In most cases when a business owner or company is looking for commercial space for lease they can typically find space in an existing commercial property within their desired location. However, there are situations where a tenant has very specific needs that existing properties are not able to accommodate, or there is not any available space in the location they want to be in. In those instances they can do what is called a build to suit, as long as they can find a piece of land and a developer that is willing and able to work with them.
Most businesses don't have the knowledge or capital to buy land and build their own free standing building so build to suit leases can be the perfect solution whether they need office space, retail space, or industrial space. Below is an overview of a build to suit lease as well as the pros and cons of this time of arrangement.
What is a Build to Suit Lease?
A build to suit lease is a type of commercial lease agreement whereby a landlord/developer will design & construct a commercial building specific to a tenants needs & requirements, and in return the tenant agrees to lease the property upon its completion from the developer for a lease term typically ranging 10 to 20 years.
In a build to suit property typically the landlord/developer either already owns the land or will purchase land as directed by the tenant. Preliminary plans are created so that estimated construction project costs can be determined and the two parties can then negotiate the the lease terms and pricing. After the involved parties finalize negotiations the tenant will sign the lease contract for the to be constructed building. The land purchase and total construction costs are financed by the developer and receives income from the tenant in the form of monthly lease payments after the property improvements are substantially completed.
Types of Build to Suite Commercial Real Estate Properties
Build to suits are done with every type of commercial property. In most cases a company has VERY specific needs that most existing buildings are not able to accommodate, or they have to be in a certain location where there are not currently any options for them to rent or buy.
- Build-to-suit office for rent
- Build-to-suit store for rent
- Build-to-suit medical office space
- Build-to-suit industrial space
How Long a Lease Do Tenants Typically Have to Commit To in a Build to Suit?
Tenants typically have to commit to at least a 10-20 year lease. The reason is that most build-to-suits are in freestanding buildings are are custom to each tenant. The custom features of the building may not work well for other tenants if the original tenant moved out, renovating to accommodate another commercial use would be costly. Also the the developer is taking a huge financial risk that takes more than a typical 5 year lease to recoup the initial investment.
What Type of Lease is a Build to Suit?
They are typically triple net (NNN) leases. This means that in addition to base rent payments, the tenant will also be responsible for the property taxes, insurance premiums, and maintenance & repair charges.
Build to Suit Advantages for Tenants
The biggest advantage for tenants in a build to suit lease is that they get a space that is customized to their exact requirements. If there is no available inventory or if no property will perfectly suit a tenants needs then a developer can build out a commercial property that meets their ideal size, configuration, and other tenant's specifications.
Preservation of Capital
Rather than tie up capital in commercial real estate assets the tenant can use that money to continue investing in and growing the business. Buying land and building construction is expensive and requires a huge initial investment as well as other building expenses such as real estate taxes, building insurance, and maintenance.
In a build to suit lease payments paid by the tenant are typically 100% tax deductible as a business expense. We always suggest you check with your CPA to confirm as the taxing authority changes rules all the time.
Rather than having to lease a commercial space in an old building that has been around for an extended period commercial tenants get to enjoy a brand new building, with modern equipment and infrastructure , within a mutually acceptable budget and commencement date.
How Does The Build to Suit Lease Process Work?
- The build to suit process entails by first selecting the property, typically in collaboration with the developer. Most developers already own or know of land that the tenant can choose from or the tenant can search on their own for land in their desired area.
- After discussions with the tenant and tenant's space planners about the scope of work the developer can get preliminary estimates to determine the total cost of construction which would include land costs, site improvements/entitlements, hard and soft costs, etc.
- From there the developer and tenant can negotiate how much the rent will be, length of the lease term, commencement date, etc.
- Once everything is agreed on the developer can finalize building plans, obtain permits, and start construction.
How is Rent Determined in A Build to Suit Lease?
There are a couple of ways to determine rent in a build to suit lease.
The first being based on a desired percentage return applied to the overall cost of the project. Total costs will include the land purchase/value plus the hard and soft construction components, market conditions, and type of commercial property. This allows the tenant to know their rent with certainty from the beginning of the project. It also gives the landlord a known rental to base his calculations. The tenants credit rating and the lease term are also considered when determining the final rent price.
- Example of percentage return – The developers total construction equal $3 million and they wish to receive an 8% return. Multiply 8% x $3M and you get $240,000 of rent per year or $20,000 per month.
The second method uses an open-book cost approach to calculate rent. The final rent is calculated as a percentage from the project's cost. This percentage is multiplied with the total cost of project to get the annual rent for the initial lease term. Negotiable increases can be made over the term.
Construction costs primarily dictate the rental rate so it's important that the tenant and developer agree on a detailed scope of work and acceptable budget.
Components of the Build to Suit that Must Be Negotiated
It's important that the Tenant understand what the landlord will be responsible for and what the tenant will be responsible for. Do not do this verbally. This must all be in writing starting with a letter of intent and work letter that outlines the scope of work and construction process. Then once all the basic components are agreed to a lease agreement will be drafted and the Tenant's broker and attorney should review and negotiate comments as necessary.
Below are some of the items to be negotiated:
Who is the Tenant and the property owner? The tenant entity name is typically the one that financials were shown for unless there is a guarantor other than the name of the tenant. Commercial developers will typically have an entity name created for each property they own.
The legal description of the property both the land and the building
The number of years of the lease contract
Describes the proposed rent that the tenant will pay to landlord
These are the taxes, insurance, and maintenance that the tenant will be responsible for.
Rent Commencement Date
The date in which the tenant starts paying rent.
Defines how many parking spaces the tenant will get to use.
This shall give the tenant the option, not the obligation, to renew the lease beyond the initial term. Rates can be pre-negotiated or based on fair market rates at the time of the renewal.
Maintenance & Repairs
Are typically further discussed in the lease contract however it's always wise to determine who is responsible for what as early as possible.
Scope of Work / Work Letter
It's important that both parties understand in detail the the construction component, project schedule, construction date, timely completion, and other significant commitments. Very detailed description from the tenant's perspective and what the landlord covers. Who will be the points of contact for the landlord, tenant, architect, contractors? What is the design process and methodology for tenant approval? What is the process for resolving delays and change orders? What will be warrantied?
What is a Reverse Build to Suit Lease?
There are situations where the tenant wants to have full control of the design and build process since they have very experienced staff and have already done so multiple markets. In this situation the tenant acts as the developer by constructing a building for itself using funds primarily provided by the landlord. Upon completion the tenant leases the building for a long term typically 10-20 years. This method is typically preferred by tenants who have their own real estate and/or construction departments but still prefers to lease vs own commercial real estate. Since the tenant has experience doing this many times in other markets landlords are more comfortable with them being in complete control of the process.
Final Words About Build to Suit Leases
If after conducting an extensive commercial real estate search prospective tenant are not able to find available space in a desired location or if the existing options do not meet the needs then build to suit projects can be great alternatives. Companies can get a brand new, customized property with modern equipment, with minimal upfront cash, which frees up more money to invest and scale the business.