No Money Down – the Allure and Dangers Of Municipal Development Projects

Series: Urban sprawl municipal budget impact

Apart from its commonly known costs, suburban sprawl is hitting municipal governments with hidden costs as a result of misguided policies.

In a growing city such as Maple Ridge, BC, leapfrogging suburban developments are adding more inventories to the city’s asset base and making its infrastructure deficit worse than it already is.

A real life example is used to illustrate how the discipline of a business case analysis can and should be applied to determine the implications of a new development project to the finance of a municipality.

See how a blighted and run-down block built in a traditional pattern compars against a shiny and new auto-oriented block built for a drive-through fast food chain restaurant when it comes to tax revenues to the city.

Lured by no-money-down and an immediate boost in property tax revenue, a city often approves development projects which end up with negative returns down the road. This concept only becomes obvious after digging into the income and expenses over a lifecycle of a project.

No Money Down

In our previous articles (here, here, here and here), we argued that certain forms of urban development – urban sprawl being one which stands out like a sore thumb – not only create endless traffic congestion and pollution and is detrimental to both mental and physical health of commuters, but also incur significant financial liabilities to a city.

Although increasingly more municipalities across North America are starting to recognize the negative fiscal impact caused by such forms of development, so far this problem does not seem to have caught the attention of most municipal councils and city halls to the point where concrete and tangible processes are being put in place to address the issue. Nor has the issue risen to the level of awareness where local residents vocally express their disapproval and demand for change.

One reason for the lack of response from residents and city officials alike is that the full fiscal impact of any urban development typically takes decades to complete, and the overall net gain/loss is not apparent until the bitter end. And for those elected decision making politicians whose planning horizon is the next election three or four years down the road, the temptation to not notice any future liabilities decades down the road can be tremendously strong.

In this article, we will examine what the financial profile of a typical development project looks like to a municipality over at least one complete lifecycle, and how projects in aggregate but developed over time affect and, more appropriately, shape the fiscal well-being of a municipality over time.

Development Project Lifecycle Revenues and Expenses

For those who just tuned in to this topic, it is first instructive to refresh ourselves with the salient variables in municipal fiscal math as it relates to urban development. A new residential subdivision will be used here as an example.

On the revenue side of the ledger, the city gets to collect:

  • property tax from the new home owners, and
  • development cost charges (DCC in British Columbia or by other names in other parts of the country) paid by the developer.

On the expense side of the ledger, there are three types of expenses:

  • Initial/capital expenses. The developer pays for the initial cost of putting in the infrastructure (roads, sidewalks, streetlights, water and sewer mains, etc., and the cost of hooking them up to the existing infrastructure). Unless otherwise negotiated and agreed with the developer, anything not directly related to infrastructure is borne by the city. Where required, these include a new fire hall, police station, library, community center, fire trucks, public works vehicles, etc. The cost of any new school is the responsibility of the school district.
  • Ongoing maintenance expenses. These include any and all expenses incurred in running and maintaining the infrastructure, including road repairs, road sweeping, fire and police services, parks and leisure center services, engineering, water and sewer utilities and waste management, etc.
  • Replacement expenses. Once different infrastructures reach the end of their lifetimes, they need to be replaced. Whereas water and sewer pipes might last upwards of 30 years, roads typically need to be completely ripped out and replaced after about 25 years.

Given the above revenues and expenses, let’s walk through the lifecycle of a typical new residential subdivision which can be roughly divided into three phases. For simplicity, let’s ignore the rise in property tax revenue as property assessment values tend to rise over time (not guaranteed as house prices do go down from time to time) and also the rise in maintenance material and labor costs (practically guaranteed over time).

  • Ribbon cutting phase. By the time the subdivision is built and the first home owners start moving in, the city would have received a decent chunk of DCC money. The incremental property tax from new home owners also contribute handsomely to the city’s coffer. This is the honeymoon period as far as the city goes: little to no money down, a fat deposit check from the developer and an increase in property tax revenue. The politicians get to cut ribbons and enjoy annual surpluses at the same time. Sweet.
  • Maturing phase. In the ensuing 10 to 20 years, the city bears the cost of maintaining the infrastructure (re-surfacing the roads and building upkeep, for example) and providing services. Depending on the additional infrastructure and services incurred by the subdivision, the maintenance cost may be greater than, less than or roughly equal to the property tax collected. During this period, the subject subdivision might result in a surplus or deficit on an annual and/or accumulated basis.
  • Replacement phase. The sticker shock comes when it is time to rip out and replace a piece of existing infrastructure at the end of its lifecycle. Depending on the type of infrastructure and its size and scope involved, the bill can be so large that any revenue surplus accumulated from the project from day one up to that point would be all used up – and then some.

Once the first lifecycle is complete, most likely the city would be in negative territory as far as the financial is concerned for this subdivision. From that point on to the end of the second replacement cycle, the financial for the subdivision will vary from negative to grossly negative as far as the city is concerned.

To put some real numbers to this concept, below are a few examples. Note that property taxes and costs do vary across locations but the concept-illustrating back-of-the-envelope numbers apply pretty much everywhere.

Per Strong Towns (article with case studies)

  • Rural road. A small rural road needs to be repaved, with the cost shared 50/50 between the property owners and the city. It would take the city 37 years to recoup its 50% contribution. The road is expected to last 25 years.
  • Suburban road. A suburban road needs to be re-surfaced for a modest cost of $354,000. The time it takes for the city to recoup the cost through property tax from the owners – 79 years. Alternatively, the city can recoup the cost by immediately jacking up property tax by 46%.
  • Street serving high value homes. A group of high value lake property owners petition the city to take over the road, proposing that they would pay about $25,000 per lot to build the road and the city upkeeps it from there on. The estimated cost to fix the road in 25 years – $154,000. The amount of property tax collected over the same period – $79,000. The city would need to bump up property tax by 25% immediately with a 3% annual increase in order for this ‘free’ street to break even.

From the above the salient financial characteristics of development projects should now become apparent.

  • The revenue and expense distributions of a development project are skewed. Whereas revenue is front-end loaded with DCCs and a steady annual income, expenses are back-end loaded with steady annual expenses culminating with a big bang at the end of one cycle.
  • It takes 20 to 30 years for one cycle to develop and the full financial impact to become apparent.

 

Municipal Financial Phases

If suburban development projects are such money losing propositions, then how come municipalities all over are not in trouble already, you wonder.

First off, not all development projects are net money losing for the city. It depends on how much new infrastructure the city gets to build and maintain relative to the tax revenue it gets to collect from the development.

More significantly, a city has many development projects starting and completing over a span of decades. For a relatively young new suburban center which derives the majority of its revenue from residential property tax, the aggregate ‘P&L’s of individual development projects spread out over time shape the city’s financial profile into three rough phases.

  • The build-out. During this early expansionary phase, many new subdivisions get built. Along with signs of growth permeating throughout the region, the city gets to rake in development charges and enjoys a growing tax base of residential home owners. With new infrastructure, the ongoing maintenance cost is easily covered by the new revenue from the new projects. Everything is peachy.
  • Treading water. As the size of the existing ‘infrastructure assets’ continues to grow and age, the maintenance bill and the onset of the replacement cycle for the older projects start to strain the city’s budget. During this time, finance departments of forward looking cities recognize that the infrastructure deficit – the gap between the eventual replacement cost of the infrastructure and how much money the city has set aside for that eventuality – is growing and getting worrisome, and introduce measures to narrow the gap by raising property taxes, a career limiting proposition politicians are allergic to and loathe to discuss.
  • The reckoning. The maintenance and replacement costs of older infrastructure overwhelm the tax revenue. Historical surplus funds are drawn down at a rapid and alarming rate. To avert a fiscal crisis, a city will resort to a combination of substantial tax hikes, service cuts and letting infrastructure slide further into disrepair, none of which would prove popular among residents.

To avoid hitting the reckoning phase, a city loaded with money losing subdivisions has only one viable choice – keep bringing on new developments and use their initial surpluses to cover the cost of existing infrastructure. This option, too, runs out when the city runs out of land to build or the infrastructure base gets too big, whichever comes first.

This formula of growth, ladies and gentlemen, is the classic definition of a Ponzi scheme.

Similar to the financial characteristics of its component development projects, the financial progression of a city loaded with money losing projects bear the same traits – front-end loaded revenue followed by debilitating back-end loaded liabilities played out over a span of decades.

This less than intuitively obvious financial profile is one of the prime reasons city councils without the benefits of prior fiscal analyses often approve deceptively sweet development proposals which not only cost the city nothing upfront but also bring in additional revenue.

For those politicians who do not see beyond the next election, the personal motives of reaping the benefits now and letting future successors deal with the mess is equally powerful – a motive vividly articulated by Canadian Finance Minister Joe Oliver who, amid criticism that one of the measures introduced by his budget favors the rich and saddles future governments with billions in tax leakage, responded that we should “leave that to Prime Minister Stephen Harper’s granddaughter to solve.” QED.

Pepsi Versus Coke?

Again, it is worth repeating that not all new subdivision projects would end up costing a municipality financially, as the financial outcomes all depend on the amount of tax collected versus the infrastructure liabilities they get to inherit and types of services the municipality needs to provide. As a rule of thumb, however, projects distant from existing infrastructure and essential services (fire, police and school to name a few) and amenities should cause major red flags to be raised.

Also, this is an attempt to steer away from the debate between living like apartment sardines for the overall good of society versus allowing more space for my children to play in the backyard, because, like Pepsi versus Coke, such are qualitative lifestyle choices to which there is no right or wrong answer.

What is not subject to debate, however, is the hard numbers in the income statement. If a city continues to accumulate projects with negative returns, then down the road the question becomes how everyone should pay for the shortfall for the city to stay financially solvent.

What a Municipality Should Do

There are a few things municipality should do to address this issue, starting with the most obvious one.

  • Everyone – council, city staff and residents included – should recognize and understand the financial characteristics of development projects. The concept is straight forward but the implications are not intuitively obvious. Look at the lifecycle benefits and costs, not just the upfront benefits.
  • Put a process in place to ensure that fiscal impact analyses become an inherent part of the development approval and, better yet, area planning processes. Fiscal impact analyses can get complex quickly depending on the level of details one intends to account for costs and how to allocate them. Start with a simple model and evolve it over time using feedback from historical data.
  • Involve the Finance department early during the development approval and area planning stages as they are the ones that will be directly impacted.
  • For those who have not already done so, create an infrastructure deficit account and quantify all current and future liabilities. Understanding the liability profile is the first necessary step in addressing the problem.

 

Further reading:

Photo credit: Lynn Betts

 

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