CRE 101 Blog

Are you having a hard time finding suitable office space in your market?

Is your office space market so tight that only small blocks of space are available? Do you have a unique or specialized need, which no building currently in your market can accommodate?  Does any portion of your business represent a long term commitment?   If any of the above questions reflects your situation, consider designing and building your next facility to suit your needs rather than renewing your current lease or taking an “as is” building available in your area.

For the first time in over a decade, many corporations are inquiring into the feasibility of a build-to-suit facility for their company.  With office vacancy rates in the single digits, quality office space becoming scarce, and the spread in rental rates between existing space and new space narrowing,  the build-to-suit option appears very attractive.  The market surge throughout many real estate markets in the U.S., has driven vacancy rates down, rents up, and made landlords jubilant.  Economists predict a drastic under supply of office space in many areas, yet lenders and developers are reluctant to construct new buildings – unless a substantial portion of their risk is eliminated.

A build-to-suit (or design-build) lease is essentially a landlord/developer’s agreement to construct a purpose built building, usually for a single tenant.

The landlord will typically own or ground lease the lands (and once constructed, the building) and has the option of re-letting the building to a new tenant upon the expiry of the term of the build-to-suit lease to the original tenant. Build-to-suit leases typically are for a longer term than a normal lease in order to permit the landlord to recoup its investment over the duration of the lease term.

The user assumes the responsibility of acquiring the land; hires a general contractor to oversee the planning and construction; and assumes the liability of financing, either with debt or equity.  Upon completion, the user has the option to continue ownership or sell the property to an investor and lease it back.  This is known as a sale-leaseback transaction.

A build-to-suit arrangement is essentially comprised of two agreements: (i) a development or construction agreement, the result of a request for proposal (“RFP”) process, which defines the relationship between the landlord and tenant from the design through to the construction of the building; and (ii) a lease agreement, which stipulates the terms of the occupancy post-construction. In some cases, the provisions regarding the construction of the building are included in the lease itself or captured in an accompanying “work letter”. The construction aspect of this arrangement is usually the key issue and the most complicated, warranting close attention to the landlord’s and the tenant’s responsibilities in this regard.

Given the interplay of traditional lease issues with design, construction, timing and financing concerns associated with making a project a reality, build-to-suit leases present a unique set of obstacles that parties must face and which require careful drafting and attention. 

Before determining the structure of a build-to-suit, the user must analyze the pre-tax, after-tax and profit/loss impact of the various alternatives.  Many factors influence the financial impact of a build-to-suit.  Each factor must be sufficiently examined for the optimal structure to be achieved.  Below is an abbreviated list of key factors:

Initially, most build-to-suit opportunities were with users whose credit was classified as investment grade which typically falls in the Standard and Poors classification as BBB and above.  However in today’s market, financing is available for tenants rated slightly below investment grade (BB, B).  Obviously, the stronger the credit rating of the company, the more favorable rental rate a company can obtain due to the reduced risk assumed by the investor and lender.

A build-to-suit lease has the potential to bind the landlord and tenant for an extended period of time and the design-build process is typically a lengthy process requiring significant commitments of capital, time and effort by each of the parties at the outset. Accordingly, the question as to the exact role each party will play warrants more than a superficial evaluation. A landlord will need to carefully evaluate the credit-worthiness of the tenant and be cognizant of the nature of the tenant’s business and its specific needs to help guide the design and construction of the building. Quite often such analysis will result in the landlord requiring a parent guarantee and/or cash security for the tenant’s obligations under the build-to-suit agreements. From a tenant’s perspective (and as part of the RFP response process), it should assess whether the landlord has the expertise and financial wherewithal to deliver the building within the required time period and as specified. Much of this will be contingent upon evaluating the landlord’s previous build-to-suit experience, local and industry reputation and organizational structure. In some cases (where, for instance, there is a significant tenant improvement allowance payable by the landlord or where the landlord is a special purpose entity), it may be appropriate for the tenant to require the guarantee of a parent entity, the securitization of an amount owing via a letter of credit and/or self-help/set-off remedies.

A longer  term lease generally allows the developer to achieve more favorable financing, translating into a reduction in rental rate.  Reducing the Lender’s and developer’s rollover risk allows the lender to amortize the loan over a longer time period.  In addition, a longer lease term reduces the real estate and property-related risk of the transaction and places greater emphasis on the credit risk of the tenant. However, if a long term lease is structured, the user must ensure the lease meets the operating lease requirements of the FASB 13 (Financial Accounting Standards Board). 

Most users prefer that the lease remain off their balance sheets to improve corporate key financial ratios such as return on assets and return on equity.

The cost of a build-to-suit is influenced by the credit of the tenant and the underlying real estate. Upon lease expiration, the developer must assume the risk of releasing the property.  In the past this could frequently mean an empty building for one to three years, new interior improvements and many other associated fees.  This gamble is minimized if the property is well located and is not constructed as a “special” or “single use” type of structure.

A commonly-encountered issue in a build-to-suit lease is the natural tension between multiple contractors in the same building. Most timetables will require that the tenant improvement contractor is working in the building at the same time as the general contractor is putting the finishing touches on the base building. The practical concern centers around meeting the needs of two contractors simultaneously and balancing their demands for the overall benefit and completion of the project in a timely manner. To address this, many landlords will suggest that the tenant avoid this issue altogether by contracting with the landlord for the construction of the tenant improvements or with its contractor directly.

Most office build-to-suits generally require the user to occupy a minimum of sixty percent or more of the property.  A higher occupancy percentage reduces the risk of leasing the remaining space to additional tenants and thereby allows more favorable financing and investment parameters.  However, in many markets with limited vacancy, a small percentage of unoccupied space allows the developer to maximize his return by charging higher rents on the initial vacant portions of space.

There are various ways a lease can be structured to achieve the needs of the user.  Below are the most common types:

Full Service – A full service lease means that the lease rate includes all operating expenses of the building and requires no additional payment from the tenant. A hybrid of this lease requires the tenant to pay their prorata share of any increases in expenses from the time of occupancy.

Net, Net, Net Lease – A Net, Net, Net lease (triple net or NNN) means the tenant’s rate does not include building expenses.  All prorata operating expenses and taxes for the property  will be paid by the tenant. However, the landlord is responsible for any structural and capital repairs.  The tenant may terminate the lease in the event of a casualty subject, of course, to provisions in the lease.

Bondable Lease – Similar to a NNN lease, but the tenant is responsible for all expenses of the property including capital items.  In addition, the rental rate may be affected by changes in the financial condition of the tenant.  The tenant assumes certain lease responsibilities and signs certain corporate covenants resulting in the lease being regarded by lenders and investors more as a corporate bond than a real estate loan.  The result is a financing cost at or near the corporate bond rate.

Synthetic Lease – This lease is structured as an operating lease for GAAP purposes and a capital lease for tax purposes.  The synthetic lease allows the tenant to finance its occupancy cost at a lower rate and still achieve the benefits of off balance sheet financing due to certain reversion risks at the end of the lease term.  This somewhat controversial structure can be fairly costly to create and has considerable technicalities, but can greatly reduce the rental costs.  It was derived for use in real estate after a proven track record in the equipment leasing area.  One potential risk of using the synthetic lease is that it may be subject to a re-evaluation by the Financial Accounting Standards Board at some point in the future.

In addition to the above, there are many other creative lease structuring methodologies including leveraged, joint venture and equity leases that should be explored by the user and it’s advisor.

As with any successful endeavor, the right project  team needs to be established to ensure the user makes the most informed decision.  Typically the user initially hires a broker/advisor to set direction and orchestrate the necessary team.  The first major task of this advisor will be to select and coordinate the formation of a “steering committee” within the user firm.  This steering committee should include the highest level of leadership available and will need a focal chairperson.  If the project is a headquarter location, the Chief Financial Officer and Director of Administration should be present, with senior representation from the legal and public relations departments.  The committee will need to be small enough to be available on a regular basis and must be empowered by the Chief Executive Officer and Executive Committee to make decisions on behalf of the corporation.  The committee will need to be sufficiently engaged in the selection and understanding process to feel confident in their many choices.

The advisor will then arrange interviews, prepare requests for proposals, negotiate with, and advise in the selection of other necessary team members who will be involved on an as-needed basis.  These other specialties can be either from an outside firm or integrated as part of the advisor’s firm, but will report through the advisor to the head of the steering committee.  The first such specialty will be a strategic planning function, to provide space sizing and growth studies, as well as other views on the impact of alternative workspace utilization.  Technology advances and attitude changes may also warrant studies into the effects of implementing programs such as hoteling, virtual officing, team rooms, and other modern occupancy concepts.  Other necessary “watchdog” team participants members will be a construction advisor and a real estate attorney.  Each of these specialties will be necessary throughout the search, selection and negotiation process of the build-to-suit.

The real estate  advisory and brokerage firm itself must be able to counsel

the corporation on all possible land and building sites available, current market conditions, comparable rental rates and  the financial impact of a build-to-suit as contrasted to other alternatives.  The advisor, must be able to calculate on an after-tax and/or profit & loss basis both the corporate user’s and the developer’s  financial perspectives to assist in negotiation, financing and/or a forward commitment from a lender.  These real estate financial engineering professionals should be capable of convincing investors of the potential gains if the corporation or developer desires to sell the property.

The negotiation and documentation of a build-to-suit transaction will take significant time and planning, being considerably more complex than the negotiation of a typical office lease.  In a build-to-suit lease transaction, provisions relating to transaction structure, rental pricing, project control, construction issues, performance standards, environmental issues, title, non-disturbance and subordination all play a very major role.  Tenant concerns relating to early termination, renewal, expansion and contraction are also frequently found in a build-to-suit lease.  An experienced real estate advisor will assist in ensuring all these items are addressed to the corporate user’s advantage.

A build-to-suit can offer several advantages to a relocating tenant.  First, a build-to-suit allows the tenant to achieve maximum space efficiency since the space is designed specifically for the tenant. Second, new construction allows a developer to incorporate the most cost-effective energy systems in the project resulting in a reduction in operating costs of the property and lower occupancy costs to the tenant.  Third, the tenant will have maximum design input to create a building that will project the desired company image.  Fourth, a build-to-suit project will allow the user space for future expansion.

A build-to-suit is not a short term solution

A user must make a long term commitment  to the property  to acquire financing.  Second, it is not a transaction that can be completed quickly.  The entire process may take several years to complete.  Third, a build-to-suit generally is still considered a more expensive alternative than leasing existing vacant space, particularly if the size required is readily available on the open market. However, the additional cost may be offset by savings in space efficiency, reduction in operating costs, and improved company image.  Fourth, due to the cost and time commitment of a build-to-suit, a tenant must reasonably forecast future expansion needs to ensure the property will meet the company’s long term needs.

Although not unique to build-to-suit leases, the following issues and concepts also warrant particular consideration in this context and should be considered carefully:

• Commencement vs. Construction Date: Build to suit lease forms often make the distinction between “construction” and “commencement” dates. While the landlord may seek a steadfast commencement date so that the commencement date for the payment of rent is established at the outset, a tenant would be wise to defer any payment of rent until the project has been substantially constructed.
• Tenant Rights re: Purchase: Given that build-to-suit projects are generally purpose built for the original tenant, such tenant may seek options in its favor to purchase the project at some point during the term of the lease, a right to be first to the table in the event of a proposed sale (a right of first offer), and/or a right to match an offer received by the landlord from a third party for a proposed purchase (a right of first refusal). Establishing these rights in favor of the tenant will typically require that a balance be struck such that the tenant has the benefit of some or all of these options without unduly limiting the landlord’s ability to deal with the project and get the best price in the market. Such provisions must specify how and when the tenant may exercise its right and set out the criteria to be met in order to exercise such an option.
• Space Mitigation Strategies: Where the project is part of an existing commercial park, the needs of the tenant for expansion flexibility into adjacent buildings and, alternatively, exit and space mitigation strategies (in particular, flexibility in larger buildings to sub-demise and sublet excess space) should be addressed.
• Warranty Items: Allocation of risk and the responsibilities for the costs of defects or deficiencies covered under warranty or which result due to faulty design, construction or defect should be expressly addressed in the lease, including as part of the landlord’s and tenant’s repair and maintenance obligations and the operating cost recovery provisions.

Build-to-suits represent one of the alternatives available to companies in today’s complex commercial real estate environment

Many executives in charge of procuring space for their companies find the build-to-suit option advantageous, while others prefer more traditional approaches to meeting space needs.  Build-to-suits make the most sense when the company can make a long-term commitment to a property, can handle the initial costs, and when the firm is seeking to maximize efficiency and possible expansion potential.