UNDERSTANDING BUILD TO SUIT leases

A build to suit lease is the foundation of every successful build to suit development project. In this guide, we break down the essential elements of a build to suit lease and some of the advantages of this type of commercial real estate transaction. 

 

What is a build to suit lease?

A build to suit lease, in simplest terms, is an agreement between a landlord/developer to build a commercial building that meets specific tenant requirements.

The build to suit process entails all the steps necessary to select, acquire, finance, and lease a property on which the landlord/developer constructs a custom building for the tenant.

Generally, the landlord/developer owns the land and the building built on that property or will acquire land designated by the tenant. The tenant will in turn lease the to-be-constructed building from the landlord/developer.

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What are the components of a build to suit lease?

A build to suit lease has several broad components: 1) the landlord work letter which specifies the work required to be completed by the landlord before the tenant takes possession, 2) other essential lease terms for the build-to-suit portion such as delivery date and further tenant improvement allowance for tenant build-out, and 3) a thorough understanding of post-delivery obligations of landlord and tenant.

Specific elements of a build to suit lease, include but are not limited to the following:

Involved parties
This simply states the names of the involved parties including the tenant, tenant contacts, guarantor, and landlord.

Description of premises
A legal description of the real property upon which the building will be constructed.

Term
A fixed, non-cancelable period for which a lease agreement is in force.

Renewal Options
A renewal option provides the tenant the option, but not the obligation, to renew or extend a lease agreement beyond its initial terms.

Commencement date
The agreed upon date for which rent payments begin. (There is often an association between commencement dates and completion dates that needs to be taken into consideration.)

Rent
As a simple definition, rent is compensation from tenant to landlord for the use of the property and building. In a build to suit, the proposed rent is calculated by the landlord, as for all investments, on a return of and on the landlord’s capital.

Taxes
Taxes are generally paid by the tenant either directly to the taxing authority or as a reimbursement to the landlord.

Use/Restrictions
These clauses typically state the permitted and prohibited uses of the property and address the ramifications if clauses are violated.

Plans/Approvals
One of the most important elements in the build-to-suit lease is the preparation of building plans and specifications for building components and materials.

Maintenance and Repair
Build-to-suit leases generally put the entire burden of maintenance, repair, and replacement on the tenant.

Work Letter
This section or addendum references the specifics of the pre-construction and construction phases of a build to suit.

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What are the advantages of a build to suit lease?

When entering into a build to suit lease, there are a number of advantages for tenants including:

Preservation of capital
Through a build to suit, tenants are able to preserve capital. So, instead of tying up money in slowly appreciating real estate, tenants can use that to help grow their business.

Tax deductions
When leasing a property through a build to suit structure, rent payments are 100% tax deductible.

Flexibility
Whereas owning a commercial property requires a long-term commitment, leasing is limited to the term of the lease. This option offers businesses more opportunity and flexibility to deal with ever-evolving business requirements and market conditions.

Then there is the physical aspect of a build to suit project. The biggest advantage is, as we’ve mentioned and as the name implies, the property is designed and built to suit the specifications of the tenant. Therefore, the tenant has significant input into the design and construction. Ultimately, this approach helps to:

• Maximize space

• Maximize efficiency

• Reduce long-term costs

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How is rent determined in a build to suit lease?

There are a couple of methods used to determine rent in a build to suit development. The first being based on a rate of return applied to overall project costs. This factors in land value/cost plus the estimate of hard and soft costs of construction, current market conditions, and the type of facility. This method allows the tenant to know its rent with certainty at the start of the project and gives the landlord a stated rental on which to base its calculations.

The second method is to calculate rent based on an open-book cost approach, with the final rent calculated as a percentage of the cost of the project. The percentage is multiplied by the total cost of the project, and the result is the annual rent for the initial lease term, subject to negotiated increases over the term.

Due to the fact that the rental rate is based so heavily on construction costs, it is imperative to have established a mutually acceptable budget and detailed scope of work.

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How long is a build to suit lease term?

For the most part, build to suit leases have long terms, often 10 to 20 years or longer. This is because of the specifications of the project and the expenditure required from the landlord/developer. If a project is more specialized, it may become more important for the lease term to be longer in order to fully amortize the landlord’s investment in the property.

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What types of build to suit leases are there?

There are a number of different types of build to suit leases.

Single Net Lease (N)
In this lease, the tenant pays base rent plus a pro-rata share of the building's property tax (meaning a portion of the total bill based on the proportion of total building space leased by the tenant); the landlord covers all other building expenses. The tenant also pays utilities and janitorial services.

Double Net Lease (NN)
A double net lease is a lease agreement in which the tenant is responsible for property taxes and insurance premiums in addition to rent. All exterior and common area maintenance costs remain the responsibility of the landlord.

Triple Net Lease (NNN)
A triple net lease is a lease agreement in which the tenant is responsible for all the expenses of operating the property, including both fixed and variable expenses, as well as rent. The tenant is required to pay the net amount for three types of costs: real estate taxes, building insurance, and common area maintenance. However, the landlord is responsible for structural repairs.

Absolute Net Leases
This type of lease is less common and more rigid than a NNN lease. This type of lease is often referred to as a bondable lease. In this structure, the tenant is responsible for all building expenses, no matter what, including structure and roof. Most often there is confusion between a NNN lease and an absolute net lease. This confusion often occurs when properties are listed or advertised as simple labels, such as triple net or full service. These terms are often commonly used by brokers and landlords, but may often conflict with the actual terms of the lease.

Net leases are usually long-term, generally ten to twenty years with a number of renewal options at fixed or formulae rates.

Build to suit development represents an advantageous, yet sometimes complex commercial real estate endeavor. Build to suit leases are significant commitments, so when it comes to addressing them, it’s important to understand all of your options and ask the right questions.

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What is a reverse build to suit lease?

In a reverse build to suit development, the tenant essentially acts as the developer. The tenant will construct its building upon the landlord's approval and at the landlord’s expense. This method is sometimes preferred by a tenant who has their own real estate and/or construction department but still prefers to lease rather than own real estate. The landlord is typically protected from additional costs, permitting, etc.

With the reverse build to suit lease, both parties benefit from the tenant's experience in constructing virtually the same building in many locations. The tenant has complete control over the construction process and the facility is custom-designed by the user.

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What are the components of a build to suit work letter?

The provisions regarding construction are normally captured in the work letter of the build to suit lease. The work letter is basically an abbreviated construction contract.

Work letters cover issues such as the description of the work to be done in sufficient detail, processes for resolving construction disputes and delays, schedules and timetables, a methodology for determining the cost of construction, and much more.

Listed below are typical components of the work letter in a build-to-suit lease.

Description of Work
This will be a detailed description of the landlord's construction duties and tenant's approval requirement concerning the property.

Representatives
Assigning representatives to manage the design and construction processes is critical to a build to suit development.

Design Phase Schedule
The design phase schedule addresses the receipt of the specifications from the tenant, drawing of space plans, drawing of "final plans", and tenant's acceptance of "final plans".

Construction Phase Schedule
This includes naming the contractors and a detailed breakdown of all phases of the construction process.

Delays
This establishes a way to identify and communicate any circumstances which result in delays, the reason for the delays, and the impact of the delays on the project schedule.

Construction Costs
The involved parties will determine the definition of what items are included in the cost of construction.

Drop Dead Dates
This includes critical dates that need to be defined such as an absolute move-in date or commencement date.

Change Orders
This establishes a procedure for changes in the original, agreed upon scope of work. Change orders initiated by the Tenant are usually made subject to the Landlord’s consent and will be subject to the Landlord’s right to charge the cost of such modification to the Tenant as well as to extend the completion date for the time it takes to implement the change.

Right to Terminate
The parties normally have a right to terminate upon the other party's breach. Many times the right to terminate is linked to liquidated damages.

Liquidated Damages
The involved parties will attempt to set liquidated damages for breaches at various points of the design and construction phases.

Covenants of Landlord Regarding Construction
The work letter usually has covenants of the landlord covering (a) Standards of Construction, (b) Progress Meetings, (c) Inspections, (d) Separate Contracts and (e) Cooperation with Tenant's Contractors.

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What other considerations are there with a build to suit lease?

The following issues, while not always or solely associated with a build to suit lease, also warrant significant consideration.

Commencement vs. Completion Date
As we previously discussed, the commencement date is the agreed upon date for which rent payments are to begin. But build to suit leases often make the distinction between this date and completion date. Because of the construction component, there is an estimated completion date for the project. During construction, a determination must be made that the property is “substantially completed”. At this point, the involved parties may likely convert the completion date into a commencement date causing the term to start.

Purchase Options
Given that build-to-suit projects are generally purpose-built for the original tenant, the tenant may seek options to purchase the property at some point during the term of the lease, a right to be first to the table in the event of a proposed sale. 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.

Warranty Items
A build to suit lease should also address the allocation of risk and responsibilities for the costs of defects covered under warranty or due to faulty design or construction.

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