Economics of tax abatement

Residents often question the need for tax abatement for real estate development. The argument against tax abatement is that it takes money out of the coffers of already tightly budgeted municipalities and school districts. However, the unfortunate fact is that tax abatement is often necessary to justify the cost of construction. 

The proposed development of the Lee-Meadowbrook site can be used as an example to explain the impact to investors and developers for tax abatement. The developer, The Orlean Company, is estimating it will cost $11,100,000 to develop a mixed-use building with 14,466 square feet of commercial space and 77 apartments. It is estimating annual rental income of $1,300,000.

Without tax abatement, the company is forecasting annual expenses, not including debt, of $633,000 ($328,000 of which would be real estate taxes). If the developer put 30 percent equity into the project ($3,330,000), it would need financing from a lending institution in the amount of $7,770,000. Assuming loan terms have a 20-year payback period at six percent interest, the developer would pay $668,000 annually in debt.  All of this means that the developer would be operating at a $1,000 annual loss.

If the developer were awarded an 80-percent real estate tax abatement, instead of paying $328,000 per year in taxes, it would pay $65,600. Instead of operating at a $1,000 annual loss, it would now have an annual pre-tax cash flow of $261,400.

Now, most will look at that and say, “I’d love to make $261,400 per year,” but this needs further analysis.  One metric real estate investors often use to evaluate an investment is the cash-on-cash return, meaning, “what percent do I earn on my investment?” An annual cash flow of $261,400 on an investment of $3,330,000 is a return of 7.85 percent. For an investment in real estate, 7.85 percent is actually lower than the return most investors expect to earn. Due to the high risk and non-liquidity of real estate investments, investors typically expect returns over 10 percent.          

Without tax abatement, the developer would be operating at a loss. With tax abatement, it would be able to justify the cost of its investment, albeit at returns lower than most real estate investors would be willing to accept. Markets dictate rental rates and, unfortunately, current market rents cannot support the cost of new construction without tax abatement for the developer.