True Believer
Grid, July + August 2001
Christopher Leinberger evangelizes for a new form of real-estate finance to underwrite innovative forms of development. He’s converted Albuquerque, but will the city’s faith pay off?
Downtown Albuquerque, New Mexico, looks like many other downtowns in the American West. It’s as if someone rolled asphalt over a couple of square miles, then dotted it with buildings here and there. You don’t find streets thronged with shoppers or latte-sipping office workers enjoying the sidewalk view. This downtown reads more like an encyclopedia of failed urban-revitalization fads: the empty pedestrian mall, mixed-use skyscrapers riddled with vacant space, the under-booked convention center.
This scene won’t last, predicts Christopher Leinberger, a partner of locally-based Arcadia Land Company. A construction site at First and Central (the old Route 66) is Ground Zero of what he expects to be Albuquerque’s meteoric revival. The mix of housing, office and retail uses for the project isn’t new, and you’ve seen the nouveau-quaint design before. What Leinberger has done that is new, and what Albuquerque Mayor James Baca has bravely backed, is to create a new development finance scheme that, if successful, could fundamentally change the real-estate development process.
From 1981 until he sold his stake in real estate consultant Robert Charles Lessor last year, Leinberger was the kind of real-estate analyst who told clients to get out of declining downtowns and into shiny-windowed office parks on the outer beltways. (“The market was saying move out, and I was often quoted on that,” leinberger says.) And yet he could not ignore the price premium commanded by such pioneering New Urbanist developments as Seaside, Florida, which Robert Davis begat in the early 1980s. Seaside, declares Leinberger, “turned the Redneck Riviera into the Hamptons of the Southeast.” He also approves of Prairie Crossing, an hour’s drive northwest of Chicago, which is a farmland-preserving development scheme begun in the late 1990s by George A. Ranney Jr. (Ranney, a longtime Chicago civic leader and industrialist, is also a major player in Chicago Metropolis 2020, the updating of architect Daniel Burnham’s master plan for the city.) According to Leinberger, home sales at Prairie Crossing have soared to 40% above the asking price.
Moved by such examples, in 1997, Leinberger decided to get deeper into development himself, founding the Arcadia Land Company with Seaside developer Robert Davis and James Duckworth of Philadelphia. But he discovered, as previous New Urbanist developers have, that pedestrian-friendly high densities, as well as the mix of housing unit types and of residential with commercial development, were difficult to finance.
Determined to find out why what seemed to make good sense for building livable working communities seemed to make no sense to lenders, he set about categorizing the kinds of projects that could qualify for conventional financing. He found that they fell into only 19 highly simplistic, rigidly proscribed real estate “products” (see chart). Obtaining competitive financing terms required (and still requires) sticking to the product formulas. For lenders, requiring developers to build familiar product types is both a reaction to the overbuilding of the 1980s and a sign of the increasing influence of Wall Street on real estate finance that began in the early 1990s. It’s cheaper to finance – and safer to underwrite - well-understood, generic real-estate “products” because, says Leinberger, “they’ve become graded and commodified – just like pork bellies.”
Because the kind of development Leinberger had in mind fell outside the sanctioned system, he had to find another way to get it financed.
The new urbanist communities Leinberger analyzed had another problem that put them outside of th typical lender’s orbit: Their cash flows peaked much later than those for conventional developments, and thus too late to be recognized by conventional real-estate analysis, which relies on discounted-cash-flow (DCF) methodology. DCF analysis, which tends to show the highest internal rate of return in the first five years of a project’s life, came to be the standard means for evaluating real-estate investments about 40 years ago. With this approach, it naturally follows that the primary way to ensure short-term returns is to reduce both hard and soft construction costs – decisions that typically translate into lower building quality.
The combination of financing-driven building-type rigidity and DCF-driven low-quality construction tends to give rise to the kind of developments that communities have come to see as destructive. “All but two of the 19 conforming products create sprawl,” says Leinberger. Worse, it’s the kind of development that either wears out or “uglies out” because it’s built so cheaply.
It wasn’t always so, according to Leinberger. “We marvel at the architectural design and quality of construction seen in the great retail emporiums, apartments buildings and office blocks built before World War II,” he says. “We think of those builders as possessing immensely greater wealth than we have. In reality, the country’s per capita gross domestic product is three times higher today in real terms than in, say, the 1920s.” The real difference is that investors expected to reap their rewards over a very long time – and did.
So Leinberger has developed a new finance methodology that he says will reward those who build for the long term with innovation and quality as their cornerstones. He calls it “time tranching,” a technique he borrowed from the Resolution Trust Corporation, the agency that found viable owners for all those early 1990s see-through buildings. “Risk tranches emerged at that time as a way to grade assets so they could expeditiously be gotten off the books of banks and other lenders,” he explains. Projects were sliced up according to risk, with the riskiest elements put first in line for repayment. And it worked.
With time tranches, investors could buy into the income streams at various periods in a project’s life, depending on their cash-flow needs. Today’s DCF methodology focuses only on the first five to seven years after a property is built, but not all investors need to get their money out in this period. Pension funds, institutions, publicly held REITs and foundations often can benefit from investments that pay back over a much longer time horizon – the sixth to the twelfth year, for example, or the period beyond the twelfth year. “We believe those that take the mid- or long-term piece will find dividends that vastly exceed their expectations,” says Leinberger.
The advantage of time tranching, according to Leinberger, is to open access to low-cost capital for projects that have higher than average initial construction costs, but that also have the potential to more richly reward those with longer-term investment-return horizons. Leinberger cites successful New Urbanist developments such as Newpoint in Beaufort, South Carolina, and Harbor Town, in Memphis, where retail leasing has naturally trailed the establishment of the housing component. But the integrated, pedestrian nature of these communities means that the infrastructure for both elements must be constructed – and paid for - up front. [What happens when doing so sets up a mountain of debt that has to be cleared too soon? See “Planned Communities at Middle Age,” GRID, June 2001.] Also, says Leinberger, “New Urbanist projects, urban infill and ecologically innovative projects demand a higher level of architecture and construction quality.” But because banks see such projects as higher risk, “you can only afford the financing if you decrease quality. It’s a catch-22 situation.”
Leinberger has traveled the country preaching his time-tranching gospel to high-net-worth individuals and trusts that are investing for generations to come rather than for a quick hit at 20% or better. He has targeted these holders of patient money because, he explains, “taking another five years is just fine for them.”
Albuquerque - only 60 miles south of Leinberger’s home in Santa Fe – became the first to agree to a large-scale test of Leinberger’s time-tranche financing.
Given the general torpor of Albuquerque’s downtown streets, Christopher Leinberger sounds quixotic indeed when he claims, “We’ll overhaul it in two years.” He’s seeding that overhaul on one block of the six controlled by the Historic District Improvement Company (HDIC). HDIC is a joint venture owned 75% by Leinberger’s Arcadia Land Company and the rest by the Santa Fe arm of the McCune Foundation, a nonprofit funded by “Pittsburgh old steel and oil money,” says Leinberger, that typically funds social services and arts programs throughout New Mexico.
Leinberger’s vision is a $30-million, 266,000-square-foot mixed-use project on five contiguous lots and designed by noted New Urbanist architects. Here’s how the MONEY breaks out: $12 million from the city in the form of land, parking structures, infrastructure improvements and tax abatements as the bulk of the third tranche; $5 million from HDIC; another $1 million in equity from private investors, whom Leinberger identifies as Robert Linton, formerly of Drexel Burnham [former CEO before it blew up] , and real estate syndicator Eddie Gilbert, OF BGK Equities. The remainder is in conventional debt from a consortium of banks let by Wells Fargo and including Bank of America and two local banks.
Leinberger is burying a 14-screen, 47,000-square-foot multiplex theater – the still-solvent Century Theatres HAS signed up - in the center of the project, wrapping it in an additional 43,000 square feet of retail and 26,000 square feet of offices on two upper levels. The theater and most of the retail will be completed by this Thanksgiving. According to Leinberger, 80% of the retail (including the multiplex) is spoken for. In a second phase – also in construction, the city is building a 640-space parking structure wrapped with a 45-foot-deep band of street-level retail and 50,000 square feet of upper-floor live/work loft spaces that will be sold as condominiums. Unlike big-earning condos in major urban centers like New York or Chicago, these are expected to sell for “barely more than break-even,” says Leinberger.
Here’s how Leinberger sees a larger renewal effort spreading from these modest beginnings: “Urban entertainment and one-of-a-kind attractions build interest in downtown. We put on festivals to get people to come down and take a look. This generates street life, and then housing comes in. When executives begin to live downtown, the office uses follow.”
Leinberger says that his project has already begun to prove its worth, delivering rents well above what the Arcadia pro forma had called for and thus providing returns to the second tranche investors more quickly than expected. The office space, to be delivered January 1, 2002, is expected to fetch gross rents of $19 per square foot – compared to the local avearage of around $10 – while rents for the retail space, projected by the developers to bring in $18 to $20 a foot on a triple-net basis, have reached to the mid-$20 range, says Leinberger.
The cost of construction is roughly $80 per square foot –almost 2.5 times the cost of a typical strip center development, Leinberger claims. “The only way we could build is at the quality level: steel frame building, lovely finishes, operable windows.”
The time-tranche financing methodology allows the process to move quickly, according to Leinberger, by reducing pressure to generate high revenues fast. Conventional real-estate investors Will receive most of the cash flow from the project’s first five years; HDIC will take two-thirds of the second-tranche revenues (years six through eleven). The city of Albuquerque will get one-quarter of the cash flow in the second tranche and evenly split the revenues with HDIC in years 13 to 20. The city will also realize whatever growth in tax revenues the project spins off – now projected at $48 million over 28 years.
So far, the principals are satisfied. “If things continue to happen the way they are, this could be the best investment we ever made,” says Owen Lopez, Executive Director of the McCune Foundation. “The rents we’re getting here are unheard of,” he continues. “I don’t think anything has ever rented here over $10 before.” Adds Mayor Jim Baca, “The City is a true partner and will get something back on its investment for a change.”
Arcadia/HDIC’s six blocks are not the only signs of new life downtown. The city is rebuilding a landmark Santa Fe Railroad depot as the Albuquerque Transit Center, a multi-modal transportation facility. There’s a new downtown business improvement district and a trolley. One major disappointment for the downtown advocates: Albuquerque citizens voted in a recent referendum to renovate an existing Triple A baseball stadium in the suburbs rather than build a new one downtown. Still, in a concrete payoff from the revitalization effort, the Gap has agreed to move a 300-person accounting and finance group from the Bay Area into an existing office building downtown.
Albuquerque’s got a ways to go. But if Leinberger’s unique financing strategy flies, dozens of cities will be knocking on his door.
(Continued)