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A Bad Deal: An Analysis of the Pending California State Office Building Sale/Leaseback Program.

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California Governor Arnold Schwarzenegger has proposed selling off 11 state-owned office properties for the purpose of helping balance the state’s huge budget deficit. The plan is to lease back the sold properties from the buyers using a relatively stringent long-term lease. The Governor’s proposed budget estimates that the sale will net roughly $1.97 billion in revenues. Many of the properties have outstanding debt on them that will need to be paid off in the event of a sale. Approximately $1.31 billion in payments will need to be made to close these bonds and pay interest penalties. As such, the plan’s proponents estimate the net proceeds to be $660 million.

The properties are slated for sale in the belief that, like similar transactions undertaken by corporations in the private sector, the state can almost immediately employ potential cash that’s currently locked up in the value of these buildings. Implicitly, it is also based on the idea that buildings managed by the private sector will be cheaper to maintain because of lower employment costs. Notably, this new policy is a direct repudiation of a tradition enacted over 30 years ago to lower the state’s cost for courts, employees, and agencies by developing state-owned office buildings.

Our analysis of this transaction suggests that the initial estimate of the net proceeds from the sale of the buildings ($660 million) may be slightly high given current market conditions – but are well within the realm of possibility. Nevertheless, we strongly recommend against selling the properties for three reasons:

  1. While the transaction may net the state a profit in the short run, ultimately the long-run costs of renting will be far greater than the cost of owning the properties directly. Even if we assume that the cost of maintaining the properties is higher under state ownership, rental prices will cost $4.2 billion more than the direct expenses over a 30-year period, $1.5 billion in current value. This expense is considerably larger than the $600 million the state hopes to raise. The reason for this gap is that the cost of capital for the state is lower than for the private sector.
  2. Even if the sale of the properties was net neutral (that is to say the funds raised in the short-run fully offset the expenses of renting the properties back in the long-run) such a transaction violates the spirit of the Prop-58 ban against using long-run debt to fund current state spending, as it imposes a cost burden on the future in order to cover current state expenditures.
  3. Lastly, using one-time revenues to try and solve a structural budget gap is always bad policy, as it simply moves the need to make tough decisions ahead in time. In this case the overall amount of cash raised is so small relative to the current budget gap that it accomplishes little in solving the state’s short- run problem. 

Critics of government often cite the numerous ways that public budgets obscure what is happening from the eyes of the electorate. This is a classic case of such a transgression. The fact that this sale increases the cost to the state over the long run is not included in the budget proposal. This is possible because the public sector is allowed to account strictly on a cash basis, unlike the private sector where an accrual basis is the law for such large transactions. If the state government used standard accounting principles, this transaction would actually end up expanding the budget gap substantially, rather than reducing it.

The following report details how we arrived at these results. The next section discusses the properties and the nature of the state’s leaseback agreement. The third section lays out the empirical analysis, and how we arrived at our net present values for the two scenarios, sell and lease, or own. The final section concludes with a discussion of the violation of the spirit of the law.