Questions arise over $18.5 million K Street purchase — and whether Sacramento paid too much

Back in July, the Sacramento City Council voted unanimously to spend $18.5 million to purchase a K Street office building from developer Paul Petrovich. At the time, it seemed like the final chapter in a painful eight-year-saga.

The acquisition of the three-story, nearly 150-year-old building was a key element in settling a 2016 lawsuit over a proposed 16-pump gas station. Petrovich wanted to place the gas station in his Crocker Village development in Curtis Park, but the city council had denied him.

The city also paid Petrovich $7.5 million in cash as part of the settlement. Add in $3.3 million for outside lawyers, and the city shelled out nearly $30 million — all to block a gas station.

Now, with Sacramento facing a $50 million budget deficit, questions are being raised about the true value of the building bought by the city — and the process that led to that purchase.

A Sacramento Bee investigation has uncovered some troubling circumstances surrounding the sale:

▪ The purchase price was overvalued by as much as $9 million, according to real estate professionals, because of various market conditions, as well as substantial revenue changes that occurred after the appraisal, but before the sale.

▪ The appraised value of $18.5 million was based, in part, on then-current lease payments that, while accurate at the time of the appraisal, the city knew were going to cease, or had already been reduced by the time council members voted on the purchase seven months later.

▪ The projected revenue for the building was $1.73 million annually. The city is currently receiving only around $341,000 in annual rent from the remaining tenants. That’s less than the building’s expenses of $449,100 in 2021, listed on the appraisal.

▪ The largest tenant in the building was its owner, Petrovich, who was paying $664,232 annually, according to the appraisal. The appraiser noted Petrovich’s intent to “occupy the suite in the event of the sale.” However, the ultimate settlement that included the purchase not only noted Petrovich’s intent to vacate the lease, but provided him three months of free rent after escrow closed.

▪ The appraisal included the $590,000 in annual lease payments from the second-largest tenant, SkySlope. However, by the time of the purchase, those payments had been reduced by nearly 50 percent to $300,638.

▪ Rite Aid vacated the ground floor of the building in 2022. Still, after Petrovich told the appraiser that “Competing drug store chains CVS and Walgreens both have an interest in the space,” the appraisal assumed a hypothetical tenant moving in and paying $477,677 in annual rent. Commercial real estate brokers told The Bee that such a tenant is unlikely to materialize in the near future.

▪ Although the appraisal that drove the purchase price included the current and anticipated revenue for commercial space, whether the city has any long-term intention of leasing commercial space in the building remains an open question. The appraisal states the “highest and best use” is retail and office space. Since the sale, however, the city has maintained its preferred use might be as affordable housing.

▪ The appraiser hired by the city, Scott Beebe of BBG Real Estate Services, had previously sided with Petrovich in 2010 at a public meeting, as residents raised environmental concerns about the Crocker Village development. “My wife and I are very much supporters of the project,” Beebe said in a video of the meeting viewed by The Bee.

▪ The settlement and purchase were discussed in a closed-session meeting with council members. It is unclear what they were told about the contents of the appraisal or the assumptions being made about tenant leases.

▪ When The Bee asked for a copy of the appraisal, the city refused, saying the document was privileged. It provided a copy only after being challenged by an attorney representing The Bee.

The Bee shared its findings with government ethics experts, a tax attorney, taxpayer advocates, and commercial real estate professionals, who characterized the process as being questionable because of its lack of transparency and whether taxpayers received fair value.

“The attempt to not disclose the appraisal wasn’t an ethical action on the part of the city because it created the appearance that they had something to hide,” said John Pelissero, Director of Government Ethics at the Markkula Center for Applied Ethics at Santa Clara University.

Over a half dozen real estate experts told The Bee the city almost certainly overpaid for the building.

One broker with intricate knowledge of downtown, who asked to withhold their name because they do business with the city, said, “The price the city paid was a joke, relative to value. The city clearly felt they were in hot soup, and had to compensate Petrovich, and was looking for ways to bury millions of dollars. They easily paid 50% over market.”

Jon Coupal, President of the Howard Jarvis Taxpayer Association., said, in general, “The city settles too many lawsuits for too much money.”

But this settlement, he said, could be particularly troubling.

“There is this concept of a gift of public funds. Gift of public funds claims are very, very difficult to prevail on because you’d have to show that there’s no compelling public interest that would warrant the overpayment. This might be one of those rare cases where you could make that case.”

The City has defended the purchase of what it believes is a building with substantial value that serves the public interest. Further, Tim Swanson, a spokesman for the city manager’s office, said, “The City Council was continually apprised of all aspects of the settlement negotiations.”

Council member Katie Valenzuela, however, told The Bee that she never saw the appraisal and was unaware of how revenue was being used to establish the value of the building. She said that City Manager Howard Chan, and others from the city manager’s office, made it sound like a sensible deal.

“The impression I had was that the city would only pay $18.5 million if the appraisal came back and said it was worth $18.5 million,” she said. “Worst-case scenario, the city could turn around and sell it.”

Mayor Darrell Steinberg’s chief of staff, Mary Lynne Vellinga, said that the mayor could not disclose what was discussed in closed sessions. Councilman Eric Guerra also declined to comment.

Steinberg suggested, in an emailed statement, that the purchase was a good decision.

“Normally when the city settles a lawsuit it just pays money and doesn’t receive a valuable asset in return. In this case, we obtained a beautiful, historic building in the heart of our downtown that has the potential to become affordable housing for people who badly need it.”

The question remains, though, was the purchase of the K Street property a costly, but expedient, way to resolve a contentious legal battle with a litigant who seemingly had significant leverage? Or did the city use taxpayer funds for reasons that are hard to justify?

A legal soap opera

The legal soap opera began when Petrovich requested a permit in 2015 to build a 16-pump gas station as part of his Crocker Village development. Gas station opponents argued that the fuel center was out of step for a development that received $15 million in grants as a transit-friendly development.

The planning commission sided with Petrovich, but the City Council overruled that recommendation and rejected his application for a permit on a 7-2 vote. Petrovich then sued.

At the heart of his lawsuit was a claim that City Councilman Jay Schenirer failed to recuse himself in the vote, despite having shown bias against the project.

The fight was bitter. Former City Manager John Shirey called Petrovich “mentally ill” in text messages discovered through court proceedings. Petrovich demanded at least $20 million when he first filed his lawsuit in 2016. That figure soared to more than $100 million, because he said the anchor tenant in the commercial part of his development, Safeway, would not move into Crocker Village without a gas station, although ultimately, it did.

A Sacramento superior court judge in 2018 agreed with Petrovich and ordered a new hearing.

In what may have been a crucial misstep, rather than hold a new hearing, the city appealed. A state appeals court in 2019 agreed with Petrovich that Schenirer “took affirmative steps to assist opponents of the gas station conditional use permit and organized the opposition at the hearing.”

The city council held another vote in 2022 over the gas station and affirmed the original decision, voting 7-0 to reject the gas station. This time, Schenirer recused himself from the vote.

Petrovich continued with his lawsuit and the city entered into mediation over damages.

At some point during negotiations, Petrovich pushed for the city to purchase his K Street office building — called the Hale building, for the department store that opened there in 1881 — as part of the settlement.

The building is not far from the bustling Golden One Center, but it is in a blighted section of downtown, with boarded up restaurants and nearly empty office buildings.

As part of any purchase, the city first had to determine what the property was worth.

The city’s appraiser backed Petrovich in the past

The appraisal, according to a letter obtained by The Bee, was commissioned on Dec. 5, 2022, after a phone call between Beebe, who leads the Sacramento office of BBG Realty Services, a leading national appraisal firm, and at least one city official, Facilities & Real Property Superintendent Richard Sanders. The letter said the city would pay $15,000 for an appraisal to be completed by Jan. 4, 2023.

BBG has an up-to-$750,000 contract over three years with the city to provide as-needed appraisal services.

Sanders wrote, “The purpose of the appraisal will be to provide an opinion of the ‘As Is’ market value of the fee interest in the Property to facilitate the possible acquisition of the Property by the City of Sacramento from Hale Bros Investment Company, LLC.”

The letter also said; “Nothing in the appraisal shall reference any settlement or lawsuit between the City and Petrovich-related entities.”

The Bee made numerous attempts to contact Beebe, who did not respond to multiple phone messages and emails..

Swanson said that, “The City has an existing City Council-approved on-call contract with this appraiser. As stated previously, the City has used this appraiser multiple times over the years, and they are licensed and reputable.”

While real estate brokers questioned the accuracy of the appraised value, ethics experts also shared concern over the selection of Beebe as the appraiser.

In 2010, at a contentious city council meeting over Petrovich’s proposed development in Curtis Park, Beebe lined up with supporters of the project. He said the city needed the development because the “area is substantially underserved when it comes to retail services.”

Karen Mann, the former president of the San Jose Chapter of the American Society of Appraisers, who testified before Congress following the financial collapse of 2008, said of Beebe’s past support of Petrovich, “You have to be careful about that kind of stuff; you can’t be biased.”

Government ethics specialist Pelissero said that Beebe’s past advocacy is “clearly a conflict. The appraiser should have an arm’s length distance from any advocacy.”

City spokesman Swanson said the city was not aware of any undisclosed business conflicts.

“If Beebe had any conflicts,” Swanson said, “he had the obligation to disclose them before he performed the appraisal.”

Petrovich took issue with any assertion that the appraisal was not handled properly.

“You should be saying it was appraised by an MAI (member, Appraisal Institute) appraiser of the city’s choice that the city has on their approved list and was reviewed internally by experts within the city,” Petrovich said in a text message to The Bee. “Instead, you are making it sound nefarious as if we are hiding something and having the uninformed public assume this was done without care for the public’s interest on just the appraisal.”

Furthermore, Petrovich maintained the city received a good deal because he believes the building is worth more than the $18.5 million purchase price.

Commercial real estate experts disagree.

The purchase price works out to $330 per square foot. One real estate professional familiar with downtown dynamics who also asked for anonymity because of business dealings with the city said, “The Hale is considered a Class B office building. $250-$300 per square foot range is what some Class A high-rises were selling for before the pandemic. And those were well-stabilized leased assets in a strong market. On the open market, the Hale would fetch, I suspect, between $150-200 per square foot.”

Bob Shanahan, Research Director for the international real estate firm Colliers in Sacramento, said that,“Capitol Mall is actually doing pretty well. 555 Capitol Mall, just across from the arena, is about 92% leased.”

“But,” Shanahan noted, when you go to the blocks near the Hale, “That is a different ballgame. 801 K Street, for example (a 28-story high rise), where a bunch of state offices moved out, is 30% occupied.”

Experts who viewed the appraisal at the request of The Bee also noted that two of five sales comparisons were from prior to the pandemic, before a drastic downturn in the commercial real estate market that hit the area around the Hale particularly hard.

Location is one issue. So, too, are the anticipated lease payments that helped drive the $18.5 million value.

The appraised value was based, in part, on the existing tenants’ lease payments. Those lease agreements, however, had been signed years earlier. Commercial real estate professionals contacted by The Bee noted that’s an issue because those agreements no longer reflected market value.

The largest tenant was Petrovich, also the building’s owner, who paid $664,232 annually and informed Beebe at the time of the appraisal that he intended to continue leasing the space. The second-largest tenant, SkySlope, paid $590,000 annually. In addition, the value assumed a replacement tenant for Rite Aid.

But, by the time the council voted on the $18.5 million purchase, the situation had changed dramatically.

Petrovich had since said he would vacate the building, which the city and council knew because it was stated in the settlement agreement. And SkySlope already had negotiated a new lease months before that cut its lease payments nearly in half. Also, there there was no replacement for Rite Aid — and still isn’t.

So by the time of the council vote, annual lease revenue of $1.28 million in 2022 had shrunk to around $341,000.

When asked if the city council was aware how much the $18.5 million price tag had been derived from Petrovich and SkySlope’s past rental agreements, Swanson did not provide any specifics.

Instead, he provided this statement: “The settlement agreement was negotiated by a team of people, which included the City Manager, the City’s Risk Manager, the City’s Real Estate Manager as well as representatives from City Attorney’s Office and outside counsel. The City Council was continually apprised of all aspects of the settlement negotiations.“

The council voted unanimously on July 25 to purchase the property as part of the settlement that also included the $7.5 million in cash to Petrovich. The purchase was on the consent calendar. No council member sought to have the sale discussed in open session.

“This appraisal and the whole process raises questions here about whether Sacramento officials were doing their fiduciary duty to ensure they were getting a fair price for this property,” Pelissero, the government ethics expert said. “It seems like a private entity would almost certainly have not paid that same price, and that is unfair to taxpayers.”

He added, “This transaction reminds me of the former relationship between appraisers and mortgage companies, where the mortgage companies basically created their own appraisal units, to put down appraisals that were going to cover the mortgage, even though the property itself wasn’t worth the appraised price. And that’s where we got into the housing crisis back in 2008.”

Coupal, the taxpayer advocate, summed it up this way: “It seems like both parties derived benefit from a transaction which looks pretty murky from the outside.”

What’s not murky is the added benefit Petrovich received from a settlement that relied so heavily on a property purchase. Cash settlements are typically taxed but a property purchase can be re-invested to avoid a heavy tax liability.

And that’s what Petrovich has done.

The developer has made no secret that he has been shifting his residence and business focus to Texas. Since escrow closed in December on the city’s purchase, Petrovich has purchased two buildings in Texas, including one that houses a Shake Shack in Austin.

He is contracted on three more Texas properties. Petrovich told The Sacramento Business Journal in January, “The anti-business climate in California, and the attempts at a wealth tax, are why I determined and still am determined to sell the asset and place the proceeds in a different, more business-friendly state.”

The Business Journal further noted: “When all the deals are complete, he’ll have spent all the proceeds from 827 K St., he said, in an exchange deal where he avoids taxes on the original sale.”

The city owns a building. So what to do with it?

Now, amid a $50 million budget shortfall, the city is confronted with just what to do with the asset it purchased.

Commercial real estate brokers told The Bee there is no way the city can flip the building for anything near what it paid.

Still, it is not without value. And the settlement was not without purpose.

“The acquisition of the property was a key component of the resolution of seven years of litigation with the Petrovich Development entities,” city spokesman Swanson said. “As part of the settlement agreement, the city was able to obtain a large building in the core of the central city with the prospect of using it as affordable housing, which aligns with City goals by serving critical needs in our community.”

The city also could try and lease the commercial space.

The Hale, however, sits in an area particularly hard-hit by changes to the economy following the pandemic and a massive shift to remote working.

With boarded-up restaurants and largely vacant office buildings, the area, in some ways, resembles a ghost town. Over a dozen restaurants and retail stores have shut down in a two-block radius. Signs trying to entice tenants, such as “Your name here,” and “2nd Generation Restaurant,” on a once-posh bistro that served chilled oysters on the half shell, abound.

Tenants stuck with leases inked before the pandemic have offered online subleases at vastly reduced rates.

Keegan Miller, a barista at Temple Coffee on Ninth Street, down the block from the Hale building, said on a recent Monday while pulling an espresso shot, “We’re doing OK, Temple is kind of this oasis because people still need a place to hold a coffee meeting.

“But this area has gotten hammered over the last couple of years. So many people are working remotely; so much has closed down. People don’t want a midday lunch or a cookie anymore. There is a lot of concern about homelessness. It’s rough right now.“

Mann, the former president of the San Jose Chapter of the American Society of Appraisers, said that K Street in Sacramento is part of a larger crisis in commercial real estate.

“The high vacancy rate in San Francisco and Sacramento in office buildings is particularly bad,” Mann said, adding, “I am personally aware of quite a few banks that are, shall we say, upside down with their loans because the value of office buildings is not as robust today as it was five or 10 years ago. As a result, we’re looking at office building prices being much less than they were before, due to the high vacancy.”

Still, the most likely use, it appears — and one that has been championed by Steinberg and Valenzuela — is to convert the building to affordable housing.

“The city is currently evaluating the best uses for the building to support overall city goals and objectives as well as enhance the vibrancy of K Street,” said City spokeswoman Gabby Miller. “This work includes examining the building’s suitability as potential affordable housing.”

No one is denying the dire need for affordable housing. But the Hale is an office building. So, converting it would come with yet another steep price tag — on top of the $18.5 million.