BCR's Daily Fishwrap Report for October 2, 2009
Why I'm voting for... Cole-McFadden in Ward 1

McLaughlins move forward without The Know on Fayetteville St. -- and why their new financial plan makes sense

Less than a couple of weeks after a Monday night City Council meeting that seemed to deeply frustrate Mozella McLaughlin and her family in their quest to gain City incentives towards the renovation of the building housing The Know bookstore on Fayetteville St., today brings news of a big shift in direction for the plans.

The building owner's son, William McLaughlin, told the N&O's Jim Wise on Thursday that The Know would no longer be a part of the renovation plans, and needed to be out of the building by December 31. The Know's owner, tenant-at-will Bruce Bridges, clashed publicly with the McLaughlins over what he says was a co-opting of his idea and a shrinkage of his space in a way that would make his bookstore no longer viable as a business. That move came after a long mediation session yesterday, Wise reports.

McLaughlin also tells Wise that City incentive dollars may or may not be a part of the plan -- a plan whose construction costs will shrink by $200,000 as the McLaughlins eliminate a planned green roof feature from the project.

From BCR's perspective, the latter is perhaps the best news to come up in some time for the McLaughlin project, representing what we'd speculate could be the difference in the effort's ability to qualify for financing.

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And that's no small issue. The economic viability of the project has been one of the key question marks floating around the public debate over the project. That's doubly true because of the effort's reliance on private-sector financing for the renovation and expansion of the structure.

Some -- notably City Councilman Farad Ali -- have argued with some persuasiveness that that inquiry goes beyond the real of what's appropriate for the discussion of public incentives. We're sympathetic to his point, but let's hold off on that to the end, shall we?

Over the past week, BCR has reached out to a half-dozen developers and financiers to gauge their opinions on the pro formas submitted by the McLaughlins to the City as part of their incentives grant (and, thus, available as part of the public record.)

Our verdict here at BCR? There's some question marks and weak points in the figures, but they're weaknesses that are much less likely to matter with a significantly-reduced price tag for the project.

Let's take a look at some of the financial questions, by the numbers -- and then talk about why it all matters.

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(Before we begin, if you're interested, the original data are available for perusal. Download Pro Forma #1 and business plan or download Pro Forma #2.)

Does the departure of The Know matter for the project's financial viability? Probably not. Out of 6,572 sq. ft. in the project, Bridges' The Know was only slated to get 400 sq. ft., or about 6% of the leasable space. The restaurant/café space taken by Dillard's BBQ and the jazz/cultural center together comprise the vast majority of the space. The pro forma carries with it a reasonable 10% vacancy allotment; assuming locked-in leases on the other tenants, and the opportunity to replace Bridges or to redistribute the square footage to other tenants, the loss of The Know by no means sinks this effort.

Is the rent rate viable? The pro forma assumes $13 per sq. ft., per year in rent. Some have criticized whether this is a realistic number, but it may not be too far off. One observer thought $12/sq. ft. would be the ceiling in this corridor, but that's not too far off the mark. Space at Wellons Village is running $8-12/sq. ft. for older space that's probably not renovated, and a look at the CoStar lease database is generally supportive of something near this rate.

Are the rest of the pro forma numbers on point? BCR got a variety of reactions to this question. On the one hand, the pro forma doesn't include a property management expense. Some experts we consulted dinged the document for this, while others thought it didn't matter; ultimately, a lender probably cares more than the McLaughlins, who likely plan to manage the property themselves -- but a lender generally wants to know that they could still be cash-flow positive if they had to take over operation of a building.

On the other hand, estimates for marketing and parking lot lighting are probably high, while some of  the common area maintenance charges listed here might be reasonably pushed back to tenants themselves (especially with the loss of a green roof.) Maintenance expenses are lower than one expert wanted to see, although another person we consulted pointed out that a freshly renovated building should be relatively inexpensive to operate at first.

We'll call this one a push, and assume a net operating income (NOI) of $42,432 per year before debt service is accurate.

Does the pre-tax/post-tax issue matter? We here at BCR suspect more than ever that it was a convenient way for Bill Bell to push the issue off two weeks. A lender gets paid their debt service from pre-tax dollars. The post-tax dollars only impact the net return on investment for the property owner or their investors. Now, it might make the project less viable to an owner who might or might not choose to invest in the project -- more on that later.

Are the construction costs in line? This is one that raised more red flags than anything else. One development community member noted that the hard and soft costs together on the structure would be sufficient to build brand-new top of the line (Class A) office space if you were starting from scratch -- which makes spending that much money on a 30-year-old building pricey.

On the other hand, two observers both noted that restaurant space brings with it its own inordinate level of costs, from grease traps to possible fixtures and restaurant equipment, depending on whether landlord or tenant is responsible for upfit.

But the real driver of cost, we speculate, seems to have been the expense to add a second floor front portion to the building and to add a green roof terrace on top of the original structure. While we have to make assumptions about the building housing The Know, which used to be a pharmacy, it's not hard to imagine that you might need to do some real reinforcement in order to hold dirt, plants and people.

Ultimately, it's these construction costs that are most impacted by the decision to drop the green roof, and to drop the project cost by $200,000. All of which brings us to the linchpin question:

Is the project economically viable from a lender's perspective? Let's dig through this one for a moment.

To start with, you have to ask yourself what a building is worth, and thus, whether there's sufficient equity in a project for a lender to take a stake in the project.

A common way to measure real estate value is through a cap-rate method, dividing a market-borne capitalization rate into the NOI figure from above. It's just like calculating the value of a bond, which in many ways a piece of real estate -- a capital investment that should throw of sufficient revenue each year to justify the risk in a market.

Using a 10% cap rate for a back-of-an-envelope (at one of our observer's suggestions), and assuming that the high-bids and low-bids on the pro forma would balance out to mean that net operating income (NOI) is still about $42,000 a year, you end up with a property value of $420,000.

Now, assuming the McLaughlins hold the property without any debt, we arrive at perhaps the one real challenge for the building owners under their original plan.

Their original proposal to the City called for about $432,000 in new construction and renovation costs, coupled with about $170,000 in soft costs and project contingencies to get to a hair over $600k total. A bank loan at 6.5% would cover $400k of cost; the City incentives grant and other programs (like the façade grant program) would catch the remainder.

Now, from the bank's perspective, what does it mean if you make this loan -- again, assuming you're the only person in line as a lender?

Well, you've lend $400,000 on a structure that only has an economic value of $420,000, meaning you've got a loan-to-value ratio approaching 95%. That's pretty high even in the recent boom times; in a bad economy, our local sources say, banks would be very wary of hanging out at such a number, even with personal recourse (that is, fallback on personal assets.)

Worse still, you've spent $600,000 -- to say nothing of the value of the structure in its unimproved condition -- for a building only worth $420,000 or so.

You'd also be worried that the ROI on the project for an investor wasn't all that great. Again, if you're the family that owns the building, you've got a range of reasons for doing this projects that go well beyond financial return. But if the ROI wouldn't attract a private investor, would a bank have a marketable project if it has to find a new buyer for any reason? (These questions aren't to doubt the family; instead, it's the question a bank has to ask to make sure they have an exit strategy on any loan, since lenders aren't really in the business of operating properties for which they lended money.)

Would a bank do this deal? Probably at a much better loan-to-value ratio, one at or well under 50%.

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I finished putting together some of the thoughts on this early on Thursday, after finishing up one final interview with an external (anonymous) project reviewer, and well before the N&O's story about the revised project plan hit the newspaper's blog.

Let me just say, therefore, how happy I was to hear the news of the McLaughlin's revised project.

Take the example above and you'll see why. Suddenly, a project whose construction costs seemed high for the end-result, and which had hard costs alone that were stretching the economic value of the property, becomes one where you're only needing a couple of hundred thousand dollars to renovate the structure.

Knock $200,000 off the renovation costs, and you're suddenly back in the ballpark where the owners can retain enough equity -- assuming soft costs and contingencies are watched like a hawk -- where private lending is still somewhat more viable. It's much easier to picture a bank being asked to step in for a $230,000 loan on the property, even without (but certainly with) the help of City incentives. And, certainly, your debt coverage ratio would be much healthier in that light.

The green terrace meant as a garden for family (and Fayetteville St.) matriarch Mozella McLaughlin might not come to pass in this project. But the project that's now described is -- from a back-of-the-envelope perspective -- a much more financially plausible one, it seems.

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Of course, underlying all of this analysis are a couple of fundamental questions.

Did the McLaughlins deserve the scrutiny they received over this project? And, is this the kind of incentive investment the City should be providing on the corridor.

To the first question: as noted above, Councilman Ali has argued passionately that the McLaughlins have seen this project looked through ten ways to Sunday when other neighborhood investment efforts haven't.

While critics of the project have pointed to financial analyses like the one above in making the arguments against the public sector incentives, Ali is quick to point out that it's the City's role to encourage investment in corridors like Fayetteville St. -- not to be a judge and jury on a project in the same way a bank might.

On first glance, that might sound illogical (especially with tax dollars involved), but there is a method to the argument.

The City, Ali notes, provides incentive funds as an inducement to investment in blighted areas, and to help provide seed funding to make projects feasible.

But Durham isn't putting out hard dollars until after a project gets going -- which means that the project still has to pass muster with a bank or outside investment.

One can think of that process as a "brake" on investments, in other words. The City can offer good-faith investments, and if the pro forma doesn't work, the project just won't take off and the City's not out any money.

Ali said this has been standard for other economic investment deals, from the Bushfan and Clark neighborhood revitalization deals to Heritage Square. And he added that the Council didn't spend long debating the Heritage Square numbers -- and that that deal has cost the City zip since economic conditions have prevented it from moving forward.

"We didn't do this for any other deal," Ali said. "This is quite unusual for me to watch this go through this process."

(In our interview, Ali also addressed one of the barbs that's been flying around concerning any role he's played in this project. Ali noted that as an executive at the NC Institute for Minority Economic Development, his staff have assisted the McLaughlins with their planning for the effort -- but that his firm also helped Joseph Bushfan and Wendy Clark with their efforts, both of which won incentive grants, and that this represented the very nature of his professional work in his non-profit.

Ali also told BCR that city attorney Patrick Baker was consulted as to whether he had a conflict of interest on deals like this, and was informed he did not.)

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Just because the McLaughlin project would seem to qualify for incentives, does that mean that this incentive program overall is the "best" way to move neighborhood revitalization forward?

One difference between some of the major (and controversial) investments like American Tobacco and even Heritage Square is that they were major catalyst projects intended to spur other nearby development and jobs.

On the one hand, smaller projects like these covered in the neighborhood revitalization program aren't able to have the same impact on any one region. On the flip side, they do bring individual points of energy to neighborhoods, and can have other benefits -- like the arrival of a grocery store in NECD that also employs ex-offenders for Bushfan's project, or a home for non-profits in Clark's effort.

The McLaughlin project could bring jazz and a new restaurant to the Fayetteville St. corridor, and that's a useful synergy with programs at NC Central, for instance.

But as one local developer pointed out, ultimately projects like this (and the discourse that goes with them) are nickels and dimes that don't move the community towards the real need: major streetscape renovations on the corridor.

One can argue that the most important investment the City could make would be to spend the tens of millions of dollars it would take to improve the roads, streets, lighting and the like along Fayetteville St.

Rather than the City investing time and money in one-off revitalization efforts on private businesses, a larger streetscape effort would provide the public dollars in an area where no one private firm can play a part -- thus incenting much more in the way of private dollars to follow.

Of course, these aren't an either/or thing. And the City has reportedly been looking for ways to finance what would be a very expensive streetscape investment effort; an individual project like the McLaughlin's isn't going to impact the big picture.

Still, the City's going to need every dollar it can for infrastructure improvements. And making the acceleration of those plans a reality seems like a reasonably well-supported priority.

Comments

Erik Landfried

I guess I don't see how the elimination of a green roof show be seen as a major positive. I understand it reduces the cost of the project, but isn't the point of green building the long-term savings that can be gained from improved energy efficiency and reduced stormwater impacts?

Is there another way to fund these types of improvements? Surely there are grants that could help cover some of those costs.

Can someone elighten me on this subject? I don't know a lot of details about how green building techniques can best be incorporated, but from the sidelines it sure seems like a shame, not a positive, that a green roof is being scratched.

Dan

Erik, I have to agree with the original post on the green roof issue. I am a big proponent of green building, but green roofs simply don't do much from a benefit-cost perspective. Even the "pure" environmental benefits are pretty minimal in terms of the small amount of energy efficiency improvements and small amount of storm water mitigation from a project like this one. I'd much rather see the project invest extra cash on more basic, practical green building features--increased insulation, water saving fixtures, use of durable materials, etc. These are the types of investments that have a real payback from an environmental and economic perspective. Plus, a small chunk of $200k could green the building in much more meaningful ways than a green roof. Anyway, that's my 2 cents...

Durham Banker

For the forseable future, Commercial Real Estate is going to be very challenging to finance regardless of the Loan to Value, strength of the borrower, or strength of the gurantor. It is unfortunate, but the reality of the credit environment we are living in today. The FDIC is not encouraging banks to increase their Commercial Real Estate exposure and banks are having to abide by their policies. Even if a loan is perceived to have very little risk and several repayment options, if the FDIC does not want the bank to lend to that market, it will not be profitable for the bank to make the loan. Banks will not lend when it is not profitable to do so.

Todd P

It's unfortunate the The Know is getting the boot, when they are responsible for the current success at this location. Losing The Know certainly makes you wonder if this venture is going to succeed.

I am glad to see that the amount of the proposed public subsidy has been scaled back, since the original amount proposed would have been sufficient to tear down the existing building and re-build from scratch. That was another Rolling Hills situation just waitning to happen.

Downtown Business Owner

First, great in-depth reporting Kevin.

I've been following this story, and I am amazed at the amount of time our city has spent on this project.

Secondly, I'm glad to hear that the owners decided to dismiss The Know. For The Know to be a mere TENANT of a space, and yet make such a staunch opposition to increased (and needed) development on Fayetteville Street that would benefit the surrounding community is ludicrous. Not to mention they were not assisting with providing any funding or taking on any additional risk for this new project to demand anything.

Finally, Kudos to Councilman Ali for being (as it seems) the only vocal person in support of treating the McLaughlin like any other developer/owner. I seriously doubt the city would treat Greenfire the same way if Revolutions or Dos Perros had an issue with their lease; or the folks at American Tobacco if Cuban Revolutions or Tylers had a complaint. This would have been an owner-tenant issue, and not the city's responsibility to interfere with owner-tenant negotiations. I say let Mr. Bridge go out and raise capital on his own and develop his restaurant like every one else, or find a better location nearby.

Natalie

A tenant who has paid rents for almost two decades deserves to be heard.

I think there would be the same investigation if a beloved institution downtown were evicted by their landlord so that the landlord could redevelop the building.

jack

They already have a jazz cultural center on Fayetteville street, it's called the Hayti Heritage Center. Put Dillards in Hayti, and you'll pretty much have what the know bookstore is going to become, for a whole lot less.

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