SUBJECT: GROUND LEASE TO DESIGN, DEVELOP, MAINTAIN AND OPERATE A RETAIL BUILDING ON CITY OWNED PROPERTY AT 1303 HERMOSA AVENUE AND APPEAL OF ENCROACHMENT PERMIT OVER CITY PROPERTY

Recommendation:

That the City Council approve the ground lease with the following conditions:

1. Initial ground lease rate at $21,000 per year.
2. CPI lease adjustments assessed every five years (maximum 15% each assessment).
3. Ground lease escalator assessed every five years at 12.5% of the effective gross rent receipts but not less than the CPI adjusted ground lease.
4. Off-site improvements consistent with the attached plan.
5. Exterior building finish consistent with the abutting City parking structure interior.
6. Reimbursements to the City for site work (electrical and telephone conduit and sewer lateral)
7. Approve an appeal to an encroachment permit for a 2’-6" encroachment at the second floor level of the project and related ground level encroachments shown on the attached plan.

Background :

On June 7, 1999 the City Council reviewed three proposals to ground lease city owned property to develop and operate a retail building at 1303 Hermosa Avenue in connection with a Request for Proposal issued on May 3, 1999. The development team of Peha Associates and Triwell Properties was selected to develop the project. The subject property is a 2,280 square foot remnant parcel created from development of the North Pier Parking Structure.

In selecting the project developer, the Council directed staff to:

• Negotiate terms for a 50 year ground lease commensurate with the fair market value for the property and to ensure that project plans include site improvements with special paving landscaping and lighting consistent with the Lower Pier Avenue streetscape improvements and compatible with egress from the City’s parking structure.
• Ensure that the exterior building finish is consistent with the abutting City parking structure interior and that the ground lease includes reimbursements for installation of a lateral sewer line and conduits installed by the City during construction of the parking structure.

Analysis:

The intent of the ground lease is to provide a site for the development and operation of a retail building. Development of the retail building will provide aesthetic benefits by creating continuous pedestrian retail frontage along Hermosa Avenue consistent with the rest of the downtown and financial benefits through ground lease revenues, sales tax and property tax revenues to the City. The developer proposes a $21,000 annual ground lease with five year CPI adjustments.

Staff is recommending additional ground lease adjustments every five years at 12.5 % of the effective gross rents the property achieves, but not less than the CPI adjusted ground lease every five years. 12.5% is based on the effective gross rental income for the project, less vacancy. (The annual gross effective rental income is $167,827 and the ground lease is based on approximately 12.5% of the effective gross building rental income.) This adjustment will enable the City to share in the successes of the businesses and property operation. The above adjustments enable the developer to absorb the start up costs associated with the project at the ground lease value they have indicated is acceptable, but enable the City to achieve a higher ground lease after the first five years to keep pace with rental levels in the area as they occur. A five year rent resetting cycle is consistent with the rent schedule proposed by the project developer for building tenants. Reconsideration of the ground lease in this manner will enable the City to be current with any significant increase in property values that may occur in the downtown over the long term and with significant changes in the CPI.

The Council’s selection of the project developer was predicated on obtaining the best project design and best development in concert with reasonable rental revenue. The Peha/Triwell project was the preferred design by City Council although it provided a slightly lower return then the project with the highest proposed lease value. The City retained Lea Associates to provide appraisal services for the property. Lea Associates indicated that the fair market value for the ground lease was $28,000 per year. Achieving the appraised value of $28,000 per year is not possible according to the developer, due to the actual construction costs which have been more fully evaluated over the past three months. The difference in ground lease value is partly due to the difference in expected construction costs between the Lea Associates appraisal and the developer’s revised estimated construction costs. The project plans have also been more fully developed providing a better estimate of costs. When the increased construction costs are factored into the pro forma for ground leasing the property, the appraised value is not attainable according to the developer. The developer has increased the ground lease value by 16% over the initial proposal based upon the most current negotiations with ground floor tenants.

Staff believes that it may not be possible to develop the project approved by Council at a lower construction cost and the tenant lease values appear to be consistent with prevailing rents in the area. (Please see attached pro forma.) The small project site also has some impact on tenant lease values. Therefore the Council may want to consider a lower ground lease value initially, but provide the option for lease escalations based upon the performance of the project and area real estate values.

The project also requires processing of an encroachment permit to accommodate a 2’-6" second level cantilever of the building. Approval of encroachments which deviate from established criteria can only be granted through appeal to the City Council. Staff is recommending approval of the encroachment permit by minute order.

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