I-91… Take 3

I just wanted to take the opportunity to share with you our take on I-91 one more time in an effort to clarify our position in an easy to understand way.

The main problem that seems to be causing so much confusion for people is that the City and County are raising debt to fund their contribution and as such are not investing “cash” from the general fund. As such, there is no “cash” investment on which to calculate the “cash-on-cash” return required by I-91. Thus, the mistake that most observers (including Chris Van Dyk) keep making is to wrongly assume that the $200 million in debt financing is a cash investment and therefore reach the dubious conclusion that the City of Seattle has to earn a 30 year treasury return on the entire $200 million investment after accounting for the City’s debt service costs.

As can be seen in Section 2 of I-91 (below), “fair value” should be computed as the net cash-on-cash return after interest and financing costs. Nowhere in the entire ordinance is there a mention of applying a premium to the City’s borrowing cost when it is using debt instead of cash to fund its investment.

Fair value is defined herein as no less than the rate of return on a U.S. Treasury Bond of thirty years duration at the time of inception of any such provision of goods or services, real property or lease; and further, such return shall be computed as the net cash on cash return, after interest and any financing costs, on the depreciated value of the cash investment of the City of Seattle in such goods, services, real property or facility, and shall exclude all intangible, indirect, non-cash items such as goodwill, cultural or general economic benefit to the City, and shall also exclude unsecured future cash revenues.

For those of you not familiar with the methodology for how to calculate cash-on-cash returns, I would simply refer you to Wikipedia. But rather than try to explain this from a technical point of view, we thought a few comparative scenarios that everyone can relate too may be more helpful.

Instead of the Arena, consider the case where you purchase a rental house for $200,000. Then assume the house rents for $1,167 a month, or $14,004 per year. For the sake of simplicity, we will assume that the house is always rented (no vacancy), and there are no other annual costs (e.g. property taxes or maintenance costs) – so your rental stream is your pre-tax profit.

Scenario 1: If you were to pay all cash for this investment property, your annual cash-on-cash return would obviously be 7.0% ($14,004/$200,000).

Scenario 2: As is often the case with investment properties, instead of paying all cash, you put down 30% and borrow 70% at a 5.5% interest rate. If you took out an interest only loan at 5.5%, your profit would simply be your $14,004 in annual rent minus $7,700 in interest costs for a profit if $6,304 and a cash-on-cash return of 10.5% ($6,304/$60,000).

In this regard, the mistake many would make is to divide the $6,304 profit by the $200,000 purchase price, instead of the $60,000 investment. This is a huge mistake as doing so would result in a return of just 3.2% and thus significantly understate the true return you earn on your cash investment.

Scenario 3: However, if you took out a conventional 30 year loan at 5.5% that included principal repayments for a total monthly payment of 7.0% of the $200,000 purchase price, your cash-on-cash return would be calculated by deducting your mortgage payment (not just your interest payment) from your rent. In this case that would be $14,004 less $9,800 (7.0% x $140,000), for a profit of $4,204 and a cash-on-cash return of 7.0%. The obvious difference is while the return is lower under scenario #3 than #2, the debt will be paid off after 30 years and you will own the house outright.

However, we would also point out that since the mortgage payment (debt service) rate of 7.0% is equal to the 7.0% rental yield on the property, your cash-on-cash return would be 7.0% regardless of whether you put down $1, $1,000, $20,000 or $100,000.

Scenario 4: But to make this point crystal clear, let’s add one last scenario in which you borrow the entire $200,000. In this case your mortgage payment ($200,000 x 7.0% = $14,000) exactly equals your rent so you have no annual cash profit. However, you also have zero cash investment. So while you have no profit, you have also risked no cash. But you will own the house at the end of the mortgage, so you would probably willingly accept this situation as you would essentially own the house for free in 30 years.

For some reason, however, this last scenario really throws people for a loop as they can’t understand the concept of having no cash invested in the house. This, in turn, often leads people to the dubious conclusion that the cash investment is $200,000 instead of zero and that the cash-on-cash return is also zero or not that good.


  1. As I think you can all appreciate, it is Scenario #4 that we are proposing for the Arena, and just as with our example of the $200,000 house the City/County are investing zero cash and financing their entire Arena investment at a debt service cost that equals its guaranteed return stream. And just as with the example of the house, while the City/County will have no annual cash profit from their investment if their return is 7.0%, they will own the Arena at the end of the lease. However, just as with Scenario #3 above, the City/County’s cash-on-cash return would be 7.0% if it invested any portion of the $200 million in cash instead of financing its entire investment.
  2. I would just like to clarify that we are not saying that the City/County is making a 7.0%+ PROFIT on this investment. The point we are making is that the RETURN on the $200 million Arena is 7.0%+. In the case where the City/County finances its entire $200 million investment the RETURN is offset by a debt service cost that is 7.0%, implying the City/County would have to generate higher that a 7.0% return to generate a profit. However, this does not change the fact that the City has no cash investment in the project and any return (even $1) it generates above 7.0% would amount to an infinite cash-on-cash return under I-91.
  3. We would also be the first to admit that just as with an investment in a bond, for the real return (not the cash-on-cash return) to the City to be equal to 7.0% on the $200 million, the City would need to recoup its $200 million investment at the end of the 30 years just as with a 30 year treasury. However, even if you assume the Arena and land are worth zero at the end of the lease, the $14 million secured return stream (growing at 1% for the first 10 years and flat thereafter) would result in a 6.6% IRR (annual return) if we consider the $200 million investment as cash (not debt).
  4. I-91 specifically calls for a cash-on-cash return of more than the 30 year treasury rate. This clearly implies a return greater than the 30 year treasury rate of 2.6% on the cash invested, not a 2.6% premium tacked on top of money borrowed to fund the investment. To do so would imply that the required return on the actual investment under I-91 would be in excess of 8.0% (assuming a City/County borrowing cost of 5.5%) – which would represent an absurd lending spread and corporate borrowing rate in this interest rate environment.
  5. Given the limitations of the cash-on-cash return methodology in a situation where there clearly is not cash investment, we continue to believe that the best approach and methodology is to calculate the return on the project as if it was an all cash investment, and then to compare this return with the City’s cost of capital to determine if the return premium is adequate.

In this regard, we have attached a detailed IRR (internal rate of return) analysis of the Arena investment which yields the following results:

Base Case (11.0% IRR): Assumes real estate is worth $200 million at the end of the lease, $5 million in incremental taxes to the City per year, and 10% substitution effect. This analysis yields an IRR of 11.0%, which is significantly higher than the City’s assumed 5.5% cost of funds.

Conservative Case (7.8% IRR): Assumes real estate is worth $200 million at the end of the lease, incremental taxes merely offset the 10% substitution effect. This analysis yields an IRR of 7.8%, which is significantly higher than the City’s assumed 5.5% cost of funds.

Ultra Conservative Case (6.6% IRR): Assumes real estate is worth zero at the end of the lease, incremental taxes merely offset the 10% substitution effect. This analysis yields an IRR of 6.6%, which is a 1.3% premium to the City’s assumed 5.5% cost of funds, and would be considered a great lending spread for a financial institution.

— Chris Hansen

I-91 IRR Analysis Spreadsheet
View on Google Docs