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/0':-88 Redwood Shores Child Care Report 11/13/00 Attachment I Page 1 of 2 Additional Measures of a Project's Value: Other measures of a development project's worth include the capitalization rate (stabilized net income after completion divided by the capitalization rate equals the projected value of the project) and the internal rate of return of the project's future cash flow. To determine the facility's value upon completion, Mr. Keech has used a capitalization rate of 11 %. This is considered a high capitalization rate. Mr. Keech asserts that the building's limited use and the fact that he will not own the site add to the project's risk, and that the resulting risk justifies a high capitalization rate. When a development project's net operating income is divided by the appropriate capitalization rate, the projected value of the asset should exceed its projected development cost. Mr. Keech was unable to produce excess value by developing a project consisting solely of 10,000 square feet of childcare. (A lower capitalization rate, however, would have produced excess value.) At 15,000 square feet, the project produced approximately $650,000 of excess value, which Mr. Keech determined acceptable. Staff further estimated the internal rate of return to equity to evaluate the project's projected value. The internal rate of return is the yield on the up-front cash (equity) produced by the receipt of future income and a future sale of the asset. Assuming a 1 O-year holding period with a three percent annually increase in rental rates and an 11.5% capitalization rate (to allow for uncertainty about the future, an increase in the capitalization rates to estimate the sale value of the building at the end of the holding period is considered appropriate), the projected cash flow is estimated to produce a yield of approximately 29.8 percent on the initial equity investment. Keyser Marston informed staff that in today's investment environment, equity seeks, and is getting, estimated yields in the mid-twenty's. Given the limited ownership features of a site lease and the restricted use of the facility, Keyser Marston believes that a projected yield to equity of 29.8 percent is not unreasonable. Calculation of land Subsidy: The cost to the developer of making the site developable (costs that the City would ordinarily assume if it were to ready the site for sale or lease) is approximately $700,000, or $13.50 per square foot of developable area (1.2 acres). Since these improvements will revert to the City at the end of the site lease, the developer is in effect paying the City approximately $700,000 for the use of the site. By comparison, the Pacific Shores project (for which the City recently commissioned an appraisal in connection with the Mello- Roos bonds associated with that project) was valued in its (then) unimproved "as is" condition at $27.84 per square foot of developable area. Even allowing for a less desirable location and the non-ownership nature of the site-lease, it is fairly clear that the developer is paying something less than full market value for use of the City's site.