Expert Says Gallium Did Hit Zero

November 7, 2003
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GRAND RAPIDS — Even though the city discounted the discount rate, which tilted the current value of the controversial project in its favor, the Gallium Group LLC still got to zero.

“They did hit zero,” said Marvin DeVries, former dean of the Seidman School of Business at GVSU from 1973-1988 and an economic consultant to Gallium.

The discount rate is at the center of the project’s financial disagreement between the city and the developers. Quite simply, the discount rate is used to determine the value of a long-term obligation in current dollars. Two components make up the discount rate. One is a risk-free factor and the other is an element that includes risk, known as the risk premium.

“Whenever there is risk and you want to invest in something, then you’ve got to have an adequate return for the risk that you are assuming,” said DeVries.

When city staff evaluated the 30-year proposal submitted by Gallium for a new hotel on Calder Plaza and a new downtown headquarters for the city, DeVries said the 5.63 percent they used as their discount rate only accounted for the risk-free portion of the rate.

The city doesn’t agree that its discount rate should be higher than that. City officials feel, that as a municipal investment, the city is relatively risk-free — sort of like an insured money market account. But DeVries doesn’t agree.

DeVries said the city should have included the risk premium in its discount rate. Why? Because no one really knows for sure what problems might surface if a deal goes through. What if Gallium razes City Hall and has to remove a costly load of asbestos no one knew the 34-year-old building contained? What if repairs to the Government Center parking ramp cost more than projections due to some undiscovered defects?

“There are risks associated with that and it seems to me that has to be reflected somehow in the discount rate,” said DeVries, who earned a doctorate in quantitative economic analysis from the University of Michigan and taught economics at GVSU for 33 years.

Because Gallium feels its project brings tax revenue and operational and capital savings to the city and is willing to absorb all the risk, the discount rate used to measure the current value of the proposal should contain a risk premium.

“If I were to take a look at this total project and try to come up with what the risk premium might be, it could be anywhere between 3 and 4 (percent). So then we’d be talking about something between 8 and 9 percent as an appropriate discount rate,” said DeVries.

Adding a risk premium to the city’s discount rate lowers the present-day value of the project and it’s a move that would favor Gallium.

For example, using the city’s discount rate of 5.6 percent, city staff said last June that the Calder Plaza hotel project would cost the city $6.45 million in current dollars. But the same financial handout from the city showed that if the Gallium discount rate of 9.5 percent were used, which included a 4 percent risk premium, the city would be $2.58 million to the good in present-day dollars from the project.

That is a sizable swing of slightly more than $9 million. Including a risk premium in the discount rate doesn’t make the deal look as bad for the city as city staff made it out to be in June, according to DeVries.

“But the developer decided, after a lot of consideration, to see if they could make the project work on the basis of what the city proposes as its discount rate, which is the risk-free component only,” said DeVries. “And they made it work.”

Gallium is willing to pay $4.9 million for City Hall and $9 million for the parking ramp below it. Gallium said the city would save $5.7 million in operating costs by moving, $8.5 million in repairs to its current building, and $8.6 million by consolidating its locations. All savings are for 30 years.

Gallium estimated that a new City Hall and new parking structure would run $19 million, a figure that doesn’t include the cost of land. The developer said the city would generate $4.4 million in parking revenue from the ramp over 30 years, and would get $1.6 million in tax revenue from the new hotel over that period.

Gallium Group LLC is an investment partnership between Blue Bridge Ventures LLC of Grand Rapids and Hines Interests LP of Houston. Gallium has proposed to build a 400-room hotel on Calder Plaza across Monroe Avenue from the new convention center.

But to do that, Gallium has to move City Hall to a new location by matching the city’s current operational costs and the cost of future repairs to its building — otherwise known as getting to zero. Reportedly, the city spent $1.3 million to operate City Hall the past fiscal year, and plans to spend $11.3 million on repairs to the building over the next 16 years.

Blue Bridge Ventures CEO Jack Buchanan told the Business Journal last week that city staff may meet with structural engineers from Engineering Systems Inc., the Aurora, Ill., firm that did a structural analysis of City Hall for Gallium. City staff is planning to report their findings from the Gallium proposal to city commissioners in roughly two weeks.

At a commission meeting two weeks ago, Mayor John Logie said the Gallium proposal was the firm’s latest offer. By saying that, the mayor implied it was a different proposal from the one the developer presented in June. But Buchanan said it wasn’t.

“We didn’t make another proposal, it’s the same proposal we made in June,” he said “They’ve already reviewed. It’s the same deal.”  

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