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Thirty years after it shut down, the old Gasco site in Iwilei is still a vacant lot. For generations, it converted heavy petroleum into synthetic gas and light oils. Now, its storage tanks, thermal cracker unit and pipelines are long gone and, in their place, is a field of gravel and weeds.
All that remains of the old gasworks is its contamination – a vast underground reservoir of viscous tar and toxic aromatics, like benzene, toluene and ethylbenzene. Indeed, the Gasco site is one of the most contaminated sites in the state, and the technical and legal consequences of that contamination are why the land sat vacant for more than three decades. Even so, three years ago, Weston Solutions, an international environmental engineering company, bought the property – and all the liability that goes with it.
That’s because the four-acre site is prime real estate. It’s near downtown, the harbor, airport, highways and the planned rail line. Weston plans to clean it and redevelop it, but three years after buying the land, Weston’s project still faces technical glitches and regulatory hurdles, and has become a symbol of Hawaii’s contaminated lands problem.
Operations manager Dave Griffin, left, and Mark Ambler are
Distribution of toxic sites
Here’s the good news: Hawaii is much less affected by contaminated sites than most Mainland states, according to Fenix Grange, manager of Site Discovery, Assessment and Remediation for the state Department of Health. That’s largely because we haven’t had as many heavy industries as in the Rust Belt or the petrochemical regions of the Gulf Coast. Also, according to Grange, it’s rare for contaminated properties here to sit idle.
“In Hawaii, because land is so valuable, most large, urban properties that have contamination on them get developed anyway,” she says. “People just make the cleanup and control costs part of their redevelopment plans,” Grange says.
Nevertheless, industrial areas like Iwilei, Campbell Industrial Park, Mapunapuna and Kakaako are heavily contaminated, which complicates land sales and development. The main issue, of course, is liability for the required cleanup, which can mean millions of dollars in uncertain expenses.
Beyond these large, well-known industrial sites, there are hundreds of anonymous, smaller sites: dumps, auto-repair shops and old underground tanks at gas stations. Former sugar and pineapple plantations have dozens of contaminated sites that were once used for fertilizer storage or pesticide mixing.
The state Department of Health has investigated more than 1,700 sites of potential contamination, nearly half of which merited further action. “We have about 800 sites in our database that have current or historic contamination that are either still dirty, or were dirty and have been cleaned up,” Grange says.
Joint and several liability
Hawaii’s rules on toxic sites are mostly derived from the U.S. Environmental Protection Agency’s regulations. “In federal law,” Grange says, “liability is ‘joint and several,’ which means anybody associated with the contamination is in the chain of responsibility. The regulators look first to the party that actually caused the contamination. Then they look to the current property owner. But anyone associated with the contamination is in the chain of responsibility.” That means, the current property owner is on the hook, but so is the previous owner.
An excellent example is Weston’s other Oahu project, the old Chem-Wood facility in Campbell Industrial Park. From 1973 to 1988, Chem-Wood, a Campbell Estate tenant, used copper chromate arsenic to pressure-treat lumber there. Campbell sold the property to Chem-Wood in 1989, but, under duress from the EPA to clean up the site, Chem-Wood went bankrupt in 1997, leaving behind tanks of the toxic chemical. In 2008, vandals broke in, spilling 300 pounds of the copper chromate arsenic. Arsenic levels in the soil are now some of the highest in the state.
In the intervening years, other responsible parties have disappeared. The most recent owner, a Japanese businessman who also faced pressure to clean up, walked away from the property, taking haven from the EPA in Japan. His predecessors went bankrupt. But bankruptcy is not an option for the Campbell Estate; its pockets are too deep. Until it sold the site to Weston Solutions, it was stuck with all the liability for the cleanup, even though it hadn’t been the owner of the property for more than 20 years. That’s the principle of “joint and several.”
The uncertainty and risk created by joint and several liability has made it difficult to redevelop parcels that are contaminated – or are even suspected of contamination. As a result, the EPA and state regulators have devised programs intended to ease liability for buyers that want to redevelop a contaminated property. The state’s Voluntary Response Program, for example, provides owners and purchasers with technical assistance, quicker oversight and some relief from future liability.
“With the VRP,” Grange says, “a developer comes in, agrees to characterize a site and take responsibility for the contamination up to a level suitable for their proposed use, and then they’re free from additional liability.” She adds that the liability for the remaining contamination doesn’t simply go away. “That liability stays with whoever caused the contamination in the first place.”
She gives an example from Iwilei: “The site of the Lowe’s store has a bunch of petroleum-contaminated soil from the old ConocoPhillips tank farm. Lowe’s wanted to build its store there, but it didn’t want to assume all of ConocoPhillips’ responsibility. So it entered our VRP and agreed to remediate within the property boundaries to a level that was safe and appropriate to build a commercial store. The VRP leaves the remaining environmental responsibility with ConocoPhillips.”
Probably the most important program for encouraging the redevelopment of contaminated lands has been the federal Brownfields Program. This law, which was mirrored at the state level in 2009, provides many of the same protections as the VRP. “We have about 20 VRP sites in the state,” Grange says. “But with the new Brownfield purchaser law, I think there will be less need for those in the future, because they can get those protections automatically now.”
One of the big differences with the Brownfield Program is its funding options. “Right now, we have what’s being presented as the poster child for Brownfield,” says Mike Yee, one of the principals at the local consulting firm EnviroServices and Training Center. “That’s our East Kapolei site, the pesticide-mixing site and surrounding area in Ewa that the Department of Hawaiian Homelands wants to put homes on.” Through the Brownfield Program, DHHL is funding some of its environmental assessment costs with a $200,000 EPA grant. DHHL is also the first entity to use a $1 million EPA revolving fund administered by the state Department of Business, Economic Development and Tourism. This money can be used for the actual cleanup and paid back after the property has been redeveloped.
“Wow,” says Yee. “What a wonderful way to use federal money: to bring that money into our state to investigate and clean up contaminated sites. It’s good for the developer, good for the state and, ultimately, good for the community – not to mention the environment.”
Weston has created an interesting business model for its Gasco and Chem-Wood projects. Typically, environmental firms are simply consultants or subcontractors; the developer remains liable for the contamination. But Weston bought these properties outright. In effect, Weston has gambled on its expertise in environmental engineering, believing it can purchase properties at a discount, clean them and sell them at a premium. In the interim, though, Weston is the responsible party as far as DOH is concerned. In the lingo of environmental engineers, Weston has bought the liability.
“I’d like to tell you that we’re really smart at this,” says Dave Griffin, Hawaii Operations Manager, “but we have a card up our sleeve: We buy an insurance policy. We engage insurance to underwrite this risk for us, so if we encounter 50 drums of methyl-ethyl that nobody knew about, we can recover some of our expenditures.”
While being the property owner is much riskier, Griffin points out some advantages. To begin with, any upside on the development end of the deal belongs to Weston. And since the company’s cleanup agreement with DOH is based upon the end use for the property, Weston can tailor its cleanup process to a specific function, potentially saving money.
There’s also the method of payment. Although Weston technically “bought” the property from BHP, the details of the contract are more complicated: The seller pays most of the downstream costs. “Instead of billing for hours,” Griffin says, “we get paid up front. So now we’re sitting on that money, drawing interest. Financially, that makes a lot of sense.”
Rick Smith elaborates: “You get paid for everything up front,” he says. “So they (property sellers) pay for the insurance. We don’t pay for that. … The cost of the cleanup, what we actually do in the field, all that’s paid up front. All that’s part of the calculation.” But he notes there’s a lot of prelude before the symphony of cash. “That reward, that big lump of money, doesn’t just stroll in the front door. There’s a lot of work that goes into putting one of these deals together.” In this case, the deal took 18 months to arrange.
“It’s not for the faint of heart,” says Griffin. “The truth is, we’re trying to do the right thing here. By redeveloping this property, we get jobs, we get tax base and we get a more vibrant community out of the deal. That’s our kind of model. Would we like to make some money at the end of the deal? Absolutely. We found a piece of property that’s been sitting vacant for 30 years (the old Gasco site), and it’s right next to the highest-selling Costco in the country. We think we’ve found a little gem here. But, in the end, it’s Weston’s contamination now.”
Bankers and Consultants
Although a large, international company like Weston Solutions can afford to self-finance its projects, most local companies interested in redeveloping contaminated property will need a lender. And that’s just the beginning, says Scott Rodie, environmental risk manager at Bank of Hawaii.
“Banks don’t like uncertainty,” says Rodie. “What we try to do, cooperatively with the client, is help them avail themselves of the experts that are out there.”
That means making sure their clients have qualified environmental consultants and appropriate insurance, and that, overall, they know what they’re getting into.
One problem is figuring out if your advisors are knowledgable. “It’s unregulated and unlicensed,” Rodie says. “Under federal law and Hawaii Revised Statutes, there are requirements that you have an ‘environmental professional,’ as defined by the rule, perform a Phase-1 (site investigation). But, again, it’s unlicensed. You have nearly nothing to go after” if they get it wrong.
“So it’s buyer beware,” Rodie says. Or, better yet, listen to your banker.
How Toxic Land is Cleaned
Environmental engineering companies have several ways of cleaning contaminated land, from the most basic method to high-tech solutions.
First, figuring out if there is anything toxic in the ground, what it is and where, can be complicated. Mike Yee, of EnviroServices, elaborates: “How far down does the contamination go? How wide has it spread? What are the actual contaminants and what is the level of the contamination? Then we look at remediation alternatives – what’s the best way to treat it? Normally, there’s not just one way to clean up a site, and there are a lot of factors that go into determining which one you select.”
One option is very basic: dig up the contaminated soil and remove it. Damon Hamura, project manager for EnviroServices, calls it “Bag it and tag it.” With this method, you’re not actually getting rid of the contaminant; you’re just moving it – often to a landfill.
That’s sometimes the only solution, particularly with metals contamination, but it presents its own problems, including moving truckloads of contaminated soil through the neighborhood.
“Sometimes,” Hamura says, “they just put it back on the same site – a kind of reinterment. They dig a pit, put all the contaminated soil in there, then cover it with concrete or asphalt. That’s called ‘encapsulation.’ ”
This is the strategy being used at the Chem-Wood site in Campbell Industrial Park.
When it comes to cleanup options, Hamura says, “Removal is a pretty short list, but when you get to remedial action, it’s a relatively long list. And it’s getting longer as technology grows.” This is particularly true for petroleum-based contaminants, the prevalent form of soil and groundwater pollution in Hawaii. For example, you have various kinds of bioremediation – basically using petroleum-eating microbes, either natural or introduced – to remove the contaminant. This is often combined with sparging, essentially bubbling oxygen through the groundwater to improve the effectiveness of the bacteria.
A more radical approach is thermal desorption. “Basically,” Hamura says, “you’re heating up the soil, trying to burn off the contaminants. But you also need to capture the vapor that’s produced. Usually, you use this method for organic contaminants. If you have a metals issue, that’s not going to do much for you.”
Often, remediation is an ongoing responsibility. Many properties, especially those that have passed through the VRP or Brownfield Program, require “administrative controls.” These controls might forbid digging or strictly limit the use of the property.
The remediation can also be engineered into the new development. In areas with petroleum contamination, like the Lowe’s and Costco sites in Iwilei, this probably involves the installation of a vapor barrier and a vapor extraction system.
Weston plans a more aggressive approach with the tar and benzene at the Gasco site. “We’re proposing to use in situ chemical oxidation,” says David Griffin, Weston’s operations manager in Hawaii. “That’s pumping 40,000 gallons of diluted industrial-grade hydrogen peroxide into the ground. That treats the contamination. (The byproducts are carbon dioxide and water.) Plus, it destroys the contaminants in place, so we’re not bringing them to the surface, putting them in trucks and hauling them through the local neighborhoods.” This drives the benzene out of the groundwater to a ventilation system on the surface, where it’s burned off. “Then, we do a monitoring program to make sure we’re meeting the levels we signed up for,” Griffin says.
This system is not without risks. Last September, the flame arrester failed on the thermal oxidizer – basically a big furnace – and the resulting backflash caused an explosion in the PVC ventilation system, which ignited a small fire in a benzene vent. No one was hurt, but the fire department arrived in HazMat gear and took two hours and 200,000 gallons of water to put out the tiny fire. Nevertheless, Weston is confident in its system – early tests suggest it’s already lowered the benzene level 60 percent – and only awaits Department of Health approval to expand from the current test grid to the whole site.
BY DENNIS HOLLIER
Photo: Courtesy of the Grand Waikikian at Hilton Hawaiian Village
It seems like a contradiction: The traditional hotel business in Hawaii is shrinking even while the hospitality industry recovers from the recession, more visitors arrive and they pay more per room than last year.
The relative decline of stand-alone hotels is a trend that has persisted for years and will stretch into the future. Over the past decade, hotel rooms have fallen from 70 percent of the state’s lodging inventory to less than 57 percent, according to a report from the state Department of Business, Economic Development and Tourism. Even as Hawaii tourism enjoyed boom times during most of the past 10 years, the overall hotel inventory actually declined by 7,599 rooms.
No stand-alone hotels are being built today while almost every other form of visitor accommodation has grown, including condominium hotels, hostels, vacation rentals and, most importantly, timeshares. As the number of hotel rooms fell over the past decade, timeshare’s share of the overall hospitality inventory doubled.
Hawaii now has 87 timeshare resorts and that number keeps growing in a time when no one is building stand-alone hotels. Almost every major hospitality company in Hawaii is developing new timeshare properties, converting existing hotels into timeshare, or rehabilitating the timeshare they have.
Timeshare also has its detractors. Many owners complain about high maintenance fees, or that the flexibility that seemed so straightforward during the sales pitch doesn’t always work out in reality. Even industry executives acknowledge timeshare’s shady past, when the industry was dominated by high-pressure sales and dubious claims about investment potential, but they say much of that bluster is gone and the industry has grown more sophisticated. This change is partly due to the introduction of more consumer protections and better self-policing, but mainly because the industry today is dominated by big corporations like Hilton, Disney, Hyatt, Starwood, Marriott and Wyndham. These are some of the best-known brands in hospitality and they’ve helped bring timeshare into the mainstream in Hawaii.
Prices in Paradise
Timeshares aren’t cheap, especially in Hawaii. A typical two-bedroom unit in Waikiki can sell for upwards of $80,000 for a prime week (though the same unit might sell for half that in the resale market). This suggests that a well-appointed, two-bedroom apartment in Waikiki is worth about $4 million, clearly an inflated price. And the cost doesn’t end with the purchase price. Timeshare owners must pay maintenance fees, which cover everything from property and excise taxes to routine maintenance and the condominium’s reserve fund.
The maintenance fee for that two-bedroom timeshare in Waikiki will likely set you back upwards of $1,000 annually for each week of ownership. Not surprisingly, these maintenance fees are one of the main objections of potential buyers. Imagine paying condo fees of $52,000 a year.
Joe Toy, president of the consulting firm Hospitality Advisors, says
Nevertheless, the role of timeshare within the hospitality sector is growing. Joe Toy, president of the consulting firm Hospitality Advisors, reports that there are nearly 10,000 timeshare units in Hawaii, or 13 percent of the total lodging inventory. The allure of timeshare is such that nearly 6,000 Hawaii residents own timeshares in Hawaii.
Timeshare’s influence is even more obvious when you start to look at occupancy rates. “In Hawaii, timeshare properties average about 90 percent occupancy,” Toy says. “And that’s down from prior years.” To put that in perspective, Hawaii hotel occupancy in the bitter year of 2009 was about 66 percent. The reason for the difference, of course, is that timeshare owners have prepaid for their lodging and they want to use it. That means their vacation plans are less likely to be thwarted by economic or political upheavals.
“Even after 9/11,” Toy says, “timeshare occupancy was in the 70 percent range, when the rest of the state was around 30 percent.”
This is one reason so many hotel companies have added timeshare to their quiver: When your hotel guests stop coming, you can still count on the timeshare crowd to help fill your restaurants and shop in your stores.
Other numbers reinforce this picture. Toy’s report shows that the average stay for timeshare visitors is nearly a week. They typically travel in larger groups, and they tend to spend more money in the community, nearly $1,600 per party. In other words, these are some of Hawaii’s most reliable and free-spending visitors. They’re also locked in; the state doesn’t have to spend its marketing dollars to find and persuade them to come.
There are other benefits to the overall state economy from timeshare. One is a marketing strategy that liberally uses incentives and gifts to attract people to timeshare sales presentations. “That’s sort of a fundamental part of our marketing,” says Bryan Klum, executive VP of Hilton Grand Vacations. “In exchange for the customer giving up some of their valuable vacation time, we usually provide some sort of gift.” These gifts might be discounts on accommodations, or credits that can be spent at the resort’s restaurants and shops. More frequently, though, the gifts are virtually cash. “We often just give customers Ala Moana gift cards,” Klum says.
King’s Land by Hilton
Hilton is far from unique. “As an incentive, we offer $125 dining coupons that can be used at several different restaurants in Lahaina,” says Robert Welch, general manager of Marriott’s Maui Ocean Club. “It’s a huge part of our marketing.” All these marketing dollars ultimately end up in the pockets of local vendors rather than in those of out-of-state media and advertising outlets. Large properties in Waikiki, which may give sales presentations to 10,000 to 20,000 customers a year, each contribute millions of dollars annually to the incomes of the shops, restaurants and activities in their neighborhoods.
Then, of course, there are jobs. “There’s a lot of economic benefit from our industry,” says Hilton’s Klum. “There’s the tax revenue that’s raised; there’s the passed-along spending of our customers; there’s the marketing money that we spend, both in state and out of state. But where the rubber really meets the road is the number of people we’re able to employ directly.” Hilton alone, he says, employs more than 700 people in its timeshare operations.
Disney estimates the construction of its Aulani project on Oahu created 1,200 new construction and permanent jobs. According to Hospitality Advisors, the timeshare industry directly contributes more than 4,400 jobs to the Hawaii economy, with a total payroll exceeding $226 million a year. It’s worth noting: That’s an average annual income of nearly $51,000.
The timeshare industry has been one of the few private sources of economic growth in the state over the past two years. For example, Disney’s Aulani project was built in the teeth of Hawaii’s most severe economic turndown in a generation. When you add in other developments, timeshare generated more than $200 million in capital expenditures in the state during 2009 and 2010, according to the Hospitality Advisors report. This year, Toy says, the industry projects an additional $80 million, which means there are currently more than 3,000 new timeshare units in the pipeline. Hotels are another matter entirely.
“Looking back over the last few years,” says Marriott’s Welch, “the only lodging construction in the state has been timeshare. And over the next 10 years, we have a plan to spend about $1 billion on more timeshare development.” That plan includes projects that are currently partially built, like Koolina and Kauai Lagoons, as well as others on the drawing board. Similarly, Hilton is in the entitlement process on two new towers at Hilton Hawaiian Village, and is selling units at the Grand Waikikian.
Dan Dinell, vice president at Hilton Grand Vacations and chair of the Hawaii chapter of ARDA, the industry trade association, puts that in perspective. “I know of no pure hotel project planned anywhere in the state,” he says, “but there are several timeshare projects planned.” He emphasizes that by adding: “There’s nobody who would develop a stand-alone hotel now in Hawaii; it just doesn’t pencil out.” In other words, the future of Hawaii’s hospitality industry is timeshare and mixed-use.
That’s because timeshare is simply a better capital machine, says Mitchell Imanaka, principal of Imanaka Kudo & Fujimoto, and the former chair of the Hawaii chapter of ARDA, the trade association for the timeshare industry. “The business model,” he says, “has to be contrasted with the hotel model, where someone comes in and builds a project, and hopes that by branding it, they’ll have a certain level of revenue and visitors.” In other words, the developer’s capital is buried in the project, and it may take years of uncertain profits to extract it again. “But the timeshare model permits a developer to go to market, sell his interest, and generate capital to either replenish his coffers, or to make a profit on the sale.” No less important, the ability to extract capital early helps mitigate the risk in the project. “It’s a very compelling model,” Imanaka says. “Because the return is likely to be higher for the developer.”
Despite timeshare’s growing importance in Hawaii’s hospitality industry, it’s still misunderstood. In January, Gov. Neil Abercrombie proposed legislation that would have more than tripled the transient accommodation tax paid by timeshare owners. According to the governor, this was an attempt to bring timeshare’s TAT in line with that paid by hotel guests. “The objective,” he said, “is to have equitable tax treatment to ensure that the people of Hawaii have adequate funds to support the impacts of visitors to the Islands.” In this sense, he believes the timeshare visitor and the hotel guest should be treated the same.
But industry advocates point out that timeshare owners are already treated differently. Toy says timeshare units already pay more taxes than comparable hotel rooms. For example, as a fee simple owner of real property, a timeshare owner pays property tax. When a timeshare unit is rented out as a hotel room, GET is charged. These visitors are also charged exactly the same TAT as hotel guests. Moreover, timeshare owners do pay a transient accommodations tax, albeit somewhat lower, when they use their own units.
It’s this last tax that industry insiders find most galling. To the governor, it’s simply a matter of equity. “In terms of sharing roads, public parks and hiking trails with our own residents,” Abercrombie says, “it doesn’t matter whether a visitor is staying in a timeshare or a hotel room – the impacts on our Islands are the same.” But the industry turns the equity question on its head. Marriott’s Welch puts it this way: “I believe Hawaii is the only state where a TAT is applied to people sleeping in their own beds,” he says.
Timeshare advocate Imanaka says another problem is what an increased TAT would say to outside developers. “The increase itself would have sent a very negative message to the timeshare industry, to the timeshare owners who visit Hawaii, and to the investment community who invests capital here,” he says. “We’re a capital-poor state, meaning we need to import money in order to keep things running here. The last thing we want to do is send a negative message to the investment community saying, ‘Your dollars aren’t welcome here.’ And that’s my fear: that this will have a chilling effect on investment here in Hawaii.”
Instead of hiking taxes on timeshares, Imanaka says, the state should be nurturing the industry. “If we did, we would not have budget shortfalls as dramatic as we’re experiencing today. We would not have Furlough Fridays; we would not have to look at closing social services, having to tax retirees’ pension benefits, having to tax away Medicaid reimbursements, and the list goes on. Timeshare is the answer; it’s certainly not the problem. And what we have to do is embrace it, make sure the industry continues to thrive. Because we all benefit from that.”
BY DENNIS HOLLIER
The mood was tense in the packed Senate hearing room in December, as angry Neighbor Island businessmen, farmers and representatives from community organizations testified before the Committee on Commerce and Consumer Protection against the Public Utilities Commission. The immediate cause for the rancor was an interim decision by the PUC in September that allowed Pasha Hawaii Transport Lines to begin limited interisland cargo shipping between Honolulu and Kahului and Hilo.
Before this ruling, interisland cargo service was provided exclusively by Young Brothers – a monopoly contingent on the barge company serving not only the state’s large, profitable ports, but also the smaller, unprofitable ones, such as those on Lanai and Molokai. But the interim order imposed no such obligations on Pasha.
That’s what caused the stir. In the wake of all the discontent, Sen. Rosalyn Baker, chair of the committee, spoke testily of the need to reform the PUC, a process that this blowup may have both hastened and complicated.
Outgoing Chair Carlito Caliboso Photo: Rae Huo
The intent of the Pasha decision, according to the previous commission chair Carlito Caliboso, was simply to find out if more competition among water carriers would help improve service and lower costs for consumers. Young Brothers, and many of its Neighbor Island customers, had a different take. They viewed the PUC’s ruling as fundamentally unfair to the highly regulated interisland barge company, and potentially lethal to the businesses that depend on its service, particularly those on Molokai and Lanai.
Even worse, they viewed the process the PUC used to reach its decision as opaque and capricious. As Baker points out, the commission held no public hearings, let alone Neighbor Island public hearings, before making its ruling. Then, one day before the Senate hearing, the commission denied a Young Brothers’ request to reconsider its decision. “I thought the commission behaved most arrogantly to the folks that came in from the Neighbor Islands to be heard,” Baker said later.
But assigning blame for the commission’s failings is more complicated than it seems.
The PUC is a small state agency with astonishingly broad regulatory powers. According to its 2010 annual report, it is responsible for regulating electric utilities, telecommunication companies, water and sewer companies, and bus and trucking companies. In other words, a huge part of the state economy falls under its jurisdiction; yet, early last year, the agency had a staff of fewer than 40 people. For most purposes, the three PUC commissioners operate like a quasi-judicial body, with the chair presiding over lawyers, engineers, analysts and accountants who conduct research and provide technical assistance. This small cadre of professionals has to provide the expertise to regulate the diverse industries under their jurisdiction.
The Division of Consumer Advocacy is in even worse straits. In 2010, this agency, which is supposed to represent the public’s interest before the PUC (and is funded out of the PUC’s special fund), had only 11 staff positions filled. Yet, the division is responsible for much the same analytical and policy footwork as the PUC. In fact, PUC actions often can’t proceed because of delays caused by the division’s understaffing. For a while, the division simply stopped processing certification applications from telecommunications providers, according to a legislative report. Consumer Advocacy officials didn’t respond to repeated requests to comment for this story.
Sen. Rosalyn Baker, head of the Senate’s Commerce Committee,
It’s not surprising that the most common complaint about the PUC is that it’s slow and inefficient. However, that fact has to be viewed in the context of how the agency works. Regulated companies typically bring cases, called dockets, before the commission for consideration. Dockets range from something as simple as an application to operate a motor carrier, to a petition for rate relief from a water carrier, to something as complicated as decoupling, a new policy that fundamentally changes the business model for the electric company. A docket isn’t that different than a court proceeding: There are motions, opportunities for interveners to join the docket, and periods for discovery and rebuttal. All of which take time.
And there are a lot of dockets. In 2010, 330 new dockets were filed before the PUC. In addition, there were still 271 dockets pending from 2009. Altogether, the commission completed 448 dockets over the course of the fiscal year, and left 153 pending. All those figures are improvements.
Even though few individuals are willing to go on the record – their companies are still regulated by the commission, after all – criticism of the PUC is widespread and diverse. For example, among motor carriers, by far the largest group of companies regulated by the PUC, the standard complaint is that there isn’t enough regulation: It’s too easy to get a certificate, and there isn’t enough rate enforcement.
Young Brothers, as we’ve seen, complains that it’s held to a different standard than its competitor – much the same complaint Hawaiian Telcom representatives make privately about its competitors.
It’s within the electric sector that we see the most complaints: that the PUC is too cautious, that the consumer advocate is too closely aligned with the utility, and that the PUC chair should be more of a vanguard. Almost all this criticism, though, comes back to those two words: slow and inefficient. Most of the complaints are justified, but that’s not the whole story.
For example, not everyone is convinced that the commission is responsible for many of these problems. Carl Freedman, an electric utility regulatory expert and frequent intervener before the commission, notes that, under the Caliboso administration, the PUC undertook an enormous number of major policy dockets. In fact, it’s largely trying to deal with those energy-policy initiatives that accounts for much of the commission’s slowness. “I think it’s a fair criticism of the PUC to say it’s not fast enough,” Freeman says. “But I don’t think that equates to criticism of (Caliboso), or even the staff. That’s a criticism of the whole state.”
Similarly, Freedman isn’t sure that slow and cautious are necessarily bad things, at least when it comes to these major policy decisions. “Some people want to see the commission be more of a vanguard. But I think cautious is certainly also one of the things we want the PUC to be.”
Caliboso also isn’t convinced that the charges of slowness and excessive caution are merited. Some of the slowness, he points out, is built into a fair and deliberative process. “You can’t really say this docket took a year, so it’s slow, for example. You really have to look at each one to see when the parties were really done with it, when was it submitted for a decision. A lot of times, it’s the parties involved in the case that slow things down, because they want time for things like review and discovery before they submit their positions and make their arguments. And all that takes time.”
Caliboso also points out that sometimes the PUC’s new responsibilities conflict with its traditional regulatory role, particularly in the complicated field of energy policy. “If you’re assuming the complaints are that we’re not moving fast enough or far enough in a particular policy direction, then you really have to look at what is the policy direction being given to the PUC from the Legislature, because we’re a creature of statute. The law says we’re supposed to be a traditional regulator. Those duties deal with trying to make sure the rates that customers pay are reasonable – so, keeping costs down. And then, we’re responsible for making sure the utilities provide reliable service and earn a reasonable rate of return. It’s all connected.
“At the same time, you’re telling the commission to try to implement these new energy policies, which should help get us off of fossil fuels, improve our energy security, reduce greenhouse emissions, improve our environment and make things more sustainable. That’s fine. I understand that task, and we’re driven to implement these policies. But those traditional regulatory responsibilities have not gone away. So, when somebody says we’re not going fast enough, maybe it’s because we still have those traditional objectives to look out for.”
Buying a Plan
The real issue is money. The PUC is mostly funded by fees collected from the utilities it regulates. This special fund should be more than adequate for the commission’s regulatory duties, but it doesn’t actually get all the money.
“In 2009, we collected $17.6 million in revenues, most of which are from the public utilities,” Caliboso says. “At the same time, our expenditures were only about $8.2 million, $2.9 million of which went to the consumer advocate. That means about $9.4 million went back to the general fund. So, the money is there. The problem, as far as money goes, is that a lot of it is being used for something other than regulatory purposes.”
Money also plays a role in another challenge facing the commission: attracting quality staff. PUC positions go unfilled for so long partly because the pay isn’t competitive with private industry. As one industry insider put it, it’s not uncommon for commission attorneys to be sitting across the table from utility attorneys making four or five times more money. This is a national problem, but, even so, according to Sen. Baker, the disparity in Hawaii is larger.
“We did a study where we looked around the country,” she says, “and other state salaries, almost without exception, are higher than ours.” Similarly, other states pillage utility commission revenues, just not so wantonly.
Utility professionals routinely complain about the underfunding of the commission. In her 2004 report on the PUC, the state auditor recommended the commission undertake serious strategic planning, pointing specifically at the agency’s deficiencies in personnel management. In 2006, the Legislature passed Act 143, which required the PUC and the consumer advocate to prepare a reorganization plan specifying their budget, resource and manpower needs. The following year, Acts 177 and 183 approved and funded most of the commission’s requests. The PUC’s reorganization plan included:
• Increasing the staff level to 62 for the PUC and 15 for the Division for Consumer Advocacy;
• Redescribing several positions to better reflect new responsibilities;
• Restructuring the agencies’ hierarchy to improve organizational effectiveness, especially by creating an Office of Policy and Research to better address highly technical policy issues; and
• Relocating the PUC offices to accommodate the larger staff and new organization.
Nothing happened as planned. In 2008, the Legislature reduced the commission’s budget again, removing nine existing positions, and not funding two new positions or the agency’s relocation. The following year, the consumer advocate lost eight positions and other new positions went unfunded. Yet, even with funding and legislative approval, the commission still can’t reorganize on its own. It needs approval from the Department of Budget and Finance to release the funds, and the Department of Human Resources and Development has to rewrite job descriptions. Both departments presented roadblocks to the PUC’s reorganization.
Finally, in the 2010 session, the Legislature relented, passing Act 130, which acknowledged that the PUC’s reorganization was essential, especially to “successfully implement meaningful energy policy reform.” Act 130 puts numbers to that, noting that the commission regulates “electric and telecommunications services worth between $3 billion and $4 billion annually.” The legislation also notes that the potential savings from appropriate regulation may save the state more than the cost of fully funding the reorganization. Put another way, a well-run PUC is good business.
Caliboso highlights the value of effective regulation differently. “Another way to think about it is to look at how much is being invested in energy,” he says. “The cost rate base for the utility – or the money they’ve invested in energy infrastructure – is almost $2 billion.” Viewed in the context of protecting that investment, the PUC budget starts to look trifling.
Similarly, Caliboso says, you can look at the state’s regulatory costs in comparison with the aims of the state’s Clean Energy Initiative. “When you think of how much we should be investing to achieve our policy goals of getting us off oil and achieving energy security, which could help both in addressing price volatility and in securing our supply of energy, the cost of (better regulation), that’s not that much more to invest.”
More of the Same?
The remarkable thing about this ebb and flow of funding is that the PUC’s reorganization isn’t controversial. “Everyone knows it should happen,” Freeman says. “Everyone agrees. Everyone is supportive.” But he acknowledges that might not be enough. After all, he points out, funding for the reorganization has been given and taken away several times. “The question is: Is the Legislature just going to wipe it out again?”
Last month, Gov Neil Abercrombie nominated Rep. Hermina
Gov. Neil Abercrombie seemed to address some of these questions in February by appointing the former chair of the House Committee on Energy and Environmental Protection, Rep. Hermina Morita, to the commission, filling the seat vacated by Leslie Kondo, and replacing Caliboso as chair.
Morita had long been the most knowledgeable supporter of renewable energy in the House and a vocal advocate for increased PUC funding. Even so, it’s not clear the PUC’s reorganization will survive the legislative session. “I would like to say, ‘Yes,’ ” Morita confided, shortly before her appointment, “but I’m only confident if the other legislators fully understand that this is a critical part of our economic recovery and our economic development.”
In fact, Morita’s appointment may add to the uncertainty surrounding the reorganization. Although she’s widely admired among PUC observers, particularly those in the energy sector, her departure from the House will deprive the commission of a powerful legislative advocate at a critical moment. She may also stir things up within the commission itself, where, as chair, Morita will have an opportunity to reshuffle PUC staff.
Some legislators simply aren’t convinced that the commission is properly structured in the first place. “I just don’t think we have the appropriate expertise on the PUC,” said Baker, shortly before Kondo’s departure. “We have two government attorneys and one private-sector attorney. We don’t have anybody with any kind of engineering expertise, accounting expertise, or financial or business expertise. We don’t even have anybody with any energy background. They don’t have to have worked for a utility, but just to understand some of the technical dynamics.”
Baker is also concerned about the PUC’s demographics. “I don’t want to impugn the background or integrity of anybody, but the commission just is not diverse. For example, there are no members from the Neighbor Islands.” She acknowledges that the addition of Morita, who is from Kauai, will alleviate some concerns, but she believes the PUC needs structural changes.
Which brings us back to the PUC’s Pasha decision. In the wake of the flack following that ruling, Baker has proposed legislation that will further complicate the PUC reorganization. “I have a bill that tries to professionalize the staff and adds two more commissioners, so there would be a total of five,” she says. This would simplify adding a requirement that the commission include Neighbor Island representation. And, according to Baker, it would also allow PUC staff to specialize. “The bill also creates two panels,” she says. “One to deal with energy and private water systems – because that’s a big piece of what the commission does – and the other would deal with water carriers, motor carriers and warehousing. That way, you’ve got some specialization, so both the commissioners and the staff can zero in.”
It seems like a good plan. But you have to wonder if the added uncertainty introduced by the bill will kill the PUC’s reorganization in the Legislature again. That’s a fate Caliboso knows is all too possible.
“Is it a done deal, pau, don’t worry about it?” he asks. “No, they could always take it away again.”
BY DENNIS HOLLIER
The state got just what it was expecting in its Christmas stocking. Unfortunately, it was another lump of coal – more bad news about the state of Hawaii Employee Retirement System, which covers both state and county employees. In its five-year report, the actuary firm of Gabriel Roeder Smith & Company claims the system’s future liabilities now exceed the assets set aside to pay for them by $7.1 billion. That’s nearly $5,500 for every man, woman and child in the state.
Worse still, because of the arcane rules governing actuarial accounting, those figures don’t fully incorporate the system’s huge market losses in 2008 and 2009. Consequently, an additional $1.5 billion will be added to the state’s unfunded liability over the next two years. This means the state’s legally required contribution to the pension system will increase to more than $671 million a year by 2015.
The actuary’s findings were hardly a surprise to those familiar with the state’s pension system. In fact, Wes Machida, the conscientious new ERS administrator, spent much of the holiday season playing Grinch, briefing legislators and members of the incoming administration on what to expect in the report.
Pension benefits for state and county workers, once earned,
One of the most remarkable aspects of the current shortfall is how quickly it has grown. As recently as 2000, the pension system covering government workers for the state and Hawaii’s four counties was 94 percent funded. This year, by some measures, the funding ratio has declined to less than 60 percent, and the prospects for paying down the deficit appear more and more remote.
There are a couple of factors behind the relentless growth of the pension liability. The first is that, like most state retirement systems, the ERS is a defined-benefit system. In other words, state and county employees are guaranteed set benefits when they retire, based on how many years they have worked and their average salaries at the time of retirement. In addition, those benefits, once earned, are guaranteed by the Hawaii Constitution; they cannot be reduced, even in response to a fiscal crisis such as the state’s recent budget shortfalls. This is typical of defined-benefit systems. In 1979, when New York City went bankrupt, it reneged on hundreds of millions of dollars owed to contractors and bondholders, but never failed to make pension payments to retirees.
To pay for these enormous liabilities, the ERS – again, like almost all state pension systems – is a “pre-funded plan.” In theory, enough assets are set aside and invested each year to generate income to offset future liabilities. A pension is said to be “fully funded” when current assets are projected to pay for all future liabilities. Funding comes from three sources: employee contributions, employer contributions and interest earned on the system’s assets. Each contributes to the shortfall.
Digging a Hole
In Hawaii, employee contributions are set by law at around 12 percent of payroll for firefighters and police, and 6 percent for other employees. According to Machida, employee contributions amounted to $361 million in 2010, which included $187 million in one-time payments as members changed plans within the system, leaving $174 million in normal employee contributions.
The amount paid by state and county employers is also governed by statute, which prescribes an “actuarially required contribution,” or ARC, sufficient to fully fund the system within 30 years. As lifespans have increased and payrolls have expanded, the counties’ and state’s required contributions have soared: In 2000, the ARC was about $175 million; by 2010, it had reached more than $550 million – $400 million for state employers, and in excess of $150 million for the counties. Even so, the unfunded liability has grown.
The system’s investment earnings scenario isn’t any rosier. Here, too, state law predominates, setting the pension fund’s anticipated rate of return on its investments at a robust 8 percent. But this number has little bearing on the system’s actual earnings. In the past 10 years, returns only reached as high as 8 percent four times. In fact, the system’s market earnings over the past decade have averaged only 2.8 percent, not even keeping pace with inflation. With such inflated earnings expectations, not only is income overestimated, but future liabilities are underestimated.
There are, in fact, a slew of other actuarial assumptions that affect the size of the pension system’s liability. For example, Machida notes, the system assumes an average life expectancy of 83 years. Every year, though, actual life expectancy increases. “The average life span of a female schoolteacher is over 90 years,” Machida says.
Other assumptions are more financial. “For example, there were more promotions than expected,” Machida says. “Salary increases were projected at 3 percent or 4 percent; but professors, for example, at one point were given a 9 percent to 11 percent raise. Police officers were getting a 9 percent raise.” Similarly, more benefits were added to the pension system without consideration for how we would pay for them. It will be hard to get back these costs.
Distressingly, most strategies to address the system’s weaknesses hinge on manipulating some of these manini-seeming assumptions: extending the age of retirement; changing the definition of “base pay”; changing the way cost-of-living allowances are calculated. Because the benefits of retirees and existing employees are protected by the state constitution, any changes can probably only apply to new hires. That means the cost of addressing the system’s long-term liability will have to be spread over a small pool of members.
Machida says these assumptions aren’t the main reason the state’s unfunded liability has grown so dramatically. He ascribes most of the increase to an old rule that allowed legislators to seize any annual earnings over 8 percent and apply them to the state’s ARC. In 2001, the worst year, the state used approximately $150 million of these “excess” earnings to help balance the budget. Between 1999 and 2003, according to Machida, more than $350 million in excess earnings were diverted from the pension system. “In 2004, with the assistance of (then) Governor Lingle, we introduced legislation to take that away,” Machida says. But the damage has been done. “If that money had not been taken,” he says, “the system today would be almost fully funded.”
Whatever the proximate causes of the pension-system shortfalls, the effect is a vicious circle: When current income and contributions aren’t enough to pay current benefits – a condition that began in 2006 and is projected to accelerate rapidly for the next five or six years – the only option is to sell off portfolio assets to cover the difference. In 2011, the ERS is projected to cannibalize nearly $200 million in portfolio assets; by 2020, that figure could reach $600 million a year. That’s the opposite of a “pre-paid pension fund.”
How to Fix It
Fixing this problem is going to take time. The formula, according to Machida, is straightforward. C+I=B: contributions plus investment earnings must equal benefits paid. To make that equation balance, each variable will have to be tweaked. First, the employer’s contribution must increase. “This isn’t an option,” it’s a necessity, Machida says. Failure to comply with state law would have disastrous effects on state and county bond ratings.
The scale of the increases necessary will be painful. The recent actuarial report by Gabriel Roeder Smith already raises the ARC to 19.7 percent of payroll for firefighters and police, and 15 percent for general employees, which should yield $671 million a year by 2015. Even that won’t be sufficient. To generate the extra $182 million needed, the actuaries recommend increasing those figures to 27.3 percent and 18.8 percent, respectively, which will yield an additional $43 million. The ARC already constitutes about 10 percent of the state’s general fund budget; it’s hard to see where the additional revenue will come from to pay for the increase.
The interest variable in the pension equation also comes into play in the actuaries’ calculation. By assuming an additional 1 percent yield on the system’s investments, they add another $117 million to the pot. (Although they don’t mention it in their report, raising the assumed rate of return also lowers the current unfunded liability.) But, as Machida points out, raising the targeted investment return comes with higher levels of risk, which further could jeopardize ERS assets.
In fact, making up the state’s unfunded liability on the left side of the pension equation is probably impossible in the long term. That means legislators are left with the politically difficult option of reducing retiree benefits. Machida outlines the possibilities:
• Raise the retirement age;
• Increase the number of years it takes employees to become vested;
• Change how final salaries are calculated; and
• Constrain future payroll growth.
Some version of all of these reductions will likely be necessary, but can the Legislature make them happen?
Although, by statute, the ERS assumes its portfolio will earn 8
To begin with, as Machida points out, the benefits of existing employees are protected by the state Constitution. That means new hires will likely bear the brunt of any changes in benefits. Calvin Say, the longtime Speaker of the House, acknowledges the challenges faced by the Legislature. “I’ve introduced a number of bills to deal with the unfunded liability,” he says. “One that I had was to increase the retirement age from 55 to 60 so you can contribute to the trust fund longer. But you can’t address these changes with present employees. You can’t change this for the current retirees. It’s all going to be based on new employees.”
Kalbert Young, the Abercrombie administration’s incoming director of the state Department of Budget and Finance, makes much the same point. “I would say that the governor is interested in looking at what are the available means for resolving the liability issue,” he says. “Admittedly, though, it’s a very big number; and given the condition and depth of the problem, our timeline for resolving it may not be in the near term.” In other words, future state and county employees will be paying the tab for generations.
That’s assuming today’s politicians can enact the necessary changes. Machida points out that, because they will likely only affect new hires, any prospective reduction in employee benefits are probably not subject to collective bargaining. Nevertheless, it’s difficult to envision the Legislature enacting major reductions without at least the tacit support of the public unions, by no means a sure thing. House Speaker Calvin Say remarks on how difficult it’s been trying to make these kinds of changes in the past: “For me, it’s been a sincere effort to try to control both the employers’ and the employees’ contributions,” he says. “But present employees do not understand that. They don’t want Calvin Say to force them to pay more for their pension contribution. But something’s got to give.”
Say remains optimistic. “Overall, I feel very confident, because, at the end of the day, the state government is obligated to fulfill its responsibility. So, yes, we’ll address that unfunded liability one way or the other. It will probably be through the guise of taxation.”
The Big Picture
“But time is of the essence,” says Machida. That’s because, as glum as the Gabriel Roeder Smith report seems, it may still understate the size of the problem. To understand why, it helps to put Hawaii’s retirement system in a national context. Since 2000, the number of states with fully funded pension systems has declined from 26 to four, according to a recent report by the Pew Center on the States. Hawaii is in the bottom quartile, one of 19 states described as having “serious concerns.” Remarkably, Pew data do not even include the effects of the Great Recession of 2008. Once those losses are incorporated into the picture, the perspective will be much worse.
Despite its baleful conclusions, the Pew report is squarely in the mainstream of actuary standards. It relies on the states’ own analyses and draws its conclusions using normal actuarial accounting procedures. There is a growing number of analysts, though, who believe that traditional actuarial accounting and its assumptions are part of the problem and help mask the true scale of the states’ pension crises. The most inflammatory of these is Joshua Rauh, a researcher at Northwestern University’s Kellogg School of Management, whose 2010 report suggests the states’ total unfunded liability may be several times larger than the findings in the Pew report. For example, he predicts Hawaii’s ERS will go broke in 2020.
Not surprisingly, Rauh’s conclusions have been largely discounted in the public pension community. “Among public pension actuaries,” says Keith Brainard, executive director of the National Association of State Retirement Agencies, “I think you would find the overwhelming perspective that Joshua Rauh’s findings and recommendations are inappropriate.” Even ERS administrator Machida – by no means an apologist for the status quo – downplays Rauh’s conclusions: “The ERS is not going to run out of money in 2020.”
But Rauh isn’t alone in raising questions about the size of the unfunded liabilities facing state pensions. For example, Andrew Biggs, of the American Enterprise Institute, uses a standard financial process called “options pricing” to reach much higher figures. In the case of the Illinois State Employees’ Retirement System, his analysis more than doubles the state’s total liability, from $23.8 billion to $47.3 billion.
Applying the same formula to Hawaii’s total liability swells our unfunded liability from $7.1 billion to more than $14 billion. Of course, the calculation isn’t that simple. It’s worth noting, though, that even pension actuaries are beginning to look at other ways of measuring pension liabilities. All of these suggest that our total liability is higher than the $18.8 billion actuarial valuation in the Gabriel Roeder Smith report. Rauh, basing his discounting rate on 30-year Treasury notes, calculated Hawaii’s total liability at $24.2 billion. The state’s own actuaries calculated a total liability of $21.5 billion when they used the market value of assets instead of the traditional actuarial method. Pessimism is clearly becoming part of the mainstream.
In fact, the actuary’s report to the ERS board in December included some startling language. Under the heading, “What does this all mean?” the report states: “If the assumptions are met for all years beginning July 1, 2010, and the current contribution policies remain, the system is not expected to run out of money. But it is very close.” (Italics added.) Worse still is how long the actuary says it will take to fully fund the system, given the same set of assumptions: never.
In FY 2010:
$925 million was paid by the plan to about 39,000 retirees and beneficiaries.
BY DENNIS HOLLIER
Makani Maeva, Hawaii director for the VitusGroup, knows from
“Building affordable housing is complicated,” says Makani Maeva.
She should know. As Hawaii director for the VitusGroup, an affordable-housing developer, she recently completed the Lokahi Apartments, 307 rentals in Kona. Between January 2007, when another developer laid the project in her lap, and July 2010, when the apartments first were offered for rent, almost all the financial and technical details of the deal changed dramatically: The permanent loan went from $16.4 million to $19.2 million; the original equity investors – GMAC, Wachovia and others – had to be replaced; $7.8 million in affordable-housing credits from the County of Hawaii became unavailable, replaced by a soft mortgage of $11.75 million from the state’s rental housing trust fund; and the cost of construction rose from $53 million to $60.6 million, largely due to interest costs.
“It’s like fried rice,” she says. “Because I thought I had one thing in the refrigerator, I thought the project was going to be structured one way.” In the end, though, the recipe changed completely.
The complexity of Lokahi’s financial arrangements is hardly unique. In fact, the average affordable-housing project in Hawaii is funded by at least seven financial instruments – industry insiders say some projects require as many as 14 – each of which comes with its own rules. That’s just the financing. The truth is everything about affordable housing is complicated and constantly changing – the money, politics, regulations, ethics. If you want to “fix” the system, you have to consider them all.
What is ‘affordable housing’?
Too often, affordable housing is equated with public housing and poverty. But the affordable-housing crisis affects a broad swath of the middle class. Developer Chuck Wathen, who recently founded the Hawaii Housing Alliance and is a longtime advocate for affordable housing, notes it would take 3.19 firemen to be able to afford the median-priced home on Oahu. It would take 3.63 school teachers or 5.2 hotel front desk clerks. “What we have isn’t just an affordable-housing problem,” Wathen says. “We have an income problem.”
He also notes that the shortage of “workforce housing” is most acute in the rental market: “A Mainland city of this size would probably have 400 apartment communities of over 300 units.” Yet there’s no financial incentive to fill this gap.
Kevin Carney, Hawaii vice president of EAH, a nonprofit affordable housing developer, explains the math. “It just doesn’t pencil out to do a rental project,” he says. “Let’s say you’re serving a market segment at 100 percent AMI (area median income) – a family of four that makes $80,000 a year or so. The rents you can charge at that income level just aren’t going to cover your debt and operating expenses. So you can’t build it. Instead, you build a condo and you sell those units to people with incomes of, say, 200 percent AMI or more. Then they turn around and rent them out as long-term investments.
“That’s our ‘shadow’ apartment market in Hawaii.”
The VitusGroup recently completed the Lokahi Apartments,
The financial puzzle
Government programs account for almost all affordable-housing development, either through subsidies or by regulations that require developers to include affordable units in their market-priced developments. But neither approach has supplied much housing in the past two decades.
The centerpiece of affordable-housing finance is HUD’s Low Income Housing Tax Credit, which is administered in Hawaii by the Hawaii Housing Finance & Development Corp. LIHTC (pronounced Lie-Tech) was created to spur the private development of affordable housing, awarding dollar-for-dollar tax credits in exchange for guaranteeing a project will remain affordable for at least 20 years. By some estimates, LIHTC has played a role in the development of as much as 90 percent of all affordable-housing units in the country. Hawaii is no different.
Darren Ueki, HHFDC’s finance manager, explains that there are two kinds of LIHTC credits, one worth 9 percent and the other 4 percent of a project’s development costs. “We’re basically giving out anywhere from $27 million to $28 million in (9 percent) tax credits a year.” Yet he acknowledges that demand for affordable housing is much greater than that. In 2007, an HHFDC report projected the state would need to create more than 28,000 rental units over the following five years. Even by the most liberal estimates, the LIHTC program creates fewer than 300 units a year in Hawaii. That’s not surprising, since those credits only account for a small fraction of the cost of development.
For example, the credits don’t cover the cost of the land or predevelopment planning. (Developers say that, for an affordable-housing project to work in Hawaii, the land must essentially be free.) In addition, the developer must find investors with tax liabilities to purchase the tax credits. During the housing bubble, developers sold credits at nearly face value, and sometimes higher. Once the credit markets crashed, the prices plummeted to 60 cents on the dollar, though they are back to about 90 cents. Typically, the proceeds from these sales account for nearly all the equity in an affordable-housing project. “The problem,” says Carney, “is that will only produce between 30 to 40 percent of your equity needs. So you’ve still got to come up with the other 60 to 70 percent.” That, too, is affected by LIHTC rules.
For example, there’s the property’s income stream, the money earned from rents or sales. As in a market-price project, the affordable-housing developer can borrow money against this revenue, but the project’s income is restricted by HUD regulations, which limits the amount of rent (or mortgage payments) the developer can charge to 28 percent of the customer’s monthly income. At 60 percent AMI, for example, a two-bedroom unit at the Lokahi Apartments rents for only $833. That’s what makes it affordable. But these rent rules limit the property’s income and the debt it can support. Moreover, the lender will usually only permit an 85 percent debt-to-income ratio, reserving the remaining 15 percent as cash flow to cover operating costs and profit. Thus, the $60.6 million Lokahi Apartment project could only secure $19.2 million in permanent financing, less than a third of the development’s total cost. The balance had to be painstakingly cobbled together from federal and state subsidies and loans. In fact, for the typical two-bedroom affordable rental unit, the state has to kick in another $150,000.
Putting the financing together is a slow process. One EAH project in Ewa has been in planning for 10 years. Maeva eschewed the cumbersome 9 percent LIHTC credits altogether, opting instead for the state’s low-interest Hula Mae loan program, in which HHFDC issues tax-exempt bonds to help finance affordable-housing projects. An added bonus is that participants automatically qualify for 4 percent LIHTC tax credits.
Government regulations also provide incentives for and hindrances to development. For rental properties, the most important are the federal, state and county regulations that affect the affordability period of a development. Since any affordable-housing project exists only because of public subsidies, it seems fair to require the developer to keep the project affordable for a reasonable period. Of course, “reasonable” means different things to different people, and today it ranges from 20 years to 60 or more.
The need for these rules became clear in 2006 when the owners of the state’s largest affordable-housing project announced plans to sell when it came out of its 20-year affordability period in 2011. The planned sale of Kukui Gardens by the Clarence T. C. Ching Foundation would have put nearly 2,500 tenants out of affordable housing. Only the investment of more than $50 million by the state – along with extensive tax breaks and bond support and a partnership with nonprofit developer EAH – preserved the project. But EAH vice president Carney acknowledges Kukui Gardens is just the tip of the iceberg. “The low-income rental industry loses two apartments for every one that’s being built.”
Some affordability advocates, like Chuck Wathen, argue that the affordability period for rental housing shouldn’t end. Maeva isn’t one of them. “I say things shouldn’t be affordable in perpetuity,” she says, “because, if there’s no risk the thing will become market (rentals), then there’s no incentive to go in and rehabilitate it. What you’re then creating are really ghettos and public housing. You need to identify and recognize the finite lifecycle of a piece of wood and the termites’ appetite for that. If there’s no risk it’s going to turn into condos, then it’s not going to get any political attention. It’s not going to get any attention from new developers. And, at some point in time, everything needs to get redeveloped.”
Although Wathen clearly admires Maeva, he’s not convinced by her arguments. “Let me explain it to you this way,” he says. “When you develop these projects and you sell the tax credits to the investor, after 10 years, when they’ve got their write-off, they don’t want to hear about this project anymore. They want it off their balance sheet. They want to get rid of it. That means the developer gets the residuals of whatever you make after 15 years.” He says the Ching Foundation got a $148 million windfall from Kukui Gardens. Wathen asks, “Should private developers profit from public investment?”
The affordability period of rental housing has its analogs on the for-sale side. There, in exchange for opportunity to purchase below market-rate housing, the buyer agrees to terms like buy-back provisions and shared appreciation equity. Buy-back provisions give HHFTC the right to buy the property back at a designated price if the owner chooses to sell within 10 years. This strategy prevents flipping. Similarly, the shared-appreciation equity program requires the owner to share any appreciation in equity with HHFTC when the property is sold. The percentage share is established in the sales contract, and unlike the buy-back clause, never lapses. Like the affordability period, these tools are designed to preserve affordable housing.
In many ways, though, the availability of for-sale affordable housing is much more affected by state and county regulations that require a developer include a certain percentage of affordable housing in market-rate development plans. In Honolulu, this so-called inclusionary housing requirement is usually 20 percent. For the most part, these rules apply to any developer seeking rezoning or a variance, and the logic is clear: In exchange for the public’s permission to build, you must contribute affordable housing. But it’s not clear at all that inclusionary housing has resulted in more affordables.
Even Carney notes: “The tradition in Hawaii has been for major developers – your Castle & Cookes, your Gentrys – to supply the for-sale product of workforce housing. But nothing is free. They pay for that by increasing the cost of market housing.” Which raises an ethical question: If we, as a state, decide that affordable housing serves a critical community need, shouldn’t the costs of that service be born by the community at large? Yet, as Carney notes, under the current system of inclusionary housing, those costs are placed only on the other residents of the new development. This not only puts an unfair burden on new buyers (or renters,) the added cost is also a disincentive to building affordable housing. If 20 percent of your units have to be subsidized (to the tune of $150,000 each), it’s hard to make enough profit on the remaining units to justify the investment.
Is there another way?
Other strategies have been tried. During the Fasi administration, the city was a successful developer of affordable housing. Projects like Chinatown Gateway Plaza, Hale Pauahi Towers and Marin Tower in Chinatown are testaments to the viability of mixed-income development. Similarly, the controversial project proposed for River Street is also on city land. It’s true that those earlier projects were built when the city was flush and there was a civic commitment to affordable housing. Nevertheless, city development might be updated to suit the needs of today. Certainly, spreading the cost of affordable housing across the tax base is more equitable than foisting it on a few new buyers. It’s also less likely to discourage market-rate development.
The state has also been an affordable housing developer. Twenty years ago, when it began development of the Villages of Kapolei, it built out the infrastructure and provided developers with ready-to-build sites. In exchange, the state required those developers to make 60 percent of their units affordables. This project created thousands of affordable units, although, in practice, the 60/40 split didn’t work out financially for the developers. Nevertheless, the process might help circumvent some of the lengthy and costly aspects of getting permits and entitlements.
It may be that the best hope for increasing affordable housing is simply to make it easier for developers, even market-rate developers, to build. If you ask affordable-housing developers – whether specialists, like EAH and the VitusGroup, or large-scale community developers like Castle & Cooke and Stanford Carr – what’s the biggest problem in creating affordable housing, almost unanimously they say it’s the shortage of entitled land. That’s why there simply aren’t enough homes being built. Bruce Barrett, executive vice president for Castle & Cooke, puts it this way, “From a developer’s perspective, the lack of supply is the major issue that limits affordability.” He points out that, during the last housing bubble, the median home price on Oahu essentially doubled. “Why did it double? Because we’re building less housing stock now than we did in the 1950s.”
Which is not to say that subsidies don’t have a role to play. Jesse Wu, vice president at Stanford Carr Development, which has major affordable-housing projects in both Kakaako and Ewa, says, “The production of affordable housing is really limited by the amount of subsidy available. For most of these units, even when the land is free, we’re putting together $80,000 to $100,000 per unit to bridge the differential between what it costs to build the unit and what we charge as affordable rent.”
Courage of their convictions
Another impediment to affordable housing is when politicians and bureaucrats get in the way. During the early stages of the Lokahi Apartments project, Maeva voiced two common frustrations when the Hawaii County Council considered delaying a rezoning vote. “I said, ‘Pardon me, but everyone here acts like you’re into affordable housing, acts like you think it’s a need. Everybody got a bruddah bruddah who lives in a car, everybody got somebody no more job, everybody got a story. I say, to do nothing is a vote ‘No.’ It should go on the record that you’re against affordable housing.’
“ ‘You’re trying to make me solve all kinds of other problems. Saying, ‘Oh, there’s going to be increased traffic because of this affordable housing;’ ‘Oh, you need to increase the sewer system;’ ‘Are you sure we don’t need more parking?’ But I’m not here to solve every problem you have in the County of Hawaii. I didn’t create them and I’m not making that kind of money. I’m saying I can help you solve your affordable-housing problem; if there are other problems, that’s your kuleana.’ ”
In other words, shut up and let me build.