The other day I was talking with a CEO who had moved his rather large business (over 200 employees) from downtown to the suburbs. There were many factors involved, he said, but the thing that made the decision easy was that, “I was offered a deal that I could not refuse.” Conversely, a real estate developer recently told me that he was putting in a new project in the same downtown because “… the city offered me a deal I could not refuse.”
What is going on here?
Incentives, tax breaks, special financing, deals, special treatment, discounts. Call it what you might, but it is all about making a business transaction possible that often would not otherwise be so. Retailers and businesses call them loss leaders, and governments call them incentives.
The key concept here is ‘feasible,” which is defined as “capable of being done, effected or accomplished.” Many of these projects are not financially feasible as the term is commonly used in the appraisal industry, meaning that the project is not “economically supported.” Nevertheless, they are feasible when one realizes that feasibility of a transaction or a project is determined by the client. So even if the so-called market does not think a project is feasible it may very well be so in the eyes of the investor or developer. Indeed, I see projects almost weekly that are not financially feasible if the investor was required to make 100 percent of the investment.
So why are these deals done? Let us look first at some private business transactions and then some government-assisted transactions. I will use three personal cases for illustration.
Last week I was in the market for a replacement for my household’s over-the-range and overage microwave oven. I did some online research about the product and current prices before visiting my local appliance store. When the sales rep told me the price I reported that I had found it cheaper online. He agreed to reduce the price by about half of the difference in the online price and his price. I told him that I would be glad to pay that price because it was worth it to me to do business with a locally owned store. He told me to wait just a minute, and then returned to tell me that he saw that his records indicated I was a repeat customer. He then offered me the product for even less than the online price. I wondered if he made any profit at all on the deal.
In the second case, I took three bids on a home repair project. The highest bid was from what I deemed to be the most qualified contractor. When I called him, I asked if his price was negotiable and told him that he was the highest bidder. He reduced his price to that of the next lowest bidder. I accepted his price and invited him to begin the work.
The third case was a coupon offer from an online coupon company offering half off a meal at one of my favorite restaurants. I purchased the coupon and used it within a week for a customarily satisfying meal.
In the above cases the business made less profit than normal, and I suspect in two of the cases made no profit. The reason they reduced their price to what might be a price that was not economically supported was because they believe (rightly so) that I will be a future customer and/or that I may refer future customers to them. They were looking ahead and not considering the benefit of only the one transaction.
Government at all levels do the same thing. The developer who is putting in the project downtown determined that it is not feasible because he demands a return on investment of 12 percent, for example. If his projected net income annually from the project — in this case a hotel — is $400,000 then the project is feasible to him only if his investment is no more than $3.3 million. That is a problem if the required investment is $4 million. But if the city funds part of the construction costs to the tune of $700,000 or provides a tax benefit that would result in the required net income, the project becomes feasible from the developer’s standpoint. It is feasible from the government’s standpoint if the $700,000 in assistance is returned to the government in the form of increased sales taxes, other revenue or other public benefit.
Unfortunately, some government organizations do not know how to define or measure return on investment. Consequently, the public does not understand why the government makes concessions to private business. Sometimes it is a communication issue, but sometimes it is a public policy issue. One view holds that because we love incentives, discounts and deals in the marketplace it figures that government wants in on the action. If incentives and deals are a factor in people buying something they would not or could not have done otherwise then in the name of __________ (fill in the blank — job creation, quality of life, saving the community, improving he economy, etc.) it would be appropriate for the government to use such tools to create a transaction that would not have otherwise occurred or been feasible.
Although “dealing” is not a bad thing, we might want to beware the time when business and government have offered so many deals and incentives that everyone expects a deal. That can lead to bad deals. And bad deals only compound themselves, especially when it comes to government incentives. When businesses automatically assume that the government will deal, and when government organizations automatically offer incentives without considering their feasibility then business development projects are no longer market driven. While most people agree that government has a role in community development and economic development most people also agree that government should not overly influence the marketplace.