How the City Manager’s MUPTE proposal would inflate developer profits …
and what to do to avoid that outcome.
1. Use “cash-over-cash” return to understate the developer’s profits. The City Manager’s proposal would continue the use of the “cash-over-cash” method of evaluating the developer’s rate of return (i.e., profit). This method simply divides the first year’s net profit before taxes by the initial investment. This approach typically understates the actual profit the developer realizes after a ten-year MUPTE (or earlier, if the developer sells the property) because it doesn’t account for profit when the property is sold.
By using this method for past MUPTE’s, the City gave Capstone Collegiate Communities in excess of $3 million more in tax breaks than was needed to meet Capstone’s profit targets, even using Capstone’s own estimates of revenue and expenses.
No bank or serious real estate investor would use the cash-over-cash method (at least not by itself) to evaluate the financial return on a real estate investment.
Instead, the “internal rate of return” (IRR) method is the preferred method of evaluating true return on a real estate investment. There’s nothing “exotic” about this approach; in fact, it’s very easy to understand. When you determine a real estate investment’s IRR, the percent return has the identical meaning as if you put your money in a CD (Certificate of Deposit) at that rate for the same number of years.
To learn more, look at the example table (on the left-hand side) that’s presented in the concise “tutorial” at: http://www.propertymetrics.com/blog/2013/11/14/cash-on-cash-return/ .
Using this example, let’s suppose that a new MUPTE program is based on ensuring that developer makes at least 3.0% “return”. In this example, we assume the MUPTE tax breaks each year lower the annual expenses so that the profits before taxes are as listed in the second column. Based on that assumption, the project meets the 3% return — if the City uses the cash-over-cash method of analysis. But, as this example shows, if the value of the development increases over time, the true profit to the developer would be almost 11% if the developer sold the property after the ten-year MUPTE expired.
Of course, the assumed income, expenses and discount rate can vary for different projects and with different economic forecasts. Nevertheless, if (for example), a new MUPTE program establishes a 10% profit as the appropriate target, the evaluation of a proposed project should calculate the necessary amount and duration of tax exemption that’s required (if any), based on the estimated IRR.
2. Don’t limit what a developer can include in their project’s initial and operating costs.
The City Manager’s proposal doesn’t limit what a developer can include in the cost side of their proposal.
That means that a developer can add optional amenities to the apartments they’re planning, which will increase the initial costs. Similarly, they can add optional services to increase their recurring expenses. Both of these reduce the cash-on-cash return, allowing almost any project to be “gilded” sufficiently to fall below the MUPTE threshold. (This is the “but for” provision — a MUPTE project application must demonstrate that it cannot produce the profit set as the MUPTE threshold “but for” the lower expenses that would result from property tax exemption.)
But the cost of increasing an apartment development’s amenities and services not only increases costs, it also increases the desirability of the apartments, which allows the developer to charge higher rents. In order to qualify for MUPTE, the developer can simply lower his estimate of the rents, despite having a superior product.
If a developer maintains artificially lower rents during the ten years of the MUPTE, the developer won’t realize all the potential revenue from higher rents.
However, he does benefit from a lower vacancy rate because of a more competitive “product” (i.e., more appealing apartments than competitors in the same rent range.) The biggest benefit to the developer comes when he sells the property, before or after the MUPTE ends. Because a buyer would take into account the higher rents that can be charged for a superior product, the market value of the project will be greater than if the apartments had been built without the optional amenities that were essentially paid for by the MUPTE. Thus, the developer gets a windfall and a much higher true return on investment than was used to qualify for MUPTE.
Using the IRR method (as in 1, above) and recapturing excess profits (as in 3, below) are necessary and very effective in preventing a developer from “gaming” the MUPTE program by “gilding” a project.
Better yet, this type of manipulation can be stopped cold by having a once-a-year competitive evaluation and award of a maximum amount of exemptions. By evaluating each year’s set of project proposals side-by-side, the projects that deliver the most benefit for the amount of exemption requested will win the exemptions. The MUPTE program is perfectly suited to take advantage of competition among developers so city taxpayers receive the most benefit for their money.
3. Not having a provision to recapture excess profits.
The City Manager’s proposal doesn’t have an effective process and criteria to ensure that City taxpayers reap the benefit when the developer’s project produces profits in excess of the MUPTE target.
Thus, there’s no natural restraint on a developer’s using inflated estimates of expenses or understated estimates of revenue when they apply for a MUPTE. As a result, Eugene can find itself having given millions in tax breaks that weren’t actually needed and yet not being able to get any of that lost revenue back.
In contrast, Portland’s similar program requires the developer to return to the City any profits in excess of their program threshold. Naturally, Portland uses the “internal rate of return” — as analyzed by an independent, certified financial analyst — to determine the true profit returned on a project.
The “free money” the developer would gain from excess profits can be avoided by using the “internal rate or return” with reasonable estimates for rents and market value at the end of the MUPTE period.
The simple solution overall — Follow Portland’s tried-and-true approach:
- Use the “internal rate of return” method to estimate a project’s true profitability.
- Award MUPTEs through an annual competition among proposed projects for a maximum amount of total exemption.
- Require the developer to return to the City those profits that exceed the MUPTE target during the years that the MUPTE is provided.