“It took about one hundred conversations to negotiate the deal,” said Gordon Merklein, the executive director for real estate at University of North Carolina at Chapel Hill. He compared negotiating this deal and other deals to dating. “If the ‘first date’ goes well then you progress to a ‘second date’ and if that goes well then there are many more, sometimes hundreds,” he said. During the “dates”, they worked through issues like who would pay for the “town square” in the middle of the development because by not building on this part of the site, the developer would lose leasable area, but Gordon’s team felt it was necessary for the quality of the development. Like dates, he explained, some meetings were jovial, some meetings were tense, some dramatic, and I sure quite a few were boring, but in the end they negotiated a deal that benefited both parties.
The deal described above is for the “pseudo” public-private partnership (PPP) Carolina Square development. I say “psuedo” because the “public” part of the partnership is the Chapel Hill Foundation Real Estate Holdings, Inc., a subsidiary of the University of North Carolina Chapel Hill Foundation Inc., which is funded by private funds, but is considered public since they represent the interests of UNC.
My colleague is the project manager for a tenant improvement project in the development, and as we were discussing the financing for the project, we determined that we had much to learn and decided to ask Gordon to lunch for a PPP tutorial. Below are some of the interesting things I learned about PPPs and their role in higher education projects. This is not an in-depth study, but it will give you the enough of what you might need to know about PPPs to get through a business lunch.
Basic Ingredients: Ground Lease and Building Lease
As we sat down to lunch, Gordon explained that in most deals, the developer is leasing and building on a university-owned site, this arrangement is known as a ground lease. In a ground lease, the university rents land to the developer at a negotiated cost and once the lease is up, the land and the improvements (buildings), are owned by the university.
At this point, I blurted out, “the ground lease sounds like a win for the university, not for the developer.”
“The developer is not going to start off with a pro forma to lose money,” Gordon assured me.
Then he explained that during the tenure of the ground lease, the developer, as part of the PPP agreement, requires the university to rent a certain percentage of the building. By having a tenant in place prior to construction, the risk to the developer is lowered.
A PPP allows a college to procure a building without incurring debt as well as capitalizing on the efficiencies of private developer teams. Merklein notes that PPPs are attractive at smaller schools because they typically do not have a depth of capital needed to fund large capital projects. Additionally smaller schools also do not have the ability to borrow money like larger institutions.
Another advantage of PPPs to smaller schools is that unlike larger universities, smaller schools do not have the professional design and construction management staff in-house (like me and my colleagues) to guide projects through design and construction. Larger state universities like NCSU and UNC-CH have the in-house staff needed to ensure that capital projects are procured, designed, and constructed per the State Construction Office requirements.
Why not PPPs?
“Mom why is the floor bouncy?” asked my daughter.
We were waiting for the elevator at the mall to take us to the level below.
“Well Emmy,” happy that I could answer one of her never ending questions, “the structural engineer didn’t make the floor heavier to dampen the vibrations. The floor is safe” I assured her, “but you’re right, it doesn’t ‘feel’ right.”
“Why didn’t they make it heavier?”
“I suppose, because it would cost more money,” I said, as we got onto the elevator.
Even though bouncy floors are disconcerting, they do meet code requirements. Even though it meets code requirements, it doesn’t meet “serviceability” requirements, meaning it doesn’t feel safe to tenants and brittle floor coverings or ceilings over/under a bouncy floor will crack. This is just one example of a serviceability issue. (See also blog post 009.) Another serviceability example is no-wax floor tile. A developer might opt for the floor tile that requires once-a-month waxing to maintain it because it is less expensive. The university will opt for the more expensive no-wax floor tile because in the long run it will save on housekeeping costs. Based on my experience, because developer-buildings are cost driven and the developer doesn’t maintain the building, the consideration of serviceability is not a priority.
Everything is Negotiable
The biggest take away for me about PPPs is that all terms are negotiable (as long as it meets NC HB 857 requirements). Gordon noted that the three main terms that are negotiated are: developer designs and builds the building, the developer finances the building, or the developer manages and operates the building.
A deal can also consist of a combination these terms, resulting in numerous variations of PPPs, each with it’s own set of challenges and opportunities. For example, a building that is built by the developer, yet maintained and operated by the university, will require thoughtful negotiation up front because of issues like no-wax floors that affect the maintenance and operation of a building. If the building is designed, built, maintained, and operated by the developer then you will have different set of issues such as, is the university getting the amount and quality of space they anticipated?
Gordon noted that the University of Merced, a school that is employing a partnership that spans all three (Design-Build-Finance-Operate-Maintain). Earlier this year they announced that they will “employ a team of private developers and an innovative, fast-track construction model to add nearly 1 million assignable square feet as rapidly and cost-effectively as possible.” (Click on link to read more about it.) It will be interesting to see how this works out over the next few years.
When you drill down into the details of the partnerships, everything is again, negotiable. For example, typically if the building is outsourced, the developer hires the architect because they are interested in controlling the design, which controls the cost. But on the Carolina Square project, the Foundation paid the architect’s fee for the tenant improvements, which allowed them to own the plans and have input on the design. Gordon didn’t go into how this will work since there may be conflicting opinions. Throughout our lunch, Gordon emphasized that it is “important to keep relationship positive,” so I’m sure it was negotiated in a manner that works for both parties.
A Fine Balance
It would be nice to wrap up this post with a concise statement about the viability of PPPs for higher education projects, but I’ve learned that no two PPP deals are alike. What may make sense for one campus may not make sense for another campus. What I have learned is that the most important part of the deal is the hundreds of conversations that shape it. These conversations set the expectations of both parties for the long-term marriage that they will embark on.