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58 Guidebook for Developing and Leasing Airport Property of money that must be collected each year, CAP rates also speak to the market and level of com- petitiveness. If the airport sponsor requires a 10% CAP rate, 10% of the value of the land is col- lected each year in ground rent. CAP rates regarding improvements on leased land, however, can be significantly more complex to calculate because the CAP rates are likely to vary depending on the type of development and the markets that exist for certain types of development, especially when the development is nonaeronautical. In the example above, the straight-line recapture rate component can be cut in half if the development takes place on a piece of property that is owned fee simple, and if the improvements have a 50-year useful life. Similarly, the discount rate, which is a function of the developer's con- fidence in collecting future rents and fees, can be affected by the range of allowable facility uses, the size of the market, and number of potential tenants for those improvements. Therefore, it is easy to see how CAP rates can vary so widely. On the other side of the comparison, development on leased property has its advantages as well because of the lack of property acquisition on the front end of the development project. For an airport sponsor to be competitive with surrounding land owners that are willing to sell their property, CAP rates for a nonaeronautical airport development project must be consistent with the immediate market and conscious of the higher CAP rate driven by the lease term. The airport sponsor should understand that term length must speak to both a reasonable amortiza- tion of investment and to the market conditions that drive CAP rates and affect project compet- itiveness. A 25-year lease term may appear perfectly adequate, for example, to construct a hangar or other aeronautical facility, amortize the investment, and still allow for a profit. Market-driven CAP rates on other types of development, however, may be very different due to options avail- able for a given nonaeronautical development project. In short, CAP rates for nonaeronautical development are generally lower than for aeronautical airport development projects and can affect the overall financial structure of the development project, including term length. While aeronautical uses may well accept a 10% capital recovery rate, industrial development or distri- bution warehousing, where the development can take place either on or off airport property, may only support a 6% to 8% CAP rate. In other words, one CAP rate does not fit all scenarios. 5.2 Developer Perspective Financing a new project at a public airport on leased land can be challenging, especially at air- ports with smaller amounts of developed property and/or when there has been no recent devel- opment of land. Because development on airports is often synonymous with development on publicly-owned property, funding of the project has its challenges from a collateral standpoint. In traditional real estate development, the developer has the luxury of encumbering the title of the property for the purpose of lender security, and the lender has the ability to place a lien on the real estate to secure its financial position. Airports, specifically publicly-owned airports, are typically precluded from allowing claims, such as liens, to be placed against the title of airport property, and are unable to offer that security to the lender for a specific development. The lender is therefore left with the improvements on the property, the length of the lease term, and the strength of any sublease or pledged revenue stream to collateralize the debt. 5.2.1 Return on Investment The financial benefits that flow from an airport development project are typically expressed as an annual percentage of the amount invested, or return on investment, representing annual cash flow. Expectations of the developer for return on investment are typically defined within the pro forma of the development project.
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Finance Overview 59 If the project is being developed by the airport sponsor, such an analysis should consider the opportunity cost associated with the use of its cash, debt capacity, or other resources to develop a facility for a tenant, versus its ability to utilize those same resources for the purpose of devel- oping public infrastructure. Once airport resources are invested in facilities for a specific tenant or group of tenants, it should acknowledge that those resources are no longer available for pub- lic infrastructure improvements, an investment that is often amplified by state and federal grant funds. An analysis of the potential for missed opportunity may reveal, for example, the inability of the airport sponsor to either invest in or place debt for other public-use projects. Any cost of missed opportunity should be considered as a component of the overall airport sponsor cost of the project. Investment by a developer other than the airport sponsor, that does not encumber airport resources, will likely have no cost of missed opportunity for the airport sponsor to con- sider, because that same private capital is likely unavailable for investment in public infrastruc- ture. Regardless of who the developer is, the developer should expect a return on investment. Development projects that do not reflect a reasonable return on investment only erode the mar- ket value of all improvements at a given airport. Replacement-based valuation considers the cost of building new facilities in today's dollars, amortizing that investment, and establishing rental rates adequate to recover the investment, with a return on that investment. If hangars are developed by an airport sponsor, perhaps with the assistance of grant funds, for example, without regard for replacement-based valuation, the improvements can be undervalued and the rents charged to occupy those facilities can be too low. Once below-market rents exist, the airport is unlikely to attract private investment for addi- tional hangar development because the market will have eroded from the undervalued develop- ment, and new development will be unable to attract the capital required to construct new facilities without market rents that will support the associated debt service. The airport sponsor will then either experience demand that exceeds supply and bring rates up to market value (hope- fully in a consistent manner) so that new development can attract capital and service debt, or invest more of its own capital resources to build additional hangars that remain undervalued. In short, undervaluation of improvements is somewhat short-sighted because it leaves the airport sponsor with fewer development options. The airport sponsor, when fulfilling the role of developer, may consider return on investment in the form of additional airport activity or from the attraction of an enterprise that has long- term benefits to the airport. Arguments can be made for both sides of this debate and certainly one rule of thumb will not fit all development scenarios. The airport sponsor should first weigh the return against other investment opportunities, such as investment in runway and taxiway improvements, and then consider the long-term implications if undervaluation of rents is to be traded for benefits the airport considers to be returns on its investment. FAA compliance should also be considered, as achieving market value on the rents an airport sets is an important part of complying with federal grant assurances. One strategy or best practice in this regard is for the airport sponsor to include grants in the project pro forma and in the calculation of return on investment. Once all project equity is accounted for, a rate that yields a positive return on invest- ment will insure a replacement-based valuation of improvements. A typical return on investment might be on the order of 5% to 10%, especially in the case of a facility that is developed for a single tenant who signs a long-term agreement and who asks for very few specialized improvements. Generally speaking, the less specialized the improvements are, the larger the market will be for the developer to lease a given property to a different tenant if need be. Return on investment can vary as the development project wanders from the param- eters described above. Specifically, in the scenario mentioned above where undervaluation on the part of the airport sponsor, and/or lack of consideration regarding grant funding, takes place in lieu of other desirable benefits the airport development might bring, the return on investment