Public-Private Partnerships: Pilot Program Needed to Demonstrate the Actual Benefits of Using Partnerships
Released: 2001-08-24T00:00:00

Letter

Background

The U.S. government is one of the world’s largest property owners, with a real estate portfolio of over 400,000 defense and civilian buildings and over one-half billion acres of land. As we and others have previously reported, federal asset managers are confronted with numerous challenges in managing this multibillion-dollar real estate portfolio, including a large deferred maintenance backlog and obsolete and underutilized properties. These challenges must be addressed in an environment marked by budgetary constraints and growing demands to improve service. In response to this backlog and limited funding for repair and alteration requirements, we have suggested that the Congress consider providing the Administrator of GSA with the authority to experiment with funding alternatives, including public-private partnerships, when they reflect the best economic value available for the federal government.

The Congress has already enacted legislation that provides certain agencies with a statutory basis to enter into partnerships. This additional property management tool has been provided to the Department of Veterans Affairs and the Department of Defense. In an effort to provide more agencies with a broader range of property management tools, two bills were introduced, but were not passed, in the 106th Congress that addressed issues of federal property management. The Federal Property Asset Management Reform Act of 2000, S. 2805, would have amended the Federal Property and Administrative Services Act of 1949 to enhance governmentwide property management. Among other provisions, the act would have allowed federal agencies to out-lease underutilized portions of federal real property for 20 to 35 years and retain the proceeds from the transfer or disposition of real property. The Federal Asset Management Improvement Act of 1999, H.R. 3285, provided for the use of (1) partnerships with the private sector to improve and redevelop federal real property, (2) performance measures for federal property management, and (3) proceeds from these partnerships being retained for the improvement of federal real property. Neither of these bills was passed, but their provisions reflect the kinds of actions that could be taken to address the issues surrounding the management of federal real property.

Public-Private Partnerships Could Provide Important Benefits to GSA

The hypothetical public-private partnerships our contractors developed and analyzed for 10 specific GSA properties indicated that partnerships could be a viable management tool. However, more detailed feasibility studies would need to be done before partnerships are undertaken. In addition, we did not compare the benefits of public-private partnerships with other alternatives for addressing problems in federal buildings, such as appropriations for renovations. Such an analysis of all alternatives would need to be performed so that the alternative offering the best economic value for the government could be chosen. OMB staff indicated that where there is a long-term need for the property by the federal government, it is doubtful that a public-private partnership would be more economical than directly appropriating funds for renovation.

Public-private partnerships can take on many different forms. The potential benefits of any partnership would be largely defined as the partnership is being formed. The various aspects of the partnership arrangement would be negotiated and agreed upon, such as the terms of the master ground lease, which is the mechanism the federal government would use to lease its property to the partnership, and the redevelopment strategy. Both the private sector and government would share in the distribution of cash flows generated by the property.

The hypothetical partnership scenarios developed by our contractors for this study entailed some basic assumptions about the structure of the partnerships but did not detail the specifics of each partnership. For example, the hypothetical partnership scenarios did not guarantee government occupancy of the properties. However, depending on how OMB scores these transactions, some of the scenarios could trigger capital lease-scoring requirements due to the implicit long-term federal need for the space. These issues will need to be further explored before public- private partnerships are created.

The redevelopment strategies developed for each property ranged from repairing and modernizing the existing building to demolishing the existing building and increasing the amount of office space by rebuilding multiple buildings on the same site. According to our consultants, the analysis of the partnerships for many of these properties showed a sufficient potential financial return to attract private sector interest in a partnership arrangement. Multiple potential benefits to the federal government of public-private partnerships were also identified. These potential benefits include the utilization of the untapped value of real property, conversion of buildings that are currently a net cost to GSA into net attainment of efficient and repaired federal space, reduction of costs incurred in functionally inefficient buildings, protection of public interests in historic properties, and creation of financial returns for the government.

When deciding whether to enter into a partnership, the government will need to weigh the expected financial return and other potential benefits against the expected costs, including potential tax consequences, associated with the partnership. Any cost associated with vacating buildings for the renovation work to be done would also have to be considered in any alternative that is evaluated.

For a public-private partnership to be a viable option, there must be interest from the private sector in partnering with the government on a selected property. The potential private sector partner’s return from the partnership is a critical factor in its decision on whether to partner with the federal government. According to our contractors, about a 15-percent IRR would likely elicit strong interest from the private sector in a partnership. However, this is only one factor, and the circumstances and conditions of each partnership are unique and would have to be evaluated on a case-by-case basis by both the private sector and the federal government. For example, a somewhat lower IRR could be attractive if other conditions, such as the risk level, are favorable. In addition, when our contractors discussed possible partnership scenarios with local developers, the developers said that to participate, they would want at least a 50-year master ground lease. The slides in appendix I, containing detailed information on the properties, show that the longer lease period would allow for the private sector to maximize its financial return from the partnership.

Our contractors determined that 8 of the 10 GSA properties in our study were strong to moderate candidates for public-private partnerships. This determination was based on the (1) estimated IRR for the private sector partner in year 10 of the project, which ranged from 13.7 to 17.7 percent; (2) level of federal demand for the space; and (3) level of nonfederal demand for space. The level of demand for space, both federal and nonfederal, affects the level of risk that the space will be vacant and thus non-income-producing. The stronger the local market is for rental space, the more likely the space will be rented and thus be income-producing for the partnership. The properties that were strong candidates for partnerships were located in areas with a strong federal and nonfederal demand for space; and many had untapped value that the partnership could utilize, such as excess land on which a new or expanded building could be built.

Public-private partnerships were not viable for 2 of the 10 GSA properties in our study. This was primarily due to a weak nonfederal demand for space and low financial potential. These properties had estimated potential IRRs of 12.4 and 10.3 percent. In addition to the relatively low IRRs, neither property had the potential of increasing the amount of rentable space available to increase the earning potential of the property, and both were in markets that had vacant office space with little or no demand for new office space.

Many factors can affect the viability of a partnership arrangement. In addition to the local federal and nonfederal demand for space, the actual cost of redevelopment of a property to meet federal needs can greatly affect the viability of a partnership arrangement. The higher the cost of renovation, the longer it will take the partnership to recoup its costs and make a profit, thus affecting the appeal of the partnership to the private sector.

In GSA’s inventory, numerous buildings either have or are at risk of having a negative net cash flow due to their deteriorating condition. Four of the 10 buildings in our study are either vacant or were expected to be vacant by 2002, with little prospect of recruiting other agencies to fill the space because of the condition of the buildings. In addition, two of the other six buildings we studied were at risk of losing their current tenants because of the condition of the buildings.

If public-private partnership authority becomes available, decisionmakers and policymakers will need to consider such issues as budget score- keeping rules, the type of facilities that would be appropriate for a partnership arrangement, and congressional review and oversight. In addition, each property is unique and will thus have unique issues that will need to be negotiated and addressed as the partnership is formed. Great care will need to be taken in structuring partnerships to protect the interests of both the federal government and the private sector. Our study designed a conceptual framework for public-private partnerships in order to identify potential benefits of these partnerships. Our study did not identify or address all the issues of partnerships that will need to be considered by the decisionmakers and policymakers as partnerships are developed.

Conclusion

Action is needed to fix buildings that are in disrepair and have a negative net cash flow due to their deteriorating condition. As a result of the analysis done by our contractors, it appears that allowing GSA and other property-holding agencies to enter into public-private partnerships may enable them to deal with some of their deteriorating buildings. Partnerships could even provide other financial benefits to the federal government, such as reduced operating expenses and increased income that could be used for renovating other federal buildings. The potential benefits of public-private partnerships do not diminish the need for GSA to pursue and consider other alternatives for addressing problems in deteriorating federal buildings, such as federal financing through appropriations or the sale or exchange of property. Regardless of whether public-private partnership authority is provided, the problems with these buildings need to be addressed.

Recommendation for Executive Action

We recommend that the Administrator of GSA use all available strategies to address the problems of buildings in GSA’s inventory that have or are at risk of having a negative cash flow as a result of their deteriorating condition. We also recommend that the Administrator of GSA seek statutory authority to establish a pilot program that would demonstrate the actual benefits that may be achieved from public-private partnerships that achieve the best economic value for the government.

Matters for Congressional Consideration

The Congress should consider providing the Administrator of GSA with the authority to proceed with a pilot program to demonstrate the actual benefits that may be achieved using public-private partnerships that achieve the best economic value for the government as a real property management tool. If such authority is granted, the Congress should consider allowing GSA to enter into master ground leases of sufficient length to attract private sector interest in participating in partnerships with the federal government. Our study found that a 50-year master ground lease was generally sufficient to attract private sector interest. As we stated in April 2001, Congress should also consider allowing agencies to retain the funds from real property transactions. If such authority is granted, Congress should continue its appropriation control and oversight over the use of any funds retained by agencies.

Agency Comments

On June 28, 2001, we received written comments on this report from GSA’s Commissioner for the Public Buildings Service. He agreed with the findings and recommendations in our report and noted a range of property management tools that GSA is currently using to address the physical conditions of its real property inventory. These comments are reprinted in appendix II. GSA officials also provided technical comments, which have been incorporated as appropriate.

Methodology

As suggested in your request letter and discussed with your offices, we hired contractors to develop and analyze hypothetical partnership scenarios for 10 selected GSA buildings to identify the potential benefits to the federal government and private sector of allowing federal agencies to enter into public-private partnerships. GSA’s National Capital Region had previously contracted for a study to analyze the financial viability of public-private partnership ventures for three buildings in Washington, D.C. As agreed with your offices, because the majority of the work for these properties had already been done, we had the contractor update its work on these 3 buildings and selected them as 3 of the 10 GSA properties.

To help us select the other 7 properties for our study, GSA provided a list of 36 properties that it considered good candidates for public-private partnerships. In preparing this list of properties, GSA officials said that they considered factors such as the strength of the real estate market in each area, the extent to which the property was currently utilized or had land that could be utilized, and the likelihood of receiving appropriations to rehabilitate the property in the near future. We judgmentally selected seven properties from this list to include properties (1) from different geographic areas of the country, (2) of different types and sizes, and (3) with historic and nonhistoric features.

To analyze the potential viability of public-private partnerships for each of the 10 selected GSA properties, the contractors did the following: analyzed the local real estate markets, created a hypothetical partnership scenario and redevelopment plan, and constructed a cash flow model.

In the contractor’s judgement, the partnership scenarios were structured to meet current budget-scoring rules and provisions in H.R. 3285. These provisions included the requirements that the property must be available for lease in whole, or in part, by federal agreements do not guarantee occupancy by the federal government; government will not be liable for any actions, debts, or liabilities of any person under an agreement; and leasehold interests of the federal government are senior to those of any lender of the nongovernmental partner.

However, a determination on how the partnerships would be treated for budget-scoring purposes would have to be made after more details are available on the partnerships.

We accompanied the contractor on the visits to the seven GSA properties that had not been previously studied. We interviewed or participated in discussions with developers and local officials in the areas where the properties were located and officials from GSA. We reviewed the contractors’ work on the 10 properties for reasonableness but did not verify the data used by the contractors.

The partnership viability scenarios developed for this assignment are hypothetical, based on information that was made readily available by representatives of the local real estate markets, city governments, and GSA. Any actual partnerships involving these properties may be very different from these scenarios. In-depth feasibility studies must be done to evaluate partnership opportunities before they are pursued. There may be other benefits and costs that would need to be considered, such as the possible federal tax consequences and the costs of vacating property during renovation in some cases.

This study only looked at the potential benefits to the federal government and private sector of public-private partnerships as a management tool to address problems in deteriorating federal buildings. We did not evaluate the potential benefits of other management tools that may be available for this purpose. We did, however, discuss the implications of using public- private partnerships with OMB representatives.

We did our work between November 2000 and June 2001 in accordance with generally accepted government auditing standards.

As agreed with your offices, unless you publicly announce the contents of this report earlier, we plan no further distribution of it until 30 days from the date of this letter. We will then send copies to the Chairmen and Ranking Minority Members of Committees with jurisdiction over GSA, the Director of OMB, and the Administrator of GSA. We will make copies available to others upon request.

Major contributors to this report include Ron King, Maria Edelstein, and Lisa Wright-Solomon. If you or your staff have any questions, please contact me or Ron King on (202) 512-8387 or at ungarb@gao.gov or kingr@gao.gov.

Appendix 1: Potential Benefits of Public- Private Partnerships

Briefing Contents

Appendix I: GSA Properties Analyzed

Identify the potential benefits to the federal government of entering into public-private partnerships

Reviewed the consultant’s work for reasonableness but did not

The partnership viability scenarios developed for this assignment are hypothetical based on information readily available from people in the local real estate markets, city officials, and GSA. Any actual partnerships involving these properties may be very different from these scenarios. In- depth feasibility studies must be done to evaluate the partnership opportunities before they are undertaken.

Property must be available for use in

Investment

Cash flow Preferred return (to the private partner)

Creates financial return for the government

Repair and modernization (FOB 8, Minneapolis,

Jacksonville, Columbia)

Demolition of existing building and rebuild like building (Andover, Charleston)

Repair/modernize existing building and construct new building on excess land (Portland)

Construct new building on underutilized land and outlease existing buildings and property (Seattle)

Repair/modernize existing building and construct new space (GSA HQ, FOB 9)

Appendix 1: GSA Properties Analyzed by Consultants

Current Conditions

Redevelopment Strategy Analyzed

Completely renovate existing VA Regional Office Building No excess land for development Parking to be provided by new parking garage to be completed in June 2001, for all federal buildings in the complex

Potential Proceeds to Partners

(50 Year Master Lease)

Potential Proceeds to Partners

(50 Year Master Lease)

Current Conditions

Eight level building specifically constructed to house the Food and Drug Administration (FDA)

FDA is scheduled to vacate the building in 2001 and return it to GSA, free of FDA-generated hazardous materials, in 2002 Very desirable location, proximity to the Capitol, Smithsonian, and the Mall Completely renovate the building to greatly update and functionally improve the space Recapture existing laboratory space as office and add an additional 150 parking spaces to the existing 50 in the basement level.

Potential Proceeds to Partners

(50 Year Master Lease)

Current Conditions

Potential Proceeds to Partners

Master Lease Term Comparison Net (50 Year Master Lease)

Business District location (due to access and parking constraints)

Potential Proceeds to Partners

Master Lease Term Comparison Net (50 Year Master Lease)

Current Conditions

Potential Proceeds to Partners

Master Lease Term Comparison Net (50 Year Master Lease)

Appendix II: Comments From GSA

Glossary

Building Owners and Managers Association International, a trade association of the office building industry, that developed a standard method of floor measurement in square feet for commercial real property.

Cash Flow

Net operating income minus master ground lease, debt service, and replacement reserve.

Central Business District

A designated downtown section of a city, generally consisting of retail, office, hotel, entertainment, and government land uses with some high- density housing.

Debt Service

Amount required for payments of interest and principal (often insurance and tax escrows, too) on money owed.

Discount Rate

Percentage rate used in discounting cash flows in calculations of net present value.

Federal Budget Scoring

The process of estimating the budgetary effects of pending and enacted legislation and comparing them to limits set in the budget resolution or legislation. Scorekeeping tracks data such as budget authority, receipts, outlays, and the surplus or deficit.

Gross Square Feet

Total enclosed floor area of a building measured in square feet.

Ground Lease

A lease for the use and occupancy of land only for a period of time.

Interest Rate

The rate of return charged by a lender for the use of funds, expressed in the form of a percentage per year.

Internal Rate of Return

The present value interest rate received for an investment consisting of payments and income that occur at regular periods; measures the return, expressed as an interest rate, that an investor would earn on an investment.

Lease

A written agreement between the property owner and a tenant (lessor) that stipulates the conditions under which the tenant (lessee) is entitled to use the property (in this case, real property) in return for periodic payments (rent) for a specified period of time.

Master Lease

A controlling lease under which all other interests in the real property are subordinate; for example, if a master lease is for a 5-year term, a sublease cannot legally exceed 5 years.

Net Cash Flow

Cash flow minus preferred return to the private partner.

Net Operating Income

Operating income minus operating expenses.

Net Present Value

Method of converting a cash flow stream over a number of years into the value of that money today, using an appropriate discount rate, in order to make investment decisions.

Operating Expenses

Broad term used to describe the expenses incurred in ordinary recurring activities of a property as opposed to nonrecurring items.

Operating Income

Earnings from normal operations that do not take into account proceeds from nonrecurring items.

Preferred Return

A distribution of income to the private partner prior to the distribution of net cash flow in accordance with the terms of the partnership, generally to compensate the private partner for its cost of capital and risk incurred.

Present Value

Value today (or at some specific date) of an amount to be paid or received later.

Public-Private Partnership

An arrangement by which the federal government contributes real property and a private entity contributes financial capital and borrowing ability to redevelop or renovate real property to serve, in part or in whole, a public need.

Rentable Square Feet

A term used in the commercial real estate market that includes occupiable square feet plus the tenants’ proportional share of common building areas, such as rest rooms, exit stairways/fire corridors, and lobbies.

Replacement Reserve

Amount set aside from net operating income to pay for renovation or replacement of short-lived assets.

Square Foot

Unit of area measurement equal to a square measuring one foot on each side.

Sublease

An arrangement whereby a lessee leases the property to a different end user while the lessor maintains ownership and the lessee retains all of its obligations under the lease; terms cannot exceed that of a master lease.