HomeMy WebLinkAboutStaff Report 2197City of Palo Alto (ID # 2197)
Finance Committee Staff Report
Report Type:Meeting Date: 10/18/2011
October 18, 2011 Page 1 of 10
(ID # 2197)
Summary T itle: Historic Tax Credit Program Use for Roth Building
Title: Palo Alto Historic Musuem’s Proposal to Use Federal Historic Tax Credit
Program for Adaptive Reuse of Roth Building
From:City Manager
Lead Department: Administrative Services
Recommendation
Staff recommends that the Finance Committee review and provide input on the Historic Tax
Credit financing plan developed by the Palo Alto History Museum.
Background
In April 2000, the City Council approved the $1,957,000 purchase of the Roth Building and its
0.41 acre site for potential development as a “public facility or alternative use if a public facility
is not feasible,” in conjunction with the South of Forest Avenue Coordinated Area Plan (SOFA
CAP).
On May 20, 2002, Council approved a Request for Proposals (RFP) and directed staff to solicit
proposals for the lease of the Roth Building. The RFP specified that: preference be given to
non-profit groups located in or serving Palo Alto; that the property be improved and operated
at no cost to the city; and that public access to the Roth Building restrooms by users of the
neighboring park be provided. In response to the RFP, one proposal was received in November
2003. The Palo Alto History Museum (PAHM) proposed to restore, preserve and improve the
historic Roth Building for use as a museum. PAHM’s proposal was accepted by the Council in
April 2004, at which time staff sent the Museum a draft Option Agreement for its review.
In February 2006, staff received the Museum’s proposed changes to the draft option including a
request that the City contribute up to $300,000 to repair leaking and drainage problems at the
Roth building. On July 10, 2006, Council created a Capital Improvement Program (CIP) for Roth
Building maintenance in the amount of $415,000 to provide funding for interim measures to
prevent further deterioration of the building until the Museum takes over the site. On May 14,
2007, Council authorized the Mayor to execute the Option Agreement and approved a City
contribution of $150,000 for repair of the leaking and drainage problems. The Option
Agreement was executed on June 22, 2007 with a twenty-four month term.
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When the twenty four month period ended, the Museum requested additional extensions
which were granted by the City Manager through December 2011. The Museum cited
difficulties with fund raising due to the severe economic downturn and was in the process of
developing a new financing plan that is discussed in this report.
On April 12, 2010, Council approved the nomination of the Category 2 Roth Building to the
National Register of Historic Places and transmittal of letter of support to the State Historical
Resources Commission. The Roth Building was recently listed on the National Register of
Historic Places, joining several other listed Palo Alto structures such as the Norris House, the
University Avenue CalTrain station and the United States Post office on Hamilton Avenue.
On March 21, 2011, in compliance with conditions of the Option Agreement and the Palo Alto
Municipal Code (PAMC) Section 18, development plans for the Museum’s proposed project
were conditionally approved for Architectural Review, Minor Exceptions, and a Conditional Use
Permit (CUP). The proposed project includes the rehabilitation of the 19,182 square foot Roth
Building and a 1,462 square foot addition for use as a museum including gallery space, office
space for museum staff, and offices for future subtenants, a community meeting room, a gift
shop, café, restrooms, archive storage space, and mechanical/ utility spaces. Minimal exterior
modifications on the east side will accommodate a public restroom and a code-required second
stairway.
On March 29, 2011, final approval of the CUP for the project was appealed in accordance with
Title 18 of the Palo Alto Municipal Code. This appeal focused on parking concerns. A public
hearing on the appeal was held on June 8, 2011 before the Planning and Transportation
Commission (PTC), which recommended that Council deny the appeal. Subsequently, the
Council accepted the PTC recommendation and denied the appeal.
Discussion
To obtain additional financing for capital improvements to the Roth Building, the Palo Alto
History Museum (Museum) has solicited the services of Christine Fedukowski Consulting (CFC).
In describing its services CFC states that it,
“works with developers, governmental agencies, community redevelopment agencies,
and investors involved in redevelopment of urban and rural communities that focus on
urban infill projects, including new construction and adaptive reuse of historic
properties. CFC works with its clients to find financing solutions for these complex
projects. Guided by the client’s strategic vision, it manages the financing process from
beginning to end, to identify sources, structure the capital transaction, and close
financing that includes federal and state historic tax credits, new markets tax credits,
other state and local government incentives, as well as conventional financing”
CFC is proposing that the Museum participate in the Federal Historic Preservation Tax
Incentives program and utilize the Historic Tax Credit (HTC) to obtain additional funds to reuse
and rehabilitate the Roth Building.
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CFC, the Museum’s Board President, and staff from Administrative Services and the Attorney’s
Office have met on several occasions to understand the HTC, its requirements, and the legal
structures necessary to fulfill all obligations. This program is complex in that numerous federal
and IRS criteria must be followed carefully and in that several different “ownership” structures
could be utilized.
The fundamental principle of the HTC program is that it provides federal tax credits to
encourage the private rehabilitation of historic structures. Under the HTC an “Investor” (such as
a bank or corporation) invests funds in an historic building rehabilitation project in exchange for
a federal tax credit. The amount and timing of such an investment is dependent on an
investor’s need for a tax credit. Per CFC, HTCs have been utilized as part of an overall financing
program for historic rehabilitation of the Fox Tucson Theater in Tucson, Arizona; the Arctic Club
Hotel in Seattle, Washington; and Mayo Building in Tulsa, Oklahoma (see response to Question
9 below for HTC use in California).
There are an array of requirements to obtain the tax credits and investor financing. The
following represent a sampling of the most important provisions (a detailed “Program
Overview” and preliminary “Proposed Roth Building Rehabilitation” can be found in Attachment
A) follows:
·The HTC can only be used by a taxpayer that owns and rehabilitates a historic
building
·Qualified buildings must by “certified historic structures” (Roth Building qualifies)
·HTC is limited to 20 percent of “qualified rehabilitation expenditures”
·The IRS requires that the project include:
o substantial rehabilitation
o qualified rehabilitation expenditures
o building must be depreciable, so it must be income producing or used in
a business
o tax exempt entities cannot lease more than 50 percent of the rentable
area…
o “economic substance” on a pre-tax basis whereby project must
demonstrate over a projected holding period of 32 years a 3 percent
return on the investor equity investment. Project must have economic
purpose beyond tax benefit by generating profits
o HTC is generally claimed in year building is placed in service
o Claimer of HTC must retain ownership for the property for at least five
years after occupancy or tax credits are subject to recapture
o HTC can be recaptured or returned to federal government if the project is
sold before the end of the minimum 5 year holding period or if the
property ceases to be income-producing
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Based on the above, intricate criteria it appears that the Museum would have to work closely
with a consultant as well as its partners or investors to comply with federal regulations. In
addition, the Museum would need to secure the legal, financial and administrative expertise
necessary to fulfill federal requirements.
In addition to the challenge of complying with all federal regulations, CFC states that “a
recurring challenge in using the tax credits is identifying an entity that can use the credits and
forming a partnership that includes that entity.” Since non-profits such as the Museum cannot
make use of the HTC, it is necessary to partner with an entity that can. The typical partner is
one that makes an equity investment in the project in return for the tax credits. CFC refers to
this as “syndication” of the tax credit. This syndication has 2 basic structures that can be
developed into different ownership arrangements. These are the “Single-Entity” and “Master
Tenant Lease” structures. In both structures a limited liability company (LLC) must be formed.
CFC states that ‘in the Single Entity, the Project Sponsor is the managing member and the tax
credit investor is the Investor Member of the LLC that owns and operates the building. Each is
allocated, according to their percentage member interest, the tax credits, and other benefits
and obligations of the project, including: 1) profits and losses; 2) depreciation; and 3) cash
flow.”
In the Master Tenant Lease arrangement, the LLC that owns the building enters into a long-
term lease with a master tenant entity. The LLC landlord would own the property (via fee
simple title or long-term leasehold interest) and passes through the HTC to the Master Tenant
entity. CFC is recommending the Master Tenant entity structure.
For more detailed information on the substance of the HTC program, please see Attachment A.
In addition, CFC has provided the following WEB sites that describe the program:
National Park Service -Technical Preservation Services: Historic Preservation Tax
Incentives. http://www.nps.gov/history/hps/tps/tax/.
Within that site: Program Summary: Click on "About the Tax Incentives" -PDF format is
in the left hand column. For more Detailed IRS Matters: Click on "IRS Connection:"
http://www.nps.gov/history/hps/tps/tax/IRS.htm (in the left hand column)
California Office of Historic Preservation:
Mills Act Property Tax Abatement Program:http://ohp.parks.ca.gov/?page_id=21412.
Based on the multifaceted aspects of the HTC program and staff’s unfamiliarity with it, several
key questions were posed to CFC. It is important to note that this would be the first transaction
involving the HTC for the City. Also based on staff’s limited research this program appears to be
more widely used in privately-owned, rather than publicly-owned buildings. It appears that in
California, the publicly-owned scenarios involve redevelopment agencies. The questions and
responses follow:
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Question 1
Recognizing the potential for additional funding for the Museum to rehabilitate the Roth
building, City staff views the tax incentive model as outlined by CFC as extremely complex.
There are numerous and strict regulations that must be followed; partnerships to be
developed; and legal questions to be resolved.At a minimum, expert consultant and legal
advice will be required to guide the Museum through the historic tax credit process and to
demonstrate to the IRS that it is compliant with the terms of for obtaining the tax credit. It
appears that consultant expertise will be required on an ongoing basis and that the Museum
will incur an ongoing cost.
Response 1
CFC has been engaged by Palo Alto History Museum ("PAHM") and continues to work on the
required materials, anticipating submitting investor proposals once there is approval of this
concept from the city staff and Finance Committee of their willingness to consider this
structure. Also, the consultant expertise is required only through closing the transaction, to
negotiate and finalize the transaction and to help put in place accounting processes and
procedures to follow after construction completion. And, most of the consultant fee is earned
and payable, if and when the transaction closes, so no significant monies are owed unless an
HTC investment is obtained.
Please note also, that using the HTC benefits does not preclude seeking other alternative
financing options -whether grants or gifts (public and private). As a matter of fact, many
organizations use the HTC investment to leverage other monies.
Although complex, with the help of the consultant, as well as the investors themselves, many
smaller, non-profit organizations in California and across the country have done this. For
example, with respect to a small group being able to successfully complete an investor
syndication,CFC has worked with, two such groups -one, a small parish in Washington, D.C.
that did a $3 million rehabilitation of 2 townhouses for use as a senior center; and the second, a
small San Antonio nonprofit in San Antonio providing early childcare that did a $6 million
rehabilitation.
Question 2
Is the Museum prepared to take on the responsibilities described above and as discussed by the
consultant?
Response 2
Yes, the museum is prepared to do this, as evidenced by engaging the consultant and bringing
capacity to its board that includes a CPA.
Question 3
Does PAHM want to pursue the HTC program or, given its complexities, pursue alternative
financing options?
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Response 3
Yes, it has analyzed the options, and concluded it wants to pursue the HTC, and also will
continue to pursue all other alternative financing options. Furthermore, PAHM has structured
its consultant agreement so that no significant costs will be incurred prior to receipt of a term
sheet, which will detail the investment terms, from a bona-fide, third-party, established Historic
Tax Credit Investor.
Question 4:
From CFC’s materials, the federal HTC program’s goals are twofold: 1) to
rehabilitate an historic building and 2) to house an ongoing enterprise capable of generating an
annual return of 2% to 3% of the amount invested in the project.This return is payable from
cash flow at the end of the year.Also, CFC states that there is a “requirement that the tax
credit investor demonstrate that the Project has ‘economic substance’ or profit motive above
and beyond the tax credit….” Has the Museum and consultant performed the financial analysis
to demonstrate that the 2% to 3% rate of return is feasible and ongoing?
Response 4
That analysis is in process, and based on preliminary projections, the project should meet these
requirements --however, the assumptions and analysis will be revised based on the final
project construction budget and post-construction operating projections, such to include lease
agreements, event rental fees, admissions (suggested donation), building operating costs, etc.
Note also that this “profit motive” is typically determined using a projected holding period of at
least 30 to 50 years, with project cash flow increasing significantly in later years (years 25 and
on).
Finally, to put this concept of “profit motive” in context, it is helpful to understand that a key
purpose of the economic substance requirement of the Internal Revenue Code,is not
necessarily to limit this tax benefit to only highly profitable ventures, but rather to preclude so-
called "sham transactions," that became prevalent prior to the 1986 Tax Reform Act, and
purposely created money-losing ventures solely as tax shelters.
Question 5
Is PAHM prepared to take steps necessary to create and follow a business model that will meet
the profile of an enterprise as described in the consultant’s discussion of the tax credit
program?
Response 5
Yes, PAHM recognizes the need to retain the business skills on staff and board necessary for
this business model. And, to specifically address the “profit-motive” IRS requirement, prior to
closing the transaction, the tax credit investor will require an opinion from tax counsel and tax
accountant that the transaction complies with all rules and regulations.
Question 6
CFC has generated a number of potential ownership structures the Museum can use to
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facilitate the HTC financing.It is unclear to staff which model is optimal and which protects the
City’s ultimate ownership of the Roth property.It appears that either the Single Entity or
Master Tenant ownership structures will maintain a to-be-created “PAHM Rehab, LLC” as the
property owner, but the question remains as to who will own the property should there be a
recapture of the tax credit or if the LLC fails to meet the IRS requirements?
Response 6
The Master Tenant structure will be used. As to the second question, the transaction structure
contemplates that City of Palo Alto is fee simple owner and enters into a long-term lease (at
least 50 years) with the LLC, the Lessee. So, that leads to the question, “what happens if the
PAHM affiliate, that controls the LLC, fails to meet its obligations to the HTC investor”? In that
event, the HTC investor could seek to remove PAHM-affiliate as controlling member, which, if
successful, would result in the HTC investor taking control of the project. However, PAHM
would take steps to mitigate possible adverse effects even if such were to occur, by providing
language in the transaction documents to insure rights and remedies with respect to potential
removal of the PAHM-affiliate as general partner, such as:
1.The HTC investor would still be bound by the terms and conditions of the lease agreement, as
well as all city requirements with respect to zoning, parking, use, etc., that are imposed on all
property owners and users.
2.While the HTC investor would require that it have the right to take control, the conditions
under which such could happen would be specifically defined, and such right could be exercised
only if PAHM-affiliate (A) were grossly negligent;and (B) such negligence had a material
adverse affect on the HTC investor. In other words, simply failing to meet attendance goals, or
generate sufficient cash flow to pay the annual return, would likely not be sufficient grounds to
remove PAHM-affiliate.
3.Typically, the HTC investment is made by a financial institution's community development
corporation, which requires that such investments be made only for projects that provide
tangible community and public benefit and/or serve the public welfare. As such, for both
business and regulatory reasons, the HTC investor’s and City’s project goals are aligned: (a)
maintaining the structure in a manner consistent with the Secretary Standards of
Rehabilitation; (b) using the building to provide space for a museum, and supporting amenities
–or similar activity –that provides community benefit, including accessibility to low-to
moderate income persons; and (c) having an overall operating strategy that supports the City’s
economic development objectives.
Question 7
CFC estimates that an equity investment of $1.08 million from an outside institution is possible.
From prior information, it appears that $4.75 million in donations has been pledged.Together
these sources total $5.85 million.The project apparently needs $6.3 million so an additional
$0.45 million is yet to be identified. Staff’s understanding is that the Museum has been asked
to identify a complete financing plan before approaching Council.What is the Museum’s plan
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for raising the additional financing?
Response 7
Additional financing will come from philanthropic contributions from major gifts from
corporations, foundations, and/or individuals. A broad-based community campaign will be
launched shortly to target approximately $250,000.
Question 8
In the current economic environment, what is the likelihood of finding a bank or corporation
willing to invest in the project for the tax credit?
Response 8
Right now, there continues to be HTC investors active in the market. And, it is this upfront work
we are doing that takes the longest. Once there is an understanding with the city as to the
required structure, we would be able to obtain a detailed proposal from the investor before the
city had to move to the next step of its approval process.
Since a key piece of PAHM’s financing plan rests on a complicated, but viable tax credit
program, PAHM staff recommend that an option extension be approved and that the Finance
Committee and the full Council have additional time to review, raise questions,and provide
input on the funding plan.
Question 9
This tax credit program is geared toward incentivizing private sector investment in historic
renovation. Can you please identify three public sector projects in California where this funding
approach has been utilized?It would also be helpful to have a specific city staff
contact/reference.
Response 9
Please see the following California projects and contacts/references:
Fox Oakland Theater, rehabilitation of historic theater and adjacent new construction using
federal historic and new markets tax credits. The Oakland Redevelopment Agency (ORA) owns
the building and entered into a long-term lease with a non-profit sponsor. ORA also provided
bond financing for a significant part of the project.
Contact: Patrick Lane, Oakland Redevelopment Agency: 510-238-7362
pslane@oakland.net.com.
Ferry Building (and adjacent Piers 1, 3, 5). Rehabilitation of piers and buildings in San Francisco
using Federal historic tax credits.
Contact: Kathleen Diehep -415-274-0536 kathleen.diohep@sfport.com
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REA Building, Sacramento. Rehabilitation using Federal Historic Tax Credits. The rehabilitation
was done through an Owner Participation Agreement with the redevelopment agency, which
also provided financing for the project.
Contact: Roberta Deering, Preservation Director, City of Sacramento: 916-808-8259
rdeering@cityofsacramento.org
Question 10
a) This transaction appears to be more complicated than even a city-sponsored bond
financing/COPs transaction or a private-sponsored “TEFRA” bond transaction.
b) In these types of transactions, the City typically engages bond counsel and a financial advisor
with significant expertise. Will these types of consultants be involved in preparing the
documentation or is tax counsel only used to issue an opinion letter?
c) Who will pay for legal counsel?
Response 10
a) There is complexity to the HTC transaction, especially when public and/or private non-profit
organizations are involved, but it is assured that as the transaction moves forward, with the
support of the investor and project sponsor tax counsel, the City will better understand and
become more comfortable with it. This is especially true since you are familiar with bond and
COP financing. CTC believes the City will find the HTC quite simple by comparison. Moreover,
there is no financial liability on the part of the city.
b) Since there is no bond or financing provided by the City, CTC does not expect such counsel or
advisors will be necessary for the City, unless the City decides to hire such expertise. As to the
transaction documents,the investor’s tax counsel will prepare almost all documentation,
except for the PAHM-affiliate entity documents and the lease agreement between the city and
PAHM. For your approval, investor or PAHM counsel will make revisions to the lease
agreement required to comply with IRC. The investor counsel will issue the opinion letter on
behalf of the investor. Also, if you would like to engage tax counsel with HTC expertise, we can
provide referrals.
c) There is no set procedure, everything is a negotiation. Our aim, however, would be to
provide as much counsel as possible to the City, so that the City or outside counsel are
reviewing rather than creating documentation. While I've seen costs for bond counsel at
around $100,000 for the City's specific HTC aspects of this transaction (if a city chooses to
engage outside counsel), CTC expects such cost to be minimal for Palo Alto since outside
counsel would be reviewing, rather than preparing documents. The City’s counsel would focus
primarily on the city's lease agreement and its consent to assignment.
Conclusion and Recommendation
As stated above, the HTC program is new to City staff, although the program has been used in
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other California jurisdictions and the CFC and the History Museum have been responsive to
staff questions. At this time, it appears prudent for the Finance Committee to become familiar
with the HTC program, ask questions, and request additional information where needed. Staff
would then return to the Finance Committee for its recommendation on whether or not to
move the History Museum’s financing proposal on to the full Council.
Resource Impact
All costs associated with CFC are being paid by PAHM. In its current financing proposal, there
are no requests for financing from the City. The City may incur, however, costs for outside
experts (e.g., financial advisor and legal to advise staff and to review documents should PAHM’s
historical tax credit financing plan move forward.
Policy Implications
The City’s goal of preserving the historical Roth structure would be achieved by PHM financing,
especially since the HTC program is, by design, meant for such purpose. Although the
ownership structure proposed by CFC preserves ownership of the land through a long-term
lease, it is possible that tenants could change should PHM not be able to fulfill its
commitments. In this situation, it is the investor and not the City that would determine the
new tenant. The Finance Committee and Council should discuss this possible scenario.
Attachments:
·-a:Attachment A: Public Private Partnership, The City of Palo Alto and Palo Alto History
Museum, Tax Incentives for Adaptive Reuse….(PDF)
Prepared By:Joe Saccio, Assistant Director of Administrative Services
Department Head:Lalo Perez, Director
City Manager Approval: ____________________________________
James Keene, City Manager
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Packet Pg. 20
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Packet Pg. 21
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Packet Pg. 22
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Packet Pg. 24
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Packet Pg. 25
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Packet Pg. 27
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Packet Pg. 28
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