Tuesday, March 26th, 2013

How Do We Finance Walkable Neighborhoods? by Francisco Traverso

[ Francisco Traverso is a student who had as an assignment getting a paper he wrote published in a blog. I told him no guarantees but I’d give it consideration if he sent it since he had to write it anyway. He wrote it about Chris Leinberger’s notion of “patient equity” which I haven’t covered before, so I thought I’d go ahead and give it a post – Aaron. ]

A couple weeks ago, an article on the New York Times presented a new development near downtown Denver that is addressing health issues through design. The project is part of a larger development, La Alma/Lincoln Park Neighborhood that was conceived under Health Impact Assessment (HIA) principles. According to WHO, “HIA is a means of assessing the health impacts of policies, plans and projects in diverse economic sectors using quantitative, qualitative and participatory techniques. HIA helps decision-makers make choices about alternatives and improvements to prevent disease/injury and to actively promote health.” Among the various principles of HIA, better transit, cycling infrastructure, and walkable neighborhoods are primary components that foster a healthier lifestyle of residents of a certain area. However, at the very end, the article mentions something that is crucial for the success of initiatives like this: financing. As explained in the article, assessment advocates “anticipate that private developers will see the tool simply as a cost-adding measure or a way for community activists to stall or stop proposed projects.” What planners may offer as a solution to address health concerns of urban environments may be seen by others as barriers or may create unintended consequences for those creating the buildings that comprise the urban environments.

This is quite the dilemma. We like to think that planning professionals are the ones shaping our cities, where adequate policies will define the shape and quality of our built environment, but that is not entirely true. At some point someone has to face it, Real Estate Developers play a huge role in shaping our cities. As long as they play by the rules of regulation, everything else is acceptable, and so far, the results are not always what we would like to see in a walkable neighborhood.

So the question is: how do we engage developers in our plans of better, walkable neighborhoods?

The answer is not an easy one. Walkable developments are those where most of the amenities can be found in a 1500 feet radius from the project, and where inter-district transit may be used to expand the size of the district. This kind of development requires higher construction quality, have a complex permitting process, so they are more expensive and have higher financial risk than sub-urban development, so why investors interested in short term returns will be willing to invest in walkable neighborhood projects when the opposite of that is an alternative that provides cheaper land, cheaper construction costs and less risk?

There are probably many answers to this problem; however, there is one that is particularly interesting: Patient Equity.

In 2007, Christopher B. Leinberger published a paper where he discusses the importance of Patient Equity in Real Estate Development Finance and how more patient equity in walkable projects, from various sources and providers, would facilitate walkable development, and yield high returns over the long term (The definitions and examples provided in this post are extracted from Leinberger’s paper).

So what is Patient Equity and how does it work?

Patient equity is that part of the development financing structure that does not have a defined payback period. It is provided by either the long-term owners of a project or through government incentives that play a similar role.

Patient equity is not a substitute for other financing. Rather, it is additive, layered on top of a conventional development budget such that the overall cost of the project increases because of the higher construction costs and consulting costs associated to a project like this.

A development budget is comprised of equity and debt. Conventional equity, which often expects a 15 percent to 20 percent internal rate of return (IRR), has ownership of the project, provides the construction guarantee, and generally comprises approximately 20 percent of the total development budget. When patient equity is provided, the role of conventional equity changes and can be referred to as “1st tranche” equity, also called mezzanine debt. In exchange for having additional equity in the project (which is behind the 1st tranche equity in cash flow priority) and no financial guarantees of the construction loan (which the patient equity provides), 1st tranche equity will receive a lower rate of return and no ownership. Instead, the 1st tranche equity will receive 100 percent of the after-debt service cash flow until both the negotiated cumulative or non-cumulative rate of return is achieved and the principle is returned. It can be expected that 1st tranche equity is retired between years three and seven of the project’s life so the patient equity providers have to wait until then for financial returns.

With the retirement of the 1st tranche equity, 100 percent of the after-debt service cash flow of the project is available for the patient equity providers. It is the 2nd tranche investor that should have the long-term benefit of the project.  Among other benefits, patient equity investors in walkable projects are likely to see substantial financial returns as the project matures. There is an upward spiral of value creation as the critical mass of the walkable place is achieved and enhanced. As more development takes place within walking distance, there are more people on the street, which drives rents and sales prices up, resulting in land and building values going up, resulting in higher tax revenues and cash flow, so this is particularly important in urban settings that will undergo growth soon.

Sources of patient equity are many, and they include: Land, existing buildings in need of redevelopment, developer fees, parking, professional fees, and of course, cash. For example, professional fees can be deferred or traded for ownership in the project.

Who’s willing to provide patient equity? Land and building owners, developers, Pension Funds, Real Estate Investment Trusts, individual investors, non-profits, government. All these parties are trading present income, or short term income, for a long term income, that given the benefits of walkable neighborhoods described above will push for higher rents and higher land values in the long run, increment that doesn’t happen in the same amount in sub-urban development, where values tend to stay more stable in the long term.

Are these providers willing to “sell” the idea? Probably, and that’s the challenge, to get these people involved. Fortunately, there is at least one tool to engage them: Patient Equity.

The Urban State of Mind: Meditations on the City is the first Urbanophile e-book, featuring provocative essays on the key issues facing our cities, including innovation, talent attraction and brain drain, global soft power, sustainability, economic development, and localism. Included are 28 carefully curated essays out of nearly 1,200 posts in the first seven years of the Urbanophile, plus 9 original pieces. It's great for anyone who cares about our cities.

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Aaron M. Renn is an opinion-leading urban analyst, consultant, speaker, and writer on a mission to help America’s cities thrive and find sustainable success in the 21st century.

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