Guide to Value Capture Financing for Public Transportation Projects (2016)

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63 I Case Selection Three premier examples of the successful use of value capture to finance public transport are in East Asian cities: Hong Kong, Singapore, and Tokyo. . . . The poster child for the use of value capture to fund public transport is the Hong Kong Mass Transit Railway Corporation (MTRC). The MTR system in Hong Kong is fully constructed, operated, and maintained without a financial subsidy from the govern- ment. In fact, the MTRC is a publicly traded corporation that earns profits for its shareholders, chief among them the government of Hong Kong (Salon and Shewmake, 2011). Asian rail agencies operate under different mandates and constraints than their U.S. counter- parts; the operating and regulatory environments, geographies, and ridership densities are differ- ent. Notwithstanding this, the success and effectiveness of Asia’s integrated transit/development agencies bear consideration for U.S. transit agencies considering value capture potential. Hong Kong’s Mass Transit Railway Corporation is an exceptional example of highly inte- grated transit and real property development. Unlike most of the world’s transit systems, MTRC is profitable in large part due to extensively integrated transit-related and transit-oriented devel- opment activities and partnerships (Cervero and Murakami, 2008, 2009). MTRC’s success at effective value creation has been widely recognized. The Atlantic magazine called MTRC’s business and service model “unique genius” (Padukone, 2013). CNN referred to Mass Transit Railway (MTR) as “the world’s most envied metro system” (Wong, 2015). MTRC’s successes, both as a rail transit provider and as an economic enterprise, stem from its Rail + Property (R+P) development model. R+P is a comprehensive strategy and is a highly devel- oped “process for planning, supervising, implementing and managing station-area develop- ment and tapping into the land price appreciation that results” (Cervero and Murakami, 2008). MTRC provides exemplary transit service and earns significant profit in the process. More than 60% of MTRC’s revenue is derived from real estate property development, leasing, and management. As such, R+P may be the most successful transit-related value capture model in the world. II History and Overview MTRC serves an average of 5.4 million passengers per weekday. In the 10 years from 2005 through 2014, total MTR ridership increased from 856 million to 1.5 billion. Over the same period, MTRC’s annual operating profit increased from HK$8.6 billion to HK$15.8 billion (approximately $2 billion U.S.), total assets increased from HK$114 billion to HK$227 billion, and dividends to shareholders increased from HK$2.3 billion to HK$6.1 billion (approximately $787 million U.S.) (MTR Corporation, 2014). Please see Figure 23 for a representation of the elements that contribute to MTR’s operating profits. A p p e n d i x d Hong Kong Mass Transit Railway Corporation, Hong Kong

64 Guide to Value Capture Financing for public Transportation projects The MTR rail transit system includes nine lines intersecting each other at 19 interchange sta- tions (as shown in Figure 24). HKSAR established the MTRC in 1975 and began operating in 1979 as a public transit util- ity. In 2000, MTRC was privatized and began trading on the Hong Kong Stock Exchange as the MTR Corporation Limited (MTRCL)7 in 2001. HKSAR sold 23% of the shares to the public and retained the balance. There are more than 250,000 private shareholders in MTRC, and it is a significant component of the Hang Seng Index. Private ownership reinforced significant market discipline in MTRC operations from the outset, and its market orientation and responsiveness remain evident today. HKSAR continues to provide public policy influence through its majority stake. HKSAR has publicly committed to retaining no less than 50% ownership through 2020. III Local Economic Conditions and Market Considerations Hong Kong, with a population of 7.2 million as of mid-2014, is one of the most densely popu- lated places in the world. Hong Kong’s most densely populated district, Kwun Tong, has a density of approximately 148,000 people per acre (Hong Kong Government, 2015). Hong Kong is served by many transit systems, which include light rail and multiple tram, bus, mini-bus, and ferry sys- tems. Approximately 90% of Hong Kong’s motorized vehicle trips are by public transit, the high- est proportion in the world (Cervero and Murakami, 2008; Lam and Bell, 2002; Zhang, 2007). The comprehensive Study of the Integrated Rail-Property Development Model in Hong Kong found that 41% of the total population and 41% of workers lived within 0.31 miles (500 meters) of an MTR station. MTR provided 24% of all public transportation in Hong Kong (Tang et al., 2004). IV Capacity, Organization, Coordination, and Partnership MTRC’s integrated rail and property development model is a unique version of joint develop- ment and P3. The R+P model goes far beyond collaboration and joint enterprise. It embodies both philosophy and strategy for maximum value creation and capture. MTRC’s R+P model incorporates four key elements (as shown in Figure 25). Source: MTR Corporation, 2014. Figure 23. MTR operating profit contributions.

Hong Kong Mass Transit Railway Corporation, Hong Kong 65 Source: Mass Transit Railway, 2016. Figure 24. MTR system map. Source: MTR Corporation, 2014. Figure 25. MTRC’s R+P model.

66 Guide to Value Capture Financing for public Transportation projects • Policy: Favorable government policy support in terms of its exclusive land grant to the MTRC and its commitment to mass transit railway as an essential mode of public transport; • Process: Far-sighted planning, management, and control procedures and effective develop- ment processes that seek to maximize the synergy between railway and property from the stages of project inception to completion; • Project: Development of high-quality real estate projects that contain high development den- sity, appropriate land use diversity, and attractive layout design and that integrate well with the railway facilities at the appropriate locations and at the right timing; and • Organization: A well-experienced and efficiently managed company that is committed to providing world-class railway services and developing top-quality property development projects in order to enhance the quality of life in Hong Kong (Tang et al., 2004). MTRC’s integrated rail-property development program is designed explicitly to minimize both direct and opportunity costs in the development of transit-adjacent development and TOD. R+P reduces the cost of imperfect knowledge on the part of transit and real estate devel- opers that would exist in the absence of intimate strategic partnerships. MTRC has extensive specialized knowledge and experience in planning and developing integrated railway properties. This contrasts with the uncertainty experienced by developers in the United States. This is par- ticularly true given the intensely urban, high-density, mixed-use nature of many of MTRC’s projects including station development. Figure 26 shows two images of this type of develop- ment near Kowloon Station. Site and architectural design, civil and structural engineering, and financial and functional programming are tightly interwoven between transit and real estate (Tang et al., 2004). Organizational integration and flexibility allow MTRC to reduce uncertainty, and hence risk, between public- and private-sector activities and to respond more quickly to changes in mar- ket conditions. Operating subject to market discipline and commercial principles has allowed MTRC to reduce financial risk and uncertainty (Tang et al., 2004). This is shown in MTRC’s strong credit ratings (see Figure 27). As a combined enterprise, the transit and real estate development divisions of MTRC are incentivized to maximize value creation and subsequent capture through synergies rather than competition between railway operations and property development. Beyond corporate integra- tion of functions, joint public–private ownership of the common stock of MTRC provides both Source: Left: Najka, http://www.panoramio.com/photo/24768060; Right: Diego Delso, https://en.wikipedia.org/wiki/Kowloon_Station_(MTR)#/media/File:Kowloon_Waterfront,_Hong_Kong,_2013-08-09,_DD_03.jpg. Figure 26. Kowloon Station area architecture and station entrance, Hong Kong MTR.

Hong Kong Mass Transit Railway Corporation, Hong Kong 67 mutuality of interest and joint benefit. HKSAR’s 77% ownership stake was worth approximately U.S.$606 million in dividends alone in 2014. V Regulatory Considerations From a value capture perspective, MTRC’s R+P program is borne entirely from regulatory entitlement. HKSAR grants or endows land, through long-term renewable leases, to MTRC at prices usually below market.8 This process between MTRC, HKSAR, and developers is illustrated in Figure 28. Given that HKSAR owns 77% of MTRC, HKSAR is granting endowments to itself to a large degree. In exchange for the 23% of the value of endowments that are essentially given away to private shareholders, HKSAR receives higher value creation and subsequent tax rev- enue from properties developed by MTRC. Additional value is created through development by others and enhanced through extensive planning and design expertise by MTRC. Additionally, HKSAR benefits from its receipt of MTRC dividends. Endowment of land is “necessary but not sufficient to ensure the success of the R+P business model” (Salon and Shewmake, 2011). Attempts to employ the R+P financial model outside of Hong Kong have failed where “government policies and actions were not fully supportive of public transport-coordinated property development” (Salon and Shewmake, 2011). Recurring problems with projects undertaken by the Guangzhou Metro Corporation are examples (Tang et al., 2004). The success of the R+P model is driven by market opportunity in creating and capturing value in real property. There is no economic incentive to provide nonmarket products such as afford- able housing. Significant profit realized by HKSAR through majority ownership in MTRCL, however, provides resources to invest in or subsidize such products.9 VI Business Case Unlike many quasi-independent agencies where commitment to specific technical solutions, operational mandates, or funding mechanisms may insulate transit development from mar- ket responsiveness (Boschken, 2000), MTRC operates on strictly commercial principles. R+P activities are focused on value creation in response to market conditions and context. The Hong Kong model is, in a sense, development-oriented transit as opposed to TOD. It is not difficult to understand the focus on development, particularly when there is so much transit demand in place, and that demand is reinforced through TOD. As seen in Figure 23, the bulk of MTRC’s revenue and operating profit is achieved through property development, real estate rental and property management services, and transit station commercial businesses. MTRC develops and evaluates prospective rail alignments and station improvements in close consultation with HKSAR. Based on preferred alignment alternatives, MTRC develops con- struction cost estimates and negotiates prospective land acquisition and development concepts. Both parties are vested in a process and end result that maximizes quality, efficiency of invest- ment, and financial return. Short-term Long-term Standard & Poor’s A-1+/A-1+ AAA/AAA Moody’s -/P-1 Aa+1/Aa1 R&I a-1+ AA+ Source: MTR Corporation, 2014. Figure 27. MTR credit ratings.

68 Guide to Value Capture Financing for public Transportation projects MTRC and HKSAR then negotiate formal agreements that include obligations of MTRC and terms of land acquisition in the form of long-term renewable leases from HKSAR. MTRC then secures necessary planning, regulatory, and development approvals. Once approvals are in hand, MTRC publishes tender packages and solicits requests for proposals from developers. Successful bidders are responsible for detailed project design and development. MTRC under- takes major civil engineering and construction and enforces technical standards regarding inter- faces with transit facilities and infrastructure. The private development team is responsible for all design and acquisition costs, marketing costs, construction, and finance. Developers may not Figure 28. MTRC, HKSAR, and developer development process.

Hong Kong Mass Transit Railway Corporation, Hong Kong 69 collateralize development financing with partnership land interests. MTRC assumes no liability for development losses but participates only in the upside. MTRC benefits not only from up- front, one-time, land premiums but from equity partnership in developed properties. Although MTRC no longer receives cash subsidies from HKSAR, it receives land grants or long-term renewable leases10 at pre-transit/predevelopment prices. These in-kind contributions of real property have created the bulk of the R+P opportunity. Although MTRC creates signifi- cant value on property owned by others, direct or joint development of its own properties creates the value that pays for transit development and creates profits. MTRC’s portfolio is diversified in terms of structure (debt, equity, partnership, management, advertising) and in terms of property type. MTRC owns interests in residential properties across a range of densities, office buildings, mixed-use properties, telecommunications facilities, and retail spaces. As elsewhere, ridership and price premiums resulting from Hong Kong residents’ willingness to pay for transit accessibility can be affected by other TOD and urban amenities. A 2009 hedonic price model of the value of scenic views found residential price premiums of approximately 3% for broad harbor views and price discounts (or penalties) of 3.7% for street views (Jim and Chen, 2009). VII Takeaways Key takeaways from the Hong Kong Mass Transit Railway Corporation case for U.S. agencies include: • Transit loss leader: Even with high population density, intensive ridership, and high market share, rail transit is not financially viable on its own. MTRCL realizes no direct financial return on its railway investment. • TOD value: When combined with transit-oriented designs, notably high-quality walking environments and mixed land uses, this case study shows that R+P projects are likely to be more successful in terms of ridership and real estate profits (Cervero and Murakami, 2008). There are hints that the combination of R+P and transit-oriented designs produces syner- gistic effects—proportionally higher rents in addition to ridership bonuses (Cervero and Murakami, 2008). • Early agreements: By means of development agreements, MTRC ensures compliance from developers in implementing the adopted master plan proposals of the station development. This is better than subsequent separate negotiations between the railway operator and the adjoining property owners, which often produce second-best and remedial outcomes (Tang et al., 2004). • TOD spurs ridership: Mixed-use, compact, vibrant street-level activity promotes transit ridership. Furthermore, integrated rail-property development projects incorporating excellent design and programming also enhance ridership as well as value creation. • Unique benefit of land ownership: MTRC does not rely on government subsidies to support its rail service, yet it does benefit from below-market property sales. • Institutional capacity: Sophisticated business and development strategy and acumen on the part of MTRCL have been critical to its success in real property development.