SUGGESTED CRITERIA FOR THE EVALUATION OF PRIVATIZED STUDENT HOUSING PROPOSALS Prepared by: Dan K. Buchly System Real Estate Office The Texas A&M University System College Station, Texas 77843-1120 Telephone: (409) 845-9612 http://sago.tamu.edu/sreo November 2, 1998 THE TEXAS A&M UNIVERSITY SYSTEM System Real Estate Office SUGGESTED CRITERIA FOR THE EVALUATION OF PRIVATIZED STUDENT HOUSING PROPOSALS November 2, 1998 Provided below are suggested criteria which may be helpful in the evaluation of proposals for the construction, operation and maintenance of privatized student housing complexes: 1. QUALIFY THE DEVELOPER Verify the qualifications and capabilities of the developer. In order for the developer to be able to perform satisfactorily under the terms of the ground lease, the developer must possess the financial capability, construction experience, operational management experience, and experience in implementing student life programs. 2. ANALYZE TOTAL DEVELOPMENT COSTS Ask the developer to fully disclose all front-end fees, construction management fees and other miscellaneous fees. Development fees are standard in the industry and are used to cover front-end costs of the developer. However, these fees increase debt which increases the liability to the University in the event the University is required to guarantee debt service or to pay off the debt at some point in the future. Ask the developer to disclose whether development line items provide hidden profits to the developer and/or affiliated companies. For example, if units are to be leased as furnished units, verify that student furnishings are included in the development costs. If additional revenues are to be generated from furniture rentals those revenues should flow through the project to be distributed between the University and the developer. 3. REQUIRE REALISTIC ASSUMPTIONS IN FINANCIAL PROJECTIONS Inflation factors for revenues should be consistent with inflation factors for expenses. Summer occupancy rates should not be overly aggressive. Unlike traditional apartments, student apartments rarely achieve annualized occupancies in excess of 85%. Operating costs should be sufficient to maintain the facility in an acceptable condition. Typically operating expenses for student housing facilities range from $875 to $1,100 per bed annually. Replacement reserves should be established and sufficient to cover operating cash short falls; scheduled replacement and maintenance of appliances, carpeting, etc.; and scheduled capital improvements (such as replacement of roofs and resurfacing of parking lots). Verify that sufficient cash is reinvested in the project to ensure the property is properly maintained. 4. ANALYZE THE BUYOUT CLAUSES The ground lease should not exceed the anticipated life of the facility. A 40 year term allows the developer to operate the facility for up to 15 years and then to sell it to a third party who then has 25 years remaining on the term of the lease to finance and amortize the acquisition and renovation costs. If a developer plans to be in the project for no more than 15 years, there is usually little incentive to make capital improvements to the facility or to fund capital reserves. A 25 year term (which is the expected life of stick frame construction for student housing) will serve to reduce the attractiveness of sale to third parties, thereby providing the developer with an incentive to stay in the project and to properly maintain the facility. In the event the University exercises its right to buyout the developer, elimination of the residual period (that period which is the difference between the 25 year life of the asset and the 40 year term of the lease) will result in a lower purchase price. The buyout clause should require the purchase price to be based on fair market valuation of similar multi-family projects in the community. Subsidies provided by the University in the form of ad valorem taxes and discounted utility rates should not be considered in valuing the project, while the depreciated condition of the asset should be considered since this has a direct impact on the project’s ability to generate a future income stream. By basing the purchase price on the depreciated value of similar multi-family projects in the community, the University will not be paying for subsidies it provides the developer, and the purchase price will not be influenced by higher incomes generated by the project in the early years of its life as a result of increased rents and deferred maintenance. The net effect is to reduce the attractiveness of selling the project to the University and providing an incentive to the developer to stay in the project. Do not allow the developer to leverage the property during the term of the lease without prior written authorization from the University. The University may be responsible for guaranteeing debt service or, in the event of sale, paying off the increased indebtedness. 5. EMPHASIZE MAINTENANCE REQUIREMENTS Retain the ability to terminate the services of the developer as manager of the project. Developers make money from these projects in four ways - (1) developer fee drawn from the development loan at the beginning of the project [see Number 2 above]; (2) management fees paid on a monthly basis; (3) distribution of surplus cash at the end of the year; and (4) sales proceeds in the event of sale. If the University retains the right to replace the developer as manager of the complex, it can eliminate management fees which is the first source of income for the developer. Because there is no guarantee the next manager will be any more successful than the developer, there is no guarantee there will be surplus cash to be distributed at the end of the year, which eliminates the second source of income. As discussed above, by eliminating the residual period and requiring the purchase price to be based on the condition of the asset and future income streams, the attractiveness of selling the property is reduced. The net effect is to produce an incentive for the developer to maintain the property so that it will continue to generate income over the life of the asset. The University should retain the right to inspect the property, or to hire an independent third party to perform those inspections on behalf of the University. Costs to conduct inspections should be considered a cost of the project and should be paid by the project. A consultant should be retained by the University at the beginning of the project to develop a Capital Reserve Program. This Program should identify those facilities or improvements, which will need to be repaired of replaced during the life of the project and the anticipated life of those improvements. The Capital Reserve Program should also include a funding plan which will ensure there are sufficient funds available to fund anticipated improvements. The funding plan should be reviewed and updated annually as part of the budget process. The University and developer should agree on a systematic apartment preparation program and exterior maintenance schedule. An apartment preparation schedule might include interior repainting of each apartment once every three years and steam cleaning the carpets at moveout. 6. CONTROL RENT STRUCTURE Increases in rent structure should not exceed increases in operating expenses for the prior year. Developers and lenders are continuing in their efforts to transfer risk to the Universities in the form of financial or occupancy guarantees. If Universities are expected to guarantee debt service and lease a sufficient number of units to achieve break-even operating costs, then Universities should also control rent structure. Presently most lease agreements provide that in the event the developer and the University disagree about budgetary issues, the tie-breaker defaults to the developer. This argument only makes sense if the developer assumes the financial risk. If the University assumes that risk, the tie-breaker should default to the University. 7. MINIMIZE FINANCIAL OR OCCUPANCY GUARANTEES Avoid providing any type of guarantee, if possible. If the University is required to provide financial guarantees, require the developer to subordinate its management fees for so long as the University is funding the deficiency. If the University is required to fund deficiencies, and if at some later point there is surplus cash from operations, the University should be fully reimbursed for all previous contributions before distributions are made to either party. Create some mechanism which eliminates the financial guarantees if the project achieves some defined objective. By way of example, the contingent payment obligation incorporated in ground leases utilized by the A&M System ceases if the project obtains an investment grade rating of “bbb” or better from Standard & Poors Corporation, or “baa” from Moody’s Investor Service, Inc., thereby allowing the loan to be sold to the secondary market. Verify that this transaction does not affect the University’s debt capacity or the rating of its debt. Moody’s Investors Service has recently taken the position that privatized housing transactions fall along a continuum of risk. At one end of the continuum is Off-Balance Sheet Financing, which does not result in direct legal commitments to the University. The other end of the continuum represents full or implied financial commitments to the project. Moody’s position is that in the event the project fails, the University will use institutional funds to support the project or buyout the developer. This financial commitment by the University will directly impact the University’s debt capacity, and ultimately the rating of the University’s debt. 8. PREPARE A MARKET STUDY AND FINANCIAL ANALYSIS If the University is prepared to provide financial or occupancy guarantees, it should do so only after a feasibility or market study has been prepared by an impartial third party who has been selected by the University. As part of the feasibility process the University should also define its role as a housing provider since the University may ultimately be required to support or manage these units. Other elements to be included in the feasibility study include: a. Supply and demand analysis of the local market area. b. Survey of similar properties at other campuses. c. Cost/Benefit analysis to the University. d. Market survey of desired student housing product type. e. Financial proforma for the project. f. Financial impact on the University’s existing debt service for on-campus housing. g. Site location and analysis of infrastructure requirements to support this project. This should include availability of utilities to the site and plant and line capacity The University should also evaluate public policy issues ancillary to privatized housing, such as whether the University should compete with the private sector in providing housing. 9. PAY PARTICULAR ATTENTION TO THE USE OF TAX EXEMPT BONDS IN FINANCING THESE TRANSACTIONS The Internal Revenue Service recently published training materials, which are aimed at identifying abusive transactions involving 501(c)(3) organizations issuing tax- exempt bonds. Specifically, this material identifies seven “red flags” which will serve to warn agents that a 501(c)(3) organization might be in violation of the tax code, thereby making its bonds taxable.