Evaluating the Sale-Leaseback Proposal: Should the State Sell Its Office Buildings?

Evaluating the Sale-Leaseback Proposal: Should the State Sell Its Office Buildings? M AC TAY LO R • L E G I S L A T I V E A N A L Y S T • A P R I L 27, 2010 AN LAO REPORT LAO Publications This report was prepared by Mark Whitaker, and reviewed by Steve Boilard. The Legislative Analyst’s Office (LAO) is a nonpartisan office which provides fiscal and policy information and advice to the Legislature. To request publications call (916) 445-4656. This report and others, as well as an E-mail subscription service, are available on the LAO’s Internet site at www.lao.ca.gov. The LAO is located at 925 L Street, Suite 1000, Sacramento, CA 95814. 2 LEGISLATIVE ANALYST’S OFFICE AN LAO REPORT EXECUTIVE SUMMARY Recent legislation authorized the Department of General Services (DGS) to sell and then lease back 11 state-owned office properties. The sale-leaseback is designed to free up the state’s equity in the buildings to provide one-time revenue for addressing the state’s current budgetary shortfall. The leaseback component would allow the state to retain use of the properties. The DGS has initiated the process for selling and leasing back the properties and expects to select a buyer or buyers as early as the end of May. In order to maintain oversight of the pro- cess, the legislation requires DGS to report on the terms and conditions of any sale-leaseback to the Legislature’s fiscal committees 30 days prior to completing a transaction. During this 30-day period, the Legislature has an opportunity to review the transaction and determine whether the sale-leaseback is preferable to maintaining state-ownership of the buildings. In this report, we outline the key issues the Legislature will need to consider in comparing the sale- leaseback to the status quo. Major Up Front Benefit…The major benefit of the sale-leaseback transaction is the one- time revenue from the sale of the buildings. Proceeds from the sale would first retire the bonds associated with the buildings, while the remainder would provide one-time revenue to the state’s General Fund. The 2010-11 Governor’s Budget estimates sale proceeds would provide $598 million to the General Fund. In the report, we find that the Governor’s estimate repre- sents the low end of what the state could expect to receive and that one-time revenue could be $1.4 billion under more optimistic assumptions. …But Higher Annual Costs. While the sale-leaseback would transfer the state’s costs and risk of owning the buildings to the new owner, 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. We estimate leasing the facilities would cost $30 million more than ownership in the first year and continue to increase over time—eventually costing the state ap- proximately $200 million more annually than maintaining ownership. Evaluating the Transaction. In deciding whether to endorse the sale-leaseback during the 30-day review period, the Legislature will need to consider whether the benefit of the one-time revenue from selling the facilities would be large enough to compensate for the higher costs in subsequent years. After taking into account the one-time revenue that the state would receive in the first year and converting the future costs into today’s dollars, we estimate the transac- tion 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. Therefore, we encourage the Legislature to strongly consider other LEGISLATIVE ANALYST’S OFFICE 3 AN LAO REPORT budget alternatives. And, more specifically, we recommend the Legislature reject the sale- leaseback if the sales revenue is at the lower end of the range presented in this report—near the Governor’s revenue estimate, for example—as the costs would be equivalent of long-term borrowing at double digit interest rates. 4 LEGISLATIVE ANALYST’S OFFICE AN LAO REPORT BACKGROUND Chapter 20, Statutes of 2009 (ABX4 22, Ev- state’s budgetary shortfalls. This report addresses ans), authorizes the DGS to (1) sell 11 state-owned the sale-leaseback component of Chapter 20. office buildings and (2) lease the buildings back The Sale-Leaseback Transaction. A sale- from the new owners through a long-term lease. leaseback is a real estate transaction in which the The sale-leaseback transaction was one compo- owner sells a property and then leases it back nent of a larger proposal from the Governor to from the buyer. The purpose of a sale-leaseback extract revenue from the state’s real estate assets. is to free up the original owner’s equity while Other components of the Governor’s state asset allowing the owner to retain use of the property. revenue proposal included in Chapter 20 were the The leaseback component is essential to the sale of the Orange County Fairgrounds and allow- state since it will continue to need space in the ing DGS to arrange long-term ground leases for buildings proposed for sale. As described in the underutilized state properties. Each proposal was nearby box, a sale-leaseback transaction is much intended to provide revenue for addressing the different than a traditional asset sale. Timeline. The DGS has initiated the process for selling and leas- Figure 1 ing back the 11 state State Office Properties Authorized for Sale-Leaseback properties authorized in Chapter 20 (see Figure 1). Building Location The process started with Junipero Serra State Building Los Angeles Ronald Reagan State Building Los Angeles DGS selecting the firm Elihu Harris Building Oakland CB Richard Ellis (CBRE) California Emergency Management Agency Headquarters Rancho Cordova through a competitive Attorney General Building Sacramento Capitol Area East End Complex Sacramento bidding process to serve Department of Justice Building Sacramento as the broker for market- Franchise Tax Board Complex Sacramento ing and managing the Public Utilities Commission Building San Francisco Earl Warren and Hiram Johnson Buildings (Civic Center) San Francisco sale-leaseback transac- Judge Rattigan Building Santa Rosa tion. Next, DGS worked with CBRE to determine the marketing timeline Figure 2 and strategy, compile Sale-Leaseback Schedule due diligence information 2010 on the properties, and prepare lease terms for February 26 Release of initial brochure and offering memorandum. the leaseback part of the April 14 Deadline for potential buyers to submit initial offer. April 23 Competitive buyers invited to participate in additional offer rounds. transaction. As shown in May 20 Deadline for best and final bids. the current timeline in May 28 Anticipated date of the selection of the buyer(s). Figure 2, CBRE officially LEGISLATIVE ANALYST’S OFFICE 5 AN LAO REPORT placed the properties on the market—advertised of the process, however, the legislation requires as the “Golden State Portfolio”—on February 26. DGS to report on the terms and conditions of the The bidding process began with potential buyers sale-leaseback to the Legislature’s fiscal commit- submitting initial offers on one or more of the tees 30 days prior to completing a transaction. properties in April. The DGS and CBRE will then This 30-day review period provides the Legisla- evaluate the initial offers and invite potential buy- ture an opportunity to review the transaction and ers who submitted competitive initial offers to determine if the state should enter into the agree- participate in a “best and final” round at the end ment. The key policy question the Legislature of May. Assuming additional bidding rounds are will have to confront (if DGS successfully ne- not necessary, a decision on the buyer or buyers gotiates a deal) is whether the sale-leaseback is could occur as early as the end of May. preferable to maintaining state ownership of the The Role of the Legislature. The legislation buildings. The purpose of this report is to outline provides broad authority for DGS to determine the key issues for comparing the sale-leaseback the sale and lease terms that are “in the best in- to the status quo and suggest approaches for terest of the state.” In order to maintain oversight evaluating the sale-leaseback transaction. S P t ’ r e M elling the roPertieS in oday S eal State arket Selling at a Low Point in the Market Will Result in Less Revenue… The commercial real estate market has experienced a significant decline during the recession. Increasing vacancy rates have caused commercial building values to drop across the state since 2007. Accordingly, the state would be selling the buildings at a low point in the market and receive less revenue than it would have in previous years. ...But Also Lower Rent Payments. Although the state would not earn the same revenue that it might have in previous years, the state would also not have to pay the higher market rents of previous years when it leases the buildings back. Rental rates in all of California’s metropolitan markets have fallen significantly since 2007 as owners attempt to attract new tenants or retain current tenants. The lower rental rates would lessen the state’s long-term lease costs under a sale-leaseback. Sale-Leaseback Should Be Attractive to Investors. Under the sale-leaseback proposal, the state would lease the entire properties for a term of at least 20 years. One advantage of pur- suing a sale-leaseback in this market is that with the significant turnover and vacancy rates, there is considerable demand among institutional investors for real estate assets that offer such long leases and secure income streams. The state’s buildings would still represent some risk to the new owners depending upon their condition and age, but carry less risk than many other commercial properties that do not offer guaranteed occupancy. As a result, we would expect a competitive bidding environment for the state’s sale-leaseback properties. 6 LEGISLATIVE ANALYST’S OFFICE AN LAO REPORT EVALUATING THE SALE-LEASEBACK Sale-leasebacks are fairly common in the pri- projects. (More details on public entities’ use vate sector because the transaction can provide of sale-leasebacks are discussed in the nearby opportunities for companies to decrease their box.) Generating revenue from a sale-leaseback, tax liability, improve their balance sheet, or gain however, also means the state would incur ad- capital to reinvest in the company. Fewer public ditional costs in later years as it pays rent to the sector entities have engaged in sale-leaseback new owners. Below, we discuss these two major transactions because most of the benefits ex- considerations—one-time revenue and ongo- perienced by the private sector do not apply to ing lease costs—that the Legislature would need governments. Most government sale-leaseback to consider in evaluating the desirability of the transactions seek to generate revenue for either proposed sale-leaseback. We then describe other immediate budgetary solutions—similar to Cali- factors concerning the transaction. fornia—or to provide capital for investing in large S -l P S ale eaSebackS in the ublic ector The most prevalent use of sale-leasebacks in the public sector is at the local government level. Governments pursuing sale-leasebacks typically want to extract the equity from their buildings in order to (1) fund new infrastructure projects or (2) balance current budget shortfalls. Using sale-leasebacks to invest in additional infrastructure projects is more common than using the revenue to meet operating expenses. We found that most public entities structure their sale-leaseback transactions quite different- ly than California’s proposal. Specifically, in most sale-leasebacks the state or local government sells certificates of participation in the building to investors and remains responsible for all of the building’s services and costs. The certificates of participation carry a specified interest rate and maturity date, and repayments to the certificate holders represent the government’s “lease payments.” The government retains the risk of ownership under this type of sale-leaseback, but the building returns to state ownership when the certificates are paid off at the maturity date. In this way, it is more like borrowing with the property serving as collateral. For example, Arizona recently sold certificates of participation on 14 buildings it owns with maturity dates ranging from three to 20 years and an average interest rate of 4.6 percent to raise approximately $735 million to help address its budget deficit. Examples similar to California, in which ownership of the building is permanently trans- ferred to the new owner, are less common. The benefit of permanent transfer in a sale-lease- back is that it results in a higher sale price, but at the cost of indefinite lease payments that do not result in any equity. We found limited use of this type of sale-leaseback by some local governments as well as the United States and Canadian federal governments. LEGISLATIVE ANALYST’S OFFICE 7 AN LAO REPORT F c buyer. The offering memorandum established iScal onSiderationS the rental rates the state would pay and outlined One-Time Revenue expected operating costs for each building. The The most obvious benefit of the sale-lease- final bid price, however, will ultimately depend back transaction is the one-time revenue gener- upon many factors including the bidding com- ated from selling the buildings. The sale proceeds petition, perceptions of the buildings’ conditions, would first go towards retiring the outstanding the economic climate, and expected returns. lease-revenue bonds associated with some of Sale Price Could Be Higher. Considering the buildings. After deducting a small amount to each of these factors, we believe the Governor’s reimburse DGS and CBRE for their expenses in revenue estimate of $598 million represents the arranging the transaction, the remaining sale pro- low end of what the state could receive from the ceeds would be deposited in the state General sale-leaseback of the 11 properties. The Gov- Fund—reducing the need for expenditure reduc- ernor’s revenue estimate assumes a sale price tions or revenue augmentations that would other- of approximately $1.7 billion. (The difference of wise be needed to balance the state’s budget. $1.1 billion between the sale price and net rev- Budget Revenue Estimate. In January, the enue would pay off the outstanding debt on the Governor’s 2010-11 budget proposal assumed buildings and cover the transaction’s expenses.) net sale proceeds would provide $598 million Based upon the projected net operating income for the General Fund over three years, with about the buildings would generate as calculated in the half coming in 2010-11 and the remainder in the offering memorandum, a sale price similar to the following two years. (This is slightly lower than Governor’s estimate would mean that potential earlier estimates of $660 million.) Upon learning buyers bid cautiously. Alternatively, under a more that DGS intended to move forward with all of the optimistic scenario, the sale price could reach property sales in the budget year, the administra- $2.5 billion, with net proceeds to the state of tion testified that the roughly $300 million in sale $1.4 billion after paying off the outstanding bonds. proceeds originally scored as revenue in 2011-12 The final bid will ultimately depend upon each and 2012-13 should instead also be counted in bidder’s independent assessment of the potential 2010-11. As part of its actions in the 8th Extraor- risk and cash flows associated with the sale- dinary Session, the Legislature accepted this leaseback as well as the bidding competition. We assumption. Consequently, the budget plan now would expect, however, that the sale price would assumes $598 million in 2010-11 revenue. fall within the range specified above and summa- Wide Range of Revenue Possible. The Gov- rized in Figure 3. (Consistent with this expectation, ernor’s revenue estimate for the sale-leaseback is the administration announced as we were going a preliminary projection. A wide range of reve- to press that it had received bids with amounts nue is possible given the variables involved in the above the Governor’s budget assumption.) transaction and the uncertainty of how investors will respond to the state’s offering. The main fac- Increased Annual Costs tor determining the amount potential buyers are The main argument against pursuing a sale- willing to bid on the properties is the estimated leaseback on state office properties is that the income stream the buildings will provide to the 8 LEGISLATIVE ANALYST’S OFFICE AN LAO REPORT 20 years to 50 years of lease payments under the $30 million more in 2010-11 than the status quo sale-leaseback will likely cost more than the state of maintaining state ownership of the buildings. would spend maintaining ownership of the build- This assumes DGS is able to rapidly implement ings. Currently, the state covers all of the costs the staff reductions and internal restructuring associated with the 11 office properties proposed necessary for the transition from state to private for the sale-leaseback. These costs include debt ownership. If the layoff and restructuring process service, utilities, building management, janitorial takes some time and the state continues to incur services, routine maintenance, special repairs, some of these costs even after the sale, the first- and security. As described in the box on page 11, year costs of the sale-leaseback would exceed DGS is proposing a modified gross lease for the the estimated $30 million—potentially over sale-leaseback in which a single lease payment $10 million. to the new owner would replace most of these In subsequent years, the state’s cost of own- costs. As shown in Figure 4, making lease pay- ing the buildings under the status quo would ments at the market rents proposed in the offering actually decrease over time as the various bonds memorandum would cost the state approximately on the facilities are retired. Some of these owner- ship savings would be offset by increasing costs Figure 3 for utilities, maintenance, special repairs, and Estimated One-Time renovations as the buildings age. As shown in Revenue From Sale Figure 5 (see next page), however, we expect (In Billions) the declining debt service payments to outweigh Purchase Net the increasing operating costs so that the overall Scenario Price Proceeds cost to the state of owning the buildings would Governor's budget $1.7 $0.6 steadily decrease until the bonds are completely More optimistic 2.5 1.4 paid off in 2028-29. (See the box on page 13 for a more detailed descrip- tion of how we estimated Figure 4 2010-11 Costs Under State Ownership and the ongoing costs.) Sale-Leaseback On the other hand, costs under the sale- (In Millions) leaseback would steadily State Ownership Sale-Leaseback increase due to the Debt service $111.8 Lease payments $198.4a increases in base rent Operations and maintenance 54.7 Gas and electricity 12.7 every five years and the Utilities 14.1 CalEMA operating costs 1.2 annual operating cost Special repairs 4.6 Sublease revenue -0.9 increases included in Parking and lease revenue -3.9 the proposed leases. Total Cost $181.3 Total Cost $211.4 As shown in Figure 5, a Assumes LAO more optimistic sale scenario, which affects the value of the proposed property tax credit. therefore, the estimated CalEMA = California Emergency Management Agency. difference between the LEGISLATIVE ANALYST’S OFFICE 9 AN LAO REPORT cost of maintaining ownership and the cost of costs associated with the sale-leaseback. Such leasing the buildings would increase over time. adjustments would be necessary because ap- Considering this in terms of the state budget, the propriations scheduled to pay the debt service difference between the two alternatives is quite on the buildings, for example, would have to be clear. Maintaining ownership of the buildings redirected as lease payments to the new owners would lead to decreasing costs over time, lend- if the sale-leaseback transaction goes through. ing a small contribution toward lessening the The Governor’s budget assumes this adjustment state’s structural budget deficit. Alternatively, the would require $20 million to account for higher rising cost of leasing the facilities would lead to lease costs. Similar to the revenue projections, an increase in the state’s structural problem. In the Governor’s rental cost projection of $20 mil- the near term, however, the greater cost of leas- lion only assumed some of the buildings would ing compared to owning would be fairly mod- sell in 2010-11. These costs would be higher if est—averaging about $34 million annually over the state sold all of the properties in 2010-11 and the first five years. However, the cost differential leased them back at the market rents proposed would increase to over $200 million annually in in DGS’ lease terms. later years. o F ther actorS The Governor’s 2010-11 budget proposal includes language allowing the Department In the previous sections, we focused exclu- of Finance to adjust budget amounts for rental sively on the financial factors that we believe Figure 5 State Ownership Costs Compared to Leaseback Costs (In Millions) $450 400 Sale and Leaseback 350 300 250 State Ownership 200 Special Repairs 150 100 Operations and Utilities Maintenance 50 Debt Service 2010-11 2015-16 2020-21 2025-26 2030-31 2035-36 2040-41 10 LEGISLATIVE ANALYST’S OFFICE AN LAO REPORT P l t roPoSed eaSe erMS The long-term lease determines the income stream the new owners will receive from the buildings and therefore the price buyers are willing to pay. The lease terms are also essential in determining the costs of the sale-leaseback to the state over time. In the offering memorandum released to potential buyers on February 26, the Department of General Services (DGS) out- lined the state’s preferred lease terms. The following are the main components of the proposed leases for ten of the buildings: ➢ Type of Lease. Under a modified gross lease, the owner would be responsible for paying most building services including building management, janitorial services, maintenance, special repairs, insurance, and scheduled upgrades. The owner would pay utilities with the exception of gas and electricity costs, which the state would pay. The DGS believes this is in the state’s best interests in order to take advantage of previous investments in energy efficiency. The state would also continue to provide security at those buildings with unique security needs. ➢ Lease Term. The initial lease would be for 20 years. After the initial term, the state would have the option to renew the lease under the same lease conditions for six additional terms of five years each—resulting in a total lease term of potentially 50 years. ➢ Rent Payments. Base rent payments would be set near current market rents for each prop- erty. The base rent would increase by 10 percent every five years. ➢ Operating Cost Escalator. On top of the base rent payments, the state would be respon- sible for paying annual changes in the owner’s operating expenses. The operating costs would be set at a fixed amount when the buildings are purchased and adjusted each year by the change in the Consumer Price Index. ➢ Property Tax Credit. As a government, the state does not currently pay property taxes on state buildings. The base rent included in the offering memorandum assumes that property taxes would be assessed on the properties. Under Board of Equalization rules, however, lease terms (including options) over 35 years are considered the equivalent of ownership, meaning that the state would still be considered the owner of the buildings for tax purposes. The state would be provided an annual credit against its rent equal to the amount of taxes not assessed on the basis that market rents reflect property tax costs. ➢ Right of First Refusal. If the owner receives an offer from a third party for the purchase of one or more of the properties, the state would have an opportunity to purchase the prop- erty under the same terms as the third-party offer. ➢ Upgrades. The owner would repaint all interior surfaces every five years and replace all floor coverings every ten years. ➢ Subleasing. The state may sublease any portion of the space. These lease terms would apply to all of the properties with the exception of the California Emergency Management Agency Headquarters. Due to the building’s specialized purpose in re- sponding to emergencies, DGS structured the proposed lease so that the state would maintain responsibility for all building services. LEGISLATIVE ANALYST’S OFFICE 11 AN LAO REPORT provide the most important information for decid- Elimination of Debt. A successful sale would ing how to proceed with the sale-leaseback. In eliminate debt that the state owes on eight of the researching the sale-leaseback, however, we en- facilities. As shown in Figure 6, the state has ap- countered other issues, which we address below. proximately $1 billion in outstanding lease-reve- Transfer of Risk and Increased Cost Pre- nue bonds remaining on the buildings proposed dictability. Leasing the facilities would result in for sale. As described above, the state would more budget certainty through fairly predictable use the sale proceeds to pay off the remaining lease payments while avoiding the risk of unex- principal debt and therefore would not have to pected and large costs associated with special pay most of the $467 million in interest costs capital repairs and renovations. In other words, (approximately $65 million of the interest would the risk of unexpected costs would shift to the still be paid to bondholders as compensation for new owner. The lease payments would not be retiring the bonds earlier than scheduled). completely predictable because in addition to While lowering the state’s debt is typically the base rent, the state would be responsible for good policy, the benefit of eliminating the debt paying increases in operating costs which would through a sale-leaseback transaction is illusion- fluctuate according to inflation (as measured by ary. First, the avoided debt service would be im- the Consumer Price Index). mediately replaced with costlier rental payments In addition to the cost predictability, leasing to the new owners. Although the rental pay- the facilities should guarantee that the buildings ments would not likely be considered debt in an receive adequate maintenance and investment. accounting sense, they would still be an ongoing During budget shortfalls, the state has tended to obligation of the state in future years. reduce expenditures for maintenance projects. Proponents have also suggested that elimi- Under the sale-leaseback, the ongoing lease pay- nating the debt would improve the state’s credit ments would be fixed obligations. position. The state currently has approximately $73 billion in outstanding general obligation and Figure 6 Debt on Proposed Sale-Leaseback Properties as of July 1, 2010 (In Millions) Remaining Remaining Total Remaining Debt Building Principal Interest Payments Debt Service Retirement Date Capitol Area East End Complex $381.1 $197.7 $578.8 2027‑28 Franchise Tax Board Complex 231.7 139.6 371.3 2029‑30 Earl Warren and Hiram Johnson Buildings 201.5 66.0 267.5 2021‑22 (Civic Center) Elihu Harris Building 101.1 40.3 141.4 2022‑23 Junipero Serra State Building 36.4 10.8 47.2 2019‑20 Attorney General Building 37.2 9.5 46.7 2019‑20 Public Utilities Commission Building 17.8 1.8 19.6 2013‑14 Ronald Reagan State Building 17.0 1.0 18.0 2010‑11 Totals $1,023.8 $466.7 $1,490.5 12 LEGISLATIVE ANALYST’S OFFICE AN LAO REPORT lease-revenue bonds plus an additional $58 bil- would no longer have control over each build- lion in authorized, but unissued bonds. Eliminat- ing’s operation and condition. Assuming DGS ing the comparably small bond debt on these and CBRE effectively incorporate minimum eight buildings—less than 2 percent of the state’s standards for the operation and condition of the total debt—is unlikely to have a significant effect buildings into the lease agreements, the state on the state’s debt ratios. Additionally, the state’s should be guaranteed a certain building stan- low credit rating is largely due to the state’s struc- dard even though it will no longer operate the tural budget deficit, which one-time solutions buildings. Another concern was whether the such as the sale-leaseback do not address. state would maintain control over subleasing Loss of Building Control. One concern decisions. For example, daycare providers in the raised with the sale-leaseback is that the state buildings were concerned that the new owners e c M S o StiMating the oSt oF aintaining tate wnerShiP o o b F the FFice uildingS There are four main costs of owning and operating the state’s office buildings: debt service, operations and maintenance, utilities, and special repairs. Only the debt-service payments are known with certainty. In forecasting the remaining costs, we attempted not to understate the potential costs and risk of the state continuing to own the buildings. Although not represent- ing the worst-case scenario (we would not expect major failures in every building due to the diversity of the portfolio), we sought to provide significant allowances for major repairs and minor renovations. Our forecast starts with the Department of General Services’ (DGS’) esti- mated 2010-11 expenditures for operations and maintenance, utilities, and special repairs, and increases them each year by inflation. Then, in order to capture risk and potentially increasing costs as the buildings age, we did the following: ➢ We assumed additional capital reserves above DGS’ estimates. To meet the need for capital repairs and tenant improvements, DGS sets aside funds each year into capital reserve accounts for each building. We increased the set aside by 50 percent. ➢ We assessed additional costs to each building every five years that increase as the buildings age. These costs are meant to capture potential costs for system failures, capi- tal upgrades, and minor renovations. Our cost estimate does not include the potential costs of major renovations, and also does not acknowledge the residual value of the buildings and land at the end of the forecast period. We assume these values would tend to offset each other. The state also receives a small amount of revenue by charging for parking at some buildings and leasing space to daycare providers and retail (for example, credit unions and coffee shops). We assume these revenues increase at the rate of inflation. LEGISLATIVE ANALYST’S OFFICE 13 AN LAO REPORT could raise their rents or evict them. Under the state would have the added flexibility to sublease proposed lease terms, however, the state would unneeded space to nonstate entities. In our view, lease the entire building and continue to have the subleasing potential is minimal. Many of the authority over which space is subleased and at buildings proposed for the sale-leaseback con- what price. For example, the state could contin- tain state government functions that are not likely ue to subsidize rental rates for daycare providers. to be eliminated or relocated so the availability Opportunities for More Subleasing. In of space for subleasing would be limited. In the promotional materials, DGS has highlighted event that downsizing did create some vacant the limited subleasing capacity in state-owned space, the state would receive the same benefit buildings. In order to maintain the tax-exempt by relocating other state agencies with shorter, status of the buildings’ financing, the amount of less favorable leases into the sale-leaseback space that can be subleased to nonstate entities properties as it would from leasing the space to is limited. One purported benefit of the sale- nonstate entities. leaseback is that under nonstate ownership, the FISCAL ANALYSIS If DGS finds a buyer and accepts an agree- is, adjusted for the principle that money available ment on a sale-leaseback, the Legislature would at the present time is worth more than money have 30 days to review the transaction and deter- available in the future), the difference is consider- mine if the state should enter into the agreement. ably less. This is because the greatest costs are As described above, the annual cost of owning heavily discounted because they occur in the the facilities would likely be much less than the latter part of the 35-year period. Still, in present cost of leasing the facilities over the long run. In value terms, the leasing costs are greater than the evaluating the deal, the Legislature would need one-time revenue. The sale-leaseback is project- to consider whether the benefit of the one-time ed to cost the state an additional $600 million to revenue from selling the facilities would be large $1.5 billion. enough to compensate for the higher costs in A simple way to measure the cost in pres- subsequent years. ent value terms is to think of the sale-leaseback As described above, we estimated the cost of as a loan with interest—the state receives cash maintaining state ownership of the office build- up front through the sale with the obligation to ings and compared it to the cost of leasing the pay it back over time through lease payments. facilities under the terms proposed in the sale- As shown in Figure 7, the state’s effective interest leaseback. Over a 35-year period, we estimated rate would be between 7.1 percent and 14.3 per- the cost of leasing the facilities would be over cent. These interest rates are greater than those $5 billion more than the cost of state ownership. the state is currently paying on the buildings’ out- As shown in Figure 7, these costs greatly exceed standing lease-revenue bonds and greater than even the more optimistic estimate for sale reve- the effective interest rates on the state’s recently nue presented earlier. In present value terms (that issued general obligation bonds. 14 LEGISLATIVE ANALYST’S OFFICE AN LAO REPORT Single Portfolio Versus Individual Sales. The The number of years over which the sale- above calculations combine the revenue and leaseback is analyzed is another parameter that costs of the state’s entire portfolio of 11 buildings effects the outcome of the analysis. For example, under the assumption that all of the buildings are if the analysis only covered the initial lease term sold. The bidders, however, are required to sub- of 20 years, the sale-leaseback would appear mit prices for each building and the legislation more favorable because the growing costs in the does not require DGS to sell every property. The later years would not be included. We chose 35 DGS and the Legislature, therefore, could choose years for the evaluation period not only because to analyze each building separately rather than it represents a reasonable useful life for the build- as a single portfolio. Such an analysis could find ings in the portfolio but also because it is likely that it is less costly to sell and lease back some that the state would renew its leases on these buildings compared to others in the portfolio. For buildings due to their role in providing govern- example, the state could receive a high bid on ment services, historic status, or proximity to one building for which DGS currently has high other government buildings. For this reason, a operating costs and decide to sell that building shorter time frame would understate the cost of while rejecting the remaining offers. the leaseback in our view. For example, limiting Results Sensitive to Various Factors. Our the analysis to the initial 20-year term would not calculations were based upon a specific set account for the significant costs in the following of data and assumptions. If new information years of renewing the lease or leasing, buying, or became available or the assumptions were building alternative space for these government changed, the analysis could be quite different. functions. One of the larger uncertainties is estimating Another factor open to different interpreta- the cost of maintaining state ownership of the tions is the time value of money. Placing a larger buildings due to the various risks and unknowns emphasis on near-term revenues and costs, for associated with building ownership. As described instance, would make the sale-leaseback more previously, we attempted to address this uncer- attractive. The level to which the transaction’s tainty by estimating these costs so as to not over- future costs should be discounted depends upon state the potential benefit of state ownership. an individual’s expectations about inflation, risk, and the value of future generations. Figure 7 Estimated Revenue and Cost of Sale-Leaseback Compared to Status Quo (In Billions) One- Cost Differential Over 35 Years Time Cumulative Net Present Effective Scenario Revenue (Nominal) (Net Present Value)a Value of Sale-Leaseback Interest Rate Governor's budget sale price $0.6 $5.5 $2.1 ‑$1.5 14.3% More optimistic sale price 1.4 5.2 1.9 ‑0.6 7.1 a Net present value with 5 percent discount rate. LEGISLATIVE ANALYST’S OFFICE 15 AN LAO REPORT RECOMMENDATION The above calculations provide some un- tion among many for balancing the budget. In derstanding of the true underlying cost of the deciding whether to endorse the sale-leaseback, sale-leaseback by showing how the lease pay- the Legislature will need to consider how its ments impact the state’s budget beyond the costs compare to other alternatives for address- budget year. The state originally invested in these ing the state’s budget shortfall, such as reducing buildings because it was determined that owning expenditures and/or augmenting revenues. Given state office space would save money compared the array of difficult budget options before the to leasing. Based on our analysis of the proposed Legislature, it would be difficult to specify how sale-leaseback, this continues to be true as the the sale-leaseback would compare. In general, cost of leasing back the buildings would exceed however, we would encourage the Legislature to the sale revenue. As a result, we would normally strongly consider other alternatives to the sale- not consider the sale-leaseback a reasonable leaseback. And, more specifically, we recom- budget solution since it would add to the struc- mend the Legislature reject the sale-leaseback if tural deficit in order to address the current bud- the sales revenue is at the lower end of the range get shortfall. Paying for the state’s annual costs presented in this report—near the Governor’s of running its programs with a one-time sale of revenue estimate, for example—as the effective critical state assets is poor fiscal policy. interest rate would be too high and make other In the current budget environment, however, options preferable. the sale-leaseback represents one imperfect op- NEXT STEPS If the bids do not match the administration’s bidding complete and terms agreed to, DGS will expectations, DGS could decide to stop the sale- be able to provide the actual sale price and lease leaseback without seeking the Legislature’s input, terms so that a more thorough analysis can be similar to DGS’ actions for the sale of the Orange completed to show the actual benefits and costs County Fairgrounds. If DGS decides to move for- of the sale-leaseback. The estimates in this report ward with the sale, the department is required to were based upon the lease terms proposed in provide details to the Legislature 30 days before the offering memorandum and assumptions completing the transaction. The 30-day reporting about how buyers would react to the sale. With requirement was included to ensure the Legisla- the actual numbers available, the Legislature can ture had an opportunity to examine the terms of use this notification period to scrutinize the deal the sale-leaseback and consider the matter again and stop the sale if it is unfavorable to the state. once all the information is available. With the 16 LEGISLATIVE ANALYST’S OFFICE