Real Estate Development-Memo writing

WORKING SAMPLE

Xue Wood, Planner

332 W Indiana Ave., St. Joseph, MO

P: 646.401.4320 I E: xuechenberry@gmail.com

Memo To: From: Date: Re:

J. Smith, Director of Planning Xue Wood, Planner November 23, 2011 Recommended Action by the City for the Preservation of the Rainbow Building

Recommended: That the City negotiate with the developer of the Rainbow Building on the basis of rehabilitating the building to a standard that will qualify the project for the use of Historic Rehabilitation Tax Credits. This may require city intervention to ensure that operating losses are covered and recognition that a change in ownership is likely within the first five years of operation.

A developer has proposed to demolish the Rainbow Building and to build 50 units on the site. Objections to the demolition were voiced. As an alternative, the developer proposes to preserve some of the building and to construct 46 units, mixing new construction and rehabilitation. This analysis shows that, if the developer will rehabilitate the building to a standard that will qualify the structure for Historic Rehabilitation Tax Credits, the developer will realize a higher return on investment despite the fact that only 42 units could be accommodated in this alternative. The table below summarizes the investment performance of the different development alternatives.

Investment Performance of the Development under Alternative Scenarios Alternative

Units Equity Required

Maximum IRR-AT

Maximum ROE

Year Sale

New Construction Mixed New/Rehab Historic Rehabilitation

50 46 42

8.3% 7.5% 22.3%

1.0% -0.8% -14.6%

8+ 8+ 4

$1,156,250 $1,150,000 $413,400

Each of the three development alternatives has been analyzed in terms of its investment performances. Only the new construction alternative generates a positive cash flow at any time during the development’s operation. The Historic Rehabilitation alternative fails to generate a positive cash flow, which will necessitate an operating reserve funded by the owners to cover these losses over the years of operation. The mixed-new construction and rehabilitation alternative does not generate a positive cash flow through eight years of operation. Only the new construction alternative generates a sufficient return on equity from operating the property that the developer will be interested in the long-term maintenance of the property. This suggests that the City must stand ready to assist in the maintenance of the property over time. However, the alternative involving the use of Historic Rehabilitation Tax Credits has several advantages, and one problem:

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The tax credits will generate funds at the beginning of the project reducing the amount of equity the developer will have to acquire. The developer’s cash equity requirement will fall from over $1,100,000 with the new construction and mixed construction alternatives, to about $413,000 plus another $240,000 to cover operating losses during the first four year of operation with the historic rehabilitation alternative. This should appeal to the developer.

The after tax internal rate of return will be higher with the Historic Rehabilitation alternative, peaking at 22 percent. Unfortunately, this IRR will decline quickly over time, unlike the other alternatives (Please see the following chart). This means that the developer will want to sell the property in order to realize the highest possible profit. This could be as early as the 4th year after the completion of construction. As a result, the City should anticipate that it will have to work with a different ownership for this project only a few years after its rehabilitation. The City can strengthen its position by having a right-of-first-refusal on the property with ongoing control over its management.

Chart Comparing Investment Performance of Three Development Alternatives

Attachment: Data Used in the Analysis of Alternative Development Proposals Item

Alternative New Cons.

50 800 3.0% 5.0%

His. Rehab 42 875 3.0% 5.0%

Operating expenses per unit for year one Operating expenses inflation per year

$4,000 4.5%

$4,500 6.5%

$4,250 5.0%

Total development costs Land value New construction costs Rehab costs Loan to value ratio Market interest APR compounded monthly Loan term in years

4,625,000 675,000 3,950,000 0 75.0% 7.0% 30

4,620,000 500,000 0 4,120,000 75.0% 7.5% 30

4,600,000 675,000 2,000,000 1,925,000 75% 7.25% 30

Appreciation of property value per year Selling costs as percent of value Capital gains tax rate of owner Recapture Rate on Depreciation Income tax rate of owner Syndication net proceeds

3.0% 4.5% 15% 25% 28%

3.0% 4.5% 15% 25% 28% 90%

3.0% 4.5% 15% 25% 28%

Residential units Residential rents per month for year one Resid. rent inflation per year Resid. vacancy loss per year

Mixed 46 850 3.0% 5.0%

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