Richard Podos, president and CEO of Lance Capital, has come up with a way to "rentalize" tenant improvement costs -- costs governments pay when they move into a commercial space. In a recent conversation, he explained what he means by "rentalize" and talked about how his approach could help a state's or locality's bottom line in this edited transcript.
What's the problem you're trying to solve?
Currently, state and local governments are looking for ways to reduce their real estate footprint, like consolidating different offices into fewer buildings and less square footage. When you do that, it costs a bunch of money to reconfigure office space. In the commercial real estate office market, when a tenant leases say 100,000 square feet, the landlord will contribute a certain amount of tenant improvement funding. In general, however, that tenant improvement contribution is not nearly enough to build out the space. The tenant is required to use their own dollars to build out the space. So problem one is that while consolidating is a good idea, using budget dollars for tenant improvement is difficult in and of itself. Problem two is construction. Given a choice, most state and local governments would rather have the landlord handle construction because the private-sector operator can be more efficient in getting it done in terms of total cost and timing.
How does your approach ease the financing of new space?
We offer a special loan to a landlord that increases the amount of tenant improvement to cover an entire project budget. Thay way, the state or local government doesn't have to use its own budget dollars and it lets the landlord take care of construction activity. The highlight example is from New York City, where the department of health and human services consolidated from six locations in Brooklyn to one and reduced the square footage from 600,000 to 400,000 -- which is huge savings. We funded the tenant improvement budget of $45 million. That is, we lent money to the landlord who paid for the entire tenant improvement budget. To pay back the loan, the city is paying an additional strip of rent associated with tenant improvements. There's another benefit: The city has converted to rent what would have been a direct capital expenditure. Rent is an administrative expense, and 70 percent of the rent for health and human service agencies is reimbursable by the federal government.
The city comes out ahead because its costs are lower. In the case of the New York deal, the city is using its own occupancy as an economic revitalization tool. The building it is moving city services into is in a neighborhood -- Fort Greene -- that's been economically challenged for a long time. By consolidating and moving into 400,000 square feet, the city is bringing thousands of jobs into the neighborhood as well as agency clients who will come to the facility.
What are the risks to this kind of deal? States and localities are increasingly wary, as they should be, of complicated Wall Street financing.
There's nothing tricky here. It's very simple. Any city or state real estate agent would totally understand the moving parts as would the agencies and anyone from a mayor's office. The locality pays rent. The landlord takes out a tenant improvement loan from us. We issue taxable municipal bonds in the private placement marketplace. We're cognizant that rating agencies pay attention to rent as part of a city's or state's overall financial condition. But this does not go on the balance sheet as debt.
We are using a special form of financing related to the municipal bond market. In the middle of our working on this deal, Standard & Poor's downgraded the U.S. credit rating. We freaked out. What would this mean for the municipal bond market? At the end of the day, the municipal bond market was and is still healthy, and we did the deal -- a taxable bond -- at a great rate.
Investors had concerns. When we were syndicating this New York City deal to our institutional investors, they asked, "What happens if New York City goes bankrupt?" You don't want to talk about it, but you have to. Thirty-five years ago, the city almost did. I turned to the investors, and said, "Okay, let's play out that thought-exercise. If the economy is so bad New York City is going to go bankrupt, there's a difference between bonds and leases. With leases, the city either stays put and pays the rent or cuts out and walks away. Would the city government politically make a decision to reject a lease for its welfare department in Brooklyn? Politically, it's a nonstarter." This deal makes it more attractive for investors.
