Is it a “Field of Schemes“?
By Alan Pryor
The COVID-pandemic has accelerated and likely made permanent huge increases in home-based, work-related remote telecommuting. This trend would dramatically decrease office space needs in sprawling business parks like the proposed Davis Innovation and Sustainability Center (DISC) (formerly known as the Aggie Research Campus (ARC), and before that, as Mace Ranch Innovation Center (MRIC)).
In turn, this reduced demand for office space will drastically decrease rental income from such large office developments. Because property valuations are strongly based on rental income, reduced rents will reduce property valuations which will, in turn, reduce property tax income to the City. And if such property tax income is sufficiently depressed in the future and exceeds the costs to the City of providing essential services to residents and business park tenants, the DISC project could turn into a net drain on City coffers.
Pre-pandemic projections of economic viability of the DISC business park were made by the City’s financial consultant for the project, Economic and Planning Systems (EPS). In their April, 2020 report, EPS projected net financial benefits to the City of over $5 Million per year over and above City costs of providing services once the project is fully built out in 25 to 30 years. However, these rosy projections were based on the optimistic assumption that the DISC developers would receive office rents from the project that are among the highest in the City and far greater than average office space rents in the greater Sacramento region.
After presenting these findings to the City’s advisory Finance and Budget Commission (F&BC), the F&BC requested revised alternative economic analyses from EPS to look at the impacts on the property tax returns to the City from the project if less optimistic rent and property valuation projections were used.
However, EPS, at the direction of City Staff, refused to provide such a comprehensive alternative long-term analysis instead insisting any possible negative impact on office demand as a result of the pandemic will be temporary and short-lived. So their revised analysis instead assumed that office space demand and rents, after a brief drop due to the current economic conditions, will return to their previously predicted elevated levels resulting in permanently high property valuations and optimistic property tax collections by the City. Unfortunately, many knowledgeable independent experts disagree with this assessment and project a permanent downturn in office space demand and that a huge glut will develop and weigh on the market.
Additionally, it has been historically shown that business park complexes associated with Universities that attempt to capture and commercialize technology transfer from the Universities have not fared well and have not provided the economic advantages to host communities promised by the developers of such projects. This further indicates the projections of financial benefit to the City as a result of the DISC project may be unrealistically optimistic even if there is not a corresponding oversupply of office space as a result of the COVID pandemic.
But by assuming such potentially unrealistically high rental income, property valuations, and future tax income, the City may be buying into an undertaking that one might characterize as a “Field of Dreams“. And by refusing to alternatively model or investigate other possible, even probable, adverse future commercial real estate demand projections as requested by the F&BC, the DISC project might really be more fairly viewed as a “Field of Schemes“.
Let me explain.
The headlines are screaming that office space demand is crumbling and will likely be depressed for many, many years:
|“Facebook CEO Zuckerberg announces permanent remote work option for employees
Mark Zuckerberg expects that about 50% of Facebook’s workforce will work remotely within the next five to 10 years.” (https://www.zdnet.com/article/facebook-ceo-zuckerberg-announces-permanent-remote-work-option-for-employees/)
|“As of today, Shopify is a digital by default company.
We will keep our offices closed until 2021 so that we can rework them for this new reality. And after that, most will permanently work remotely. Office centricity is over.“, Tobi Lutke, Shopify CEO (https://twitter.com/tobi/status/1263483496087064579)
|“Twitter and other companies allowing employees to work from home indefinitely…
Twitter told employees earlier this week that, so long as their position allows for it, they have the option to permanently shift to remote work.” (https://www.businessinsider.com/twitter-needs-additional-tech-amid-permanent-work-from-home-policy-2020-5)
|“The pandemic has shown managers that workers can be trusted to do their jobs without constant supervision…
The corona virus pandemic has created new fans of remote work, among those who don’t miss the commute have found new heights of productivity away from meetings and office chitchat…Corporations seeing an opportunity for cost savings are eager to oblige employees who want to stay home…The insurer Nationwide moved 98% of its 27,000 employees to working from home. It’s worked so well that Nationwide “plans to shrink from 20 physical offices, pre-crisis, to just four” (In The Week, “Workplace: The post-pandemic office”, p. 33, May 22, 2020)
|The impact on office space demand will be particularly negative due to social distancing requirements and anxiety about working in close quarters.
“People are going to be really uncomfortable about being in close offices, tightly packed elevators…You’ll see people worried about social distancing within the office environment…This is really looking like a long and incredibly painful recession the likes of which I think no one currently alive has ever seen before…Bottom line, I could easily see downtown office buildings in the center of big cities falling by 60-70%”, Nick Bloom, Professor of Economics, Stanford Graduate School of Business.
“Uncertainty is actually killing real estate deals at the moment… I’m privy to 10 recent potential real estate transactions. Six have stopped negotiating. I don’t know if they will ever negotiate again. Three of them were negotiated and have gone hard which means the deposit was accepted and would not be returnable if the deal was not consummated…They walked away because it would have required many millions more to complete the transactions and they felt that…real estate transactions were uncertain and they weren’t willing to risk the additional dollars“, Robert H. Edelstein, Professor Emeritus of Real Estate, University of California at Berkeley. (In Making Sense, PBS NewsHour, June 4)
|Tenants’ Troubles Put Stress on Commercial Real Estate
“Just over 2 percent of loans to office-space landlords were past due, but that figure could grow if the economic downturn deepens — and in some New York offices, the impact is already being felt. In April, Empire State Realty collected only 78 percent of its office rents, its largest source of revenue” (In New York Times, Business – Economy, June 5, 2020 – https://www.nytimes.com/2020/06/05/business/economy/coronavirus-commercial-real-estate.html
|This week, the Centers for Disease Control and Prevention released updated guidelines for safely reopening offices…Future offices are going to look a lot different.
“In addition to recommending that employees wear face coverings at all times and abstain from handshakes and hugs, the CDC advises that employees should get their temperature and symptoms checked upon arriving at the office, desks should be spaced six feet apart and use methods to physically separate employees in all areas of the facilities including work areas and other areas such as meeting rooms, break rooms, parking lots, entrance and exit areas, and windows should be opened more to improve ventilation. The CDC recommends that people limit their use of elevators, but that if they must use one, individuals should stay six feet apart.” (https://www.cdc.gov/coronavirus/2019-ncov/community/office-buildings.html)
The COVID-19 pandemic has upended the world in only 4 months on a scale and pace previously unimaginable. One outcome is what is expected to be a permanent decrease in market demand for office space. That is, there has been a very rapid and broad transition toward telecommuting (i.e. office workers working from home) as efforts were taken to isolate people from co-workers to prevent disease transmission. This transformational shift in work environment is rapidly evolving into the “new normal” as tens of millions of white collar jobs have transitioned to work from home. Many companies are now saying they have no intention of ever moving back to the old mode of moving their workers in from widespread locations on a daily basis to work in a centralized office environment.
This trend toward remote site work and a generally declining market demand for office space had already begun well before the COVID-19 pandemic and was previously noted as a risk factor in the 2015 EPS innovation center economic analysis report for the Mace Ranch Innovation Center (the predecessor proposed project to DISC). In that report (“Davis Innovation Centers Fiscal and Economic Impact Assumptions”, July 8, 2015 – See LINK), EPS noted the following as one risk factor for the project and barriers to feasibility:
“Decreasing demand for office space as companies move to operate virtually” (p.29)
This pre-COVID trend away from large business park settings is somewhat confirmed by the fact that the large business park offering on Hwy 113 north of Davis, the Woodland Innovation Center, still has not announced the signing of a single major tenant to occupy any commercial portion of the mixed use development despite it’s availability for years in the until-recent booming economic environment and offering many of the same advantages as the proposed DISC business park.
For instance, the Woodland Innovation Center will functionally be as close to UC Davis as the proposed Davis Innovation and Sustainability Campus and has demonstrably easier access to campus via Hwy 113 compared to access from DISC via I-80 and/or Davis surface streets. The failure of the Woodland Innovation Center to attract any customers by now despite presumed lower costs and equal or better physical access to the University speaks to the difficulty that traditional business parks have in developing their economic models sufficiently to attract businesses and become profitable for the developers and the host communities.
The economic risk factors facing these business parks have now have been compounded exponentially with the advent of COVID-19 pandemic. This massive social trend now casts doubt on the potential economic viability of the DISC business park concept because of the rapid pandemic-induced accelerating shift away from use of central offices by employees and towards remote work from home. This could potentially render the entire concept of large office parks obsolete. Further, it is expected that the current massive recession will probably take years to recover from and to reach former employment levels which will further reduce demand for the new proposed office complex.
THE FINANCIAL VIABILITY OF THE DISC BUSINESS PARK MODEL IS OVERLY OPTIMISTIC WITHOUT EVEN ADEQUATELY ACCOUNTING FOR THE POST COVID PANDEMIC ECONOMC ENVIRONMENT
EPS has stated that the estimates of property tax income to the City are based on valuations of the property in the project which are almost entirely driven by rents obtained for leasing those properties. “For most of the commercial uses in the analysis, the property valuation is determined using a capitalized income approach. Rent is a key driver of value for this. The rents assumed in the analysis are $2.92 per square foot per month ($35 annually) for office space and $2.33 per square foot per month ($28 annually) for flex/R&D and retail space. ”
Rents, of course, are determined by both local economic trends and larger macro-economic impacts on the entire economy. It is worth noting, however, that the current EPS report assumes substantially higher valuations that the one they prepared for the predecessor proposal, MRIC, in 2015. Office space went from being valued at $225/sq ft in the 2015 EPS report for MRIC report to $332/sq ft in the latest report. Flex (R&D/office) went from $245/sq ft to $321/sq ft and ancillary retail went from $225/sq ft to $334. in the ir most recent estimates for DISC.
Note actual office valuation rates from the Sacramento region are at just below $200/sf for 2019: https://kidder.com/wp-content/uploads/market_report/office-market-research-sacramento-2019-4q.pdf.
Office market lease rates are also listed for sub-regions in that report. Davis is listed at $22.20/sf, which is right at the $22.44 listed for the Sacramento region as a whole. Meanwhile, EPS assumed $35 for office and $28 for flex/R&D in their current report for DISC
EPS is overvaluing DISC property by a large amount over actual regional and Davis rates. Howver, the DISC project would have to compete against other similar business park offerings in the region, including ones in Woodland, West Sacramento, and Rancho Cordova, and likely would not be able to command premium rents. With respect to the local commercial rental market, EPS acknowledges that the rents they are assuming (and hence the property valuations) are among the highest in the region and base this on a company’s desire to locate close to the University. According to EPS,
“Development costs and land prices in Davis are not conducive to attracting businesses seeking the lowest operating costs. Rather, businesses that seek to be in Davis do so for specific reasons, such as proximity to educated workers and related businesses. The Project is intended to build on these attributes and attract tenants that value being near UC Davis and being part of an R&D focused campus environment.”
However, as discussed above, EPS does not at all explain why a company might not alternatively choose to locate in the equally close Woodland Innovation Center which presumably will offer substantially lower costs but offer equal proximity to the University and far easier access to the University via Hwy 113 compared to DISC.
Even more daunting challenges face the DISC business park in terms of the rapidly-changing macro-economic environment imposed by the COVID pandemic – i.e. the potentially crumbling demand for office space. Questions concerning these impacts of larger macroeconomic developments on the DISC project viability and potential economic impacts to the City were first posed to EPS during the first meeting held by the Davis Finance and Budget Commission (F&BC) on May 11, 2020 to evaluate the projections made by EPS. In that meeting the following questions was posed.
“Is there a risk that if the project moves forward and values are lowered due to COVID and the present reduced demand, that could have an effect on the ongoing financial for the project as a whole?…we would end up with an ongoing reduction in revenue just because the building that was $1 million… is going to be $900,000 due to the effects of COVID.”
“There’s no way that we can say with any certainty about what the effects of COVID are with where we stand today. There’s just so many unknowns that it would be folly for me to just sit here and say that there would be no impact…How we emerge from this crisis is going to have effects on every project across the US and across the world.”
Assistant City Manager Ashley Feeney added,
“With COVID, we likely see this project remain as it stands today—continuing farm operations until it makes sense to move forward with the project. I don’t see them building and financing a project and infrastructure and doing that kind of investment… We’re talking about the opportunity to zone land… for future business use.”
Some members of the F&BC obviously remained skeptical, however, and a subcommittee formed to summarize additional questions and comments in writing to be forwarded to EPS for answering or further clarification. In that subsequent communication to EPS they stated,
“COVID-19: We recognize that the EPS analysis was done prior to the global pandemic and that it would be very difficult to forecast the effects of COVID-19 on the model. However, it is our new reality and tough to ignore. Unless it is believed that a full economic recovery will take place prior to completion (and thus property tax valuation of the initial construction) it’s reasonable to assume follow-on effects in the overall will affect at least initial demand for ARC property, and thus the underlying valuation. As property tax increases are capped at 2% regardless of any increase in the value of the underlying property (i.e., as a result of economic recovery), any shortfalls in initial valuation would roll through the financial model.” (Item 4B Ad Hoc Subcommittee on Aggie Research Campus – see LINK).
The response by EPS to the F&BC was less than compelling as stated below.
“COVID- 19 Impact: It is very difficult to say at this time what the impact of COVID-19 will be on the fiscal impact of the Project. The fiscal impact has been analyzed at the end of each of the four phases, all in 2020 dollars and based on the 2019-20 Budget. Following a slower start than originally anticipated, the Project could be operating as projected by the time Phase 1 is complete. Since the fiscal analysis is in constant dollars, any delay in and of itself will not impact the results. In an exceedingly pessimistic scenario, where Phase 1 values are only 80 percent of their pre-COVID projections, overall values by the end of Phase 4 would be back to 98 percent, assuming that Phases 2 through 4 were at their previous estimates of value.” – Item 4B Response to FBC Questions Memo – http://documents.cityofdavis.org/Media/Default/Documents/PDF/CityCouncil/Finance-and-Budget-Commission/Agendas/2020/2020-05-27/Item-4B-Response-to-FBC-Questions-Memo.pdf
Essentially, EPS is saying that any adverse impacts imposed on the project by the current pandemic are short-lived and “Don’t Worry!…things will get better by the time the whole project is built out.” and they have otherwise refused to quantitatively look at more long-term pessimistic forecasts.
ECONOMIC VIABILITY OF UNIVERSITY-AFFILIATED BUSINESS PARKS IS TENUOUS EVEN IN THE BEST OF TIMES
Research has shown that university-affiliated office parks like this have a poor track record for delivering on their rosy promises.
Data from a study by the Batelle Institute for the Association of University Research Parks (AURP) that investigated the real-world track record of University-affiliated research/business parks show that these types of facilities still have huge amounts of available space across the country with a majority not even generating a profit. In the document, “Characteristics and Trends In North American Research Parks: 21st Century Directions”, Batelle Technology Partnership Practice in cooperation with the AURP, 2007 (see LINK), the following statistics were noted:
- Only 46% of available acreage in all existing research parks surveyed has been developed (21,961 out of 47,274 acres).
- The median facility has only built out about 26% (30 out of 114 acres) of capacity
- 94% of the business parks have room for expansion
- Vacancy rates for existing built space average 14%
- There is limited or no profitability as 75% of the parks have no retained earnings or retained earnings of less than 10%.
Another study further investigated the track record of University-affiliated research/business parks. In this study, “The False Promise of the Entrepreneurial University – Selling Academic Commercialization as an Engine of Economic Development, Mark Levine, Center for Economic Development, University of Wisconsin Milwaukee, 2009 (see LINK), the following conclusions were presented,
- “…the relationship between research universities and local economic development in 55 major US regions finds no meaningful correlations between any gauges of entrepreneurial university activity (research expenditures, patents, or licensing) and core measures of city and regional economic well-being.”
- “Improving regional economic competitiveness by forging partnerships with local businesses and commercializing university-generated knowledge is now regularly cited as one of the core missions of the modern university Such characterizations have taken on an aura of conventional wisdom…They have been embraced by civic leaders and trumpeted in media accounts, almost always accompanied by tendentious references to the classic entrepreneurial university success stories: Stanford and Silicon Valley, MIT and Boston’s Route 128, and North Carolina’s Research Triangle Park….fervor over academic commercialism strongly resembles the “irrational exuberance” of the bubble economy: hyperbole about economic benefits, based on surprisingly little evidence or analysis.”
- “In fact…the contribution of university-based technology transfer to local economic development has been wildly exaggerated. Although it has become almost a cliché for entrepreneurial universities and regional leaders to boast of becoming “the next Silicon Valley,” a systematic review of the historical record reveals that the celebrated success stories of university-led economic development are more the exception than the rule. Far more typically, the commercialization of academic research and investments in university technology transfer have had little discernible impact in reshaping the economic trajectory of cities or regions.“
- “Notwithstanding tendentious accounts of “success stories” such as Silicon Valley or Boston’s Route 128, as if they represent the general historical pattern, these data as well as case studies such as Johns Hopkins University and Yale University reveal that even world-class research universities are neither necessary nor sufficient in promoting local economic development. University research parks are particularly oversold as engines of local economic growth.“
- “Local economic development is a public policy field with a checkered history, prone to fad chasing and a “herd mentality” among decision-makers and often dominated by powerful business interests…In many ways, the entrepreneurial university is the “next new thing” in this long line of oversold economic development fixes.”
LACK OF FORMAL AFFILIATION WITH UC DAVIS IS A NEGATIVE FACTOR
According to the Battelle study, most successful business parks attempting to leverage their location near a major university parks are operated by university or university-affiliated nonprofits. The lack of such a formal affiliation with UC Davis is a negative factor when evaluating the potential success of the DISC project.
In their 2015 economic report for the MRIC project, EPS acknowledged this shortcoming stating,
“It should be noted that the research park concept the City is pursuing differs from a traditional URP [university research park] in that the sites considered mostly are disconnected by a few miles from the university itself, and UC Davis has not committed to any official partnership with any Innovation Center proposals. The report also stated “The lack of university commitment in any of the Innovation Center proposals places them well outside the norm…” (p. 33)
Their current report for DISC does not even mention this factor, however. Indeed it only even uses the word “university” 3 times total in 101 pages. It does say that “One of the key goals of the previous MRIC project was to leverage the economic potential of the University of California and create high-quality jobs in the City.” But then it neglects to state there there is no stated interest in the project from UC Davis and no commitment to fill any of the space. Indeed, DISC was recently forced by UCD to change their name from the Aggie Research Campus (ARC) because the University claimed it was infringing on the name of the Aggie Square the University is developing in Sacramento on 200 acres near the University’s Medical Center on Stockton Blvd.
Adding to the general economic uncertainty and potentially grossly overoptimistic projections of vlease rates, property valuation, and property taxes from the DISC project, huge uncertainties also exist due to the adverse long- term impacts of diminished office space use as a result of the ongoing pandemic. The City, EPS, and the Developer all conveniently minimize these negative impacts as transitory and of little concern to the long term health of the project. Unfortunately, this completely ignores the overwhelming evidence that the entire demand structure for office space is irrevocably being altered by the rapid transition to remote telecommuting.
The Developer seems blithely unconcerned about these rapidly changing macroeconomic changes occurring in the recent months. In a recent article in the Davis Enterprise announcing yet another name change in the project (the 3rd name), Dan Ramos of Ramco inexplicably stated that, “We like this thing coming out of COVID” This rather tone-deaf overoptimistic statement is one we might otherwise expect from President Trump rather than a reasoned, hard-nosed assessment of current pandemic-induced economic impacts on the viability of the DISC project.
In similarly ignoring the known failures of university-affiliated business parks in addition to the potentially devastating impacts of the pandemic on office space use, our civic leaders have embrace a “Field of Dreams” mindset that believes “If you build it, they will come”. Unfortunately, it is far more likely that they have instead bought into the Developer’s “Field of Schemes” that can very possibly result in serious financial harm to the City. This is because the City’s costs of service to the project may very well exceed diminished property tax and retail revenues as a result of the above identified economic factors leaving a legacy of crushing traffic and further deterioration of our crumbling infrastructure
Projections of dramatic stimulus of the local and regional economy and financial returns to the City are extremely suspect because of the inherent difficulties of business parks to capitalize on technology transfer from local universities. Yet this mantra continues to be loudly shouted through the bull-horns by the Developer and our local civic-leaders while ignoring the fact that the most successful university-related business parks are those owned by the university or which have formal relationships with the university. The DISC business park has neither.
None of these macroeconomic and other developments in the past 6 months bode well for the long-term success of the Davis Innovation and Sustainability Campus in Davis which could result in substantially fewer economic benefits, even losses, to the City of Davis.