This week, we continue our effort to untangle the Gordian knot with an exploration of the time value of money. One of the challenges in planning for and executing successful large-scale redevelopments is that a mix of public and private capital is necessary, but communication is often hampered because of the very different ways that each party thinks about the time value of money.
TIME VALUE OF MONEY
A problem with large-scale redevelopments is that they involve both substantial up-front costs and back-end revenue. As such, any policy solution must acknowledge the time value of money (discount rates). Time value of money is based on the cost of capital, but it is subjective insofar as the cost of capital can be very different for various economic actors. In this case, we’re going to dig into the time values placed on money by the County and real estate developers.
The County invests very safely, with returns often well below 1%. The County also borrows money and does so at very low interest rates (say, 3%-4% on general obligation debt, and maybe 4%-5% on other debt). Over time, the County’s time value of money changes with financial market conditions but is usually in the 1% to 3% range.
On the other hand, a developer’s time value of money is higher. Borrowed funds are borrowed at much higher interest rates (say 4.5% to 5.5%) because they aren’t backed by a government with taxing powers. Equity returns, i.e., what is necessary for capital to be deployed here rather than somewhere else, are likely to be in the 14% to 16% range. As a result, the time value of money for real estate development projects often falls in the 9% to 11% range.
To flesh out a simple example, imagine a project that is funded with 50% debt and 50% equity, and where the cost of borrowed funds is 5% and the market is demanding a 15% return on equity. In this example, the weighted average cost of capital is 10%. An increase in the amount of debt – say to 60% – changes the equation somewhat to something like this: (60% times 5%) plus (40% times 15%) equals 9%. Alternatively, a shift to more equity would result in a higher weighted average cost of capital: (40% times 5%) plus (60% times 15%) equals 11%.
The different public and private sector discount rates aren’t philosophical, they are based on the different opportunities and constraints affecting the public and private sectors. The “weighted average cost of capital” is simply a term that means “average cost of money,” reflecting the reality that the money referred to is a mix of debt and equity. Another way of saying “weighted average cost of capital” is perhaps more familiar: “discount rate.” The discount rate is what is used when calculating a “net present value.”
One way that these different discount rates play out in a large-scale redevelopment is that the private sector places a very high value on the revenue earned early in the life of the project. A stream of future revenue loses value very quickly when the discount rate is, say 10%. On the other hand, the value of a stream of future revenue is much more valuable to the public sector with its much lower discount rate.
As a result of these very different “time values of money,” the public and private sectors often experience a disconnect in these conversations. The public sector might, for example, overestimate how much the private sector values future revenue. Alternatively, the public sector might overestimate how much more valuable near-term public sector revenue is versus long-term public sector revenue.
HOW ALL THIS AFFECTS REDEVELOPMENT POLICIES, STRATEGIES, AND NEGOTIATIONS
At a basic level, the different time values of money can and should inform the strategies that are employed to facilitate development. The challenge for the property owner is at the beginning – high costs that need to be recovered very quickly. Whereas oftentimes the public sector focuses too heavily on near term costs – money spent up front really isn’t that much more valuable than the money spent later, and the additional tax revenue that the public sector might realize at the back end is much more valuable to the public sector than it is costly to the private sector, whose time horizon is so much shorter.
In thinking about how these principles can be applied to economic development issues, the following examples might be helpful:
- In incentive negotiations, the private sector is much more likely to be looking for up-front grants rather than longer term or annual payments or credits.
- Some tax credit programs inherently recognize this, e.g., the Enterprise Zone law provides substantial benefits in years 1-5, with reduced benefits at the back end.
- There is a reason that developers and property owners often chafe at impact taxes, the cost of planning and entitlements, and the cost of public benefits/infrastructure/amenities (as discussed last week) – those costs come when the money is most valuable. Money that is spent early in the project and which does not generate revenue really reduces the financial feasibility of projects.
- One other reason that development projects really value public sector infrastructure spending that is timed in coordination with their projects is that the bump they might get in rents (for example, resulting from proximity to a new public facility) will do a lot more to help the financial viability of the project if that increase in rents is realized early on (say, in the first 3-4 years).
Tying the concept of “time value of money” and “time value of amenities” together, you can see why many governments are willing to eschew years of tax revenue to spur economic development and growth, production of affordable housing, etc. The community need is now, and the value of the revenue stream won’t change that much if it gets pushed out additional years. In fact, earlier this year the D.C. Council approved tax abatements of 40 years for some affordable housing projects, reflecting how much more valuable “units now” are than “revenue later” to a government that is trying to address an urgent need. And obviously, many local governments are willing to do the same in exchange for jobs, development, and future revenues.
In the end, whether such combined public and private efforts succeed often depends on whether (a) the public sector understands the private sector’s time value for money and amenities, and (b) whether the public sector understands its own time value of money and amenities.
If a problem needs to be solved right now, then probably it is a problem that needs to be solved with front-loaded public sector participation. Problems that the public sector wants the private sector to address are often expensive – sometimes very expensive. Making sure that the development projects that are required to deliver those benefits can be feasible is essential if you actually want the benefits. And in negotiating, it is often the case that the public sector will focus too much on denying the private sector what it is asking for, rather than thinking about its own interests in achieving the stated objective. That kind of “penny wise but pound foolish” negotiating can be somewhat puzzling when viewed from the outside but is not uncommon in public-private negotiation dynamics. November and December are really heavy months for economic data. I’ll be back next week with some important data, and if that isn’t your thing then please consider this your trigger warning…