In our whitepaper, The State of Parking in Downtown Austin, we covered parking in the CBD and how it correlated with rental and vacancy rates. Through our research we came across several questions that we did not have enough space to cover in our report. Instead, we decided to write this additional piece to go into more detail on the economics of parking and ask the question we’ve all been asking: Should we build more parking downtown?
How Much Do Commercial Real Estate Developers Need to Charge for Parking to Achieve Acceptable Returns?
One way landlords may determine what to charge tenants for monthly parking is the required return on their commercial real estate investment. For example, developing above-ground parking downtown today costs close to $20,000 per space, and a below-ground space may cost a developer as much as $35,000. For this analysis we will assume an average construction cost of $25,000 per parking spot in downtown Austin.
Accordingly, to be incentivized to build more parking in lieu of office space, developers are going to want an acceptable return on what it cost them to build the parking. This is where interest rates fall in.
Today, a good estimate for the rate on a loan with a 25-year amortization is 4.25%, which results in a debt yield of 6.57%, which means every $100 in debt costs $6.57 per year. So if the developer takes out a loan for 70% of the total project cost and gets equity CRE investments for the remaining 30%, the debt cost of every $100 in total project cost is $4.60.
In order to determine if a project is feasible, they will calculate the total income required to provide a return that not only covers the cost of debt, but provides an acceptable return to the equity CRE investors. A common metric used by developers for this analysis is the yield on cost. This is the blended return the debt and equity receive on their commercial real estate investment. In today’s market, we are seeing leases being signed at rates that give the landlord an 8.5% yield on cost. Under our debt assumptions, this suggests the developer requires a return on equity of approximately 13% to make it worth the time, effort, and risk of taking on the project.
Therefore, in our scenario parking revenue needs to average $2,125 ($25,000 cost times 8.5%) per space per year, or a monthly rate of $177.08 per space. Since we know that not all spaces will be fully leased, using a utilization rate of 80% would suggest the developer would need to set a monthly parking rate at $221.35 per space (per our whitepaper, average parking rates are $219, as of 2Q 2016) to make building parking seem more attractive than building office space. Why would it be more attractive you ask?
That’s because many developers in Austin are making arrangements with tenants that require them to take and pay for all of the parking to which they are entitled. This arrangement greatly benefits the developer, as they are still able to charge the $221.35 per month for parking, while at the same time requiring tenants to take their pro-rata share of spots. In this scenario with all the parking utilized, the developer gets a windfall in their returns. Their return on cost now goes up to 10.63% rather than the 8.5% they received before, and their return on equity goes from 13% to over 20%!
But the potential returns do not stop there for the developer. If parking spots are opened to the public on nights and weekends, there is even more revenue to be made outside of the monthly revenue from tenants. Some public parking spots in downtown Austin can cost as much as $25 a day, and because the developer already achieved their target yield (and then some) from the tenants, all the revenue from offering public parking is gravy!
Economics of a Basic 3:1000 Building?
So why not build more parking? What is the tradeoff between building office space vs. parking space?
Whether you are developing parking or an office space, the land costs the same. Let’s say under a traditional scenario, an office building was being developed and would offer a parking ratio of 3:1000. Each parking space requires somewhere between 325 to 350 SF, so building 2,000 SF of office with 6 parking spaces would require an additional 2,000 sf for parking for a total building size of 4,000 SF. Today’s construction costs would probably put the total cost at $450 per rentable square foot of office (“RSF”). This accounts for shell office space, market tenant improvements, rent concessions, land purchase and structured parking costs.
Under such a scenario, the cost to build parking would amount to approximately $75 per RSF (6 spots at $25,000 each divided by 2,000 RSF) and the land would cost roughly $50 per RSF, or $100,000. Let’s say the landlord charges $221.35 for parking and, in order to achieve an 8.5% stabilized yield on cost for the office, they charge $34.27 per SF in rent to the tenant. In this case, the tenant is paying $68,548 in NNN rent plus $15,938 in parking for a grand total of $84,486.
Assuming there is one person per parking spot, that makes for a per-employee cost of $14,080 per year. However, it is likely that two out of five people can find alternative transportation, allowing the company to increase its density to five employees per 1,000 SF and therefore reducing its cost per employee to $8,449 per year. This is our base scenario.
What do the Numbers Look Like for Tenants and Landlords?
Things become interesting when we change the parking ratio from 3:1000 to 6:1000. Under the same 4,000 SF building used in our base scenario, the developer could build 8 parking spots and 1,333 SF of office space. Rather than needing 2,000 SF to house 10 people, the tenant could house 13 people at the same ratio in less space, that’s 8 in the garage and 5 finding their own parking.
So how do the economics work under this scenario?
Under our original assumption, the building cost was $450 per RSF. With the higher parking ratio, construction is now more expensive on a per RSF basis. (Booooo! Everybody Boo!) Parking still costs $25,000 a space, so with eight spaces the cost has gone from $150,000 to $200,000, or $150 per RSF (up from the original $75). The land is still $100,000, but the square footage of office space went down to 1,333 sf, so the land is now $75 per RSF.
There are some additional costs that will make these numbers increase even more. With greater density, the building will need extra HVAC and restrooms to handle the additional load. And if you know me, you know what kinda load I’m talking about. The kind that requires a lot more plumbing to handle it! Taking this into account, and assuming those costs will add about 10% to the cost of the building, that now brings construction costs to $582.50 per RSF. Considering we started at $450 per RSF, that is quite an increase!
Using the same 8.5% yield on cost calculation we did in our base scenario, the new rental rate comes to $39.53 per SF. Why would the tenant pay $39.53 a SF? Why would they pay $5.26 per SF more for the same space? No lender is going to understand this, no future buyer is going to understand it, and tenants are too smart for this.
A smart developer would say: I can continue to charge $221.35 for parking, but now on eight spaces. I can charge rent on 1,333 SF for $52,695 NNN per year. That is $73,945 in net rent. As a landlord that is less rent than the original 3:1000 scenario? As a tenant you’re paying less rent? I’m increasing my returns while still saving the tenant money?
Yes! And because we know that no good developer will break the mold without a promise of greater returns, you can split the difference of the tenant’s savings and increase your rate. This gives your commercial real estate investors an additional 2.1% annual cash on cash return! That’s a 14% annual increase!
So what are the savings per employee? If 40% (2 of 5 in our base case) of the workforce finds alternative transportation at the same parking ratio as discussed in our base scenario, the cost per employee is just over $5,500 per year. This is a 33% annual savings on a per-employee basis, making it a win for everyone!
Could you capture more profit if you are a landlord? Sure, but you should hire AQUILA to help you figure it out. Could you prevent the landlord from capturing that profit and pass more savings on to yourself, the tenant? Possibly, but you’d have a much better chance if you hired one of our brokers to help navigate you through the process. We perform complicated analyses, such as this one, for our clients all the time. Helping them save money and mitigate risk.
What is the Future of Parking in Austin?
So, what happens when autonomous cars come on the scene and parking is no longer necessary? Well, darnit! That would seem to destroy our theory, or does it? Is there a day where autonomous vehicles are used predominantly and parking a car that sits for hours becomes obsolete?
Probably. You old codgers are now saying, “you are full of crap!” Maybe, but no one thought Rice would beat Texas in 1994. And my Owls proved that no one beats us 29 times in a row! I just got back from California, where testing underway for autonomous vehicles that should be available for Uber and individuals who want to make money by having their cars drive people around. And if you’ve ever seen me drive, you would much rather I put it on autopilot than drive consciously.
So how are developers accounting for this risk? Some developers are building above ground parking that consider a higher clear height rather than the typical 9 feet from deck to deck in case it one day gets converted to useable office space. This idea, however, is most likely five years out before initial adoption and 15 – 20 years out before full adoption where parking is really impacted. Don’t underestimate the impact of these self-driving cars on commercial real estate and specifically parking. This article discusses how Denver is one of several cities already modifying their developments in anticipation of this transformation. Similar to the onset of the internet, it’s difficult to imagine the broad reaching impact this technology will have on our lives.
As densities continue to skyrocket due to changes in company culture, advances in efficient furniture design and desire to cut cost not through rental rate, but through efficiency, demand for parking will surely push new buildings to offer more parking.
I believe the developer who can build a building that can be adapted in 20 years, while taking advantage of today’s demand in parking, will be the winner. Whether fully autonomous vehicles become a reality or not, we do know that the supply of parking downtown is lagging far behind the demand, and any developer that can take advantage of that will likely be better off.
As we said in our whitepaper, The State of Parking in Downtown Austin, the influence parking has on rental and vacancy rates in the CBD is hard to nail down. With that being said, economics would tell us that supply tends to follow demand, so we will continue monitoring the downtown parking situation to see whether new buildings begin to offer more parking, or if other change happens altogether.
Another development we will keep an eye on is the introduction of density restrictions by landlords, limiting the amount of employees allowed in a given space. We are starting to see this in the suburbs, and similar limitations in the CBD could have an interesting impact on tenants, including parking.