St. Paul rent control vote turns builders, bankers away from capital city

Just a few days after St. Paul voters approved the rent control measure now recognized as the nation's strictest, Mayor Melvin Carter III said, "We just can't afford to do anything that is going to slow the growth of new housing construction in our community."

He thought the City Council should now exempt new construction from the measure that caps rent increases at 3%.

Three weeks before Election Day, Carter came out in favor of the rent control measure, suggesting it could be tweaked once enacted. He should have said then — when it mattered — that he had real concerns about stalling new construction. His own re-election did not seem in jeopardy.

Now, developers and their lenders are locking up the brakes in St. Paul. And that includes Minneapolis-based Ryan Cos., working on the biggest project in the Twin Cities: what's routinely described as the billion-dollar redevelopment of the old Ford Motor site, rechristened as Highland Bridge.

Real estate projects really don't age well when put on hold. The land might still be there, the cracks in the asphalt growing wider and the weeds a little taller, but the investors move on.

The Highland Bridge project illustrates just how big a problem this is for the city.

The plan for the 135-acre site has space for offices, stores and other uses. Eventually, there was to be roughly 3,800 units of new housing, from single-family houses along the Mississippi River to apartments for seniors.

About 3,000 units were intended to be market-rate apartments. Developers were also going to build about 760 units of affordable apartments, including some that were going to be within reach of very low-income households.

When Ford turned the site over to Ryan, it was just an open expanse of stirred up dirt. Ryan had to build most of the streets ($12.8 million in the budget) and stormwater systems ($16.5 million) and everything else first. Only then could buildings get built and rented.

The rent control ordinance knocks the legs out from under the market-rate housing that was going to pay for Highland Bridge.

The mechanism for making the whole project work is tax increment financing. That's where money borrowed to finance things like a stormwater system gets paid back from the incremental property taxes generated by new buildings.

The city approved the creation of the TIF district for Highland Bridge five years ago, and it was meant to fund about $53.5 million worth of infrastructure. Other TIF districts totaling more than $40 million at Highland Bridge, so far, will fund affordable housing.

But no new apartment buildings means a lot less incremental property value to tax.

Full disclosure, I have friends and relatives with a stake in the rent control debate. One affordable-housing developer selected for Highland Bridge is Project for Pride in Living, a Minneapolis nonprofit organization. My wife is a PPL board member and donor. Separately, a development firm co-founded by my brother has an apartment project in St. Paul.

In a short conversation last week, Ryan executives Maureen Michalski and Tony Barranco confirmed how tightly connected the various aspects of the project are, and how painful delays in generating incremental tax value will be. As Michalski pointed out, some of the incremental tax collections were planned to go to affordable housing in the rest of the city.

One thing they really need, Barranco said, is greater clarity. For instance, there's a provision in the rent control measure that would allow for a "reasonable" rate of return on capital investment. Nothing's more capital-intensive than putting up a new building, but what's meant by the word "reasonable"?

Ryan clearly can't let the site become pasture. It's at least possible the company could turn to condominiums and other for-sale housing. That would mean fewer housing units on the site, not much for renters and far fewer affordable units.

Advocates for rent control in the Twin Cities frequently point to Portland, Ore., as a model. But the state of Oregon's rent control law, to which Portland is subject, exempted new construction for 15 years because its leaders wanted new housing built. Oregon also caps rent increases at 7% plus the rate of inflation, far above St. Paul's 3%. Last year's rent increase limit in Portland exceeded 9%.

St. Paul doesn't exempt new buildings and has no provision for inflation, which was 6.2% in the latest federal data.

In St. Paul, operating expense increases could easily exceed 3% a year. It won't take that much of a hit to cash flow to move the dial on returns.

It takes about $50 million to build a 180-unit apartment building, including all the soft costs like architect's fees and building permits. Developers get most of that money from a bank and the rest from investors or their own checkbook.

A target return, or yield, might be 5.5% after the building is fully leased. To arrive at that number, you take all of the rental income left over after paying the operating expenses and divide that by the cost.

Operating expenses growing faster than rent could mean that 5.5% yield that attracted the money to build it doesn't last that long.

The owners can't go back and put in cheaper appliances. They must keep paying their property taxes and scooping the snow.

Cutting building maintenance is the only real option, and it's not a good one.

After the Nov. 2 vote in St. Paul, it didn't take long for bankers and investors to understand how the recipe changed.

"While the cap limits the amount of rental income increases a unit can receive, there are no limits on the amount property expenses can increase," Nick Place, chief lending officer of St. Louis Park-based Bridgewater Bank, told me in an e-mail.

"This will certainly add a layer of uncertainty as the bank tries to project the amount of net operating income a property will produce going forward," he wrote. "We may have to limit our [loan-to-value] or increase our debt service coverage ratios in order to account for this increased uncertainty."

Place sounded measured, talking about tweaks to underwriting. But the bank won't be applying the same standards across the river in Mendota Heights.

And that is the interesting thing about how markets work, how capital flows to where the better returns are. If a market rate of return is in doubt in St. Paul and still achievable in Mendota Heights, investors and lenders have easy decisions to make.

Money will flood into apartment construction in the Twin Cities next year. St. Paul will be lucky to see a trickle.