Local in Ann Arbor

This is the continuation of a discussion of the Valiant partnership’s proposal for a development on the Library Lot. Part A was a consideration of the hotel and the conference center.  In Part B we discussed the issue of parking (availability and cost).  Now we consider another critical financial issue, namely the payment to the city for the land (the Ground Rent) and its effect on other factors in the package.

4. The Ground Rent

a. Calculation of NOI: As we explained in Part A, the Net Operating Income (NOI) for the hotel is based on wildly optimistic assumptions.  As might be supposed, the NOI is calculated by subtracting expenses from revenue.  So for example, in Year 2 (2014) the Total Revenue is $13,753,971, from which expenses and administrative costs are deducted to obtain a Gross Profit of $3,702,862.  After subtraction of management fees, insurance and taxes, we finally arrive at a NOI of $2,627,869, which is about 19% of the gross revenue.  Obviously, if the revenue is below what is projected (as we predict), and assuming that the expenses and fees would remain nearly the same, the NOI could approach zero rapidly.

b. Calculation of Ground Rent :The Ground Rent is the amount that would theoretically be paid to the city for a 75-year lease of the land, or alternatively as an outright purchase of the land.  It is based on the NOI, as plugged into a very complicated formula.  Here’s what the Cost Proposal says:

The (Ground Rent) will be based on the Residual Value of the Land. Residual Value is determined by taking the net operating income in the (3rd) stabilized year, and capitalizing that on a 8% cap rate, and attributing 10% of that finished Project Value to land. Given the NOI of $3,487,837, the Residual Land Value is projected at $4,359,796. …On a Ground Rent basis, developer’s offer is 8% of the Residual Value, or $348,784 per year. This Ground Rent will be increased by 10% every 10 years.

Note that if NOI in that third year (which was based on a hotel revenue of over $15 million) is below the (very optimistically) projected amount, the Ground Rent is also cut.  If the NOI (revenue minus expenses) approaches zero, so might the Ground Rent.  It is not clear from the proposal whether they would feel contractually obligated to pay the Ground Rent if future years’ NOI is less than projected.

UPDATED: Here is an effort to illustrate how vulnerable the NOI is to overly optimistic assumptions about hotel occupancy and ADR (average daily rate).  The figures in the first two rows are directly from the Valiant pro forma.

In the third row, an attempt has been made to estimate the effects of a more likely scenario, with an ADR 50% higher than the current citywide average and an occupancy of 55%. Since the proposers forecast an occupancy of 55% in their first year, presumably the “distributed” expenses (due to room occupancy) would be about the same. We used a figure for revenue that was proportional to the RevPAR ratios of the 3rd year and the estimate case. The undistributed and fixed expenses from the 3rd year were used.  (Gross Profit is the difference between the revenue and distributed plus undistributed [for example, administration and marketing] expenses; the NOI is the amount left after subtraction of the fixed expenses like management fees.}

Note that under this scenario the operation is at a deficit and there is no Net Operating Income.

A more easily read version of the table is available here.

c. Subordination of the Ground Rent to the First Mortgage: But even if the NOI is sufficient to pay the Ground Rent, another complication is that the developers would have financed the hotel with a first mortgage of approximately $28 million.  They state very explicitly that the Ground Rent must be subordinated to the mortgage: in other words, if the profit from the hotel is not sufficient to make both the rent and the mortgage payments (estimated at $2,483,010 per year), the Ground Rent will not be paid.  (Even by their estimates, Year Two falls short, since there is only $144,859 left over after paying the mortgage.)  Yet, in the updated proposal, the Ground Rent amount is increased to $775,000 (no explanation about the increase).

d. Use of the Ground Rent to Pay for the Bonds: But in the reconsidered proposal presented as a table in the Roxbury Group report,  the city would not actually receive the Ground Rent as cash.  Instead, it would be used to pay for the bond (confusingly noted as an EDC bond and a TIF bond in two different places) and to put money into reserve.

Presumably, if the NOI was not adequate to pay the Ground Rent, the bonds have a risk of going into default.

Note that in the original proposal, there was an alternative payment scheme to the city for full purchase of the land, but that has evidently been dropped, since the Ground Rent is now obligated to the bonds.

Yes, it seems that this series must go into another segment. Coming next: the bonds.

UPDATE: A recent article on AnnArbor.com quotes Charles Skelton, a nationally recognized hotel analyst, as saying that hotel occupancy in the Ann Arbor area was 60% in 2010, and room rates (ADR) fell from $96 to $94.

This entry was posted on December 20, 2010 at 9:08 pm and is filed under Business, civic finance. You can subscribe via RSS 2.0 feed to this post's comments. You can comment below, or link to this permanent URL from your own site.