about the situation.  It cannot be ignored that the City and County do retain key control in this manner and also own a building asset. Future options to address any significant and sustained deviation in occupancy rate assumptions include, but are not limited to, the sale of the asset or utilization of the asset or a portion of the asset by the City or County for governmental purposes.  Any economic development proposal carries risk; the key is the risks are reasonable and the anticipated return appropriate, which we believe are the case with this proposal. 

 

Professor McClure poses five issues/questions in his letter.  Next, we will address those issues/questions in the order they are posed. 

 

1. Purchase price

 

Professor McClure writes:  “The proposed purchase price is $2,900,000.  The financial projections for the property show the property generating a net operating income of about $12 per square foot.  It also assumes a capitalization rate (net operating income / property value) of about 6 percent which is too low.  Capitalization rates should reflect the cost of borrowing, the return on equity invested in such properties, and the risk associated with this type of space.  This suggests a capitalization rate of 8 percent or higher.  With a capitalization rate of 8 percent, the purchase price of the property should be $2,300,000, and this assumes that the building can maintain 89 percent occupancy.  If the occupancy falls to a lower level, the value of the property will be lower, possibly much lower.”

 

Response:  The proposed purchase price of the building is $2.3 million, not $2.9 million, which is consistent with Professor McClure’s analysis.  The $2.9 million of proposed financing provides $600,000 to upgrade and zone the building’s HVAC systems to increase energy efficiency and reduce operating expenses.  The current HVAC system is very complex and not zoned, which significantly drives up operating costs.  Addressing this issue is a key one with the building acquisition and will greatly enhance marketability of the lease space.

 

Additionally, it appears that the capitalization rate based on a $2.3 million sales price is between 9 and 10 percent.  The capitalization rate is calculated by dividing the net operating income (which is the annual operating expenses and does not include principal and interest payments) by the purchase price of $2.3 million.  Over the 21 years that the property is fully leased, the capitalization rate is over 10 percent.  If the first 4 years are also included, the capitalization rate falls to 9.4 percent.  These results appear consistent with Professor McClure’s analysis that the capitalization rate should meet or exceed 8 percent and may even suggest that a purchase price of $2.3 million is below market rate, rather than above.

 

That the City and County may be purchasing the building below market is reinforced by a comparison of our building purchase price per square foot relative to new construction.  At the $2.3 million purchase price, the cost per square foot is $132.  Including the HVAC improvements brings the cost per square foot to $166.  The going rate to construct lab space is approximately $250/square foot, or greater.  See information provided by Marilyn Bittenbender, Grubb & Ellis/The Winbury Group. 

 

Given these factors, we believe that the purchase price and improved price is significantly under the market rate, and certainly well below the cost of constructing the space. This enables the community to take advantage of an existing building to utilize as a graduation facility at a much lower cost than otherwise would be necessary.  As pointed out in the LDCBA request, the provision of a facility of this nature is key to enabling companies which are emerging from the incubator, but perhaps not quite ready to construct their own facility, to stay in Lawrence and Douglas County.  Not having this space available would likely mean these companies would have to explore moving to other communities. 

 

2. Identity of interest between the seller and the tenant

 

Professor McClure writes: “The purchase price becomes immediately suspect because one of the current owners of the property is a principal in the CritiTech firm which is to be a subsidized occupant of the property.  The sellers have an interest in obtaining as high a price as possible for the property, even a price higher than it can command in the private market.  CritiTech as an occupant has an interest in leasing the space at a low lease rate, even a rate that is below the market rate because it is subsidized.  With no arm’s length separation between the seller and the tenant, the taxpayer cannot trust either the purchase price or the lease rate. This suggests that the city should closely investigate the calculations of the purchase price and lease rates to ensure that the taxpayers are not being asked to provide more subsidies than are necessary.”

 

Response:  In the response to the previous question, it is demonstrated that the purchase price is appropriate given the market rate to construct a facility of this type.  It should also be noted that the CEO of CritiTech has made it clear from the beginning of the first meeting with City officials that he has a “dual role” as both a minority owner of the West Lawrence Labs building and as the CEO of CritiTech.  The CEO has been forthright in negotiations with the City, the property sales price has been publicly available for some time, and the final purchase price reflects a substantial reduction relative to what the building’s investors were seeking on the open market.

 

Also, the proposal to purchase the building came from the LDCBA, and not the building’s owners, and reflects our belief that this avenue would be the most effective at reducing operating expenses, keeping CritiTech in the City, and protecting taxpayer risk in the event that the lab space remains unoccupied (by owning the facility, the City and County can sell or reuse it and thus recuperate some or all losses).  Importantly, CritiTech is not receiving a subsidized lease rate in their space.  CritiTech will be paying an appropriate market rate given special features of the building.  This rate will be $21/square foot plus utilities, maintenance, taxes and insurance, and is $5 more per square foot than CritiTech is currently paying.   

 

3.  Form of financing

 

Professor McClure writes:  “The proposal is for the city to issue general obligation bonds to finance the purchase of the property.  This obligates the city to cover all principal and interest payments on the debt if the property does not generate sufficient income. 

 

It is more common for projects of this type to be financed with revenue bonds.  With revenue bonds, the city promises only the revenues from the project for payment of the debt.  Revenue bonds insulate the taxpayers from a heavy financial burden if the project fails.

 

This is a highly risky project. This risk will raise the interest rate on revenue bond debt, if the debt can be issued at all.  If the project is too risky to be financed with revenue bonds, it suggests that the project is too risky for to be undertaken.

 

If the city wants to purchase this property, the city needs to explore financing mechanisms that minimize the risk absorbed by the taxpayers.”

 

Response:  It is true that many private economic development transactions are assisted with the use of private activity bonds, or industrial revenue bonds.  In these transactions, the government is utilized as a conduit and these bonds rely on repayment by a third party.  However, it is important to note that this transaction is very different in one key way- the City and County retain a building asset.  General obligation debt is typically utilized to construct or purchase City or County building assets. 

 

4. Projected occupancy

 

Professor McClure writes: “The financial projection for the property assumes that the project will achieve 89 percent occupancy after 4 years and will maintain that level of occupancy for the remaining 21 years of the bond financing.

 

This is an eleven year old property with a checkered history.  The property’s occupancy levels over its life need to be detailed.  It seems highly unlikely that this property will suddenly transform from a poor performing property to a fully occupied property and remain fully occupied for over two decades.

 

The city should closely examine the occupancy history of the property and should examine the market for such laboratory space.  The market is saturated with facilities being offered to bioscience firms.  It is unlikely that this property will attract firms from outside of Lawrence; all of the firms are likely to come from spin-offs of KU. 

 

A compelling case needs to be made that KU will produce sufficient firms to maintain 89 percent occupancy in this property for over two decades, despite the fact that KU has not produced these firms in the past.”

 

Response:  The LDCBA has carefully examined the market and visited with potential tenants.  Based upon this analysis, LDCBA believes that the occupancy rate assumptions are very reasonable.  Additionally, a summary of the ownership and leasing history, along with comparable sales and lease rates has been provided by Marilyn Bittenbender, Grubb & Ellis/The Winbury Group. 

 

There is also a “safety cushion” built into the building operations.  The financial projections show that revenues should exceed operating expenses and principal and interest payments in most years.  As outlined in the deal terms, this money will be placed into a “Building Fund” that can be used, among other things, for maintenance, attracting firms, prepaying debt or covering temporary operating losses should occupancy rates fall below 89 percent for a period of time. 

 

We also believe that it is also important to examine the potential impact upon the City or County if we do not develop graduation facilities in the community.  This impacts the ability of our community to recruit and retain companies in the most important phase of their development, their growth phase.  As Tom Kern, President/CEO of the Lawrence Chamber, indicates in his letter, only four of the 17 companies that have spun out of KU over the last ten years have remained in Lawrence due to lack of lab space. A building of this type meets an important current and future need in order for the Lawrence/Douglas County area to grow bioscience opportunities.

 

5. Property taxes

 

Professor McClure writes:  “The LDCBA proposal states that the property will remain a taxable property.  This is not correct.  If the city is to own the property, it is not a taxable property.  Under some circumstances, a tenant could be charged a lease rate that is high enough to cover the debt on the property and an amount that would be paid in property taxes had the property been taxable.  This is usually referred to as a payment in lieu of taxes or PILOT. 

 

The financial projection for the property shows a PILOT, but it also shows that the project will not generate sufficient revenue to cover its own costs.  The losses are covered by the taxpayers.

 

It is disingenuous to claim that the property is on the tax rolls when it is publicly owned and generate losses that must be covered by the taxpayers.

 

The proposal should not mislead the taxpayers into thinking that this property will be anything other than a subsidized property.”

 

Response:  It is inaccurate to state that the property will not be on the tax rolls.  The proposal clearly indicates that it will remain on the tax rolls and this has been an important point regarding this project. Case law and state statutes are very clear on this point- ownership by a public entity does not determine the taxability of a property, the use does.  It is clear that the anticipated use will be for private activities.  While Kansas does have a recently approved property tax exemption provision for incubator-type facilities, it is an agreed upon point in the proposal that the property WILL remain on the tax rolls.  This will ensure that the current property tax will continue to flow to the taxing jurisdictions from the property.  The stipulation regarding the taxability of the property would also be included in the LDCBA/City/County agreement.