Metro Pulse/Insights/Worsham Watkins

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by Joe Sullivan

If Earl Worsham and Ron Watkins succeed with their ambitious downtown redevelopment plan, they deserve to be handsomely rewarded for their accomplishment. The plan represents a highly risky undertaking; and, by any financial standards, high risks should carry with them the potential for high rewards to the risk takers.

Yet the proposed terms contained in Worsham Watkins' submissions to the city and the Public Building Authority raise numerous questions about the level of the fees that WW is seeking and other elements of the deal. Proposed up-front fees to WW totaling $36 million appear far in excess of any norm for a public/private partnership in which a $240 million private investment would be supported by a $130 million outlay of city funds. These fees would seem to impinge on the city's chances of getting a return on its investment. Moreover, if WW collects $36 million up front, it's unclear how much, if any, risk the developers would be bearing on the $240 million private investment that would be financed primarily by the sale of bonds.

The $36 million takes the form of proposed project management fees on both the public and private sectors of the development. A 2.5 percent fee totaling $2.7 million on the garages, Henley Street "walkover" and World's Fair Park conservatory that comprise most of the $130 million public investment is in line with fees customarily charged by the PBA. (But they raise the question why WW should be overseeing these projects and collecting these fees instead of the PBA.) The 2.5 percent is dwarfed, however, by proposed 21 percent project management fees totaling over $33 million on the costs of private sector construction. These include the hotel, office building, cineplex, a "shoppertainment" mall over Henley Street and a Scripps/HGTV Center that WW plans to develop itself as well as residential projects and improvements to Market Square and the Sunsphere for which subdevelopers are envisioned.

These fees leave specialists in downtown redevelopment joint ventures shaking their heads in dismay. A leading authority on such public/private partnerships, at least in terms of what's been written on the subject, is a Philadelphia-based developer and former consultant, John Stainback. In his book, Public/Private Finance and Development, Stainback states that, "the fee for a typical midsize project is 3 to 4 percent of the total development budget...."

WW's financial consultant, Perry Miles, insists that this is an apples-to-oranges comparison. Included in the 21 percent, he says, is a 7 percent contingency fee that matches PBA's standard allowance for construction overruns. Other WW costs account for another 7 percent, he claims, and then ventures that, "If the city wanted to pay a straight fee on a cost-plus basis at 3 percent, I think Earl and Ron would be receptive." By Stainback's standards, though, "Development management fees...[should] cover the project costs incurred and the management personnel required by the private developer to complete the predevelopment and construction phases of a project."

If the level of these fees impacted only private investors in the development, then they might be purely a matter for private negotiation and none of the public's business. However, WW's proposal to the PBA—and eventually the city—presumes that an important element of return on the city's investment is participation in the profits of a successful venture. Under the WW proposal, the city would get 20 percent of the profits in excess of a 12.5 percent rate of return on costs. Pushing up the costs by the amount of the proposed project management fees makes it that much harder for a rate of return in excess of 12.5 percent to be attained. In the case of the office building, for example, they contribute $10.5 million to its $70 million cost; in the case of the hotel, it's $7.8 million out of $52 million.

While WW has offered to make some fixed lease and parking fee payments to the city on the publicly owned land and garage underlying these buildings, the developers are known to be pushing profit participation as an alternative to any fixed payments to the city. This runs counter to another Stainback admonition: namely that returns on the public investment in a public/private partnership should include both fixed and contingent components.

Further impinging on the city's profit-sharing return potential is the fact that WW is looking to get a management fee of 5 percent of the entire project's revenues on an ongoing basis. This fee is projected at $1.1 million annually and is derived for the most part from projected lease payments by WW's tenants. To invoke Stainback once again, a management fee of 3 percent to 4 percent is typical. After all these fees, WW's own projection of returns during the first five years after completion of the development range between 10 percent and 11 percent. According to its submission to the PBA, it would be 15 years before the 12.5 percent threshold for city profit participation is attained. All other profits would go to WW.

Assuming the city proceeds with the development, just how much financial risk WW will be bearing on an ongoing basis depends on how much of the $240 million the firm (or Worsham and Watkins individually) has invested. WW's investment banker, Merrill Lynch, has attested to the feasibility of financing the entire deal with revenue bond issues (i.e. the city and its taxpayers will not be obligated). It's a safe bet that the developers will be looking to invest a little as possible in these risky bonds—especially since their holdings would be subordinated to those of senior lenders. On the other hand, their submission to the PBA states that, "it is expected that Earl Worsham and Ron Watkins will purchase a portion of this debt personally." Watkins says, "no decision has been made" on how much that might be.

Of course, if the development fails to get off the ground, Worsham and Watkins will be out the $2 million they claim to have already expended, plus the opportunity cost of all the time they've spent working on it to the exclusion of other projects.

Still, their risk appears small compared to the city's exposure on its prospective $130 million outlay. Another cardinal Stainback rule is that a city must expect a positive return on its investment in a public/private partnership. It will take about $10 million in annual revenue to service the city's $130 million debt. While incremental sales taxes and amusement taxes are projected to yield the city about $9 million, property taxes, lease payments and parking fees that would push the total to about $12 million are all in a state of flux under the terms of WW's proposal.

The time has come for the PBA, acting on the city's behalf, to take a hard bargaining position with the developer. Scrutiny of all developer fees and insistence on a mix of fixed and contingent returns are just a few of a host of issues that should be on the table in these complex negotiations. The PBA's chief, Dale Smith, is also questioning whether WW should get parking revenues in the first place rather than letting PBA operate the garages (as is the case with all the other public garages it has built). Moreover, he's looking for ways to reduce the city's investment in order to enhance its returns. The costs of the glass-enclosed, climate-controlled, elevated walkways proposed by WW are singled out in this regard, as is city assumption of the $15 million cost of the proposed conservatory.

At the same time, it must be kept in mind that a great deal of effort has gone into the WW proposal. In all probability, only home-grown developers who care a lot about the city's future would have devoted themselves to a downtown revitalization undertaking of this scope—the need for which was underscored by last week's lamentable closing of Lula restaurant on Market Square. Changes that could undermine private sector financing of the deal need to be avoided just as much as overreaching on WW's part.