HomeMy WebLinkAboutStaff Report 13478
City of Palo Alto (ID # 13478)
City Council Staff Report
Report Type: Action Items Meeting Date: 10/18/2021
City of Palo Alto Page 1
Title: PUBLIC HEARING: Discussion of an Updated Commercial Linkage Fee
Feasibility Study and Adoption of an Ordinance Amending the City's Fiscal
Year (FY) 2022 Municipal Fee Schedule to Adjust the Affordable Housing
Commercial Impact Fee; the Current Fee is $39.50 per Square Foot ($20.37 /
Square Foot for Hotels).
From: City Manager
Lead Department: Planning and Development Services
Recommendation
Staff recommends that the City Council review the attached affordable housing commercial linkage fee
feasibility analysis (Attachment A) and Adopt an ordinance amending the City’s FY 2022 Adopted
Municipal Fee Schedule for commercial/R&D development to $68.50 per square foot
(Attachment B) or alternative.
Executive Summary
The City Council directed staff to prepare an updated feasibility study to consider a possible
change to the City’s affordable housing commercial impact fee. The City’s consultant studied
the feasibility of different fee levels based on three different prototype designs (buildout
potential). The results show smaller office projects are unlikely to be developed even at the
current fee, while more moderate projects may be able to support an increase up to $50 per
square foot of office development, and larger projects on sites with a commercial floor area
ratio of 2.0:1 could support a significant increase up to $150 per square foot. The current
commercial impact fee of $39.70 is based on the more moderate analysis that assumes a
development potential with a floor area ratio of 1.0:1.
The feasibility study also includes information related to life science / biotech Research &
Development (R&D) space and hotel development. This analysis is provided in the event the
Council wants to make policy changes for these land uses, though the study suggests any
increase in the impact fee for these land uses may make such projects either infeasible or less
likely to be built.
The City Council has discretion in how it chooses to adjust the affordable housing commercial
impact fee or how that fee is applied to different land uses and building sizes. A fee that makes
development less unlikely to be built is permissible, but it carries some legal risk and it may
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negatively impact the amount of fees collected not only for the affordable housing fund but
other City services supported by commercial development. This may include both direct impact
fees and economic benefits such as visitors or business generating revenues such as sales taxes
or hotel taxes (Transient Occupancy Tax). The Council in its deliberation should consider how
these various interests are balanced.
The City Council will also want to discuss how this fee applies to pipeline projects. There is
currently about 75,000 square feet of commercial/R&D development in the pipeline.
Background
On June 21, 2021, the City Council considered a colleague’s memo1 requesting Council direct
staff to prepare an ordinance increasing the affordable housing commercial development
impact fee to match Santa Clara County’s fee of $68.50 per square foot applied to academic
space within the Stanford University Community Plan area. The Council postponed its decision
pending its review of the subject feasibility study. In September 2019, the City Council endorsed
a previous colleague’s memo2 directing the preparation of the feasibility study that is now
before the Council’s for consideration.
The last substantive change to the affordable housing commercial impact fee occurred less than
five years ago. On March 27, 2017,3,4 following review of a 2015 Commercial Nexus and
Feasibility Study,5 the City Council raised the commercial development impact fee from $20.37
per square foot to $35 per square foot ($20.37 for hotels, retail and other non-residential).6
The commercial housing impact fee has been adjusted annually since then based on changes in
the San Francisco Bay Area construction cost index and is currently set at $39.70 per square
foot ($23.11 for hotels) in the Fiscal Year 2022 Adopted Municipal Fee Schedule.
Financial Feasibility Study Summary
1 Colleagues Memo, dated June 21, 2021: https://www.cityofpaloalto.org/files/assets/public/agendas-minutes-
reports/reports/city-manager-reports-cmrs/2021/id-12347.pdf
2 Action Minutes from September 23, 2019 Colleague’s Memo:
https://www.cityofpaloalto.org/files/assets/public/agendas-minutes-reports/agendas-minutes/city-council-
agendas-minutes/00-archive/2019/09-23-2019-action-minutes.pdf?t=66804.19
3 Council Report, dated March 27, 2021: https://www.cityofpaloalto.org/files/assets/public/agendas-minutes-
reports/reports/city-manager-reports-cmrs/year-archive/2017/7661.pdf
4 March 27, 2021 Action Minutes: https://www.cityofpaloalto.org/files/assets/public/agendas-minutes-
reports/agendas-minutes/city-council-agendas-minutes/00-archive/2017/03-27-17-action-minutes.pdf
5 Commercial Linkage Fee Nexus Study, Including Feasibility Study (Attachment C, starting on page 39):
https://www.cityofpaloalto.org/files/assets/public/agendas-minutes-reports/reports/city-manager-reports-
cmrs/year-archive/2016/6862.pdf
6 In late 2016, the City Council had initially proposed that the fee be increased to $60 per square foot ($30 per
square foot for hotels), but this action was not finalized. Council Report, dated December 12, 2016:
https://www.cityofpaloalto.org/files/assets/public/agendas-minutes-reports/reports/city-manager-reports-
cmrs/year-archive/2016/6862.pdf
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The nexus study prepared in 2015 established a maximum justifiable commercial linkage fee of
$264 per square foot ($177 for hotels). The accompanying (2015) feasibility study
recommendation was much lower and provided a threshold for when the fee, in combination
with all other costs of construction, would likely make construction and redevelopment
financially infeasible. Since it has been over five years since the last feasibility study was
prepared, Council endorsed the preparation of a new analysis to better inform its deliberation
on a potential new affordable housing commercial impact fee.
The updated analysis, included in this report as Attachment A, provides information on three
land uses: research and development (life science / biotech lab space), office space
(professional office, including software development or tech office), and hotels. Prototypical
development buildout scenarios (five total) are based on recent Palo Alto development activity
for each land use.
The attached report provides information on the approach used to determine feasibility,
including assumptions on economic returns for each land use, a summary of the prototypes
used (development potential, lot size, parking, etc.), estimates on hard and softs costs, and
revenue projections based on recent sales data and rental rates for comparable spaces.
Financial feasibility for each prototype is determined based on a pro forma analysis that
estimates the profitability of a development based on two metrics, yield on cost and return on
cost.
Yield on Cost (YOC) is a commonly used metric that indicates the profitability of a tenanted
commercial project and allows an investor or property owner to analyze the financial risk
before pursuing a project. The YOC is then estimated by dividing the annual net operating
income by the total development costs.
The capitalization (cap) rate is a standard used by developers to assess their potential rate of
return. It is calculated by dividing the net annual operating income over the total project value.
When developers assess the potential feasibility of a project, they often base their YOC profit
expectation to be 125 basis points higher than the project's expected cap rate. Based on the
current published cap rate, a project that has a YOC less than 6.75% for commercial office space
is less likely to be built because it does not present a high enough return for a developer. A YOC
that is below the cap rate is considered to be infeasible.
Return on cost (ROC) is another measure to analyze the expected profitability of a commercial
project based on the developer selling the building, not renting it to tenants. ROC is measured
by dividing the net capitalized value over the total development costs. When the ROC is
positive, then the investor or property owner would consider the project financially feasible. A
project that has a low ROC is less likely to be built and a negative ROC is considered infeasible.
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Both of these measures are two different ways an investor or property owner would determine
whether or not to move forward with a development project. If an office project has a YOC
under 6.75% but a positive ROC, it is less likely to be built but is still considered feasible.
Commercial / R&D Office (professional and tech office, including software development)
Three prototypes were analyzed for commercial/R&D office, including development on parcels
with a maximum development potential of a 0.4 floor area ratio, or FAR (the maximum floor
area size of a new building cannot exceed 40% of the total lot area); a 1.0 FAR (building floor
area equal to lot area); and, 2.0 FAR (twice the building floor area as lot area).
The feasibility analysis suggests smaller office development on parcels that allow up to a
maximum 0.4 office FAR are unlikely to be built regardless of the affordable housing
commercial impact fee, including no fee. This finding is based on the pro forma analysis, which
shows the expected profitability of this type of development would fall below the target YOC
threshold (a yield of 6.75%). These projects result in a negative net value or ROC at $110 per
square foot in commercial linkage fees.
Notwithstanding this finding, the City Council and Palo Altans are aware of recent
commercial/R&D office projects recently built and currently in the pipeline that have been or
are being pursued based on the current fee structure (nearly $40 per square foot). As indicated
in the report, there are a number of reasons a property owner will consider redevelopment at a
lower YOC in Palo Alto, including tolerance for risk, differences in land acquisition costs, or
other factors that make the development work in some instances, where it wouldn’t in others.
The pro forma analysis does not consider every scenario and applies expected costs and returns
for typical redevelopment projects and based on interviews with developers and surveying
recent property sales, rental and construction cost data. Accordingly, the Council may want to
refrain from drawing absolute conclusions based on the report (in support of higher or lower
fees) and consider the range of fees presented as an indicator of whether a project is likely to
be built under typical conditions.
For redevelopment on parcels that allow up to 1.0 office FAR, typically downtown, the
feasibility analysis suggests a higher fee of $50 per square foot remains highly likely to be built,
but less likely at $60 per square foot. While YOC and ROC make development unlikely at higher
fees, the report concludes redevelopment is not financially infeasible (negative yield or return)
within the outer range identified in the 2015 nexus study.
It is worth noting that the current affordable housing commercial impact fee, established in
2017, is based on this prototype analysis (1.0 FAR).
Lastly, for projects located on parcels that allow up to 2.0 office FAR, typically the California
Avenue area, the feasibility analysis indicates a substantially higher impact fee up to $150 per
square foot is highly likely to redevelop.
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Figure 19 in the attached report summarizes the feasibility analysis for the commercial/R&D
office prototypes summarized above.
R&D (life science / biotech)
While not principally the focus of the Council’s request for an updated feasibility analysis, staff
asked the consultant to study the implications of an affordable housing commercial impact fee
on R&D space dedicated toward life sciences and biotech. Demand for this type of space is
increasing in some markets, including the Bay Area, and the Research Park and other areas in
the City may be suitable for this type of development. The City’s impact fee policies could have
an influence on the siting of life science companies either as an incentive to locate in Palo Alto
or disincentive.
The feasibility analysis finds the higher construction costs associated with this type of
development, coupled with the City’s high land value, results in a negative ROC even if no
affordable housing commercial impact fee is assessed. YOC also remains below the
capitalization rate. Any life science development proposed in the City today would be subject to
the current impact fee of nearly $40 per square foot.
Figure 14 in the attached report provides a detailed pro forma analysis for this prototype.
Hotel
Hotels were also not the primary focus of the feasibility study but were included to provide
Council contemporary information to help inform its impact fee policies, whether to retain the
current fee or make changes one way or the other. Based on the consultant’s analysis, the
current fee of nearly $24 per square foot is challenging for some and suggests that an increase
at this time would make hotel development infeasible. As stated in the report, a developer’s
tolerance for risk, expected return or other considerations influence decisions to build and the
City has recently processed applications for new hotel developments along El Camino Real and
San Antonio Road.
Figure 22 in the attached report provides a detailed pro forma analysis.
Discussion
Councilmembers have expressed an interest in raising commercial impact fees to better align
the impacts of this type of the need for more affordable housing in Palo Alto that supports for
lower wage industries and services that support new workers. Higher commercial impact fees
may also serve another expressed interest to reduce the amount of commercial office
development in the City and its associated impacts.
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Over the past several years, the City Council has imposed restrictions on office development in
the form of an annual office cap in certain geographic areas of the City and an overall cap on
office development citywide. The annual office cap is 50,000 square feet per year, but unused
floor area can rollover for one year. The citywide cap has 562,408 square feet remaining and
approximately 75,000 square feet is in the pipeline (pending applications currently under
review). 7
A history of net office loss and gain since 2001 will be shared with the Council in staff’s
presentation and will include information on commercial/R&D affordable housing commercial
impact fees collected since 2004. The affordable housing commercial fund presently has
$2,028,8032 ($4,781,110– all affordable housing funds) based on August unaudited figures.
The feasibility study includes impact fee information from nearby communities. If the City
Council increases the affordable housing commercial impact fee to $68.50 it would be among
the highest in the region, trailing only San Francisco with a fee of $69.60. Some jurisdictions
reduce or discount impact fees depending on the size of the development or if the project pays
prevailing wage or includes community-serving facilities.
The Council may choose to continue to use the prototype analysis for commercial projects
redeveloped on lots that allow 1.0 FAR as was previously done. This approach would support a
fee up to $50 per square foot and many properties would still be considered likely to develop.
The Council is not precluded from assessing a higher fee, including $68.50 per square foot even
though this fee may discourage some future commercial office development – particularly on
lots that allow less than 1.0 FAR commercial development. However, there are some legal risks
associated with a development fee that that exceeds the amount determined to be feasible
under the study and there are additional risks associated with fee levels that would result in a
negative return on all possible land uses for a parcel.
The Council could consider a tiered impact fee structure based on a property’s development
potential. Tiered fees, when applied, are typically based on building size, but could also be
assessed based on development potential (such as FAR). Regardless of the approach, flat fee or
tiered, the City Council will want to consider the amount that adds increased revenue to the
affordable housing fund while not completely discouraging office development that would
contribute those funds and other impact fees that support a variety of other City services.
Life sciences / biotech lab space is a land use that is currently captured in the City’s
commercial/R&D impact fee. The Council may want to consider based on the analysis whether
it wants to continue to group these land uses together or separate them to create a greater
7 3300 El Camino Real: 50,355 square feet (commercial)
123 Sherman: 23,075 square feet (commercial)
486 Hamilton: 2,108 square feet (commercial)
436 Waverly: 113 square feet (commercial)
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incentive to encourage more biotech development. The results of the study suggest elimination
of the affordable housing impact fee would still not be feasible due to other costs and the City
may not want to eliminate the fee outright. However, as seen with the other prototypes, there
are outlier conditions and a reduced fee in this regard may provide an opportunity to
encourage biotech land uses, if that is the Council’s interest. Typically, biotech uses larger floor
spaces and a lower employee density than other professional office spaces.
With regard to hotels, the feasibility study suggests increases in this impact fee may lower the
likelihood of future hotel development based on typical development patterns, density, costs
and expected returns. Presently the City’s zoning code encourages hotel development
authorizing a higher FAR compared to other land uses. No change to this fee is recommended
at this time.
Timeline
The ordinance attached to this report amending the municipal fee schedule does not require a
second reading and the fees would become effective 60 days thereafter, if adopted by Council.
Resource Impact
Preparation of the feasibility study cost approximately $46,000 and was an expense absorbed
by the Planning and Development Services budget. The Council’s direction to modify the
affordable housing commercial impact fee may result in additional revenue in the City’s
commercial affordable housing fund and used for the production, preservation or acquisition of
affordable housing units. If impact fees are too high, it may discourage commercial office
development and lower the amount of money collected through commercial impact fees that
support a variety of City services beyond the City’s affordable housing fund, such as parks,
community centers, libraries, and other public facilities. Based on the Council’s direction and
staff analysis of estimated revenue impacts, budgetary adjustments will be brought forward as
appropriate to reflect these fee changes.
Policy Implications
Adjustments to commercial impact fees may impact pending and future commercial
development in Palo Alto and, there are different perspectives as to why and how much fee
should be applied to development. Generally, impact fees are intended to off-set the financial
impact caused by the development on City services, including the amount of affordable housing
needed to support new office workers and related jobs generated when new businesses
established.
Palo Alto assesses a variety of impact fees on commercial development to mitigate costs to
support or create new opportunities for affordable housing, parks, community centers,
libraries, transportation improvements and other public services.
If the affordable housing impact fee is set at a level that discourages office development, fees
that support these community programs and services will not be collected from those foregone
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projects. A fee above the feasible levels identified in the report could also result in legal
challenges or an increase in requests for administrative relief from the fees pursuant to Palo
Alto Municipal Code section 16.65.110. On the other hand, it can also be argued that a fee set
too low may require taxpayers to subsidize these programs to a greater degree. For these
reasons, the attached feasibility study attempts to provide information to help the Council
balance these interests.
In addition to the commercial/R&D impact fee being considered, the City Council may want to
discuss its interest in establishing a tiered fee structure. This approach could be used to help
incentivize certain development, such as biotech – if that is desirable, and support smaller
professional office spaces, including medical office. Lower fees can be assigned to less impactful
or desired land uses with moderate and higher fees assigned to more typical and larger projects
that, due to their higher YOC or ROC can afford higher impact fees.
Staff notes that there are some pending commercial office projects (totaling ~75,000 square
feet) that may be impacted by the City Council’s decision to change impact fees. Typically,
development impact fees can be paid following a planning entitlement (such as ARB) and often
around the time of building permit issuance. The City Council may consider exempting pending
entitlement applications from an increase in fees, though it is not obligated to do so.
Lastly, AB 602 was recently signed by the Governor and will go into effect on January 1, 2022.
This law creates new standards for development impact fees and associated nexus studies
adopted after January 1, 2022. While the law does not directly affect the matter presently
before the Council, it will be relevant to future actions to set or changes development impact
fees like the commercial linkage fee.
Stakeholder Engagement
Following release of the commercial linkage fee feasibility study on October 4th, staff sent
mailed notices on October 1st to parties that have requested information from the City in the
past, including local and regional chapters of the Building Industry Association, and sent
courtesy notices to applicants with pending projects potentially impacted by a change in the
impact fee, and notice of this public hearing was published two weeks in a row in the Daily Post
starting on September 30th. Staff has been contacted by some property owners or
representatives concerned about an increase in the impact fee and attempted to inform others
of the Council’s scheduled public hearing.
Environmental Review
The recommendation in this report does not result in a City action and does not qualify as a
project in accordance with the California Environmental Quality Act (CEQA); rather, the City
Council is providing direction to staff on the parameters of a future ordinance that may modify
the City’s municipal fee schedule. That future ordinance is subject to CEQA and is anticipated to
be exempt from CEQA pursuant Sections 15378(b)(4), 15305 and 15601(b)(3) of the State CEQA
Guidelines.
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Attachments:
• Attachment14.a: Attachment A: Commerical Linkage Fee (CLF) Feasibility Report
(September 2021)
• Attachment14.b: Attachment B: Ordinance Amending FY 2022 Municipal Fee
Schedule, Housing Impact Fee for Non-Residential Projects
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COMMERCIAL LINKAGE FEE UPDATE
FINANCIAL FEASIBILITY ANALYSIS
Prepared for:
City of Palo Alto
September 20, 2021
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TABLE OF CONTENTS
Introduction .......................................................................................................................................... 1
Approach ............................................................................................................................................... 2
Development Prototypes ......................................................................................................................... 3
Key Assumptions ...................................................................................................................................... 5
Results ........................................................................................................................................... 11
Peer Cities...................................................................................................................................... 19
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TABLE OF FIGURES
Figure 1: Maximum Commercial Linkage Fees, Previously Recommended Commercial Linkage Fees,
and Existing Commercial Linkage Fees ...................................................................................................... 1
Figure 2: Expected Yield on Cost for Development Projects ..................................................................... 2
Figure 3. Description of Development Prototypes ..................................................................................... 4
Figure 4. Hard Costs Assumptions by Prototype ........................................................................................ 5
Figure 5. Sales Prices for vacant mixed-use and Commercial Sites Sold 2016-2021 ........................... 6
Figure 6. Soft Cost Assumptions by Land Use ........................................................................................... 7
Figure 7. Lease Rates at Comparable Class A Office Buildings with Professional Office Tenants ......... 8
Figure 8: Lease Rates at Comparable Class A R&D Buildings .................................................................. 9
Figure 9. Revenue Assumptions by Prototype......................................................................................... 10
Figure 10: Expected Yield on Cost for Development Projects ................................................................ 11
Figure 11: Fee Levels Tested in Pro Forma Analysis .............................................................................. 11
Figure 12. Summary of Financial Feasibility of Prototype 1 R&D with 0.4 FAR .................................... 12
Figure 13. Prototype 1 R&D with 0.4 FAR Linkage Fees as % of Total Development Cost .................. 12
Figure 14. Prototype 1 R&D with 0.4 FAR Pro Forma Results ............................................................... 13
Figure 15. Summary of Financial Feasibility of Prototype 2 -A Office with 0.4 FAR.............................. 14
Figure 16. Summary of Financial Feasibility of Prototype 2 -B Office with 1.0 FAR ............................. 14
Figure 17. Summary of Financial Feasibility of Prototype 2 -C Office with 2.0 FAR ............................. 15
Figure 18. Professional Office Linkage Fees as % of Total Development Cost..................................... 15
Figure 19. Prototype 2-A, 2-B, 2-C Professional Office Pro Forma Results ........................................... 16
Figure 20. Summary of Financial Feasibility of Prototype 3 Hotel ......................................................... 17
Figure 21. Prototype 3 Hotel Linkage Fees as % of Total Development Cost ....................................... 17
Figure 22. Prototype 3 Hotel Pro Forma Results .................................................................................... 18
Figure 23. Office and R&D Linkage Fees (per Gross Sq. Ft. of Net New Space) in Nearby Cities ....... 20
Figure 24. Hotel Linkage Fees (per Gross Sq. Ft. of Net New Space) in Nearby Cities ........................ 21
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INTRODUCTION
The City of Palo Alto is considering updating its commercial linkage fees on new office, R&D, and hotel
development projects. Commercial linkage fees are used to mitigate the impacts of an increase in
housing demand from employee households that require below-market-rate housing. Revenues from
linkage fees are deposited into a housing trust fund for the construction of affordable housing.
Commercial linkage fees are one of several funding sources that jurisdictions can use to help meet
affordable housing needs of new workers.
In 2015, Strategic Economics and Vernazza Wolfe Associates completed a nexus study that
established maximum commercial linkage fees for office/R&D and hotel uses. The study also included
an analysis of the financial feasibility of updated commercial linkage fees and other policy
considerations that led to the recommended fees, which are significantly lower than the maximum
fees justified by the nexus study. Figure 1 below summarizes the maximum commercial linkage fees
justified by the 2015 nexus study, the recommended fees based on the policy analysis, and the current
(2021) commercial linkage fees on office/R&D/medical office and hotel uses.
FIGURE 1: MAXIMUM COMMERCIAL LINKAGE FEES, PREVIOUSLY RECOMMENDED COMMERCIAL LINKAGE FEES, AND
EXISTING COMMERCIAL LINKAGE FEES
Land Use Maximum Justified Commercial Linkage Fee
from Nexus Study, 2015
Previously Recommended
Commercial Linkage
Fees, 2015
Existing Commercial Linkage Fee, 2021
Office / R&D $264 $35 $39.70
Hotel $177 $30 $23.11
Source: City of Palo Alto, 2021; Strategic Economics, 2021.
Since the previous nexus and feasibility studies, the value of commercial real estate and the cost of
development in Palo Alto and the greater Bay Area have changed. The City of Palo Alto has
commissioned Strategic Economics to provide an updated financial feasibility assessment and policy
analysis to analyze how an increase in fee levels for office/R&D and hotel uses would affect the
probability of development.
This memo report summarizes the results of the analysis.
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APPROACH
The analysis is based on four office and hotel development prototypes summarized in Figure 3.
Strategic Economics built a static pro forma model for each prototype that measures the profitability
of a project for the developer or investor.
It is important to note that investors consider a wide range of factors to determine if a development
project makes financial sense, and some investors may have different levels of risk tolerance than
others. However, this study relies on broadly accepted indicators to establish the likely expectations
for a typical development project in the Palo Alto market.
In this case, the return is calculated as yield on cost (YOC), a common indicator for measuring the
profitability of a commercial project from the perspective of a long-term property owner or investor.
The pro forma model tallies all development costs, including land, direct construction costs, indirect
costs (including financing), and developer fees. Revenues from lease rates or hotel room rates are the
basis for calculating annual income from the new development. The total operating costs are
subtracted from the total revenues to calculate the annual net operating income. The YOC is then
calculated by dividing the annual net operating income by the total development costs. The fee levels
were then added as an additional development cost to measure the resulting change in the YOC.
• Office/R&D – In order to attract new investment, the expected YOC for new Class A office/R&D
developments would be 125 basis points higher than the published capitalization rate (cap
rate) for similar Class A products, which is currently 5.5 percent. Therefore, the analysis
assumes that office/R&D projects that exceed a YOC of 6.75 percent are highly likely to be
developed. Projects that achieve a YOC of less than 6.75 percent, but still have a positive net
value are less likely to be built. Projects that have negative net values (the cost of development
exceeds the value from rental income) are infeasible.
• Hotel – In order to attract new investment, the expected YOC for new hotel project would need
to be 100 basis points higher than the published capitalization rate (cap rate). Cap rates for
hotel properties are currently approximately between 8.0 and 8.25 percent. Therefore, the
analysis assumes that hotel projects that exceed a YOC of at least 9.25 percent are highly
likely to be developed. Projects that achieve a YOC of less than 9.25 percent, but still have a
positive net value are less likely to be built. Projects that have negative net values (the cost of
development exceeds the capitalized value of the net operating income at a stabilized year)
are infeasible.
FIGURE 2: EXPECTED YIELD ON COST FOR DEVELOPMENT PROJECTS
Prototype
Published
Cap Rate
High Likelihood
of Development
Office/R&D (Class AA) 5.5% 6.75%
Hotel (Limited Service/Boutique) 8.0% - 8.25% 9.25%
Source: CBRE Cap Rate Survey, H2 2018; HVS, 2019; Developer interviews.
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Development Prototypes
The analysis estimates the feasibility of potential linkage fees for three land uses: R&D, office, and
hotel. Because there are a variety of different types of office and R&D development projects in Palo
Alto and the Peninsula, the analysis examined four different building prototypes. The building
characteristics of each development prototype, including size, density (floor-area-ratio), and parking
assumptions are based on a review of projects that were recently built or currently in planning stages
in Palo Alto.
The following summarizes the prototypes:
• Prototype 1: R&D Lab with FAR of 0.4. This maximum FAR for medical research R&D projects
applies in ROLM and RP districts, and is typical of recently built and proposed R&D projects.
This building type is assumed to include lab space for research and development, and used
primarily by biotech firms.
• Prototype 2-A: Professional Office with FAR of 0.4. This maximum FAR for commercial
office/R&D projects applies in CS and CN zoning districts of Palo Alto, even when part of a
mixed-use development. This prototype is similar to recently built and proposed office projects.
It is assumed that the tenants would be professional office businesses, including software
R&D.
• Prototype 2-B: Professional Office with FAR of 1.0. This maximum FAR would be possible in the
CD-C zoning district, even when part of a mixed-use development. It is assumed that the
tenants would be professional office businesses, including software R&D.
• Prototype 2-C: Professional Office with FAR of 2.0. This maximum FAR would apply to the CC(2)
zoning district, even when part of a mixed-use development. It is assumed that the tenants
would be professional office businesses, including software R&D.
• Prototype 3: Limited Service or Boutique Hotel with FAR of 2.0. Hotels are allowed at a 2.0 FAR
in the CC(2), CS, and CD-C zones. This building type is typical of recently built and proposed
hotel projects in Palo Alto.
The details regarding the size, density (floor-area ratio), parking, and other key assumptions for each
prototype are summarized in Figure 3 below.
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FIGURE 3. DESCRIPTION OF DEVELOPMENT PROTOTYPES
Development Prototypes
Assumptions Prototype 1
Prototype
2 -A
Prototype
2 -B
Prototype
2 -C Prototype 3
Type R&D Labs
Professional
Offices
Professional
Offices
Professional
Offices
Boutique or
Limited
Service
Hotel
Parcel Size (Sq. Ft.) 130,680 43,560 43,560 43,560 43,560
Parcel Size (acres) 3.00 1.00 1.00 1.00 1.00
Building Height and FAR
FAR (without parking) [a] 0.40 0.40 1.00 2.00 2.00
Building area
Gross area (gsf) 52,272 17,424 43,560 87,120 87,120
Efficiency Ratio [b] 90% 90% 90% 90% n/a
Net leasable area (nsf) 47,045 15,682 39,204 78,408 n/a
Number of rooms n/a n/a n/a n/a 120
Parking
% Underground 40% 70% 90% 90% 90%
Surface 103.0 17.0 14.0 29.0 10.0
Underground 69.0 40.0 130.0 258.0 86.0
Total Spaces 172.0 57.0 144.0 287.0 96.0
Parking Ratio (per room) n/a n/a n/a n/a 0.80
Parking Ratio (per gross 1,000 SF) 3.3 3.3 3.3 3.3 1.10
Source: City of Palo Alto, 2021; Strategic Economics, 2021. Notes:
[a] The Floor-Area Ratio (FAR) is often used as a measure of density. In this analysis, it is calculated as the gross building area, not
including parking, divided by the parcel size.
[b] The Efficiency Ratio refers to the ratio of gross building area to net leasable area. An efficiency ratio of 90% means that 90% of the gross building area is leasable space. In hotels, revenue is informed by room count, rather than square footage, and therefore the net area is omitted.
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Key Assumptions
DEVELOPMENT COSTS
The development costs incorporated into the pro forma analysis include hard costs (construction
materials and labor), land costs, soft costs (indirect costs), and financing costs.
HARD COSTS
Hard costs, or construction costs, include labor and materials. The hard cost assumptions are based
on Strategic Economics’ review of pro formas for similar development projects, industry publications,
and interviews with developers with projects in Palo Alto and nearby jurisdictions. It is important to
note that construction costs are currently at an all-time high due to COVID-19, which has caused
disruptions in the labor market and supply chain throughout the United States. For the purposes of
this analysis, it is assumed that hard costs return to pre-pandemic conditions.
As shown in Figure 4, hard costs include building construction, parking and the tenant improvements
typically required for professional offices and R&D labs. For hotels, there is an assumption for the cost
of Furniture, Fixtures, and Equipment (FF&E).
FIGURE 4. HARD COSTS ASSUMPTIONS BY PROTOTYPE
Cost
Unit of
measure
Prototype 1
R&D Lab
0.4 FAR
Prototype 2 -A
Professional
Office 0.4 FAR
Prototype 2 -B
Professional
Office 1.0 FAR
Prototype 2 -C
Professional
Office 2.0 FAR
Prototype 3
Hotel
2.0 FAR
Site and Building Costs Construction Costs
(includes site prep)
per gross
building SF $350 $300 $300 $300 $225
per room $163,350
FF&E per room $20,000
Parking Costs Cost per Space
Surface $7,500
Underground $100,000
Land Costs
Entitled land per site SF $300 $300 $425 $650 $300
per acre $13,068,000 $13,068,000 $18,513,000 $28,314,000 $13,068,000
per FAR $5,227,200 $5,227,200 $18,513,000 $56,628,000 Tenant Improvements
(PLSF) Tenant Improvement Allowance per lsf $150 $80 $80 $80 $0
Source: Strategic Economics, 2021.
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LAND COSTS
One of the critical cost factors for a non-residential development project is land cost. To determine the
land value of sites zoned for commercial and mixed-use, Strategic Economics analyzed recent sales
transactions for properties in Palo Alto and interviewed property owners and developers. As shown,
there is a wide range in value for mixed-use and commercial properties in Palo Alto. Generally,
properties in Downtown Palo Alto tend to command higher prices than properties on commercial
corridors.
FIGURE 5. SALES PRICES FOR VACANT MIXED-USE AND COMMERCIAL SITES SOLD 2016-2021
Property Site Area SF Sale Price Sale Price per SF
630 Cowper St
15,520 $10,000,000 $644.33
4115 El Camino Real
15,969 $7,650,000 $479.05
2755 El Camino Real 19,602 $7,500,000 $382.61
796 San Antonio Rd (Part of Multi-Property Sale)
30,491 $7,712,762 $252.95
788 San Antonio Rd (Part of Multi-Property Sale)
22,651 $3,837,238 $169.41
2515 El Camino Real
41,382 $23,000,000 $555.80
Source: CoStar Group, 2021; Strategic Economics, 2021. For the purposes of this analysis, it is assumed that sites zoned for 0.4 FAR office and 2.0 FAR hotel
uses would have a value of $300 per square foot ($13 million per acre). Sites zoned for 1.0 FAR would
have a higher value of $425 per square foot ($18.5 million per acre). Sites zoned for 2.0 FAR office
uses would have the highest value of $650 per square foot ($28 million per acre).
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SOFT COSTS
Soft costs (often referred to as indirect costs) include items such as architectural fees, engineering
fees, insurance, taxes, legal fees, accounting fees, city fees, and marketing costs. Major impact fees
were calculated based on the City’s Development Impact Fee schedule for 2021, and inflated to 2022.
Palo Alto’s Traffic Impact Fee and other permits and fees were calculated by City staff for 2022. Soft
costs were estimated as a percentage of hard costs based on standard industry ratios. These
assumptions are shown in Figure 6.
FIGURE 6. SOFT COST ASSUMPTIONS BY LAND USE
Cost Unit of measure Office/R&D Hotel
Impact Fees (inflated to 2022)
Parks Impact Fee per sq. ft. $16.84 $2.87
Community Centers Impact Fee per sq. ft. $1.30 $0.22
Public Safety Facilities Impact Fee per sq. ft. $0.66 $0.66
General Govt Facilities Impact Fee per sq. ft. $0.83 $0.83
Libraries Impact Fee per sq. ft. $0.78 $0.13
Citywide Traffic Impact Fee per sq. ft. $11.89 $3.64
Planning Fees per sq. ft. $0.79 $0.53
Building Fees per sq. ft. $8.66 $6.91
Subtotal City Permits and Fees per sq. ft. $41.73 $15.78
Other Soft Costs % of hard costs
Arch, Eng & Consulting % of hard costs 4.0% 4.0%
Taxes, Insurance, Legal, Accounting % of hard costs 3.0% 3.0%
Contingencies % of hard costs 4.0% 4.0%
Developer Overhead % of hard costs 3.0% 3.0%
Other Soft Costs (Excluding Fees) % of hard costs 14.0% 14.0%
Construction Financing
% of hard +
soft costs 6.0% 6.0%
Source: City of Palo Alto, 2021; Strategic Economics, 2021.
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REVENUES
The commercial real estate market has been greatly affected by the COVID-19 pandemic, with
declining occupancy rates for hotel and office properties, and declining room rates and lease rates.
Because of the historical strength of the office and hotel markets in Palo Alto and the greater Silicon
Valley economy, this analysis assumes that market conditions will be healthy within the next few years.
The revenue assumptions are based on market values for office, R&D, and hotel uses prior to the
onset of the pandemic. The data sources include commercial broker reports, hospitality industry
reports, and Costar, as well as from interviews with developers and brokers active in Palo Alto and
Santa Clara County.
Professional Office: For professional office rents, Strategic Economics reviewed data for Class A office
buildings in Palo Alto that are tenanted by professional firms, summarized in Figure 7 below. The rental
rates vary significantly by building, but at the higher end of the range, the median monthly triple-net
(NNN)1 rent is $6.71 per square foot. The top quartile rents are $9.58 per month. For the purposes of
this analysis, Strategic Economics assumed a rental rate of $9.50 per square foot NNN, which is at
the higher range for a new, multi-tenant tech office building in Palo Alto.
FIGURE 7. LEASE RATES AT COMPARABLE CLASS A OFFICE BUILDINGS WITH PROFESSIONAL OFFICE TENANTS
Property Address Year Built Tenant Submarket
Mid-Point Monthly Rent/SF NNN
3223 Hanover St 2021 JP Morgan Tech HQ Stanford $6.71
2747 Park Blvd 2019 Tencent Other $6.58
3421 Hillview Ave 2018 Vmware Other $7.04
2555 Park Blvd 2018 Globality Inc California Avenue $9.54
500-508 University Ave 2017 Accel Downtown Palo Alto $6.42
550 High St 2016 EY Downtown Palo Alto $13.88
385 Sherman Ave 2016 VISA Research California Avenue $6.46
611 Cowper St 2015 Amazon Downtown Palo Alto $9.63
3305 Hillview Ave 2002 Tibco Other $5.71
3307 Hillview Ave 2002 Tibco Other $4.17
435 Tasso St 1984 Formation Group Downtown Palo Alto $10.07
Median $6.71
Top Quartile $9.58
Source: CoStar Group, 2021; Strategic Economics, 2021. Notes: Mid-point of the rental ranges estimated by CoStar are based on historical lease transactions, historical asking rents, market trends, and more. Tenants listed are based on the most recent data available online. Buildings may host more than one tenant at an address, and tenants listed may no longer be the current tenants.
1 A triple net lease (triple-Net or NNN) is a lease agreement on a property whereby the tenant or lessee promises to pay all the expenses of the property including real estate taxes, building insurance, and maintenance.
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R&D/Labs: For R&D rents, Strategic Economics reviewed data for comparable buildings in Palo Alto
that are occupied by R&D firms, summarized in Figure 8 below. The rental rates range from $3.71 to
$9 per square foot, with a median monthly triple-net rent of $7.37. For the purposes of this analysis,
Strategic Economics assumed that the monthly rent for a new R&D building would be $7.50 per square
foot NNN.
FIGURE 8: LEASE RATES AT COMPARABLE CLASS A R&D BUILDINGS
Property Address Year Built Tenant Submarket
Mid-Point
Monthly
Rent/SF NNN
3181 Porter Dr 2018 Stanford Research Park Stanford $6.50
900-908 Arastradero Rd 2018 Stanford Research Park Stanford $9.00
1450 Page Mill Rd 2017 Argo AI Stanford $6.95
278 University Ave 2013 Invitae Downtown Palo Alto $7.79
3301 Hillview Ave 2002 Docomo Innovations Stanford $3.71
925 Page Mill Rd 1998 DuPont Stanford $8.04
Median $7.37
Source: CoStar Group, 2021; Strategic Economics, 2021. Notes: Mid-point of the rental ranges estimated by CoStar are based on historical lease transactions, historical asking rents, market trends, and more. Tenants listed are based on the most recent data available online. Buildings may host more than one tenant at an address, and tenants listed may no longer be the current tenants.
Hotel: The assumptions of hotel revenues are based on a combination of data sources, including
interviews with hotel developers in Palo Alto, and data from STR, a hotel research firm that tracks hotel
room rates, vacancy rates, and revenues per available room for properties in Palo Alto (see Figure 9).
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FIGURE 9. REVENUE ASSUMPTIONS BY PROTOTYPE
R&D Monthly Rent per Sq. Ft. (NNN) $7.50
Annual Rent per Sq. Ft. (NNN) $90.00
Vacancy 5%
Operating Expenses 7.5%
Net Operating Income per Sq. Ft. $78.75
Cap Rate 5.50%
Capitalized Value/Sq. Ft. $1,431.82
Office
Monthly Rent per Sq. Ft. (NNN) $9.50
Annual Rent per Sq. Ft. (NNN) $114.00
Vacancy 5% Operating Expenses 7.50%
Net Operating Income per Sq. Ft. $99.75
Cap Rate 5.50%
Capitalized Value/Sq. Ft. $1,813.64
Hotel Daily/room Annual/room
Gross Room Income (RevPAR) [a] $250 $91,250
Gross Other Revenue [b] $88 $31,938
Gross Revenue $338 $123,188
Less: Vacancy [c] $0
Less: Operating Expenses 70% ($86,231)
Annual Net Operating Income $36,956
Cap Rate 8.25%
Capitalized Value per Room $447,955
Source: Costar, 2021; Smith Travel Research, 2021. Host Almanac, 2018; Strategic Economics, 2021. Notes: [a] RevPAR is a measure of revenue per room, calculated as occupancy percentage times average daily rate. [b] Other Revenue for hotels based on data from STR Consulting, and from hotel developer interviews.
[c] Vacancy is already reflected in RevPAR estimate.
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RESULTS
The financial feasibility of development is assessed using two metrics described below:
1. Yield on Cost
As described in the Approach section of the report, the pro forma analysis estimates the profitability
of a development project using the yield on cost (YOC) metric. Projects that achieve the target YOC for
feasibility are much more likely to be built. Projects that achieve a lower YOC but still have a positive
net value are less likely to be built. The target YOC thresholds for office/R&D and hotel projects are
shown in Figure 10 below.
FIGURE 10: EXPECTED YIELD ON COST FOR DEVELOPMENT PROJECTS
Prototype Published Cap Rate Target YOC for Feasibility
Office/R&D (Class AA) 5.5% 6.75%
Hotel (Limited Service/Boutique) 8.0% - 8.25% 9.25%
Source: CBRE Cap Rate Survey, H2 2018; HVS, 2019; Developer interviews.
2. Return on Cost
In addition to the YOC metric, Strategic Economics also calculated the return on cost. This is the net
capitalized value of the project divided by the total development cost. Some of the projects produce
a negative net value and a negative return on cost. Projects with a negative return on cost are
infeasible because the cost of development is greater than the value generated from rents or room
rates.
Using the metrics defined above, the following summarizes the results of the financial feasibility of
different commercial linkage fee levels for each prototype. The fee scenarios tested in the analysis are
summarized below.
FIGURE 11: FEE LEVELS TESTED IN PRO FORMA ANALYSIS
Office and R&D Fee Levels Tested Hotel Fee Levels Tested
No Linkage Fee No Linkage Fee
$40 Existing Linkage Fee $23 Existing Linkage Fee
$50 $30
$60 $50
$70 $177 - Maximum Nexus Fee
$150
$160
$264 Maximum Nexus Fee
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R&D
R&D Lab/BioTech (Prototype 1) None of the commercial linkage fee levels tested for the R&D lab
projects with a 0.4 FAR are financially feasible based on current market conditions. Even without a
linkage fee, the prototype does not meet the target YOC as shown in Figure 12. The R&D lab spaces
have extremely high construction costs. This, combined with the high value of land in Palo Alto, render
this prototype infeasible. The development costs for the R&D prototype are greater than the value
generated from the development, resulting in a negative net value and a negative return on cost. It is
possible that a higher intensity R&D project would be more likely to be feasible. Most new R&D projects
built recently in the Peninsula have allowable FAR of 1.0 or higher.
As shown in Figure 13, the existing linkage fee (inflated to 2022) accounts for approximately 2.6
percent of total development costs. Increasing the fee to $70 would raise the burden to 4.5 percent
of total development costs. The maximum nexus fee of $264 would be a much higher cost burden on
projects, accounting for 17 percent of total development costs.
The detailed pro forma for the R&D prototype is shown in Figure 14.
FIGURE 12. SUMMARY OF FINANCIAL FEASIBILITY OF PROTOTYPE 1 R&D WITH 0.4 FAR
Linkage Fee per Sq. Ft. Yield on Cost
Return on
Cost
Feasibility of
Development
No Linkage Fee 4.57% -16.86% Infeasible
$40 - Existing Linkage Fee 4.46% -19.42% Infeasible
$50 4.43% -20.08% Infeasible
$60 4.40% -20.73% Infeasible
$70 4.38% -21.37% Infeasible
$150 4.17% -26.53% Infeasible
$160 4.15% -27.18% Infeasible
$264 - Maximum Linkage Fee 3.91% -33.89% Infeasible Source: Strategic Economics FIGURE 13. PROTOTYPE 1 R&D WITH 0.4 FAR LINKAGE FEES AS % OF TOTAL DEVELOPMENT COST
Linkage Fees as % of Total Development Cost
$40 - Existing Linkage Fee 2.6%
$50 3.2%
$60 3.9%
$70 4.5%
$150 9.7%
$160 10.3%
$264 - Maximum Linkage Fee 17.0%
Source: Strategic Economics, 2021.
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FIGURE 14. PROTOTYPE 1 R&D WITH 0.4 FAR PRO FORMA RESULTS
Assumption Prototype 1
Parcel Size acres 3.00
Gross Building Area square feet 52,272
Net Building Area square feet 47,045
FAR (without parking garage) 0.40
Revenues
Gross Revenue $4,234,032
Net Operating Income $3,704,778
Capitalization Rate 5.50%
Capitalized Value $67,359,600 Costs Land Costs $39,204,000
Direct Costs Gross Building Area $18,295,200
FF&E n/a
Tenant Improvement Allowance $7,056,720
Parking $7,672,500
Subtotal Direct Costs $33,024,420
per net square ft $701.98
per gross square ft $631.78
Indirect Costs
Soft Costs $4,623,419
City Permits and Fees (excl. commercial linkage) $2,181,525
Subtotal Indirect Costs $6,804,943
Financing Costs $1,981,465
Total Development Cost (TDC) $81,014,829
per net square ft $1,722
Profit (Net Value - TDC) No Linkage Fee $0 ($13,655,229)
Existing Linkage Fee - Office/R&D $40 ($14,863,042)
$50 ($16,268,829)
$60 ($16,791,549)
$70 ($17,314,269)
$150 ($21,496,029)
$160 ($22,018,749)
Maximum Nexus Fee - Office/R&D $264 ($27,455,037)
Yield on Cost (NOI/TDC)
No Linkage Fee $0 4.57%
Existing Linkage Fee - Office/R&D $40 4.46%
$50 4.43%
$60 4.40%
$70 4.38%
$150 4.17%
$160 4.15%
Maximum Nexus Fee - Office/R&D $264 3.91%
Source: Strategic Economics, 2021.
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Professional Office (Prototype 2-A) Professional office projects with a 0.4 FAR are unlikely to be able
to support a higher commercial linkage fee. As shown in Figure 15, the 0.4 FAR professional office
development prototype does not achieve the target YOC with the existing and higher commercial
linkage fee levels. It is unlikely that a development project would move forward with a higher cost of
development. The maximum fee level of $264 per square foot would be infeasible because it creates
a negative net value and negative return on cost.
FIGURE 15. SUMMARY OF FINANCIAL FEASIBILITY OF PROTOTYPE 2 -A OFFICE WITH 0.4 FAR
Fee per Sq. Ft. Yield on Cost Return on Cost Likelihood of Development
No Linkage Fee 5.90% 7.22% Unlikely
Existing Linkage Fee - $40 5.75% 4.61% Unlikely
$50 5.71% 3.93% Unlikely
$60 5.67% 3.28% Unlikely
$70 5.64% 2.62% Unlikely
$150 5.28% -2.64% Infeasible
$160 5.28% -3.29% Infeasible
Maximum Nexus Fee - $264 5.03% -10.12% Infeasible
Source: Strategic Economics, 2021.
Professional Office (Prototype 2-B) A professional office development with a 1.0 FAR can support a
commercial linkage fee of up to $50 per square foot. There are limited locations in Palo Alto where
this prototype would be allowed under the existing land use regulations. However, as shown in Figure
16, the 1.0 FAR professional office project can support a linkage fee of $50, with a YOC of 6.77%. At
higher fee levels, the development prototype becomes less likely to be built because it does not meet
the target YOC, although it remains close. The impact of each fee level on total development costs is
shown in Figure 18.
FIGURE 16. SUMMARY OF FINANCIAL FEASIBILITY OF PROTOTYPE 2 -B OFFICE WITH 1.0 FAR
Fee per Sq. Ft. Yield on Cost Return on Cost Likelihood of Development
No Linkage Fee 7.05% 28.11% Highly likely
Existing Linkage Fee - $40 6.83% 24.99% Highly likely
$50 6.78% 24.18% Highly likely
$60 6.73% 23.40% Unlikely
$70 6.68% 22.61% Unlikely
$150 6.30% 16.33% Unlikely
$160 6.26% 15.55% Unlikely
Maximum Nexus Fee - $264 5.84% 7.39% Unlikely
Source: Strategic Economics, 2021.
Professional Office (Prototype 2-C) A professional office development with a 2.0 FAR can support a
commercial linkage fee of between $70 and $150 per square foot. There are a small number of sites
in Palo Alto where a 2.0 FAR for office development would be allowed. As shown in Figure 17, the 2.0
FAR professional office project can support a linkage fee of up to $70, with all of the fee levels tested
resulting in a YOC of more than 6.75%. The development prototype is not likely to support the
maximum nexus fee of $264, which does not meet the target YOC. As summarized in Figure 18 fee of
$70 would increase the cost burden to 6.1 percent of total development costs. A fee of $150 would
represent 13 percent of total development costs. The maximum nexus fee would account for 23
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percent of total development costs. The detailed pro forma for the professional office prototypes is
shown in Figure 19.
FIGURE 17. SUMMARY OF FINANCIAL FEASIBILITY OF PROTOTYPE 2 -C OFFICE WITH 2.0 FAR
Fee per Sq. Ft. Yield on Cost Return on Cost Likelihood of Development
No Linkage Fee 7.66% 39.33% Highly likely
Existing Linkage Fee - $40 7.41% 35.94% Highly likely
$50 7.35% 35.06% Highly likely
$60 7.29% 34.21% Highly likely
$70 7.23% 33.36% Highly likely
$150 6.79% 26.53% Highly likely
$160 6.74% 25.67% Unlikely
Maximum Nexus Fee - $264 6.25% 16.80% Unlikely
Source: Strategic Economics, 2021.
FIGURE 18. PROFESSIONAL OFFICE LINKAGE FEES AS % OF TOTAL DEVELOPMENT COST
Linkage Fees as % of Total Development Cost
Prototype 2-A
0.4 FAR
Prototype 2-B
1.0 FAR
Prototype 2 -C
2.0 FAR
Existing Linkage Fee - $40 2.6% 3.1% 3.4%
$50 3.3% 3.9% 4.3%
$60 3.9% 4.7% 5.1%
$70 4.6% 5.5% 6.0%
$150 9.9% 11.8% 12.8%
$160 10.5% 12.6% 13.7%
Maximum Nexus Fee - $264 17.3% 20.7% 22.5%
Source: Strategic Economics, 2021.
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FIGURE 19. PROTOTYPE 2-A, 2-B, 2-C PROFESSIONAL OFFICE PRO FORMA RESULTS
Assumption
Prototype 2 -A Professional Office
0.4 FAR
Prototype 2 -B Professional Office
1.0 FAR
Prototype 2 -C Professional Office
2.0 FAR
Parcel Size acres 1.00 1.00 1.00
Gross Building Area square feet 17,424 43,560 87,120
Net Building Area square feet 15,682 39,204 78,408
FAR 0.40 1.00 2.00
Revenues Gross Revenue $1,787,702 $4,469,256 $8,938,512
Net Operating Income $1,564,240 $3,910,599 $7,821,198
Capitalization Rate 5.50% 5.50% 5.50%
Capitalized Value $28,440,720 $71,101,800 $142,203,600
Costs Land Costs $13,068,000 $18,513,000 $28,314,000
Direct Costs Gross Building Area $5,227,200 $13,068,000 $26,136,000
FF&E n/a n/a n/a
Tenant Improvement Allowance $1,254,528 $3,136,320 $6,272,640
Parking $4,127,500 $13,105,000 $26,017,500
Subtotal Direct Costs $10,609,228 $29,309,320 $58,426,140
Indirect Costs Soft Costs $1,485,292 $4,103,305 $8,179,660
City Permits and Fees (excl. commercial linkage) $727,175 $1,817,937 $3,635,874
Subtotal Indirect Costs $2,212,467 $5,921,242 $11,815,534
Financing Costs $636,554 $1,758,559 $3,505,568
Total Development Cost (TDC) $26,526,248 $55,502,121 $102,061,242
Profit (Net Value - TDC) No Linkage Fee $0 $1,914,472 $15,599,679 $40,142,358
Existing Linkage Fee - Office/R&D $40 $1,222,726 $13,870,315 $36,683,631
$50 $1,043,272 $13,421,679 $35,786,358
$60 $869,032 $12,986,079 $34,915,158
$70 $694,792 $12,550,479 $34,043,958
$150 ($699,128) $9,065,679 $27,074,358
$160 ($873,368) $8,630,079 $26,203,158
Maximum Nexus $264 ($2,685,464) $4,099,839 $17,142,678
Yield on Cost (NOI/TDC) No Linkage Fee $0 5.90% 7.05% 7.66%
Existing Linkage Fee - Office/R&D $40 5.75% 6.83% 7.41%
$50 5.71% 6.78% 7.35%
$60 5.67% 6.73% 7.29%
$70 5.64% 6.68% 7.23%
$150 5.28% 6.30% 6.79%
$160 5.28% 6.26% 6.74%
Maximum Nexus Fee - Office/R&D $264 5.03% 5.84% 6.25%
Source: Strategic Economics, 2021.
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Hotel
As summarized in Figure 20 for hotel projects, the existing linkage fee of $24 per square foot is
challenging for hotel projects, with a yield of cost of 8.31%. The threshold for feasibility is 9.25%. At
higher fee levels, the prototype becomes infeasible, with total development costs exceeding the net
value of the project. The existing linkage fee represents 4.0% of total development costs (see Figure
21). A higher fee of $30 per square foot would increase the burden to 5.1% of total development costs.
The current market for hotels is exceptionally challenging due to the impacts of COVID-19 on business
travel and tourism. The results of the feasibility analysis indicate that further increases in the cost of
development are likely to inhibit future development projects.
The detailed pro forma for the hotel prototype is shown in Figure 22.
FIGURE 20. SUMMARY OF FINANCIAL FEASIBILITY OF PROTOTYPE 3 HOTEL
Fee per Sq. Ft. Yield on Cost Return on Cost Likelihood of Development
No Linkage Fee 8.65% 4.88% Unlikely
Existing Linkage Fee - $23 8.33% 0.95% Unlikely
$30 8.23% -0.22% Infeasible
$50 7.97% -3.62% Infeasible
Maximum Nexus Fee - $177 6.65% -25.21% Infeasible
Source: Strategic Economics, 2021.
FIGURE 21. PROTOTYPE 3 HOTEL LINKAGE FEES AS % OF TOTAL DEVELOPMENT COST
Linkage Fees as % of Total Development Cost
Existing Linkage Fee - $23 3.9%
$30 5.1%
$50 8.5%
Maximum Nexus Fee - $177 30.1%
Source: Strategic Economics, 2021.
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FIGURE 22. PROTOTYPE 3 HOTEL PRO FORMA RESULTS
Assumption Prototype 3
Parcel Size acres 1.00
Gross Building Area square feet 87,120
Net Building Area square feet n/a
FAR (without parking garage) 2.00
Revenues
Gross Revenue $14,782,500
Net Operating Income $4,434,750
Capitalization Rate 8.25%
Capitalized Value $53,754,545
Costs
Land Costs $13,068,000
Direct Costs
Gross Building Area $19,602,000
FF&E $2,400,000
Tenant Improvement Allowance $0
Parking $8,675,000
Subtotal Direct Costs $30,677,000
per net SF/per room $255,641.67
per gross SF $352.12
Indirect Costs
Soft Costs $4,294,780
City Permits and Fees (excl. commercial linkage) $1,375,125
Subtotal Indirect Costs $5,669,905
Financing Costs $1,840,620
Total Development Cost (TDC) $51,255,525
per room $427,129
Profit (Net Value - TDC)
No Linkage Fee $0 $2,499,021
Existing Linkage Fee - Hotel $23 $485,999
$30 ($114,579)
$50 ($1,856,979)
Maximum Nexus Fee -Hotel $177 ($12,921,219)
Yield on Cost (NOI/TDC)
No Linkage Fee $0 8.65%
Existing Linkage Fee - Hotel $23 8.33%
$30 8.23%
$50 7.97%
Maximum Nexus Fee - Hotel $177 6.65%
Source: Strategic Economics, 2021.
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PEER CITIES
A large share of municipalities in the Bay Area have adopted commercial linkage fees. Figure 23
summarizes commercial linkage fees for office and R&D, and Figure 24 shows linkage fees for hotel
uses in peer cities.
For office and R&D uses, most cities have set their linkage fees within the range of $15 to $30 per
square foot, well below Palo Alto’s current fee. Some jurisdictions, including Mountain View and San
Francisco, have set lower fees for R&D than professional office uses. Burlingame, Mountain View,
Santa Clara, and Sunnyvale have set lower fees for smaller-scale office projects.
San Francisco charges significantly higher fees on office and R&D than most other cities. San
Francisco increased its commercial linkage fees to $46 per square foot for R&D and nearly $70 for
office uses in December 2019. It is important to note that a feasibility analysis and an economic
impact study conducted for San Francisco found that the increased fee for office uses would likely
postpone or halt the construction of development projects, and would likely have a negative impact
on jobs in the city.2 Santa Clara County charges all non-residential space on Stanford University land
(in unincorporated Santa Clara County) a commercial linkage fee of $68.50 per square foot. Strategic
Economics is not aware if Santa Clara County conducted a financial feasibility assessment for the fee.
Commercial linkage fees for hotel uses in the Bay Area range from $5 to $23 per square foot with
most fees around $10 per square foot. The cities of Palo Alto and San Francisco have the highest
linkage fees on hotels. These cities also have higher average hotel room rates than other Bay Area
locations.
Many municipalities provide exemptions or fee reductions for certain types of projects, including:
• Smaller projects. For example, commercial linkage fees do not apply to projects adding less
than 5,000 gross square feet in Redwood City, San Carlos, San Mateo City, or Burlingame.
Projects adding less than 3,500 gross square feet in unincorporated land in San Mateo County,
and less than 10,000 gross square feet in Menlo Park or East Palo Alto are also exempt. Some
cities also tie their fee to building size on a sliding scale. Mountain View offers a 50% fee
reduction for office projects under 10,000 square feet and hotel projects under 25,000 square
feet. Sunnyvale also offers a 50% fee discount for the first 25,000 square feet of any project.
• Prevailing wage. Multiple jurisdictions, including Redwood City, San Carlos, San Mateo City,
and San Mateo County, provide 25% fee reductions for projects that pay prevailing wage.
• Community-serving facilities. Most cities exempt projects such as hospitals/clinics, childcare, public, educational, religious, and/or non-profit uses. Additionally, projects that are replacing
property damaged from natural disasters are also often exempted.
It is common for jurisdictions to allow alternative means of complying with commercial linkage fee
requirements. Developers can typically satisfy the requirement by providing affordable housing either
on or off-site, or by dedicating land for affordable housing. In most cases, the applicant must first prove
that an alternative is necessary.
2 https://commissions.sfplanning.org/cpcpackets/2019-011975PCA.pdf
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Many cities have either enacted or updated their fees in the last four years, and fees are typically
adjusted annually, based on either ENR’s Construction Cost Index for the San Francisco Bay area, or
on the national Consumer Price Index.
FIGURE 23. OFFICE AND R&D LINKAGE FEES (PER GROSS SQ. FT. OF NET NEW SPACE) IN NEARBY CITIES
Jurisdiction Base Office
and R&D Fee
Reduced Office
and R&D Fee
Date Fee Was
Adopted or Updated
Burlingame $25 $18 (a) 2017
Cupertino $23.76 2015
Los Altos $25 2018
Menlo Park $17.79 2018
Mountain View $29.62 $14.81 (a)
$26.22 (b) 2021
Palo Alto $40 2017
Redwood City $20 2015
San Carlos $20 2017
San Francisco $69.60 $48.98 (a) $38.37 (b) 2019
San Mateo City $25 2016
San Mateo County $25 2016
Santa Clara City $20 $10 (a) 2017
Stanford University
Properties in Santa Clara County (c) $68.50 2018
South San Francisco $15 2018
Sunnyvale $16.50 $8.25 (a) 2015
Source: City Ordinances and Fee Schedules; 21 Elements, 2019; Silicon Valley at Home, 2019; Strategic Economics, 2021.
Notes:
(a) Fees vary based on project size in four cities: In Burlingame, Mountain View, Santa Clara, and Sunnyvale, office projects under
50,000 sq. ft., 10,000 sq. ft., 20,000 sq. ft. and 25,000 sq. ft. respectively pay the lower fee.
(b) Fees vary based on a differentiation between Professional/High-Tech Office and R&D in two cities. The lower fees are for R&D.
(c) Santa Clara County's fee is specific to Stanford University's academic space. Academic space is defined in the Code of Ordinances
as all building uses, except building uses for housing and parking facilities, within the Stanford University Community Plan Area.
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FIGURE 24. HOTEL LINKAGE FEES (PER GROSS SQ. FT. OF NET NEW SPACE) IN NEARBY CITIES
Jurisdiction Hotel Fee Date Fee Was Adopted or Updated
Burlingame $12 2017
Cupertino $11.88 2015
Los Altos $15 2018
Menlo Park $9.66 2018
Mountain View (a) $1.60 - $3.17 2021
Palo Alto $24 2017
Redwood City $5 2015
San Carlos $10 2017
San Francisco $23.36 2019
San Mateo City $10 2016
San Mateo County $10 2016
Santa Clara City $5 2017
South San Francisco $5 2018
Sunnyvale $8.25 2015
Source: City Ordinances and Fee Schedules; 21 Elements, 2019; Silicon Valley at Home, 2019; Strategic Economics, 2021.
Notes: (a) Fees vary based on project size in Mountain View. For hotels under 25,000 sq. ft., the fee is $1.60 per square foot. The fee increases to $3.17 for hotels over 25,000 sq. ft.
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Ordinance No. ____
Ordinance of the Council of the City of Palo Alto Amending the Fiscal Year 2022
Municipal Fee Schedule to Update the Housing Impact Fee for Non-Residential
Projects.
The Council of the City of Palo Alto ORDAINS as follows:
SECTION 1. Findings and declarations. The City Council finds and declares as follows:
A. To ensure that future development projects mitigate their impact on the need for
affordable housing in Palo Alto, and to ensure that any adopted housing impact fees for non-
residential development do not exceed the actual affordable housing impacts attributable to the
development projects to which the fees relate, the City Council received and considered a report
from Strategic Economics and Vernazza Wolfe Associates dated November 2015 and entitled
"Commercial Linkage Fee Nexus Study," (the “Nexus Study”) and the findings of the Nexus Study
are incorporated into this Ordinance by this reference.
B. The Nexus Study used generally accepted and appropriate methodology to
determine the maximum amount needed to fully mitigate the burdens created by nonresidential
and mixed-use development on the need for affordable housing and establish that there is a
reasonable relationship between the need for affordable housing and impacts of development
for which a fee is charged, and that there is also a reasonable relationship between the impact
fee’s use and the type of development for which the fee is charged.
C. In October 2021, the City Council received and considered a study prepared by
Strategic Economics dated September 2021 and entitled “Commercial Linkage Fee Update,
Financial Feasibility Analysis.” This study analyzed economic returns and the likelihood of non-
residential development at various fee levels not exceeding the actual affordable housing
impacts identified in the Nexus Study.
D. The City Council now desires to update its housing impact fees for certain
nonresidential and mixed-use development projects as authorized by Palo Alto Municipal Code
Chapter 16.65, which fees do not exceed the justified fees needed to mitigate the actual
affordable housing impacts attributable to the development projects to which the fees relate, as
determined by the Nexus Study.
E. At least ten days prior to the date this ordinance is being heard, data was made
available to the public indicating the amount of cost, or estimated cost, required to provide the
service for which the fee or service charge is levied and the revenue sources anticipated to
provide the service, including general fund revenues, in accordance with Government Code
Section 66019.
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F. At least fourteen days prior to the date this ordinance is being heard, notice was
provided to any persons or organizations who had requested notice, in accordance with
Government Code Sections 66004 and 66019.
G. Notice of the hearing on the proposed fees was published twice in the manner set
forth in Government Code Section 6062a as required by Government Code Sections 66004 and
66018.
SECTION 2. The Council of the City of Palo Alto amends the Fiscal Year 2022 Municipal Fee
Schedule by adopting the Housing Impact Fees for Non-Residential development, as set forth in
Exhibit “A” and incorporated here by reference.
SECTION 3. If any section, subsection, sentence, clause, or phrase of this Ordinance is for any
reason held to be invalid or unconstitutional by a decision of any court of competent jurisdiction,
such decision shall not affect the validity of the remaining portions of this Ordinance. The City
Council hereby declares that it would have passed this Ordinance and each and every section,
subsection, sentence, clause, or phrase not declared invalid or unconstitutional without regard
to whether any portion of the ordinance would be subsequently declared invalid or
unconstitutional.
SECTION 4. The Council finds that the adoption of this ordinance is exempt from the provisions
of the California Environmental Quality Act pursuant to CEQA Guideline section 15305 because
the adjustment of a fee represents only a minor change in land use regulations and section
15061(b)(3) because it can be seen with certainty that the minor adjustments herein will not have
a significant effect on the environment.
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SECTION 5. As an amendment to the City’s budget, this ordinance shall be effective upon
adoption pursuant to Palo Alto Municipal Code Section 2.04.330, subdivision (a)(3); however, the
updated fees be effective no sooner than 60 days from the date of adoption, pursuant to
California Government Code Section 66017.
INTRODUCED and PASSED:
AYES:
NOES:
ABSENT:
ABSTENTIONS:
NOT PARTICIPATING:
ATTEST:
____________________________ ____________________________
City Clerk Mayor
APPROVED AS TO FORM: APPROVED:
____________________________ ____________________________
Assistant City Attorney City Manager
____________________________
Director of Planning & Development
Services
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EXHIBIT A
Fiscal Year 2022 Municipal Fee Schedule
Planning and Development Services Fees
Impact & In-Lieu Fees
Office/R&D Hotel/Retail/Other
Housing Impact Fee Non-
Residential
$65.80 per sq. ft. Office/R&D $23.11 per sq. ft. Hotel,
Retail, Other Non-residential
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