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Special Report: Buying blind: Lack of oversight leaves state in dark on real estate deals The state of Indiana knows how much it's spending to lease property statewide -nearly $40 million a year. But it doesn't know if that's too much.

August 15, 2005

The state of Indiana knows how much it's spending to lease property statewide -nearly $40 million a year. But it doesn't know if that's too much.

State contracts for third-party real estate services give government officials few safeguards to ensure they're paying a fair price for office, laboratory and storage space outside of state-owned buildings, those in the industry say.

And state administrators have no control over seven-figure commissions paid to two Indianapolis real estate brokers in the past decade, even though those fees could boost rents above market rates. In fact, brokers don't even tell the state what they're paid.

That's about to change, however.

Officials are soliciting proposals to replace the real estate contracts when they expire in November. The state's request makes it clear the new administration expects more services from brokers and will wield more influence over how they're paid.

It also is an example of Gov. Mitch Daniels directive that state government operate more efficiently, with a common strategy across agencies, said Kevin Ober, deputy commissioner for the Indiana Department of Administration.

"Real estate is one area in which we may not have been doing that as well as we could have in the past," he said. The IDOA oversees most of the state's real estate leases and land holdings.

Issued July 28, the state's request for real estate proposals is intended to help the department meet its efficiency goals by seeking ideas from private-sector consultants, Ober said.

Real estate is no small business for the state, to be sure. Last year, Indiana paid $38.7 million to lease 2.8 million square feet of space, in nearly every county, including $16.9 million in Marion County alone. All told, the state has nearly 400 leases for everything from boat ramps at state reservoirs to office space in Indianapolis skyscrapers.

That's a lot of work for the lone employee in the administration department's real estate leasing division, who may also be called upon to negotiate new deals and renewals. So when a property lease promises to be especially complex, outside brokers are called in to help.

Indianapolis commercial real estate veterans Gus Miller and R.J. Rudolph have negotiated 23 leases on behalf of Indiana government since 1999, when their firms-NAI Olympia Partners and CB Richard Ellis, respectively-won the contracts.

Since then, they've handled some of the state's biggest and most expensive leases, including relocation and expansion of the state departments of health and education, consolidation of Family and Social Services Administration offices in Gary, and construction of a new motor pool on McCarty Street and a manufacturing/distribution facility on the grounds of the state penitentiary in Plainfield.

But the way those contracts are structured raises questions about whether the state has adequate control over the deals the brokers handle. Under the terms of their contracts with the state, the two essentially operate as free agents, negotiating compensation directly with landlords-some of whom they also represent.

In those five big deals alone, the two brokers split more than $3 million in commissions, assuming they were paid the industry standard of 4 percent. Miller would not disclose the pair's fees, but Rudolph said compensation never exceeded the standard percentage.

The point is, state officials and taxpayers will never know.

What is 'fair'?

Their contracts offer only a two-sentence guideline for how the brokers are paid: "In all instances, contractor shall look to the landlord for compensation," the agreements read. "Compensation may not cause the rent or purchase price to exceed fair market value."

But the contracts offer no criteria for determining that value. Nor do they set a cap on fees or require the brokers to disclose how much they are paid. And they don't prohibit Miller and Rudolph from representing both the state and the landlord as long as both parties are aware of the relationship. That practice typically boosts commissions to about 6 percent.

The result, several other real estate professionals said, is the brokers have little incentive to get the best deal for taxpayers.

In some cases, rents paid by the state on leases Miller and Rudolph brokered have raised eyebrows. For instance, FSSA pays nearly $19 per square foot per year for 90,000 square feet in Gary, a market where office rents rarely exceed $11 per square foot.

And many of the leases Miller and Rudolph worked on are in effect for 10 years, even though the state's leasing handbook calls for four-year leases unless the IDOA commissioner approves a longer term. Commissions on a 10-year lease are two-and-a-half times as much as a four-year lease.

Miller nevertheless defended the practice, saying the state's annual costs in each case were lower for a 10-year lease than a fouryear lease. And in three cases-the FSSA consolidation in Gary, the Plainfield facility and the state motor pool-landlords built new facilities for the state and wouldn't consider shorter-term leases, he said.

He offered thick folders with detailed space and cost analyses for those deals, noting that the state, assuming it exercises two 10-year lease options, will own two of those buildings in 30 years.

The commissions weren't easy money, Miller said. Files for several of the largest deals indicate brokers worked on the leases for two years or more before a lease was signed. And in 16 cases, the brokers were assigned to work on transactions that never resulted in a signed lease, meaning they weren't paid for months of work.

The current system isn't intentionally flawed or designed to favor one person or group, several local real estate veterans said, nor is there any proof that Miller and Rudolph-both well-regarded in their industry-served their own interests above the state's.

Still, change is coming.

Other state governments increasingly are subjecting real estate contractors-and other consultants-to greater scrutiny when it comes to compensation and potential conflicts.

In Wisconsin and Michigan, for example, recent contracts for real estate services leave the compensation up to the landlord but require the contractor to disclose it, officials in those states said. Michigan bases the compensation in part on how much money the company saves for the state through new deals.

And both states contracted with companies that have policies against representing both tenants and landlords.

"The public sector is becoming very manic about those conflicts for political reasons and because of ethics standards," said David Montross, chief operating officer of Chicago-based Equis Corp., which won Wisconsin's contract and maintains an office in Indianapolis. "A lot of [private-sector] businesses ... are much more tolerant."

Other brokers have a policy of disclosing their standard fee up front to the tenant, even though the landlord ultimately will pay it.

"The broker has a fiduciary responsibility to the tenant, so that's where disclosure becomes very important," said Gerry Roth, a veteran broker and principal of locally based Roth Properties. Roth said he discloses his fee up front and notifies his client if it changes during negotiations with the landlord.

New day dawning

The Department of Administration, like most government agencies, has spent the months since Daniels took office evaluating how its duties are carried out. The governor hired retired phone company executive Earl Goode, who has a reputation as a tough businessman, to lead the department shortly after the election last fall.

IDOA issued its request for real estate proposals at Goode's direction. Firms that respond are asked to detail their strategies for lease transactions, as well as surplus land disposition and an overall assessment of how the state handles its real estate.

"We've been taking a look at that whole program since we got here," said Ober, who joined the agency in February from the Indiana Republican Party. "There's a lot more expertise in the marketplace for how you administer leasing than simply broker representation. ... The old contracts were limited to that. If we're going to engage these services, we should pursue them on a larger and broader scale."

Among other things, the request asks firms to detail how they would handle six parcels of surplus state-owned land, ranging from 212 acres of landlocked forest in Lawrence County to 1.8 acres in Posey County no longer needed by the Indiana Department of Transportation.

The request, which weighs in at 43 pages, makes a distinction between services for state-owned property and leased property. Firms have the option of bidding for either or both of those tasks, Ober said.

As for compensation, the state is asking firms to "be creative" in structuring their payments, and asks them to include a maximum amount they would collect under the contract. That particular detail also counts for a lot when the state judges responses: Out of 100 maximum points, 25 are reserved for compensation.

Some potential respondents said they expect competition to be fierce and judging to be tough.

"It's a more sophisticated request than I've seen in a while," said Tim O'Brien, a principal of locally based Resource Commercial Real Estate and a partner of Rudolph's. "[The state] has done more homework than they maybe have in the past."

Olympia's Miller said his firm plans to submit a proposal under the new requirements, which he believes are well written and a positive step for the state. However, he suspects his chances of winning the next contract are slim.

Both Miller and Rudolph said they believe the Daniels administration's policies will affect the Department of Administration, the same way it's resulted in a changing of the guard in other state agencies from FSSA to the Bureau of Motor Vehicles.

When Rudolph left CB Richard Ellis in April, the state contract stayed with that agency. Although his new firm plans to respond, Rudolph said he'll play a minor role in the proposal, deferring to O'Brien and his other partners to take the lead.

"It's time to take a back seat and let the new blood come in with their creative ideas," Rudolph said.
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