Fool’s Gold 3: The Empire Strikes Deals

On October 8, 2010 California Governor Arnold Schwarzenegger signed a compromise budget that closed the $19 billion dollar state budget shortfall, 100 days overdue.  Three days later, Ron Diedrich, acting director of the California Department of General Services, proclaimed he had completed a deal to sell 24 government buildings to a consortium called California First, LLC.  The deal, in which California will lease-back the space, was completed for the sum of $2.3 billion, one billion of which will be used to pay off the current debt on the buildings, and rest going to the state’s general fund.  Is this good public policy?  Is California selling off the family jewels to meet structural budget shortfalls?   Should other states follow California’s lead?

Assets sales are not a new idea.  In fact, recently there have been many such announcements.  The UK government plans on selling $25 billion worth of assets including the Channel Tunnel rail link and a bridge over the Thames River. The Irish government, on July 23rd, announced plans to sell $115 billion of assets which include airports, railroads, ports, and the national television service.  And, the Russians outlined plans to sell $29 billion of minority stakes in state owned companies.  Closer to home, in December 2008, Chicago leased out parking meter rights for 75 years for $1.2 billion to a group called Chicago Parking Meters LLC (Morgan Stanley, Abu Dhabi Investment Authority, and Allianz Capital Partners).

Let’s take a closer look at the Chicago meters deal.  In December of 2008, Mayor Daley said, “This proposed agreement, which will provide the city with a one-time payment of just under $1.2 billion comes at just the right time.  This use of metered parking proceeds will give us the flexibility to address our worsening economy, protect our city’s finances and taxpayers, and keep investing in our city’s human needs over the next few years.”  Here is where the money went: $ 400 million went into a long-term reserve fund which they claim will earn them $40 million (that’s 8% a year!).  $325 million of the sale went to balance Chicago’s budgets through 2012, (in 2009 Mayor Daley claimed the city had annual structural deficit of $200 million),  $100 million went to support human infrastructure projects, and the last $324 million to another reserve fund called Budget Stabilization, which can be tapped at the Council’s will.  Sounds good right?

Not so fast said Alderman Scott Waguespack in a recent Bloomberg news release. “Chicago gave up billions of dollars in revenue when it announced in 2008 that it leased Morgan Stanley its 36,000 parking meters, the third-largest system, for $1.15 billion to balance its budget.”  Waguespack was one of five to vote against the deal, (there are 50 on the Council).  He could be right.  Chicago Parking Meters’ revenue rose 48% to $18.3 million for the quarter ended June 30, 2010.  Based on new projections, the lease deal could yield more than $11.6 billion over the 75 years to Morgan Stanley and Partners.  And it could rise even higher depending on rate increases the partnership has the right to make over the next five years, (increases after that must be approved by the Council), and CPI adjustments the partnership can make over the lifetime of the lease.  The office of the Inspector General concurs with the Alderman, and believes that, “the city’s chief financial officer, who negotiated the agreement, failed to calculate how much the system would be worth over 75 years.  The present value of the contract was $2.13 billion, more than the $1.15 billion the city received.”  With the Mayor’s recent retirement announcement, this deal could leave a bad taste in Chicagoans’ mouths for years to come.

In January 2010, Los Angeles City Council released $500,000 in funds to finance a feasibility study on leasing 41,000 parking meters.  Mayor Bloomberg of New York also likes this idea and assigned Deputy Mayor Stephen Goldsmith to look into it.   Milwaukee is proposing selling its water supply, and in Louisiana and Georgia, airports are being put on the block.  Warren Buffett said in Congressional testimony that he is worried about how municipalities will pay for public workers retirement and health benefits, suggesting that the federal government will eventually have to step in.

Returning to California, it looks like Governor Schwarzenegger agrees with Warren Buffett.  He stated, “There are similarities in what’s happening in Great Britain and what’s happening in California.  We’ve got to go and spend less money. I think governments have promised people too much.”

So did California sell off the family jewels?  To answer that question let’s take a closer look at the transaction.  California First, LLC., a group made up of Hines (a privately owned real estate firm with $23 billion in assets and offices worldwide) and an international private equity firm, Antarctica Capital Real Estate, offered $2.33 billion for the 24 buildings on 11 parcels of land.  California First will lease back the space to the state for 20 years at market rates.  The state will also have the right to buy back the buildings at anytime.

Governor Schwarzenegger has said, “This sale will allow us to bring in desperately needed revenues and free the state from ongoing costs and risks of owning real estate.”   But, while the state does exit the risks associated with real estate ownership, it subjects itself to long term lease liabilities.  A report from the Associated Press stated that the deal would end up costing the state $5.2 billion in rent over the next 20 years.  This was confirmed by a study from Beacon Economics which looked at the rent over 30 years.  A recent report from the California State Analyst’s office entitled, “Should the State Sell its Office Buildings?”, stated that California originally bought office buildings to save money.

The problem here is that such short term revenues do not change the long term structural deficits. Schwarzenegger appears to understand the long term structural problems of California recently saying, “We’ve got to roll back the pensions. And that’s not just in California but all over the world.”  But it doesn’t appear that the California Legislature has accepted that there has been a paradigm shift, a “New Normal” as Mohamed El-erian of PIMCO puts it.  Instead, the Legislature appears to have decided to band-aid the current budget shortfall, using assets sales as a bridge loan. The Legislature hopes that the economy will recover, and return to the so called Old Normal.  Robert Kurtter, a managing director at Moody’s said, “We view these asset sales as 1-shots…that create structural budget imbalances in future years, but that may be necessary actions to bridge the time gap until revenue stabilization or growth returns.”  These types of one time budget maneuvers were cited in a recent downgrade of Arizona’s debt by Moody’s.

In reality, using such asset sales as bridge financing will only work if the structural deficits are addressed.  That is, the budget needs to be in balance before the state’s assets are depleted.  This can be done by a) reducing spending and fixing such things as the state pension plan, b) by raising taxes, or c) combinations of the two. It’s a roll of the dice with low odds to assume a return to the Old Normal.  One thing is for sure.  Whether or not spending is reduced, look for the next Califorina legislature to raise taxes on it citizens and corporations.

Robert Barone, Ph.D.

Joshua Barone, Managing Partner

October 15, 2010