Economic and Development Services

MEMORANDUM

To:  John Warner
Portland Development Commission    

From:    Eric Hovee & Tess Jordan

Subject:  Economic Feasibility Analysis Review – Headwaters Apartments

Date:    May 12, 2004

This memorandum provides a review of the financial feasibility of the proposed Headwaters Apartments. As proposed, the project comprises a 100 unit apartment development featuring green building elements including a daylighted creek on-site. The project is proposed for SW Dolph Court and SW 30^th Avenue, just west of Barbur Boulevard.

This review memorandum is organized to cover the following topics:

Summary Observations
Review Purpose & Approach
Pro Forma Review
Stress Testing
Financial Feasibility Options

A preliminary draft of this report was provided for review and discussion with PDC. Revisions have been made based on questions and comments received. This updated memorandum also reflects updated pro forma financial modeling conducted by PDC.

SUMMARY OBSERVATIONS

A project pro forma was provided by PDC; this memorandum offers comment on the project’s assumptions, over-all risk and feasibility. In general, we have found the pro forma to be very thorough and well organized.

Based on this review, the primary risks associated with the project appear to be market related, notably:

•  Ability to realize projected rents; and

•  The associated risk of a longer than anticipated schedule for lease-up.

While these risks are present for all apartment projects, they are worth noting for this project because it is in a somewhat pioneering location, in which it will ask significantly higher rents than existing vicinity area properties.

The project’s success will also be influenced by its neighboring uses – most notably, the Aladdin Motel immediately to the east. While the project site does offer some neighborhood retail within a half-mile radius along Barbur Boulevard (e.g. a dry cleaners and coffee shop), retail is not within a pedestrian-oriented environment. Any influence that the city can have in encouraging commercial redevelopment of the project’s immediate vicinity will benefit the project.

The proposed Headwaters Apartments will offer high end finishes and on-site open space, including the creek. These amenities together with location in the generally higher income area of Southwest Portland should serve to attract higher rents. The crucial question associated with this project is whether green design features alone can support top of the market rents for what might otherwise be considered a secondary near-suburban location.

Whether or not the project can realize its target rents has primary relevance to the project’s return rates, rather than its ability to cover its debt obligations. Stress tests performed by both PDC and for this review indicate that average rent would need to fall by 18% below projections to compromise its ability to repay its primary City Lights bonds.

The primary consequence of less than optimal market acceptance would be deferred developer payment and lower returns on the City’s investment; debt service obligations could still be met from project revenues. Given the public objectives this project strives to achieve, this may be an acceptable level of project performance. Other options for mitigating future performance below projections are also suggested in this report – including increasing PDC equity, payment-in-lieu-of-tax (PILOT) deferral, neighborhood and business improvements, and/or condo conversion.

REVIEW PURPOSE & APPROACH

The approach we have taken to this review is influenced by the character of this project and purpose for which the assessment is to be used.

Purpose: The primary purpose of this review is to provide an independent third-party assessment of the market and financial feasibility of the proposed Headwaters Apartment project. More specifically, this review is intended to comment on the project’s assumptions, over-all risk and resulting financial feasibility.

This purpose and resulting assessment approach is influenced by the following specific project features – including ownership and design – which are unique to the Headwaters Apartments:

•  Funding is proposed primarily via revenue bonding of the City of Portland’s new City Lights Housing Program – intended to stimulate both moderate and middle income housing not currently being built and contribute to public purposes including green design elements that the private market would not generally provide on its own.

•  Repayment of City Lights bonding for this project is assured by: a) the full faith and credit of the City; and further by b) PDC commitment to backstop repayment by covering any deficiency in debt service not covered by project cash flow.¹

•  Consequently, while repayment is essentially guaranteed, financial viability of each project is nonetheless important to the City of Portland – in the context of maintaining the City’s overall credit rating and standing in financial markets.

•  Successful financial performance of Headwaters is particularly important as the first multi-family project to be funded by City Lights – the results of which set a precedent for other multi-family projects to follow.

•  While PDC has long been involved in funding and financial incentives for housing throughout the City of Portland, Headwaters will be the first multi-family development that is owned directly by PDC and maintained in a new permanent portfolio of PDC owned housing.

•  Finally, PDC is looking for pay-back of its project equity in a maximum of 10 years.

As this listing indicates, Headwaters Apartments is being developed for reasons that extend beyond the financial objectives typical for private developers. In effect, there is a public return on investment that goes beyond monetary values alone. However, for reasons noted above, it is important that the proposed project perform well from a financial perspective as well. It is to the objective of successful financial performance that this review is primarily addressed.

Approach: The approach taken to this feasibility assessment has involved a review of background documentation provided by PDC, meeting with PDC and phone contacts with both PDC and the City Office of Management & Finance (OMF), contacts with representatives of similar projects, and review of in-house files for comparable developments. Key documents reviewed include:

•  Rent Survey: The Proposed Headwaters & Tryon Creek Apartments conducted by PGP Valuation, Inc. for PDC.

•  Financial pro forma worksheets (version 11.1, updated as of May 7, 2004) for the proposed project as provided by PDC.²

A meeting with project staff was held to review pro forma assumptions and methodology. In general, we have found the pro forma to be very thorough and well organized.

Our subsequent review has consisted of formula auditing and comparison of PDC assumptions and results with our own experience in market and financial feasibility assessment for similar multi-family projects in the Portland metro area.

PRO FORMA REVIEW

This review is organized to cover the order of the pro forma worksheet presentation, notably:

A. Sources & Uses of Funds
B. Project Cost & Construction Cash Flow
C. Income & Expense (Normalized & Lease-Up)
D. Operating Cash Flow

Comments made in the following sections are focused on pro forma items and underlying market assumptions that we found to be particularly noteworthy.

A. Sources & Uses of Funds

Anticipated sources and uses reflect what amounts to summary statements drawn from other more detailed portions of the pro forma analysis. Two statements of anticipated sources and uses are provided – for construction and permanent financing. Primary attention is given to permanent financing.

Sources of Funds: The Headwaters pro forma describes a project brought to feasibility with a PDC equity investment of just under $1,150,000. Any substantial cost increases or revenue decreases could result in an increase in this subsidy, if these changes are reflected in revised pro formas prior to finalization of bond financing. If the project receives the full $11.6 million in City Lights Revenue Bonds, rents, occupancy or absorption that falls below the projected levels will result in decreased cash flows, low debt service coverage and decreased return on investment.

Uses of Funds: This permanent uses statement is drawn from and consistent with the detailed projected cost analysis (described below). Major use categories are acquisition, construction, indirect (or soft) development costs and developer fee.

B. Project Cost

Critical cost items on which we focused our attention include construction costs, value engineering, construction contingency and developer fee. As the following narrative indicates, our conclusion is that while project costs are on the high side compared with other multi-family developments, the reasons for added costs are consistent with purposes of the City Lights program and can be supported – to the extent that overall project feasibility is not unduly compromised.

Land Cost: Site acquisition is estimated at $650,000 and includes demolition of existing improvements and haz-mat. Site costs equate to $6,500 per unit which is relatively attractive compared to other projects – particularly for sites closer to the Portland Central City.

Construction Costs: At $88 per square foot (including contingency), construction costs initially appear to be in the mid-to-upper end of the cost range wood frame construction over a concrete podium.³ However, this estimate is affected by what appears to be the inclusion of ground floor parking within the March pro forma building gross square footage (GSF) figure of 112,627 square feet (meaning that the residential component GSF costs are likely higher than this average indicates).⁴ A more comprehensive evaluation of construction cost would be possible by separating residential unit from parking podium costs.

Given this limitation in the cost data provided, another perhaps more useful comparison can be made for all-in cost of land, construction, soft and developer fee. This calculates to approximately $132,390 per unit, or $180 per net rentable square foot (NRSF). This is well above values for newly constructed apartment averages throughout in the Portland metro area but more comparable to apartment costs in the Central City area.⁵

Headwaters incorporates two specific features that increase costs above what would normally be expected for apartment construction – whether in a Central City or less urban location:

•  A higher level of interior finishes and specifications – to condo level quality.⁶

•  Inclusion of green design features – including daylighting of the creek, street design, water quality and interior features.⁷ Together, these add an estimated $1.1 million to project cost, or nearly $15.60 per NRSF.⁸

In summary, the Headwaters Apartments is clearly positioned as needing to compete for Central City rather than suburban rents to recover atypically high costs of construction.

Value Engineering & Construction Contingency: The project’s hard cost estimates initially reviewed (from March 8) included value engineering savings of around $460,000. This projected savings has been removed from the updated pro forma of May 7. This adjustment is accompanied by changes to construction contingency line items. A relatively small construction contingency of 4% (plus a 1.15% cost estimating contingency) has been allocated. However, this appears reasonable since the pro forma represents design at 100% and construction drawings at 30%. PDC’s required $100,000 contingency line item brings total contingency to 6.26% of total hard costs, a relatively low percentage.⁹ It is recommended that construction costs and their impact on the pro forma again be reviewed as construction costs are locked in.

Soft Costs: Soft costs are also significantly lower than average (often in the range of 30%-35%) at just under 16%. If the developer fee which is shown separately is included, soft costs increase to over 20%. Some reasons for soft costs below the norm include low cost for construction financing and low permanent financing costs with City Lights funding.¹⁰ This percentage appears more supportable as numbers are locked in; again, the pro forma should be reviewed if soft costs change appreciably.

Developer Fee: The Headwaters pro forma includes a developer fee of just under $370,000. This is in line with – if not below – fees that public agencies typically offer for multi-year projects.

Construction Cash Flow: One comment relates to lease-up marketing expense, as described in the review of income and expense (below). No other comments are noted.

C. Income & Expense

This review incorporates income/expense statements at: a) stabilized occupancy; and b) on a month-by-month basis over than anticipated year of lease-up. Topics of importance are supportable rents, on-site parking, operating expense, absorption and marketing.

Supportable Rents: Probably the most significant question affecting the feasibility and investment return for the Headwaters project relates to rent levels that are supportable. A critical part of this question is whether the near-Barbur Boulevard location for this project will support rent rates typical for urban versus more suburban developments.

Rent levels recommended by the PGP Rent Survey for the Headwaters Apartments are: $1.29 for 75 one bedroom, one bath units; $1.13 for 24 two bedroom, bath units (and $1.35 for a single one bedroom, one bath unit). Average recommended rent for all 100 Headwaters units is $1.24 per square foot per month.

Base rents contained in the PDC pro forma are close to PGP recommendations, escalated by 2% for projected 2005 completion and initial lease-up, and by 3% annually thereafter. Average base rent indicated by the PDC pro forma is $1.28 per square foot monthly, but this appears to be an average weighted by number of units. A revised project average weighted by square footage comes in at $1.26 per net rentable square foot.

In reviewing the PGP Rent Survey, a wide range of rental rates is noted for the 11 comparable Portland area projects – ranging from a low of $0.78 to $1.73 per square foot (a variation of more than 100%). The comparables can be divided into two categories:

•  Seven urban (Central City) projects – with average rents ranging from $1.06 - $1.73 per square foot.

•  Four suburban (or non-Central City) developments – with average rents ranging substantially lower at $0.78 - $1.13 per square foot.

In making its rent recommendations, PGP focused on a mix of Central City and other projects. The Central City comparables highlighted are located outside the downtown on the eastside and in the Macadam area.¹¹

To test these conclusions, we have taken a somewhat different tack than PGP by essentially excluding all Central City comparables. This approach results in what we would term as a more conservative or worst case view of potential rental rates.

The two closest PGP listed comparables – Capitola Commons and Crescent Hill – are both located in Southwest Portland and report average adjusted rents of $0.83 and $0.92, respectively. These rent rates are 27% - 33% below what is projected for the Headwaters Apartments. However, an important caveat is that these comps are older than the subject property, at between 3 and 7 years old.

A third comparable in a similarly pioneering non-Central City location is Center Commons (at 60^th and NE Glisan St.), with asking rents averaging considerably more at $1.13 per square foot. If adjusted for unit mix comparable to the Headwaters project (with more one bedroom units), average rent would be in the range of $1.16. This adjustment becomes the basis for the added stress test we have provided with this analysis (as described in the last section of this report).

In summary, a primary concern is that the Headwaters Apartments location may not support the rent levels projected. This is reinforced by the observation that the Headquarters location is more comparable to the non-Central City projects reviewed – lacking urban amenities including pedestrian connections to nearby retail services.

The visual and aesthetic barrier posed by neighboring properties, particularly the Aladdin Motel – situated between the proposed development and Barbur Boulevard – further diminishes the attractiveness of this site. The target market of middle income renters who value green building amenities can also be expected to value nearby retail and aesthetic amenities associated with a more urban and pedestrian-friendly environment.

These issues are counterbalanced, at least in part, by the relatively strong demographics of the Southwest Portland area, the anticipated development of adjoining townhomes by Jim Winkler and, most notably, green design features which are essentially unmatched by any other apartment project to date in the Portland metro area. Whether or not these amenities are valued sufficiently to offset the issues noted above remains unproven to date in the Portland market. Mitigating the potential effect of these location-specific issues could prove important to achieving rental rate and absorption expectations.

On-Site Parking: The project’s relatively low parking ratio represents a potential marketing barrier, particularly for its 24 two bedroom units. A ratio of 1 space per unit or less can be expected for an urban Central City project but is low for a suburban development. However, it is likely that street space can accommodate at least some overflow.¹²

If the project’s demographics match those of a project such Center Commons, less than 20 tenants would require an additional parking space. This number could likely be accommodated through street parking.

However, if the on-site parking ratio proves to be an impediment to full lease-up or target rents, the project would benefit from a back-up plan for acquiring additional land or accommodating additional on-site parking within the existing site.

Operating Expense: The Headwaters Apartments operating expenses are calculated to be 24% of effective gross income, or just over $2,600 per unit annually.¹³ This is indicated as a median figure for PDC projects – within a range of $2,300 - $2,900 as reported by PDC. However, it may be on the low side for more urban housing product and residential developed by other housing development agencies.¹⁴

One component of operating expenses specifically noted relates to property management fees, which are most typically 4-5% for projects in which property management assumes a limited accounting function (e.g., is not responsible for mortgage payment). The 3% assumed in the Headwaters pro forma is within the normal range but at the low cut off.

Two added factors indicate the likely need for careful monitoring of operating expense for the first few years as the project is placed in service:

•  Attracting and retaining tenants with a relatively high rent project may require greater than normal levels of operating and maintenance expense. Expenses may also rise if the development experiences abnormally high levels of turnover, with moderate and middle income residents able to transition more readily to owner housing.

•  As the owner of its first apartment development, PDC has no track record of property management experience on which to draw. Controls likely will need to be established to monitor and address unforeseen variations in expenses as they occur, since a private fee management firm may not necessarily have strong incentive to control operating costs (particularly if these costs are passed directly through to the owner).

Absorption & Marketing: The PDC prepared pro forma estimates a six month absorption period to lease-up, or 12 units a month with 20 units pre-leased. Lease-up marketing expense has been allocated in the amount of $100,000 over six months, $25,000 of which is designated as reserves. This budget (including reserves) equates to $1,000 per unit – slightly more than one month (1.08) of free rent, a fairly common incentive in today’s leasing market.

The adequacy of marketing funds is dependent upon the absorption rate the project is able to realize. The risk associated with a pioneering project is that more marketing dollars may be required than initially expected, either for incentives or to sustain marketing through a longer absorption period.

Three potentially comparable projects have been reviewed as to their experience – with more information provided for lease-up than marketing expense:

•  Center Commons (NE 58^th Ave. & NE Hoyt St.) provides perhaps the best available example of an urban apartment product in a fringe, non-Central City location – with asking rents well above those of other vicinity area properties. Although marketing budget information was not available, that project leased its 56 units within 3-4 months, for a pace of about 16 units per month. The developer attributes the project’s short lease-up period to the building’s quality and proximity to both the I-84 freeway and MAX light rail transit service.

•  Vancouver’s recent downtown market-rate apartment project – Vancouvercenter – reports a similar monthly lease-up allocation – although with no associated time frame or budget cap – to market that project’s apartments, retail and office space. That project has realized an absorption rate of around 13 units per month since the fall of 2003 with rents within the range proposed for the Headwaters project – but with substantial leasing incentives offered.¹⁵

•  One project that stands out as an example of the challenges that multi-family projects can face in emerging market situations is Russellville, located in outer Southeast Portland at 102^nd Ave. and Burnside St. It took two years to lease up its 283 units, attributed to its pioneering nature but also to a lack of required lease commitment during its first year, which increased turnover. Its long absorption timeframe is also, however, related to the size of the project – even a two-year period translates into 12 units per month, as is projected for the Headwaters project.¹⁶

While we find there to be some risk associated with this project’s projected absorption, a rate of 12 units per month does not appear to be out of line with the experience of similar projects, provided that rents are viewed as competitive. Less certain is adequacy of the marketing budget. Added reserves might be appropriate in the event that leasing incentives or additional marketing is required to attract tenants to what may considered as a less than prime location.

Capitalized Valuation: The income/expense worksheet provided estimates the capitalized value of the Headwaters Apartments based on stabilized net operating income (NOI) of $837,790 annually. Value is estimated at $11.5 million using a capitalization rate of 7.3%. Even at this relatively low cap rate (predicated on below market tax exempt financing), valuation is $1.8 million less than the project cost of $13.2 million.

With low interest rates, the private market cap rate for Portland area apartment transactions has fallen to 7.6% as of 2003 – suggesting a value of $11.0 million.¹⁷ If interest rates increase and cap rates return to a more normal 8-10% range (say 9%), completed project valuation could fall to about $9.3 million, or $3.9 million below project cost.

This analysis suggests that the value of the completed Headwaters Apartments likely would not be adequate to recover costs in the event that the City and PDC elected to sell the project. In effect, financial feasibility is predicated on the assumption of maintaining on-going ownership of the project as a long-term public asset (consistent with stated City/PDC ownership objectives). This valuation conclusion also means that financial feasibility to the City/PDC is predicated more on cash flow than valuation – a subject to which this analysis now turns.

D. Operating Cash Flow

Two cash flow statements are provided with the PDC-prepared pro forma: a month-by-month projection for the first year of lease-up followed by a separate worksheet providing annual projections over 20 years. With the exception of questions related to the pace of absorption (or lease-up) as described above, no comments are noted for the first year projections. The following comments relate to the longer 20-year projection worksheet.

Income & Expense: Base case annual projections made by PDC appear to be consistent with the stabilized year projections. Revenues are projected forward assuming a 3.0% annual rate of escalation; expenses are projected at a more rapid 4.0% annual rate. Projecting expense growth at a more rapid rate of increase than revenues provides for an appropriately more conservative view of out-year cash flow.

Financing: Bond financing in two series is assumed – a 30-year Series A issue for $10.8 million at 5.00% annual interest, and a 10-year Series B issue for $800,000 with interest at 4.50%. The City Lights program is intended to assure maintenance of debt coverage ratios of 1.20 and 1.10 for the Series A and B issues, respectively. These coverage objectives are readily met with the PDC-prepared base case pro forma.

Application of Remaining Cash Flow: After deducting required bond payments from NOI, remaining amounts are used to pay interest on the deferred developer fee and an asset management fee, and then applied toward making added principal payments on the Series B bond. Any remaining cash flow is applied towards payment of principal on the deferred developer fee. Using this priority of payment, all cash is drawn down each year until the B-bond and developer fee obligations are fully repaid.

With the base case pro forma, this means no remaining cash flow to allocate until year 8. Positive residual cash flow starting in the 9^th year would be allocated to the Housing Investment Fund.

Financial Cushions: At least two additional sources of added financial cushion can be identified in the pro forma:

•  Interest earnings on a debt service reserve capitalized at $265,000. To the extent that debt coverage is maintained, it is likely that interest could be applied to faster repayment of debt, though this is not explicitly modeled in the pro forma.

•  Real estate taxes on improvements, deferred as a limited property tax abatement project for 10 years. The pro forma shows property tax payments starting in Year 11 (at about close to $165,000); however, as publicly owned property, tax payments are not required. Any payments made essentially would be as Payments-in-Lieu-of-Tax (PILOT).

Cash Flow Summary: The PDC base case pro forma indicates a financially feasible project – able to cover operating expenses and meet debt service with more than adequate coverage requirements. While no cash flow would accrue directly to the owner until year 8, this time period allows for full repayment of the Series B Bond and the deferred developer fee. Thereafter, cash flow can be applied toward the City’s Housing Investment Fund.

This financial structure would likely be unattractive to a private owner and investor – offering a negative 10-year internal rate of return (IRR, year 2 through year 11) . However, the project meets other City Lights program objectives and does offer substantial net revenue after year 8 – with a substantially higher IRR through year 21 of just over 11%. From a financial perspective, this structure is clearly more conducive to a long-term hold rather than short-term profitability.

The key remaining question for financial feasibility relates to the reliability of the cash flow projections – and particularly to underlying assumptions of absorption and supportable rent levels. The potential risk of not achieving these assumptions and associated financial implications have been explored with PDC-prepared stress testing – the next section of the analysis.

STRESS TESTING

PDC has varied key market and financial assumptions embedded in the pro formas, to ascertain resulting implications for financial feasibility. E. D. Hovee & Company has prepared one additional scenario, to further stress test performance of the project under less favorable market assumptions.

PDC Stress Testing: Four separate stress test scenarios were initially run by PDC (as of March 8 with pro forma Version 10.5):

•  Reducing income and expense escalation to 2% and 3% annually and increasing stabilized vacancy from 5% to 7%.

•  Breakeven 1 – also with 2/3% escalators but increasing vacancy to 13.5%.

•  Breakeven 2 – with no income escalation for the first 5 years and 2% thereafter and 7% average vacancy.

•  Breakeven 3 – similar to Breakeven 2 except that income is escalated by 1% annually for the first 5 years and rents for 2-bedroom units are reduced.

The first of the stress tests as described meets debt service requirements with adequate coverage except in Year 11 (with Series A bonding) as taxes on improvements are made. However, adequate coverage could be maintained if the City opted not to make PILOT payments in this year.

Financial feasibility is more problematic with the three breakeven scenarios but still resolvable. In all three scenarios, Series A bond debt coverage (DCR) drops below the City-set target of 1.20 for 5-7 years (and again in Year 11). Of greater concern is that coverage drops below 1.00 for Series B repayment for between 2-4 years, meaning that revenue is inadequate to pay this debt. Also noted is that the deferred developer fee is not capable of being repaid over the entire 20-year projection period – essentially putting repayment at risk.

However, the amount of the DCR deficiency can be accommodated with the $265,000 debt service reserve. Total DCR deficiency within the project’s first 20 years ranges from $44,200 with Breakeven 1 to $106,400 with Breakeven 2 and $57,100 with Breakeven 3. While not meeting City Lights underwriting objectives, the reserve is adequate to cover these debt service deficiencies.

EDH Reduced Rent & Increased Vacancy Stress Test: One additional scenario has been run by E. D. Hovee & Company, to test the combined implications of: a) not achieving projected rents; and b) higher than projected vacancies. As indicated by the worksheet attached to this memorandum, this more conservative market scenario is based on an average rent of $1.16 per square foot, equivalent to NE Portland’s Center Commons (adjusted for unit mix), but still achieving a rent premium 27% above the highest rent Southwest comparable. Long-term vacancy is adjusted up from 5% to 7% reflecting potential marketability and turnover issues with a premium rent property at a secondary location.

With reduced rents and increased vacancy, Headwaters falls below Series A Bond debt coverage requirements in years 2-5 and 11-13. Series B debt coverage requirements are not met in years 2-9. Debt coverage for Series B falls below 1.00 in year 2; however, the $8,330 shortfall is easily covered through the project’s debt service reserves. Perhaps more seriously, PDC realizes a 20 year IRR of less than 1% and a 30 year net present value (NPV) of an approximately negative $68,100. The developer fee would be deferred for a prolonged period, but could be fully paid off by year 16.

However, this additional stress test indicates more favorable (though not desirable) results than the three PDC breakeven scenarios. Even more severe stress test assumptions are required to drive the project to a point where debt payments could not be covered from project revenues on its primary City Lights bond. For example, if average rents fell below $1.07, the DCR on Bond Series A falls below 1.00 with a 7% vacancy rate.

Additional PDC Stress Test: Subsequent to our preliminary draft report, PDC updated its pro forma analysis (with Version 11.1). As part of this most recent pro forma, PDC created an additional income and expense spreadsheet differentiated by average rents of $1.19 per square foot (a 5% reduction), property management fees of 4% (versus 3%), and a $15,000 annual unit turnover expense (versus $9,500). Cash flow was further stressed by reducing revenue and expense escalators (to 2% and 3% respectively), and by increasing vacancy to 7%.

In this final stress test, the project requires additional funds of $125,000 over 10 years to meet Series B bond obligations. No excess cash flow is produced over 20 years as a source to repay the developer fee. For the developer fee to be paid, property tax payments would need to be deferred beyond the assumed 11 years. With these amendments – enabled through the addition of $185,000 in PDC contingent funding – the project remains viable.

As noted by PDC analysis, with this stress test, the developer fee note would need to be restructured and/or partially forgiven. Alternatively, the planned property tax payment (or PILOT) would need to be further deferred to allow for accelerated repayment of the developer fee note.

FINANCIAL FEASIBILITY OPTIONS

As a final step in this analysis, potential options for improved financial feasibility are briefly outlined. These options might be considered in the event that the Headwaters project performed well below projection (and are not presented in any particular priority order):

Added PDC Equity: While PDC will be committed to underwrite any operating loss, an optional approach might be to further capitalize on-going operating losses. This approach might be warranted if, for example, it became clear after an adequate marketing period that achievable rents and/or stabilized occupancy could not achieve pro forma expectations.

Rather than relying on an on-going operating subsidy, PDC could capitalize its losses by providing added equity, for example, to immediately buy down remaining Series B debt. For PDC and OMF, this might have the advantage of using known resources early on rather than relying on less certain PDC revenue availability in out-years.

PILOT Deferral: Starting in Year 11, $165,000 in operating expense (inflated at 3% thereafter) could be de-obligated and instead applied as a source to avoid DCR deficiencies or to more rapidly repay deferred obligations such as the developer fee.

Since this savings is not available in the early years, it can not be used as directly to offset Year 1-10 cash flow problems. However, this could be identified as a potential source of later year repayment of added early year gap financing.

Neighborhood & Business Improvement: If the condition of the immediate neighborhood and lack of supporting nearby businesses prove to be a significant deterrent to achieving project lease-up or rent targets, additional PDC programming for business and neighborhood improvement could be considered. Any case for targeted neighborhood investment likely would have to stand on its own merits – as well as for benefits to the Headwaters project.

Condo Conversion: The intent of the City is to maintain ownership of the Headwaters Apartment units as a long-term public asset. Although not a project objective, we have assessed the potential implications of disposing of the property should this become necessary for financial reasons.

Our assessment has focused on the question of whether construction costs could support condo conversion as a possible exit strategy in a worst case scenario. One impediment to marketing for condo units would be the unit’s wood frame construction; however, this is not untypical for condo conversion projects (with appropriately discounted pricing).

Sales prices in the range of $190 per square foot would net just under $13 million after a 7% sales expense is deducted. This recovers the project’s costs, though without any allocation for unit improvements that might be desired prior to marketing as condos.

The $190 per square foot minimum sales price is just below asking prices for Beaverton’s The Round, a similarly pioneering project, although of a larger scale and with notable amenities (e.g. the proximity of light rail, a 24 hour fitness and two new restaurant tenants). However, it suggests a strategy that could be considered if financial concerns warrant or City/PDC policy priorities change in the future.

ATTACHMENT. SUPPLEMENTAL E. D. HOVEE STRESS TEST

ENDNOTES