The Build-to-Suit - Is it for you?
Introduction
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.
Definition
A build-to-suit is a building specifically constructed to meet the design, location and physical specifications of one major user. A building may be developed based on a build-to-suit requirement of one user. Excess space in the building could be leased to additional tenants or set aside for the planned expansion of the original tenant.
A user has several alternatives in which to originate and transact a build-to-suit opportunity. The following three are the most typical:
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.
The user approaches a developer with a requirement and transfers the construction, ownership risk and potential profit to the developer.
A hybrid between the above choices, including shared equity and joint venture arrangements.
Cost Factors
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:
Credit of the Tenant
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.
Length of Lease
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.
Location and Construction
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.
Space Requirements
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.
Lease Structuring
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.
Team Structure
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.
Advantages
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.
Disadvantages
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.
Conclusion
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.
Mark Larsen, a CCIM and Senior Vice President of CB Richard Ellis, is currently negotiating various large build to suit assignments. Paul Kramer, a CPA and Vice President/Regional Manager with CB Richard Ellis’ Financial Services Group, leads the financial consulting group for CB Richard Ellis’ Northeastern Division. Both are based in the Washington, DC area. CB Richard Ellis Corporate Real Estate Group is a group of highly trained, experienced real estate advisors who design and implement creative approaches to corporate real estate issues. Services include strategic real estate planning, acquisition and disposition services, property valuation and location advisory services.