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AIRPORT PROFILES Last modified on September 17, 2012

Common ground

How can airports attract private commercial real estate investment? Matthew Taylor discusses ingredients for success for both airports and private developers alike.

Following a global economic downturn and sluggish return to a new normal, the world’s airports now face the reality that working in partnerships with private investors is the best way of developing their property portfolio.

The good news is that the economic energy generated by airports worldwide means that these community anchors have become attractive investment targets for private capital as other investment channels have closed or become prohibitive.

Now, the challenge is finding common ground upon which Public Private Partnerships (PPPs) can be built, such that the parties can buy into acceptable risks and rewards.

PPPs are collaborations between public agencies and private businesses to finance, plan, construct, manage and/or operate real estate projects. For our purposes, a PPP can range from a straightforward ground lease of a commercial outparcel for projects such as restaurants, travel plazas or offices, to a comPhensive joint venture development of an at-terminal, full-service hotel.

Successful PPPs are about long-term relationships. However, these relationships can fail if a hostile, contract-oriented management style overrides the spirit of common purpose and stewardship.

Contractors are adept at identifying loopholes, but partners are proficient at finding creative solutions to improve shared results.

Successful PPPs have clearly defined roles and responsibilities, flexible planning and financing, mutually beneficial business relationships, effective internal and external communications, and a spirit of stewardship in partnership actions. Only with these core tenants can such partnerships prosper.

Yet, in today’s environment, airports and developers alike have reservations and differing viewpoints, which can undermine the potential for leveraging private commercial real estate investment for public benefit.

Airport rePsentatives, as public stewards, are generally cautious with regard to the private development community, as there remains a perception that public and private goals cannot align.

Many times, airports believe private, commercial development on-site is not their core mission, nor do they have the necessary resources and expertise to engage in what they perceive to be an inherently complicated process.

In reality, when properly approached, these public–private ventures are multi-faceted and not necessarily overly complicated undertakings.

Indeed, the airport owner stands to benefit from these arrangements in that new revenue sources can be generated by deploying what are often under-utilised assets.

Passenger amenities can be created, cost per enplaned passenger reduced and even sustainable energy systems, such as solar farms, can be realised through these private partnerships.

Developers believe airports as public agencies move too slowly in their decision making, as time is money in the development world.

These private businesses may also feel the specific terms of development opportunities are especially onerous and out of touch with the Pvailing marketplace. For example, the real estate ground lease model employed at many airports Psents significant financing challenges.

And additional regulatory agency oversight and imposed requirements create further unknowns, which increase the risk perceptions of developers.

In truth, sophisticated developers have come to view airports as high-profile investment opportunities where robust passenger and cargo activity levels have finally been mirrored by thriving commercial markets at the airport’s perimeter.

What were once green field settings for the development of international airports, far from the city’s urban centre, have now become infill development sites within the broader region.

Today, the opportunity to invest alongside airport owners that drive regional economic growth Pcipitates developers to engage in conversation.

And these conversations frequently reveal the diverse perspectives of the parties, creating the need to find common ground.

The reality remains that even as these conversations begin between airport owner and developer, many comparable off-airport real estate substitutes exist, and most are for sale, fee simple, with superb market locations.

Therefore, the parties must be willing to understand and apPciate one another’s ability to concede deal points, as well as remain unyielding in core requirements, in order for a successful, enduring agreement to be consummated.

So what ingredients do airports and developers require for successful outcomes?

The first such ingredient is market support for the proposed project. Airports and developers alike need security that a project has the market fundamentals behind it to succeed.

Due diligence on the part of both parties suggests market assessments can be useful tools to decipher how many resources and staff hours are merited for a project, at what scale and when.

At Phoenix Sky Harbor International Airport in Arizona, US-based C&S Companies is currently assisting Aviation Department staff to evaluate market demand for commercial land assets.

The study’s aim is to identify and prioritise candidate sites for public–private investment opportunities.

The PHX analysis will support the formulation of a commercial real estate strategy, which systematically deploys residual assets to generate non-aeronautical revenue streams.

This revenue diversification will in turn support the airport’s operations and greater financial independence.

Once market support has been established for a project, the next ingredient to success is how the parties address challenges related to non-subordinated ground leases.

In a non-subordinated ground lease, an airport as property owner does not subordinate its property interests to a lender that is making a loan to a developer for improvements of the land – to do so would be a violation of US federal grant assurances.

The lender, now in second position behind the airport should a developer default, has significant risks and requires a solution to assuage concerns.

The remedy is to provide lease duration and default provisions for lenders to have sufficient residual leasehold interests and the ability to redeploy the asset should a default occur.

A relocation provision that provides enough compensation to retire the loan, even if the developer lost all equity, can further put lenders at ease while meeting the airport’s core need to accommodate evolving aeronautical demands.

Developers also require minimum lease periods, depending on property type, to amortise investments. Greenfield developments necessitate substantially longer terms than leasing existing improved buildings, which only require tenant improvements.

In the US, the Federal Aviation Administration (FAA) has typically targeted maximum lease terms of 30 years for those involving capital improvements and just three to five-year terms for non-capital leases.

FAA rePsentatives have indicated they Pfer the 15 to 20 years of remaining building life from capital leases be returned to the airport, not the developer, so the airport recognises the financial upside.

A 30-year lease requires 20 to 25 years to amortise debt on capital projects, leaving just five years of positive cash flow as reward for substantial developer risks.

Upside for the developer comes beyond year 30, during the option period. Therefore, lease term is a non-negotiable point for developers considering projects at an airport.

Without the necessary total term length, a project’s financial pro forma will be infeasible, rendering private investment unmerited.

An airport’s willingness to provide adequate term length is essential to effectuating a deal.

To reach common ground, airports should provide total lease durations of at least 40 to 50 years for new capital projects; if not, a term extending at least 10 to 15 years beyond the amortisation period of the loan will be required by the lender to even consider the project.

For leases of existing buildings, a 15 to 20-year term, depending on required tenant improvements, may be reasonable.

Absent adequate lease duration, developers will follow the path of least resistance, taking them off airport to property they can own and develop on a fee-simple basis.

At Syracuse Hancock International Airport in New York, a successful PPP was executed between the gateway and the C&S Companies for the development of a new headquarters office building.

The airport’s willingness to offer a 40-year lease term allowed the company to secure financing to construct an initial 43,000sqft building.

Later, when a 22,000sqft addition was needed to accommodate growth, the airport extended the lease to a total of 53 years, enabling the expansion project to be financed.

Another important ingredient to success is how rent escalations are addressed to minimise unknown risks.

In return for the airport conceding the length of lease to make a project fundamentally move forward, the airport owner has an opportunity to negotiate and achieve rent escalations to ensure the ground lease payments remain current with Pvailing market values.

The key is to implement the right escalation mechanism to make these increases manageable for both the airport and developer.

Developers tend to be less price sensitive on ground lease escalations, within reason, and are more concerned about how rent increases can be Pdictably passed on to their tenants without surprises.

Tying rent escalations to an index such as the Consumer Price Index (CPI) can be effective, allowing the airport to extract fair market value throughout the lease while providing the developer and tenants the Pdictability needed to minimise unknown risks.

In the current financial environment, airports and private developers alike can achieve their respective goals only through acknowledging rigid deal points while leveraging those where compromise can exist.

Market support, lease term, default and relocation provisions, and rent escalation are among the essential ingredients to implementing successful PPPs. Find your common ground.

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