How to Use Incentives Wisely

Spring 2021 Issue
By: Scott Ziance and Sean Byrne
Economic incentives for real estate projects can help reduce development costs or increase future revenue. Getty Images

A four-pronged approach to state and local economic development incentives can help draw tenants and boost profits.

State and local economic development incentives can help attract and keep tenants and increase investment returns. It’s important to keep the focus on four key principles: reducing occupancy costs; facilitating an efficient financing structure; creating a win-win arrangement with the community; and preserving disposition optionality. 

Incentives can increase the rate of return by reducing costs or increasing revenue. There also are benefits to thinking broadly about return on investment. By developing a positive relationship with the community, the economic development supported by the community likewise benefits the investment. Using state and local incentives thoughtfully can lower costs and increase values when it comes time to sell.  

Reduce Occupancy Costs

The tenants’ occupancy costs help drive the rental and occupancy rates for a project. Lowering overall occupancy costs through a combination of lower taxes, lower utility costs or lower common-area maintenance (CAM) charges will maximize the value for both the building owner and the tenants. There are three common ways economic development incentives can reduce occupancy costs for tenants and owners.

Property tax abatements can substantially reduce the annual occupancy expense of the project while also providing substantial value to the developer. With commercial real property tax rates as high as 3% or more of assessed (fair market) value in some jurisdictions, a 50% property tax abatement on a $10 million building reduces the out-of-pocket costs by $150,000 per year. Adding that $150,000 (or sharing it to help attract a tenant) back to the net operating income can be a meaningful increase in value.

For instance, assuming a $10 million property value with an 8% cap rate yields an annual net income of $800,000, plus an additional $75,000 from effectively splitting the tax abatement with the tenant. That $875,000 income with an 8% cap rate results in a value of $10,937,500 – a 9.375% increase — while still attracting tenants with lower occupancy costs.  

Utility and energy incentives offer another avenue for reduced occupancy costs. In some jurisdictions, economic- incentive utility rates are available for large energy users or certain types of projects. In other cases, the developer can use less expensive financing to reduce the costs of energy-efficiency measures. This can include programs like property assessed clean energy (PACE), which allow the costs of energy infrastructure to flow through like real estate taxes, or low-interest loans. Whichever path a developer chooses, reducing the actual costs of energy may benefit the bottom line. 

When considering incentives, it is critical to plan and negotiate a development agreement with the local jurisdiction. Not only can these agreements make the development process smoother, but they can also lead to negotiations for dedicating public infrastructure improvements such as roads to the city or township. This reduces repair and maintenance obligations.  

The value of a project, and ultimately the return on investment, will be driven by both capital investment and annual operating costs. State tax incentives may be able to help with certain capital investments, including public roadwork, but look closely at operating costs and determine if a tax abatement, a utility cost reduction incentive, or an opportunity to shift a maintenance cost might reduce occupancy costs and drop more net income to the bottom line. 

Develop an Efficient Financing Structure 

Incentive financing can provide efficiencies that enhance value for the developer. Some incentive programs provide unique financing opportunities by establishing certain costs upfront. For instance, using tax increment financing (TIF), the parties may agree to an annual payment in lieu of taxes (PILOT) that is set over the period of the TIF. This model can be attractive to lenders, who get certainty from the collateral assignment of TIF payments, and to tenants, who get certainty with respect to future property tax obligations. 

Other financing incentive programs can drive down the costs of a project, depending on the developer’s needs. There are incentive loan programs focused on different types of projects that include low or no interest. There may also be tax-exempt bond financing. 

By exploring potential incentive financing options, the developer may lower the costs of capital or spread those costs over time. Those lower costs may make the project attractive to potential tenants while improving the developer’s rates of return.  

Create a Win-Win with the Community 

There are many opportunities for a developer to build a relationship with the community that will support the project and ultimately its profitability. State and local incentives are, by their nature, partnership agreements. The community is investing in the project, and the developer is investing in the community. There are going to be both transactional win-win opportunities and relationship opportunities. 

There are opportunities for both sides to get something of value without giving anything up to each other. For example, a developer needs improved roadwork for a project. The state may be willing to provide roadwork funds for a project that creates jobs. The developer gets what he needs, and the local jurisdiction benefits from the roadwork.

Training funding can offer similar optimal outcomes. The developer may be able to secure state money to train workers, which in turn benefits the community by increasing the pool of skilled labor.  

Another win-win is when the developer and the incentive provider work together to support tenants in a developer’s project. For instance, the developer may have built a multitenant spec building with a partial tax abatement. Working with the city and a potential tenant, the developer may be able to persuade the city to increase the abatement to attract the potential tenant. The developer benefits by securing a tenant, as well as through lower taxes on the entire building. 

The value of a strong relationship may come many years into a project. While it is important to have a comprehensive development agreement, it’s not possible to anticipate every potential issue. A developer who has earned credibility in the community by doing what they commit to doing, supporting local initiatives, and perhaps leaving a little on the negotiating table will have a reservoir of goodwill when requesting cooperation from a local jurisdiction on any unforeseen issues.  

Preserve Disposition Options

State and local tax incentives can also help position a project for a later sale. The key to maximizing disposition options is to plan ahead. When negotiating project incentives, consider how and when a transfer may occur. Whether a developer is seeking sales tax exemptions, real property abatements or other incentives, local jurisdictions may agree to be flexible during negotiations to allow assignability of the project incentives. 

For example, if a multibuilding site is being developed, might the buildings be sold separately? If so, negotiate terms that will allocate jobs, investment and any other requirements in the event of a third-party sale. Similarly, with certain sales tax or other exemptions, it may be possible to negotiate terms to provide incentive providers with guaranties or indemnification to protect the benefit of their bargain without sacrificing flexibility. 

In addition, pay attention to the statutory details, such as notice and publishing requirements, and prepare complete incentives transaction binders promptly after the execution of the incentives agreements. It is not unusual for local governments to make mistakes when approving agreements, and it is not unusual for local governments to approve agreements correctly and then misplace key documents. A purchaser who is unable to confirm that incentives agreements were duly authorized may walk away from a transaction or insist on lowering its purchase price. 

Easily assigned and clearly documented incentives mitigate the purchaser’s risks. That can help the seller maximize price. No purchaser wants to step into a liability, but thoughtful planning on the front end will save heartburn (and reserves) at disposition.   

Lessons Learned

It’s important to rely on more than one of the four prongs of economic development incentives to increase the rate of return. Incentives can lower occupancy cost, lower financing costs, provide value-added opportunities for the developer and the community, and facilitate a later sale of the project. As with any partnership, diligent planning on the front end allows for success throughout the relationship.   

Scott J. Ziance is a partner who leads the national economic development incentives practice at Vorys, Sater, Seymour and Pease LLP. Sean P. Byrne is of counsel at Vorys, Sater, Seymour and Pease LLP and former chief counsel to the Ohio Development Services Agency. 

Know Your Terms

Property Assessed Clean Energy (PACE). According to a Fall 2014 article in Development magazine, PACE is a program to fund energy infrastructure in which a local property tax jurisdiction issues “bonds to the private sector to raise the necessary capital and makes loans to property owners, tenants and/or investors, who are also taxpayers in that jurisdiction. The jurisdiction also arranges for the taxpayer to make regular payments of the principal and interest as part of their regular property tax payments. Finally, the jurisdiction places a lien on the property to secure the financing.”

Payment In Lieu of Taxes (PILOT). A real estate tax-abatement program that eliminates taxes for developers for a set period of time to encourage improvements to a property. The developer pays a lower “service charge” to the local government during that period.

Tax Increment Financing (TIF). According to CityLab University, TIF “creates special tax districts around targeted redevelopment areas from which future tax revenues are diverted to finance infrastructure improvements and/or development. At the beginning of the TIF period, tax revenues in the TIF district going to general city services are frozen at a certain rate. All additional tax revenues go toward directly funding new development or servicing debts related to new development until the end of the TIF period, which usually lasts 20 to 30 years.”