City Hall Annex: Concerns About the Fine Print

Jersey City currently rents office space at several locations other than City Hall for a total of about $2.7 million per year.  City Hall Annex MapTo cut costs and give residents a single location (other than City Hall) to access services, the City wants to create a City Hall Annex (“the Annex”).  A key question has become: how much money should the City pay for the new space?

Under Mayor Fulop’s proposal – codified in Ordinance 14.099 – the City would enter into a 25-year lease with a developer for a cumulative cost of $45 million. In year 26, the City could purchase the building for $1.

Mr. Fulop’s proposal received initial approval from the City Council on August 18th.  It now requires one more vote – scheduled for September 10th – to be finalized.

City Hall Annex Timeline v2At the August 18th Caucus meeting, City officials cited the merits of Mr. Fulop’s proposal, including:

  • The proposal lowers rent from the current rate of $2.7 million/year to between $1.28 and $2.4 million/year.
  • The proposal spreads the cost of a long-term asset (a new building) over a long-term timeline, thus freeing up funds for other expenses.

But a closer reading of the fine print reveals potential flaws with Mr. Fulop’s plan:

  1. The lease agreement bonds the City to 25-years of rent with no escape clause.
  2. The lease agreement requires the City to pay adjustable interest for a majority of the lease term.
  3. The lease agreement provides an approximate 64% profit margin for the private developer.

Let’s take a closer look at the three fine print items.

Fine Print Item #1: This is a “Bond” Lease (aka “Hell or High Water” Lease)

With a bond lease, all risk is transferred from the landlord to the renter.  There is no escape clause; “come hell or high water,” the renter must pay for the entire lease term, even if the building is partially or fully destroyed.  This type of lease is similar to the interest paying obligation on bonded debt, thus its name, “bond lease.”

Bond lease info graphic v2As a concept, a bond lease is not “bad” or “good”; it is simply a financial instrument that serves a specific purpose for landlord and tenant in a specific context.  However, a bond lease passes risk from owner to renter, regardless of unforeseen circumstances that may harm the renter.  This risk is important for taxpayers to understand.

Fine Print Item #2: The City Must Pay Variable Interest Rates

The bond lease contains annual payments that increase over time.  For instance, the City will pay $1.28 million rent in year 1, $1.67 million rent in year 10, and $2.42 million rent in year 25.  This gradual increase presumably  accounts for inflation.  Yet despite these increasing payments over time, the lease binds the City to adjustable interest rates above 4.6%.

Rent schedule w callouts vfinal2

Variable interest rates are an inherent financial risk that companies deal with in the ordinary course of business.  Companies generally hedge this risk.  Yet Ordinance 14.099 provides no explanation about how the City will hedge the risk of rising interest rates.

Fine Print Item #3: Developer Profit Margin May be as High as 64%

Every developer must earn profit, otherwise he would have no incentive to do business.  But as taxpayers, we should understand the profit we are funding.

Ordinance 14.099 is effectively a 78-page lease contract between Jersey City and a private corporation named Jersey City Municipal, LLC (“JCM LLC”).  The contract was not put out to bid; the land is owned by the Jersey City Redevelopment Agency (JCRA) and there is no legal requirement to solicit multiple bids.  JCM LLC was formed in April 2014 and is owned by Brandywine, a Pennsylvania-based developer that currently manages “the Hub,” a commercial property complex where the new Annex will be located.  According to NJ.com, the Hub has been a “financial hole” for Jersey City and Brandywine; further, Jersey City owed Brandywine $262,000 in back commissions as of June 2014.

Cost Breakdown-CH AnnexFIXEDv2Under this lease plan, total revenues to JCM LLC are $45 million.  The cost to build the new Annex can be estimated at approximately $16 million (based on a $215 per square foot cost estimate for new commercial construction from RSMeans, a research company that compiles construction cost estimates).  Thus JCM LLC’s profit would be approximately $29 million, or 64% margin.  This 64% profit margin does not directly account for inflation.

According to research firm IBIS World, average profit margin for U.S., nonresidential commercial construction ranged from 4.84% in 2006 to 0.78% in 2010.

Some Civic Questions

The Mayor’s lease proposal contains fine print that demands answers from taxpayers.  When average taxpayers speak up, the City Council listens.  Here are some questions you should ask the Mayor and your Council members:

  1. Why was this project not put out to bid?  While the JCRA is not required to solicit bids, wouldn’t a bid process be more transparent?
  2. Should the City enter into a 25-year bondable lease?  Is this type of lease typical for municipalities?
  3. Is the City exploring other alternatives, such as Mr. Yun’s plan to build the annex, or using an existing City building that may be vacant (e.g. the old Golden Door Charter School, aka the PS 37 Annex, located at 9th and Marin)?
  4. Does Jersey City have a plan to hedge its risk associated with rising interest rates from years 6 through 25 of the lease?
  5. What is the maximum potential cost if interest rates do rise above 4.6%?
  6. What is the typical profit margin for new commercial construction in northern NJ/tri-state?
  7. If the City Council approves this lease, will 64% profit margin be expected from other developers who want to do business with the City?
  8. The developer will pay zero property taxes on the Annex (since the Annex is a public building and thus exempt from property taxes).  Has the City Council factored this cost reduction into its analysis?
  9. If Jersey City currently owes the developer unpaid commissions, could this unusually high profit margin be interpreted as a quid pro quo attempt to make the developer whole on prior losses?

City Council contact information is here.

3 Comments

  1. Great write-up. I work in commercial real estate and have a couple of things for you to ponder/consider re: Fine Print Item #3.

    • I am not clear what the $215 PSF entails in the RS Means summary you linked to, but the linked chart for constructing costs of office buildings shows $231 for NYC, not $215 (I would consider NYC / Jersey City construction prices to be very similar). Of equal importance is the date of these cost estimates. As you can imagine from all of the cranes up in Manhattan, Jersey City, Brooklyn, there has been a tremendous amount of construction cost inflation over the past few years from the increased demand (20%-40% in the past year alone!). I would expect the costs to be at least $250 PSF and likely closer to $300 for something like the annex.
    • Another thing to consider is what exactly the RSMeans $231 estimate represents. Is it just the construction costs (which are what I suspect it is given the figures)? That would mean it excludes “soft costs” like architects, designers, fees, overtime police (based on what I have seen at the 90 Columbus developments, this must be a huge expense in Jersey City) and any other cost not going to the main construction contractor. The soft costs can end up being very large when all is said and done. Depending on the terms of the deal of the city, the Developer might also need to fit out the Annex with furniture, IT equipment and other items, further adding to the costs.
    • The construction profit margin you are referencing seems to be an average contractor profit, not a developer profit. I would argue that Developers in general have substantially higher profit expectations than contractors due to risks inherent in real estate development. The fact that this is a government deal with all the bells and whistles you pointed out in the write up (no real estate taxes, using the city balance sheet as the guarantor, having the adjustable interest borne by the City) likely meaningfully changes the potential structure. Return expectations can differ greatly between different deal types and I have no idea how the governmental nuances change the equation here. For a standard office development opportunity in the tri-state area, I would guess that developer likely needs annualized returns of at least 8-10% before leverage/debt is taken into account and quite a bit higher. This could easily get a developer up to a 65% profit on a deal over a 5-10 year period, let alone 25 years.
    • There could also be other real costs the developer needs to deduct from the revenue in your calculations that need to be taken into account before getting to their profit level.
    • To me the 65% profit (which is likely lower once the proper costs are used and other ongoing costs are taken into account) is not unreasonable level for the Developer. I caveat that I would need to spend substantially more time reviewing the actual facts of the deal before I would be able to stand behind this statement.

    Definitely seems like this deal was given to Brandywine as some sort of exchange / forgiveness of the fees owned to Brandywine, but the profit levels don’t seem to out of whack with where they should be based on my very high level review of your post (I have not read the actual documents).

    The real concern to me is the potential interest rate exposure the city is taking on – the city can be a 25-year interest rate hedge, but those can be expensive and the cost needs to be factored into the analysis. I would also want to understand why existing city owned space wouldn’t be considered first, but I would imagine the answer has something to do with trying to use the annex to salvage the Hub Development (and Brandywine’s position in it).

    Keep up the good work.

  2. Pingback: Open Letter to City Council – Ordinance 14.136: Why Should Taxpayers Take on Variable Interest Rates?‏ | Civic Parent

  3. Brigid,
    I get to this a bit late.

    You indicate that the developer’s profit will be 64% while standard profits are in the 1-2% range (profits have greatly increased since 2010). But those are yearly profits, and 64% over 25 years translates to 2%/year.

    I’m much more concerned about the variable interest rate issue.

Leave a Reply

Your email address will not be published. Required fields are marked *