Build-to-Suit

By William V. Gonnering, CCIM, SIOR

One of the inevitable truths about success is growth. Often,

as a business prospers, it outgrows its original building sooner than owners

are ready to move or rebuild. In other instances, a regional or national

organization seeking a prime location may have needs that aren’t available in

the local market. When businesses have specific requirements for their

buildings, but local availability doesn’t accommodate their needs, the logical

step would be to build a customized building. However, initial capital outlay

is often prohibitive and prime land locations may be too expensive. What is the

solution?

Build-to-Suit — Benefits Both

Sides

A build-to-suit transaction can be a win-win situation for

landowners and end-users alike. In a build-to-suit, the end-user signs a

long-term lease and the owner of the land pays for the cost of building the new

facility. This type of transaction can be beneficial to both parties for

several reasons.

Tenants receive two primary benefits from participating in a

build-to-suit. First, since the property owner is paying for the cost to build

the new facility, the tenant’s capital expense will be greatly reduced or

eliminated. This allows the tenant to retain its capital, which can then be

used to fund growth. Second, the tenant can sometimes secure a preferred

location that might not be available for sale.

Landowners receive several benefits as well. A vacant lot is

not generating income. In fact, the owner has to absorb holding costs such as

paying real estate taxes. A build-to-suit provides the opportunity of improving

the property and creating a positive income stream. Since most build-to-suits

are structured with a primary lease term of 10 to 15 years, the landowner has

the opportunity to amortize a significant portion of the improvements costs.

Additionally, depreciating the improvements in accordance with IRS standards

provides for tax advantaged income.

Credit is King

The financial strength of the tenant is critically important

in structuring a build-to-suit. Since the property owner is paying for the cost

of constructing the facility specifically for the tenant, the owner wants a

high degree of confidence that the tenant will fulfill all of the terms and

conditions of the lease, the most important of which is paying rent.

Additionally, assuming the owner wants to finance all or a portion of the cost

of construction, the owner’s lender needs to review and approve the tenant’s

credit. Factors such as interest rate, amortization period, and personal

guaranties will be dependent on the tenant’s financial strength. As a general

rule, the more specialized the building, the more critical the tenant’s credit

strength becomes.

Pricing & Structuring The

Deal

Determining the pricing and structure of the deal can be

complicated. It is best to learn as much about the tenant as soon as possible.

Assuming the tenant passes basic credit underwriting, it is time to start formulating

a letter of intent, which addresses basic business issues. It is preferable to

have the owner and tenant agree to the fair value of annual payments for the

land. The next step is to determine the fair rate of return the property owner

should receive on funds spent on design and construction of the building. Once

this rate of return is established, it is time to design the facility and

secure competitive bids. The owner and tenant should be actively involved in

this process. The tenant must recognize that if expensive construction

techniques and finishes are chosen, the cost of the project will be greater,

and the resulting rental rate will be higher. Construction costs typically

included in the total project cost, include architectural, engineering and

impact fees, construction costs, interest fees, bank fees and developer and

brokerage fees. Once the total project costs are determined, the pre-determined

rate of return is applied to the total cost to calculate the rent on the

building. This figure combined with the rent on the land becomes the total

rental payment owned on an annual basis by the tenant. Since most build-to-suit

leases are structured on a net basis, the tenant also will pay for all

operating costs associated with the building, including real estate taxes,

utilities, insurance and maintenance.

Examples in Our Market

Perhaps the most visible examples of build-to-suits locally

are the Eckerd and Walgreens stores seen on most every corner. Many of these

transactions were structured on a build-to-suit basis. Other successfully

negotiated build-to-suits include Frito-Lay, Inc., Fidelity Investment, Bank

One and Sherwin Williams. Participants in build-to-suit transactions are

advised to be familiar with all aspects of the transaction including financing,

construction and leasing. It is essential to have a coordinated team approach

with all parties having clearly defined areas of responsibilities.

A build-to-suit can be the perfect arrangement for both a

property owner and a business. Look for opportunities to let this strategy work

for you.

William V. Gonnering, CCIM, SIOR is a principal with Grubb & Ellis|IPC, a full-service

commercial real estate company serving southwest Florida.