HR&A Advisors, Inc. Ocean Ave Project Financial Feasibility Findings | 1 (sent via email)
MEMORANDUM
To: Susan Cola, Esq. and Roxanne Tanemori, City of Santa Monica From: HR&A Advisors, Inc.
Date: June 29, 2022
Re: Financial Feasibility Review of the Ocean Avenue Project
INTRODUCTION, PURPOSE OF THE REVIEW AND APPROACH
This memorandum presents HR&A Advisors, Inc.’s (“HR&A”) findings from detailed review and evaluation of confidential financial feasibility analysis and supporting documentation provided to HR&A by Ocean Avenue Partners LLC c/o The Worthe Real Estate Group, Inc. (the “Applicant”) for the proposed Ocean Avenue Project (the “Project”) in the City of Santa Monica (the “City”). As we understand it, the financial feasibility analysis provided by the Applicant represents critical information shaping negotiations between the Applicant and City staff about community benefits that City decision makers may ultimately require in return for granting approval of a Development Agreement to vest development rights over the period of Project implementation.
The Project consists of the full redevelopment of eleven assembled parcels totaling about 2.4 acres located at 101and 129 Santa Monica Boulevard, and 1327, 1333 and 1337 Ocean Avenue (the “Property”). It includes the design, construction and subsequent operation of a 120-room luxury boutique hotel, 100 apartment units, approximately 36,000 square feet of mixed-use retail space, 35,000 square feet of museum and event/cultural center space (including rehabilitation of two designated City landmarks) (the “Cultural Use Campus”), an outdoor public garden and a public observation deck. Of the 100 residential units, 11 units will be rent-controlled and an additional 25 are proposed to be deed-restricted for the life of the Project at below-market rents. The entire Project is projected to be completed in 2026 in a single phase.
At City staff’s request, HR&A conducted a thorough, independent review of the Applicant’s discounted cash flow (“DCF”) financial feasibility model, which was provided in an Excel workbook form, along with other documents containing supporting data and analysis for key program, cost and revenue assumptions used in the Financial Model. Following an initial review of the Financial Model and the supporting information, HR&A submitted several requests to the Applicant and City staff for additional information. The Applicant was responsive to these requests and answered HR&A’s questions through e-mail and updated documents, including an updated financial feasibility Excel workbook model.
For evaluation purposes, HR&A developed a separate DCF model which assumes the same revenues and cost inputs as the Applicant’s but differs regarding the pace of equity contributions and construction loan draws. In addition, HR&A’s DCF model is a monthly cash flow model, whereas the Applicant’s model calculates cash flows on a mixed monthly and then annual basis depending on the phase of construction and operations.
HR&A Advisors, Inc. Ocean Ave Project Financial Feasibility Findings | 2 For comparison purposes, HR&A also specified a Tier II development scenario for the Property (the “Base Case”), consistent with the alternative in the Project’s Draft Environmental Impact Report (i.e., Alternative 2- Mixed-Use Housing Projects Compliant with Ocean Transition and Bayside Conservation Districts), including on-site affordable housing and the replacement of the rent-controlled units (as provided by City staff).1 HR&A developed a DCF model for the Base Case development scenario to understand the financial feasibility of an as-of-right development assuming more typical project design, development costs and Net Operating Income (“NOI”) assumptions. The assumptions used in our Base Case DCF model and our evaluation of the Applicant’s DCF model relied on review of third-party real estate market data, information provided by the Applicant and our market experience to determine reasonable constructions costs, other development costs, projected hotel revenues, commercial and residential rents, and other real estate metrics.
INITIAL FINDINGS
Applicant’s Discounted Cash Flow Model
Program Assumptions
The DCF modeling approach used for the Project and the Base Case utilizes the levered (i.e., including financing) Internal Rate of Return (“IRR”) as a key investment return metric to determine feasibility, which is suitable for this type of real estate development.2 The Applicant’s DCF model includes line items for construction and other development costs, including significant cost premiums associated with the design by Gehry Partners, professional design fees (also including Gehry Partners-related premiums) and other soft costs, financing costs, and projected revenues and annual operating expenses for the hotel, apartments, Cultural Use Campus and retail components.
The model also includes financial contributions for the mandatory replacement of the 19 existing rentcontrolled units with 11 rent-controlled units and 25 deed-restricted affordable units,3 along with costs for certain additional community benefits that have emerged from negotiations between the Applicant and City staff (e.g., historic preservation components and publicly accessible open space), as of the date of HR&A’s analysis (see Appendix A –Community Benefits Summary).
We understand that City staff does not agree, however, that all of the community benefits listed in the Applicant’s model are consistent with their definition of items suitable for that list. But regardless of how they are classified, the Applicant’s estimated costs to provide them are included in the Applicant’s DCF model. 1 HR&A’s model does not assume any upgrades to the existing landmarks; it only takes into account new development. 2 The Applicant’s financial model also includes two addition investment return metrics, return on Project value and return on total development cost, but for purpose of this memo, we focus on IRR results.
HR&A Advisors, Inc. Ocean Ave Project Financial Feasibility Findings | 3 Table 1 summarizes the development budget provided by the Applicant.3 Table 1. Applicant’s Development Budget (2023 Dollars)
TOTAL:
ALL COSTS Hotel
Historic
Preservation
and Cultural
Use Campus Retail
Overall
Multi-Family
Value of Property Developed $21,554,593 $9,091,735 $4,597,000 $1,427,310 $6,438,549 Open Space Contribution $4,074,319 $4,074,319
Total Property Value $25,628,912 $9,091,735 $8,671,318 $1,427,310 $6,438,549 Hard Costs
Hotel $85,479,288 $85,479,288
Residential $60,534,385 $60,534,385
Retail Shell $13,419,378 $13,419,378
Historic Preservation & Cultural
Use Campus $43,220,383 $43,220,383
Rooftop Public Observation Deck $4,064,603 $4,064,603
Parking $18,701,509 $7,888,303 $3,988,516 $1,238,383 $5,586,307 Offsite $1,327,787 $560,061 $283,180 $87,924 $396,622
Direct Hard Costs $226,747,335 $93,927,652 $51,556,683 $14,745,686 $66,517,314 Utilities $869,990 $366,962 $185,545 $57,609 $259,874
FF&E $11,531,028 $9,801,374 $1,729,654
TI's $3,867,023 $3,867,023
Total Hard Cost $243,015,376 $104,095,988 $53,471,882 $18,670,318 $66,777,188 Soft Costs
Core Soft Costs $43,871,193 $18,504,884 $9,356,514 $2,905,079 $13,104,716 Community Benefits Soft Costs $6,065,000 $2,558,219 $1,293,497 $401,614 $1,811,669 Temporary Housing $183,364 $183,364
Replacement Buyout $257,030 $257,030
Leasing Commissions $966,756 $966,756
Project Contingency $14,125,021 $6,005,852 $3,076,936 $1,100,974 $3,941,259 Developer Management Fee $16,314,400 $6,936,759 $3,553,862 $1,271,625 $4,552,155 Total Soft Costs $81,782,765 $34,005,714 $17,280,810 $6,646,047 $23,850,193 Total Budget (excluding financing
costs) $350,427,054 $147,193,437 $79,424,010 $26,743,675 $97,065,931 Below are the key components of the development’s stabilized annual NOI (inflation-adjusted to 2023 Dollars) for each of the Project land uses:
• Multifamily
o Including affordable housing and the replacement of the rent-controlled units: $4.13 million. 3 Maurice Robinson & Associates Ocean Avenue Project Financial Feasibility Model. March 1st, 2022. Community Benefits Soft Costs have been updated to reflect the latest City analysis.
HR&A Advisors, Inc. Ocean Ave Project Financial Feasibility Findings | 4 o Excluding affordable housing and the replacement of the rent-controlled units: $7.06 million. • Hotel: $13.89 million.
• Retail: $1.88 million.
• Cultural Use Campus: Negative $1.85 million.
All the underlying assumptions from the Applicant were well justified and confirmed by our independent analysis, except for Cultural Use Campus assumptions as discussed below. HR&A reviewed comparable property and existing asset data produced by the Applicant and additional research and recent development comparables in Santa Monica.
Financial Returns
As noted above, the Applicant’s financial model is structured as a discounted cash flow including the costs incurred and revenues received during pre-construction entitlements and design period, the 30-month construction period and 6 years of annual operations. It also includes a snapshot of the Project’s financial performance for the first year of stabilized annual operations (i.e., 2028) for all land uses. The DCF model enabled us to audit nearly all calculation assumptions, other than a handful of “hard-coded” (as opposed to calculated) inputs, including an amount of theoretically forgone Net Operating Income (NOI) from the new Cultural Use Campus and publicly accessible observation deck. HR&A was able to trace the key calculation assumptions driving the IRR results through independent due diligence and additional information requests and subsequent conversations with the Applicant.
The Applicant has stated that they could potentially find additional funding sources or strategies, as explained below in the Cultural Use Campus’s Operations Cost and Value Calculation Approach Concerns section, to reduce the need for subsidy from other uses over time. Because the above is not guaranteed to occur, the model shows theoretically forgone Net Operating Income (NOI) from the new Cultural Use Campus and publicly accessible observation deck, thereby reducing apparent project returns to a below-market rate.
The Applicant’s DCF model results in an IRR of 8.0 percent (including assumed financing) with the Applicant’s identified community benefits, including updated impact fees provided by the City. Based on recent IRR trends in metro Los Angeles4, investors would be likely to purchase the uses proposed at the Project once constructed for an average IRR of around 9.0 percent, higher than the model's IRR. However, this figure was calculated for existing assets, which are a less risky investment than a development project, and therefore a market rate of return for this project would likely be higher. The MRA report cites a market IRR range of 13- 15 percent for a development project, and we concur that this is a reasonable investment return for a development project of this type. Without all the affordable housing and other community benefits, the Applicant’s DCF model shows that the Project would achieve a much more commercially viable 28.3 percent IRR.
HR&A’s Base Case DCF model, which assumes a more typical project design and development costs as noted before and discussed below, demonstrates the significant cost premium associated with the Gehry Partners design.
4 RERC Real Estate Report 4Q 2021. Los Angeles | First-Tier1 Investment Properties HR&A Advisors, Inc. Ocean Ave Project Financial Feasibility Findings | 5 HR&A’s Separate Discounted Cash Flow Model
Program Assumptions & Financial Returns
Assuming the same revenues and cost inputs as the Applicant’s but differences regarding the pace of equity contributions and construction loan draws, HR&A developed a separate DCF to compare return metrics with the Applicant’s cash flows. HR&A’s model assumes that after land acquisition, equity is contributed based on a 70 percent loan to cost ratio to cover 30 percent of construction costs as incurred. In addition, HR&A’s DCF model is a monthly cash flow model, whereas the Applicant’s model calculates cash flows on a mixed monthly and then annual basis depending on the phase of construction and operations. For all the scenarios, HR&A’s approach results in overall somewhat higher equity contributions and somewhat lower construction and permanent financing amounts (and therefore lower financing costs). • Equity from Applicant’s Model: $107 million (29 percent of total development costs including land acquisition, or 24 percent of development costs excluding land acquisition) • Equity from HR&A’s Model: $151 million (41 percent of total development costs including land acquisition, or 37 percent of development costs excluding land acquisition) For each one of the scenarios, HR&A relies primarily on assumptions from the Applicant’s model. The HR&A DCF model includes the same community benefits, including the negative NOI of the Cultural Use Campus and the publicly accessible observation deck.
Base Case Discounted Cash Flow Model
Program Assumptions
City staff provided HR&A with specifications for land uses, physical parameters, and other assumptions for a mixed-use alternative scenario that aligns with as-of-right development under Tier II zoning regulations, as presented in the Project’s Draft Environmental Impact Report as Alternative 2 (the “Tier II Alternative”).
The Tier II Alternative includes 150 residential units and 69,837 of restaurant and retail uses. Overall, the Tier II Alternative features 50 more residential units than the Project, but no hotel or cultural use campus and substantially less public open space.
Financial Returns
HR&A’s Tier II Base Case DCF model for the Property includes the mandatory affordable housing units and the replacement of the rent-controlled units. None of the other community benefits presented by the Applicant were included in the Base Case analysis since the Base Case represents as-of-right development. The IRR from the Base Case is 16.3 percent, in line with investor expectations for a development of this type.
HR&A also developed a Tier II Alternative DCF to understand the impact of cost premiums associated with the design by Gehry Partners, professional design fees (also including Gehry Partners-related premiums) and other soft costs, financing costs, and projected revenues and annual operating expenses.5 The IRR from this scenario is 18.0 percent, still comparable with acceptable returns. This scenario also assumes higher residential and retail rents, comparable to the applicant’s assumptions, noting that the costs premium could potentially be counterbalanced by the rent premiums.
5 Based on broad assumptions provided by the applicant, and for illustrative purposes, HR&A assumed the design/engineering budget to be three times higher and hard costs 50 percent higher than a typical project.
HR&A Advisors, Inc. Ocean Ave Project Financial Feasibility Findings | 6 ***
Based on the analysis and finding above, HR&A believes the actual profit margin is potentially higher than shown in the Applicant’s Financial Model, for reasons largely associated with the operations for the Cultural Use Campus (i.e., negative NOI) and a resulting negative value of the Cultural Use Campus based on its negative net operating income.
Cultural Use Campus’s Operations Cost and Value Calculation Approach Concerns With no changes to Project design or mix of land uses that could improve that level of return, the Project (Scenario 1) appears infeasible based on the IRR calculated by the Applicant’s feasibility model.6 For this reason, HR&A believes the Applicant may be making conservative assumptions about the cost to operate the Cultural Use Campus and the publicly accessible observation deck, which adversely impacts Project cash flow and substantially reduces the Project’s IRR. The DCF model shows that the Cultural Use Campus is operating at a loss every year because it is subsidized internally by other Project revenues. This results in negative net income of approximately $1.85 million per year, distributed between $1.14 million for property taxes and $0.71 million of operating expenses.7 The Applicant’s cash flow does not anticipate any positive contribution to overall Project cash flows from the facility. Beyond the annual operating loss of $1.85 million, the Applicant assumes a negative value of the Cultural Use Campus based on its negative net operating income and the same income capitalization rate (“cap rate”) as the retail component when calculating the Project IRR. In other words, the Applicant is suggesting that the Cultural Use Campus would be operationally subsidized in perpetuity by transferring this obligation to any future owners and operators of the rest of the Project, thereby reducing the Project’s overall value significantly.
The Applicant has stated that they could (a) potentially pursue a tax exemption during the first few years, and (b) that they could potentially raise money to support museum capital costs and/or operations, thereby reducing the need for subsidy from other uses. Because neither condition is guaranteed to occur, the model shows neither tax exemption nor philanthropic support, thereby reducing apparent project returns to a below-market rate.
HR&A created an alternate scenario (Scenario 2) to understand the impact of having a Cultural Use Campus that is not subsidized by Project cash flow in perpetuity, but which instead is either self-funding or subsidized by a separate third-party entity, such that it has an NOI equal to $0. The purpose of this scenario is to understand the impact that a subsidized Cultural Use Campus is having on the feasibility and IRR for the Project, and to estimate the present value savings that could be used for other potential community benefits beyond the mandatory provision of on-site affordable housing and replacement of the rent-controlled units. • Scenario 1: Applicant’s assumptions with community benefits as proposed (including full subsidy of Cultural Use Campus operational costs from Project cash flow); • Scenario 2: Applicant’s assumptions with all included public benefits, but assuming financially neutral Cultural Use Campus operations (either self-funding or subsidized by a third party). 6 It should also be noted that because the Project is in the City’s coastal zone, it will be subject to a Coastal Commission exaction for “moderately-priced overnight accommodations.” Based on the formula used by the Coastal Commission for the Fairmont-Miramar Hotel redevelopment, this may cost about $3,810,000 (i.e., 25% x 120 new hotel rooms x $127,000). This cost is not yet reflected in either the Applicant’s DCF model or the HR&A DCF model and will reduce the Project’s IRR. 7 Note that the Cultural Use Campus’s annual operating expense is based on a lump sum provided by the Applicant; we have not received any line-item details indicating what would constitute such expenses.
HR&A Advisors, Inc. Ocean Ave Project Financial Feasibility Findings | 7 Scenario 1
As mentioned above, the Applicant assumes that Cultural Use Campus operates at a loss every year with an approximate net income of negative $1.85 million, distributed between $1.14 million of property taxes and $0.71 million of operating expenses. The Applicant also assumes a sale value for the Cultural Facility based on the negative NOI and using the same cap rate. Under that approach the value of the Cultural Use Campus is close to negative $41 million. That has a clear impact on the feasibility of the Project as it reduces the Project value by almost 10 percent ($390 million versus $432 million).
Impact on Financial Feasibility Conclusions: As previously noted, the Applicant’s IRR is 8.0 percent, which is lower than standard investment returns for real estate development. HR&A’s DCF model shows a slightly lower IRR of
7.7 percent due in part to a larger modeled equity contribution.
Scenario 28
For this scenario, HR&A assumes the Cultural Use Campus, like most other such entities, operates on a breakeven basis by using some combination of visitor fees, on-site sales revenue, and donations to cover its operating costs. In addition, if the Cultural Use Campus is operated by a non-profit organization, for example, it may qualify for a full “welfare exemption” from property taxes, and would be eligible to attract philanthropic or public grants to help render it self-sufficient.9 HR&A believes that a scenario that assumes some degree of third-party operational subsidy and/or tax exemption is more likely than a scenario that assumes the Project must provide the full operating cost from other Project cash flow. If Cultural Use Campus operation does not need to be funded entirely from Project cash flow, the Cultural Use Campus would neither add to nor reduce the Project’s value. Under that approach the value of Project would be more than $41 million higher than Scenario 1 ($432 million versus $390 million).
Impact on Financial Feasibility Conclusions: Using the Applicant’s model, this scenario projects an IRR of return of 11.9 percent due to the elimination of the Cultural Use Campus’ operational subsidy from Project cashflow.
HR&A’s monthly DCF model shows an IRR of 12.0 percent. Stated another way, the additional $41 million in Project value from a more cost-neutral Cultural Use Campus could theoretically be translated into additional community benefits and still maintain the Applicant’s 8.0 percent IRR. The ability of the Project to offer additional public benefits depends largely on whether the Cultural Use Campus can achieve tax exempt status and/or identify alternate sources of operating funds. It should be noted, however, that the Applicant agrees that the modeled Project return is conservative insofar as it assumes a permanent lack of operational support for the Cultural Use Campus outside of revenues from other Project uses, and the Applicant argues that any additional return beyond the current modeled return that brings Project returns more in line with typical development returns is not necessarily available to support additional public benefits. 8 In addition to operating model adjustments, a less ambitious and expensive vision for the Cultural Use Campus and open space components of the project could free up additional value to be allocated to other community benefits. Note that these two components add substantial costs to the Project’s construction budget but do not directly contribute to Project cash flow.
9 Note that in order to obtain a welfare exemption, the Cultural Use Campus may require separate parcelization from the rest of the Project.
HR&A Advisors, Inc. Ocean Ave Project Financial Feasibility Findings | 8 Community Benefits Package
The table below summarizes both the original list of community benefits provided by the Applicant and a reduced list reflecting only the subset of community benefits over and above what would be required regardless, per City guidance. This reduced list of community benefits during construction totals up to $74 million. Note that the community benefits excluded from the City’s list are still required Project costs and impact the Project’s overall return. See Appendix A for more details.
HR&A Advisors, Inc. Ocean Ave Project Financial Feasibility Findings | 9 APPENDIX A –COMMUNITY BENEFITS SUMMARY
Table A.1. Applicant's Community Benefits Summary, with City Impact Fee Updates Item Community Benefits
Upfront Benefits
Construction*
Affordable Housing
Affordable and Rent Controlled Housing Land Contribution $2,172,407 Affordable and Rent Controlled Housing Development Cost Contribution $30,578,247 Historic Preservation and Cultural Use Campus $69,991,591 Public Open Space -- Land Contribution $4,074,319
Public Open Space and Observation Deck -- Hard Cost Contribution $4,064,603 Subtotal Construction $110,881,167
Other Community Benefits**
Affordable Housing Commercial Linkage Fee Contribution $400,000 Transportation Infrastructure Contribution $2,255,000
Parks and Recreation Contribution $2,160,000
Early Childhood Initiatives Contribution $1,000,000
Economic Equity/Clean and Safe Downtown Santa Monica Contribution $250,000 Private Developer Cultural Arts Requirement (note: developer may pay fee or seek waiver per Zoning Ordinance) n/a Subtotal Other Community Benefits $6,065,000
Ongoing Annual Benefits
Cultural Use Campus Subsidy $1,853,934
Open Space $122,600
TDM Plan $245,000
Subtotal Operations $2,221,534
* Construction costs include land costs for each use based on the ratio of per use square footage divided by the Project's total square footage. ** Other community benefits include updated Impact Fees provided by the City.
HR&A Advisors, Inc. Ocean Ave Project Financial Feasibility Findings | 10 Table A.2. Community Benefits Summary per City's Guidance Note: Excludes mandated items such as affordable housing and other items per City's staff guidance Item Community Benefits
Upfront Benefits
Construction*
Affordable Housing
Affordable and Rent Controlled Housing Land Contribution $0 Affordable and Rent Controlled Housing Development Cost Contribution $0 Historic Preservation and Cultural Use Campus $69,991,591 Public Open Space -- Land Contribution $0
Public Open Space and Observation Deck -- Hard Cost Contribution Up to $4,064,603 Subtotal Construction Up to $74,057,497
Other Community Benefits**
Affordable Housing Commercial Linkage Fee Contribution $400,000 Transportation Infrastructure Contribution $2,255,000
Parks and Recreation Contribution $2,160,000
Early Childhood Initiatives Contribution $1,000,000
Economic Equity/Clean and Safe Downtown Santa Monica Contribution $250,000 Private Developer Cultural Arts Requirement (note: developer may pay fee or seek waiver per Zoning Ordinance) n/a Subtotal Other Community Benefits $6,065,000
Ongoing Annual Benefits
Cultural Use Campus Subsidy Up to $1,844,239
Open Space $122,600
TDM Plan $245,000
Subtotal Operations Up to $2,211,839
* Construction costs include land costs for each use based on the ratio of per use square footage divided by the Project's total square footage ** Other community benefits include updated Impact Fees provided by the City