Editor’s note: This is the fourth installment in a series analyzing the failed VCU Health-anchored development in downtown Richmond.
The disclosure this spring that VCU Health System had to pay $73 million to back out of a costly downtown development project revealed another financial detail that has kept some observers scratching their heads.
When the health system released, in response to Freedom of Information Act requests from Richmond BizSense, its so-called defeasance agreement with the project’s capital providers that wound down the development and stipulated the payment, it also revealed an additional, previously unknown and eye-catching number: $425 million.
That was the amount of the loan that was secured to finance the redevelopment of the city’s old Public Safety Building, even though the proposed multi-building high-rise office complex that VCU Health was to anchor had been budgeted to cost no more than $325 million.
That $100 million difference has drawn scrutiny from some real estate professionals who have experience with such deals.
People familiar with the VCU Health deal or others like it say the difference could amount, at least in part, to capitalized interest and reserves that were worked into the financing to cover cost escalations over the course of the four-year project, as well as fees for the firms that structured the financing, attorneys, and other front-end expenses.
But some observers, who agreed to share their insights on condition of anonymity, maintain that the amount of funds that could have been spent on the project before VCU Health pulled out and it stalled last year could not have amounted to more than $20 million or so, leaving the bulk of the financing overage a mystery.
“Where did the money go?” asked one local observer experienced in real estate development and financing who asked not to be named in this story.
“The big question is why the financing was $100 million higher than the projected cost, and where did that money go,” the person said. “The project hadn’t started, so even though the financing was secured, it should not have been drawn down. That $100 million went somewhere and VCU had to make up the difference.”
Loan amount was not initially known
The $425 million was apparently news to VCU Health, which, according to multiple people with knowledge about the discussions, only learned of the loan amount last year – well after it had signed on, in mid-2021, to be the privately developed building’s master tenant.
The overage was explained to health system officials only after they agreed to a non-disclosure agreement, the people familiar with the events told BizSense.
Doing the explaining were representatives of the group led by Oak Street Real Estate Capital and Mesirow Financial, the Chicago-based firms that structured the financing and were among several contenders brought to the table by project developer Capital City Partners.
Oak Street, now part of New York-based investment firm Blue Owl Capital, secured the loan based on VCU Health’s involvement through a credit tenant lease. Credit tenant leases are a form of longer-term financing based on a tenant’s good credit – in this case, VCU Health’s AA- and Aa3 credit ratings as of March 2021 from rating agencies Moody’s and Standard & Poor’s.
Mesirow was the group’s bond placement firm, while Oak Street, through an entity called Project 10th Street Owner LLC, was to effectively serve as VCU Health’s landlord – an arrangement aimed at keeping the 3-acre property at 500 N. 10th St. taxable to the city, as real estate owned by VCU Health or Virginia Commonwealth University is typically exempt from local taxes.
The financing structure was fashioned with an option for VCU Health to purchase the property, which it had sought for over a decade, at the end of its 25-year lease at 10 percent of the fair market value or $31 million, whichever was greater at the time the option was exercised.
VCU Health’s lease would have totaled more than $617 million over the 25-year term, with rent increasing annually from $12.8 million the first year to nearly $32 million the final year.
According to the defeasance agreement between VCU Health, the landlord LLC and Kansas City, Missouri-based UMB Bank, which served as the escrow agent and the investors’ trustee, the $425 million loan had an interest rate of 3 percent, allowing for lower lease terms that were attractive to the health system.
The financing was dependent on VCU Health being the master tenant and was backed by the health system’s credit rating. The deal also put the health system on the hook for any project cost overruns, as well as real estate tax payments to the city that continue to be made despite the project’s collapse.
Emails obtained from VCU Health through FOIA requests state that Oak Street and Mesirow procured the $425 million in full, three months before the deal with VCU Heath was consummated in mid-2021, through a multiparty agreement and lease agreement that were signed July 15.
The agreements had been delivered to VCU Health by that March, but delays pushed back the deal’s closing. According to an executive summary of the project by VCU Health around that time, the delays prompted the financing group to request multiple times that the health system reimburse it for $2 million in costs plus expenses.
VCU Health denied the request, contending the delays were multiparty in nature and due in part to delays in information provided by Capital City Partners. According to the summary, CCP – led by principals Susan Eastridge of Concord Eastridge and Michael Hallmark of Future Cities – also sought reimbursement for a $450,000 deposit, which the health system also denied.
That the financing was secured in full and in advance of the deal closing came across as abnormal to one prominent local real estate developer, who shared their observations with BizSense on condition that they not be named in this story.
“It seems unusual that the lease and full funding of the financing…would happen on the same day,” the developer said, noting the project was still being defined with subleases and other issues that remained outstanding when the deal was closed.
‘Most beneficial structure for the project’
In a November 2021 email, CCP’s Eastridge described to Brian Jenkins, VCU Health’s chief real estate officer, how the financing had been secured at risk to the financing group, given that the delays meant the group’s investors – described in the defeasance agreement as unnamed insurance companies – were not receiving immediate returns.
“We were lucky from a market perspective to get the project capital at a favorable cost,” Eastridge told Jenkins, who had just come on board with VCU Health and was the health system’s point person on the project.
“Oak Street went to pretty unbelievable risk putting their equity out three months earlier than the closing in order to execute a favorable rate lock and grant us with certainty of closing,” Eastridge said, adding that such certainty could not be achieved with a traditional credit tenant lease.
Stating that doing so created a risk period in which Oak Street had to pay its investors while earning no return on the project, Eastridge told Jenkins: “That risk would have been dramatically punishing to our capital provider if we hadn’t finally gotten to the delayed closing.”
To line up the project’s capital providers, CCP had worked locally with commercial real estate brokerage Colliers, which connected the parties and helped capitalize the project using a credit-backed, single-tenant “build-to-suit/leaseback structure,” according to an interview published on Colliers’ website with then-agents David Wilkins and Will Bradley, who worked the deal.
In the Colliers interview, Bradley said Mesirow “was in conversations with the CCP team early on.”
“From prior experience we had a good relationship with Oak Street who specializes in acquiring properties with long-term net-leases to investment grade and creditworthy tenants,” Bradley is quoted as saying, adding that “the project checked all the boxes.”
“Ultimately, a partnership between Mesirow and Oak Street presented an attractive cost of capital with execution certainty,” Bradley said in the interview. “CCP decided this was the most beneficial structure for the project.”
Bradley and Wilkins, who are no longer with Colliers after taking jobs with other firms, did not comment for this story.
Blue Owl Capital, which acquired Oak Street last fall, said it wouldn’t comment on the financing when contacted last week. A spokesperson for Mesirow fielded questions from BizSense but said the company could not respond to them due to a confidentiality clause in the defeasance agreement.
‘To avoid…potential litigation’
The financing appears to have been a point of contention that contributed to VCU Health’s decision to back out of the project, according to language included in the defeasance agreement.
The health system had asserted, according to the agreement, various “claims and/or potential claims against Landlord and Developer, including, but not limited to, potential claims relating to the financing of the Project and the proceeds that Landlord received from the Loan.”
Referring to the investor insurance companies as certificate holders, the agreement continues: “However, to avoid potential harm to the Certificateholders and thereby protect VCUHS’ access to the debt markets and to avoid the burden, expense, and distraction of potential litigation, VCUHS desires to contribute funds towards the defeasance of the Loan and perform its other covenants hereunder subject to the terms and conditions of this Agreement.”
The document adds that the landlord LLC and the lender, meaning the investors, had rejected those claims, as well as VCU Health’s position that it was impossible for the health system to fulfill its lease due to the inability to develop the project within its original budget and scope.
“However,” the document states, “to avoid the burden, expense, and distraction of potential litigation, Landlord is willing to perform its respective covenants hereunder subject to the terms of this Agreement.”
Those covenants included that the landlord and lender would pay the amount of funds from the loan that remained in escrow, which by the agreement date totaled $319.5 million. That amount, along with VCU Health’s $73 million defeasance payment, would be used to purchase nearly $400 million in U.S. Treasury bonds that, with a slightly higher interest rate due to increases since the loan was secured, was “sufficient to defease” the $425 million loan.
VCU Health and the landlord LLC split legal fees and expenses owed to the law firms that represented the investor insurance companies as part of their overall payments, while the LLC was responsible for paying the rest of the firms that were involved in preparing the defeasance. A closing statement obtained from VCU Health shows a breakdown of the payments to the various firms.
The defeasance payment at one point could have been as high as $142 million, emails show. Fluctuating interest rates would dictate the final payment amount, which came out to $72.9 million by the time the process was completed in February. Meeting minutes indicate that the VCU Health System Authority Board of Directors authorized the defeasance last December.
As for what became of the $100 million overage, one thing that’s apparent is that the excess financing was not used to make the $73 million defeasance payment, which VCU Health has said was made using health system reserve funds. The payment was made Feb. 1, two years after the financing was secured.
In a July 2021 email to VCU CFO Karol Gray, Kellermann said: “I understand the University’s strong interest in this property. The developer astutely leveraged it and VCU Health’s financial strength to its maximal benefit.”
Gray and others had lobbied Kellermann to sign off on the deal, which he ended up doing despite his concerns. Last fall, Kellermann resigned as CEO at the request of Michael Rao, president of VCU and VCU Health. An announcement at the time did not specify a reason for the leadership change.
Lease ‘had them holding all of the risk’
That a defeasance payment was required at all has struck some observers experienced in real estate as strange.
“I don’t understand the extremely high defeasance cost,” said another local developer who asked not to be named. “The purpose of defeasance is to compensate the lender for the interest they would have earned. However, when this loan was closed, the prevailing interest rates, if fixed, would have been lower, meaning the lender would be thrilled not to have to actually make the loan at, say, 4 percent, versus they can earn much more now” with higher interest rates, the developer said.
“Most lenders under that scenario would welcome defeasance of the loan. If they did a swap, same thing,” the developer said. “It could have been that the loan was floating, but frankly most lenders today would be happy to be able to sit on the cash and not have to make the loan, so they wouldn’t need ($73 million) to go away.”
Another local observer shared a similar view, noting that long-term bond interest rates went from the 3 percent secured in July 2021 to over 5 percent last fall, when the deal was unraveling and the defeasance was being worked.
Of the defeasance, the developer added: “I am guessing that the payment was the penalty that VCU agreed to pay to get out of a really poorly structured, open-ended lease which had them holding all of the risk.”
Note: This story has been updated to clarify the lender, which was the investor insurance companies, not UMB Bank. UMB Bank was a trustee for the investors in the credit tenant lease and also served as the project’s escrow agent.