Critics slam state property sale

APRIL 28, 2010

By KATY GRIMES

Recently, Department of General Services (DGS) Director Ron Diedrich removed several of the oversight appointees from building authorities in San Francisco and Los Angeles  for making waves about the 11 state properties for sale, replacing the critics of the sales with people who support it. The oversight appointees must sign off on the state’s plan to sell those California state office buildings.

The state of California has 11 properties up for sale for nearly $2 billion. The sales proceeds are estimated to be $660 million, after bond debt on the properties is retired. While there are some worthy objectives, there are some fundamental problems with the entire project, according to real estate experts and insiders.

The proposed leases have been made available to potential buyers, and there are some unusual and questionable issues within. All of the real estate experts and insiders I spoke with asked to remain unnamed because they represent clients who may be bidding on the properties.

The Legislative Analyst’s Office released its report this week, critical of the state property sales: “We estimate that the sale of buildings would result in one-time revenue to the state of between $600 million and $1.4 billion, but that annual leasing costs would eventually exceed ownership costs by approximately $200 million. Over the lives of these buildings, we estimate the transaction would cost the state between $600 million and $1.5 billion. The Legislature will need to weigh how these costs compare to other alternatives for addressing the state’s budget shortfall. In our view, taking on long-term obligations—like the lease payments on these buildings—in exchange for one-time revenue to pay for current services is bad budgeting practice as it simply shifts costs to future years.”

One industry expert interviewed explained his issues with the state’s sale properties: “My concern as a professional who looked at the portfolio for a client, is that the state will receive an offer based on very preliminary due diligence and then have both the price and lease terms changed after other competitors are removed. We have looked for footprints in the sand that should have been left by other serious buyers and have seen none. It tells me that there are not that many buyers out there or they are not really looking carefully at the buildings.”

The same expert is concerned with the draft form lease, which was provided to him a couple of weeks ago. It includes what he referred to as a “payoff for the SEIU”; purchasers of the properties are required to pay the trades (janitors, security guards etc.) a set percentage of their total state of California compensation package for the same classes of workers, even if it is far higher than the “prevailing wages.” The lease states that public works projects must comply with prevailing wage requirements, which requires prevailing wages be paid to appropriate work classifications in all bid specifications and subcontracts. Other workers are required to be paid the prevailing wages (union scale even if the unions only represent 5 percent of the industry workers). Prevailing wages are not a problem with the major trades in a building, but is with some of the specialty workers.

The draft lease was provided to potential buyers with the caveat that the state could make modifications during the bid process. However, interested parties are told that the key lease terms are not open for negotiation according to industry insiders. Since the price is critical to the state because of the bonds needing to be retired, that leaves the rent as the variable, unless other lease terms are modified.

Most large or long-term leases have the tenants pay for their share of all operating costs or their share of cost increases. Most shopping center and office-building owners pass the operating costs and operating cost increases on to the tenants.

The proposed lease instead lists Consumer Price Index (CPI) adjustments. CPI may not be adequate to pay for utility rates and many other costs. Utility costs are calculated by real estate experts using between twelve and 18 cents per square foot. For example, using 15 cents per square foot for 5,658,822 square feet, (the total available square footage of the 11 buildings), totals $848,000 per month, and $10,200,000 for the year for gas and utility expenses for the year, paid by the state.

Several of the properties have parking that the state will have to pay $100 per space, per month. The Sacramento “East End Complex” property has 1,611 parking spaces, totaling $161,100 per month and $1,933,200 annually in costs. The Attorney General Building has 593 parking spaces, totaling $59,300 monthly and $711,600 annually. The lease abstracts state that parking rates will increase on the fifth anniversary date and on each anniversary date, increasing the East End Complex costs $193,320 and the AG building costs $71,000 in five years.

The economic summary in the lease indicated that the building owner(s) would be responsible for future tax increases. The summary also states that the landlord is responsible for the costs if Proposition 13 is ever repealed.

Some industry experts have speculated that Capitol legislative staff represented to the Legislature that they would craft a lease (potentially as long as 50 years with renewals), which shifted all of the operating risks to the owner. However, this will only work with unsophisticated buyers, or prearranged deals with underlying motives, according to real estate experts.

The ongoing problem of the historically large state deficit of $20 billion, the other state deficit issues within CalPERS, CalSTRS, and the state unemployment fund all are likely to need future bailouts. This is relevant because with the state as the tenant, if the purchase is financed, the lender is going to want a large reserve to wait out the state’s apparent pending insolvency, since filing bankruptcy is not an option for the state.

The lease is very clear that rent can be paid only from legally available funds. And, according to real estate experts who have analyzed the lease, rent is paid in arrears. Rent is usually paid in advance, and mortgages are paid in arrears.

Several real estate experts I spoke with looked at the potential purchase of a number of buildings where the state is a major tenant and rejected most of them because the seller’s operating costs are not enough to comply with the requirements of the leases. It’s a process that discourages legitimate and above board owners from owning facilities with a large state presence.

An important issue in real estate now is that national and international investment managers are retreating from “non-core” areas and this includes Sacramento, Oakland and Santa Rosa. Core areas are Los Angeles, Seattle, New York, Chicago and Boston. The state properties in Los Angeles are located outside the established business area and are actually considered “class B” because of the locations, according to real estate insiders.

The governor has indicated that one of the key elements of this process is to get the state out of the building owning and operating business. While this is a worthy goal that may save the state perhaps $40 million a year, many real estate experts say that the leaseback arrangement will cost taxpayers upwards of $1 billion in rents and operating expenses over the next 20 years.

The LAO apparently agrees. “The state would make ongoing lease payments to the new owner that would be greater than the amount the state currently spends to own and operate the buildings,” the report states, concluding, “The main argument against pursuing a sale-leaseback on state office properties is that the 20 years to 50 years of lease payments under the sale-leaseback will likely cost more than the state would spend maintaining ownership of the buildings.”

However, simply by hiring private sector businesses to run the buildings in an efficient manner, the state can achieve the same operating economies. Many large corporate owners have outsourced their property management with excellent results.

Just as some of real estate experts predicted, the Sacramento Bee reported last week that the state received “multiple bids” greater than the nearly $2 billion total purchase price on the 11 buildings. But the winning or losing deal will be based upon lease documents, and whether they are full service, modified gross or triple net. This makes a substantial difference as the state could very well end up still paying for most maintenance on the property, and even paying property tax for the new owner depending on the final lease.

“There are too many aspects of the deal, which give the look, feel and smell that the entire process is a play whose ending was written before the curtain lifted,” commented one insider.

When asked about the critical LAO report, Eric Lamoureux with DGS Public Affairs office said, “DGS needs to complete its negotiations with buyers and conduct a full analysis of the numbers before any final conclusions can be made.” The statement released by State and Consumer Services Agency Secretary Bill Leonard repeated the same statement.

At a press conference last week, Gov. Arnold Schwarzenegger said Californians could be confident that his administration will call off the deal if the numbers don’t pencil out. “I can guarantee you that I will never sell state property that doesn’t make any sense from an investment point of view,” the governor said.