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Greedy Sheep Meet a Hungry Tiger.

 

The City Has Been Outwitted in Itís Real Estate Deal With the Developer of the Montage Hotel Project.

 

In previous columns, I argued that the Montage hotel project will cause a huge increase in traffic.  This week I will address the primary argument of those who favor the project Ė the City is going to make a lot of money.

 

I agree that if the project is successful, the City will make a lot of money.  Itís always nice to think about how much money will be made if the deal is successful.  

 

Itís also important to consider and plan for the possibility that the deal will not be successful.   If this happens, then the City could be left with a huge parking structure with 1,000 to1,500 spaces, most of which are empty, a bankrupt hotel and a need to allow further development of the area in order to try to fill the parking.  I have seen no guarantees that this cannot happen and it appears to me that the City has failed to cover its downside risk.

 

Also, itís scary for the City to enter into a perpetual partnership with a private business.  Whatís going to happen five or 10 years from now when the Montage says that it needs special consideration in order to stay in business?  Will the City be able to afford to say no?  Or will the City Council decide to enter into another joint venture to bail out the hotel?  Maybe we could eventually have a McDonalds in Roxbury Park or a Wal Mart at the Civic Center?  

 

In my opinion, the City is taking a significant risk.  I have been involved in a few real estate deals in my life, and one of the most basic principles is that the allocation of potential rewards depends on the relative bargaining positions of the parties and the allocation of risk. 

 

The deal that the City has made is the kind of deal that might make sense if the other party was taking most of the risk, or if the other side had a vastly superior bargaining position. 

 

First, letís look at what the developer had going into the deal.  The developer had eight contiguous lots north of Wilshire, bounded by Beverly Drive on the west and Canon drive on the east.  Such lots were zoned for a maximum of three stories.

 

According to the website of the Los Angeles County Assessor, six of the developerís lots were acquired on August 6, 1997 and the remaining two lots were acquired on September 7, 2001.  The current assessed value of the developerís eight lots is almost $15.5 million.  Last year, the total property taxes payable on the developerís eight lots was approximately $208,700.

 

Pretend that you are the owner of these eight parcels.  You have over $15 million invested and you are paying $208,000 per year in property taxes.  You have been assembling these lots over a fairly long period of time and you are probably paying a lot of interest every year to carry this investment.

 

If the City knew anything about real estate deals, it might have realized that the developer was not dealing from a position of strength.

 

Now letís look at what the City has tentatively agreed to contribute to the deal Ė six lots, $36,750,000 of taxpayer dollars, and a zoning variance allowing the developer to build seven stories instead of three.

 

The basic deal, as outlined on the Cityís website is as follows.  The City will provide the developer with $36,750,000 to build underground parking under all fourteen lots.  The City will own this parking structure, and the developer will lease most of the parking structure.  The City will also continue to own its original six parcels and the retail space that will be built there, but the developer will have the right to build eight condominiums over the retail space.   Thus, any future use by the City will be restricted in perpetuity by the ďair rightsĒ of the owners of the eight condos.

 

The City will receive 3% of gross room revenues in the first year after opening, 4% in the second year, and 5% in the third year and thereafter. 

 

The City will be required to contribute its $36,750,000 once the developer has acquired its eight parcels, has arranged for financing and has obtained a construction contract.  At that point, the City will be kissing this money goodbye forever, but the developer is agreeing to absorb any cost overruns.  Assuming that the developer remains solvent and nothing major goes wrong, this guarantee will be meaningful, but its also possible that the developer could default, in which case the City could be left with a huge mess that it would have to deal with. 

 

The developer has twelve months to meet its financing requirements, but if it fails, it can purchase two extensions of one year apiece from the City for $100,000 per year.

 

The project is expected to take approximately 36 months to construct, but the Developer will have 60 months after the City coughs up its $36,750,000 to substantially complete the project.  If the developer does not substantially complete the project in 60 months, a minimum annual payment to the City will commence, as if the hotel were operating.  The minimum payment for the first 12-month period is a minimum of $273,000; $364,000 for the second year and $455,000 for the third year or any year thereafter.  Thus, assuming that the developer does not go bankrupt, the City will get back at least $1,092,000 of its $36,750,000.  In my opinion, this no more than a fig leaf of protection from a huge downside risk.

 

If the developer fails to complete the project on time or defaults on its payment obligations, the City can terminate the parking lease, which is required in order to operate the hotel.  However, in this scenario, the City could end up with a very expensive and very empty parking structure, and would have to tap into its general fund to repay its borrowing of the $36,750,000. 

 

To sum this up, the City is contributing approximately 43% of the land (six out of 14 parcels) plus $36,750,000 of cash.  The City has valued its land at $12.75 million, which I believe is at least $5 million too low, but even using the Cityís numbers, the total contribution of the City will be $49.5 million.  I also believe that itís only fair to place a value on the Cityís agreement to allow seven stories instead of three, which I believe is worth at least $15.5 million, making the Cityís total contribution an even $65 million.   

 

Using exactly the same land value per lot as the City has assumed for its six lots, the developer will be contributing $17.5 million of land, plus the balance of the construction costs.  The developerís projected construction costs appear to be a closely guarded secret, which makes it difficult to judge the overall fairness of the deal.  However, the developer is projecting a property tax increase of $790,000, which suggests an increase in assessed values of approximately $57.5 million.  Based on these assumptions, the developer will be contributing a total of $75 million.    

 

Thus, based on the information that is available to the public and some informed guesswork, the City will be contributing a total of $65 million and the developer will be contributing a total of $75 million.  Theoretically, the City should be a 46% partner in the whole deal, but all the City is getting is the parking revenues plus 3% to 5% of the gross hotel revenues plus the net retail revenues plus tax revenues that the City would get even if the City was not a partner.

 

In my opinion, this is not a fair deal.  First, the developer is being allowed to build 33 condominiums and the City wonít get a dime from the sale of the condos unless they sell for more than $1,172 per square foot.  Assuming that the condos are each 2,500 square feet and that they sell at the ďbargainĒ price of $1,000 per square foot, the developer will collect $82.5 million from the sale of the condominiums and the City will get zero.  In my opinion, in a FAIR deal, the City would get at least 30% of the gross proceeds from the sale of the condos.

 

I would also note that the developerís position that it needs to build a huge hotel project in order to profitably develop the property is not honest.  If the City was not so blinded by greed, maybe someone would notice that a decent profit could be made from the developer building three stories of condos with underground parking.  Assuming three condos per lot per floor, the developer could build 72 condos and make a decent profit without any concessions from the City and with far less strain on our gridlocked streets.  Based on some rough estimates, I believe that the developer could generate a profit of over $30 million from such a project.  However, this is small potatoes compared with what the City has agreed to.

 

Based on my analysis, after the developer rakes off the proceeds from selling the 33 condos, it will basically own the hotel/restaurant/spa operations for free, then can sit back and reap an additional $10 million to $30 million of net profits per year while the traffic piles up on Wilshire for miles in both directions and the City collects its $5 million or so per year.

 

As before, I oppose the Montage project, because it is out of scale and will further clog traffic for miles in all directions.  A smaller project would make sense, but the developer would only make $30 million or so as compared with hundreds of millions of dollars.

 

Since the Cityís bargaining position is so strong and the developerís is so weak, I am amazed that the City has made such a pathetic deal.  If we are going to have to endure huge gridlock and take the risk that the developer will screw up or that the hotel will fail, then it seems only fair that the City get a fair cut if the project succeeds.  To me, the current deal is not even in the ballpark of being fair.

 

I would suggest that the City hire a smart, independent real estate attorney to take a close look at this deal and provide an opinion as to whether it is far to the City.  Such attorney should be someone who can swear a blood oath that he or she has never met any of the City Council members and that he or she has no other connections to Beverly Hills politics.  Also, ideally, such attorney should have been involved in similar deals.

 

I remember an episode of ďThe HoneymoonersĒ when Ralph and Ed bought a run down hotel and expected to make a huge profit, because they had inside information that a new highway would pass right next to the hotel.  As it turned out, their key assumption was correct.  The new highway was built and passed within feet of the hotel.  However, it was an elevated highway, so there was no benefit.  Regrettably, Jackie Gleason is no longer with us, but Ralph Kramden lives on in the real estate skills of whoever has been making decisions for the City.

 

In the case of the Montage project, I believe that the City is bringing almost as much to the table as the developer, and that the deal should be structured so that the City gets at least 40% of the upside.  Alternatively, the developer needs to provide ironclad guarantees (such as irrevocable letters of credit) that the City can never lose money.

 

Again, I oppose this project.  The City Council should do something about traffic before even considering a project of this scale, and the people who say that a smaller project would not be profitable need to reconsider either their math or their integrity.  Also, someone should consider the potential effects on the other hotels in town and the future temptation for the City to give special favors to Montage in perpetuity.

 

This project was a bad idea from the start, hatched in secrecy and nurtured by greed on both sides.  It is out of scale and will set a bad precedent.  Thus, I want to be clear that I will oppose the project even if the City awakens and insists on a fairer share of the upside.

 

On the other hand, if the City Council is going to make a deal of this magnitude, they should at least get a fair price.  In my opinion, this deal is not fair to the City.  Not even close.

 

This is the kind of deal that would result if the City hired Ralph Kramden to negotiate against Donald Trump

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