Goldilocks and the Three Development Models


Imagine you need new or better space and nothing suitable exists in the market currently.  You decide the best thing to do is have a building built that fits your specific needs.  How should you structure such a transaction to ensure the best pricing, the least amount of risk and the best developer/tenant relationship?  There are three main ways to structure such a transaction; each with its own risks and benefits.  Unfortunately businesses don’t live in the land of make believe and, unlike Goldilocks, they don’t have the luxury of sampling each alternative before determining which structure is just right.

The “Trust Me” model.  Most developers promote this model as it allows them to sell the dream with few details, little up front effort or cost and lots of upside for them.  Typically a developer has control of a building site and they are waiting for a tenant to express interest before getting too far down the path with project design.  Under applicable zoning and land use codes, they know how much space they can build, how big of a building footprint they can handle, relative parking requirements and so forth, but the actual design is left open so the ultimate tenant can have some say in the matter.  In many instances the developer has commissioned some pretty schematic renderings of what a building could look like and has some basic specifications that reflect the relative quality of the proposed building.  Based on this scant information, the developer markets the property to potential end users with a quoted rental rate.

While this approach is helpful to tenants in assessing relative cost and whether they are buying a Chevy or a BMW, there are lots of holes in this approach and many dangers.  Assume that the tenant likes the building generally described by the developer and the quoted rent is in the tenant’s ballpark budget.  Since the building is not fully designed or specified (and probably won’t be at the time the lease is executed), how can the tenant get any level of comfort as to what it is buying and what the final cost will be?  It’s like asking a builder if they can build you a house for $750,000.  Would you be comfortable if the builder simply said “yes”?  What if the builder said, “Yes, I can build you a four bedroom, three bath house which is three stories and 3,500sf?”  Would that be sufficient detail for you to proceed on a contract?  Luckily for many buyers of new homes (especially when dealing with large builders), there are model homes and fully developed plans and finish schedules so they have a very good sense as to what they are signing on for.  However, with buildings, there are rarely existing clones or fully developed plans. As a result, this model is inherently risky.

When tenants agree to a rental rate on an as yet undefined project, there is immediately a tension that is created between the developer and the tenant.  The developer is now incented to try and include as little as possible in the building for the agreed upon rental rate and the tenant wants as much as possible included in the building for that same rate.  This tension becomes particularly clear in the demarcation between where the landlord’s base building work ends (paid for by the landlord and covered by the rent) and the tenant’s leasehold improvements begin (paid for by the tenant). In a typical commercial lease deal, the landlord provides the tenant with a cash improvement allowance which the tenant uses to help defray the cost of building out its premises to its specific needs (as opposed to the building shell provided by the landlord).  However, if the tenant is the only occupant of the building, what is considered base building work and what is considered tenant specific work which must now be funded by the tenant?  Is the landlord providing an upgraded lobby area, internal staircase, restrooms and venting for the new cafeteria within the agreed upon rent number or are these outside the rent and, therefore, the tenant’s responsibility?  Will the landlord be supplying horizontal distribution of the HVAC ductwork within the premises and variable air volume boxes and controls to distribute and control the flow of air as part of the base building or is this all on the tenant?  There can be upwards of $25/sf at stake in this definition of base building work alone.

Unless the project is clearly defined with plans and specifications or by reference to another similar building, the tenant is fully exposed in this model when the lease is signed.  In essence, the developer is saying “I’m going to build you something great, just trust me.”  Goldilocks might say this approach is too adversarial.

The “I’ll build you whatever you want ” model.  Here the developer and the tenant acknowledge that the building is undefined and, therefore, no price tag can be put on the rent when the lease is signed.  Instead, the developer agrees to build whatever the tenant wants but the rent will ultimately be determined based on what it ultimately costs to build.  Typically the rent will be driven by an agreed upon formula which is tied to the actual cost of the project, the developer’s blended cost of capital (i.e., both cost of debt and equity), customary lender underwriting requirements (i.e., a debt service coverage ratio and a loan to value ratio) and some assumed amortization period for the improvements.  In some cases, in order to simplify things, these factors are all boiled down into a negotiated “Lease Constant”, defined as some percentage (i.e., the rent will equal the final documented Total Project Cost multiplied by X%).  This approach provides the tenant with the flexibility to get what it really wants and eliminates much of the developer/tenant tension in the “Trust Me” model above. But it comes at a hefty price:  uncertainty as to the ultimate cost of the project at the time it commits to going forward and uncertainty as to what the tenant’s budget will buy.

Imagine being the CEO of a company and asking your Board to approve a headquarters move but you’re not sure what it’s going to cost or what you’re actually going to get and you really won’t know for sure for another two years or so.  This would be very difficult for many CEOs and boards to stomach.

Assuming the company can get comfortable with the uncertainty, this approach provides the ultimate flexibility for them.  Within reason, the developer will build what the tenant wants and the rent will reflect the cost.  Sounds simple right?  Unfortunately, it’s not that easy.  The landlord will want some control over what it is developing as it has to be concerned with the residual value and remarketing potential of the building after the lease expires if the tenant moves (or goes out of business). Thus, it may want features incorporated into the building which make it more suitable for multiple tenants in the future. It may also balk at very high end finishes or architectural details which are unique to this tenant but of no value to other tenants. In this case, the developer may either veto certain design elements or accelerate the depreciation schedule on them so that the costs are fully amortized over the lease term (as opposed to amortizing them over a 25-30 year life as is typical of more generic base building work).

A further problem involves cost containment. Once the tenant commits to the developer, the tenant is at the developer’s mercy to efficiently design, bid and construct the structure.  If it is getting rent on every dollar it spends, what incentive does the developer have to be cost effective?   In addition, there are certain costs which are not bid out and are controlled by the developer. These need to be negotiated up front including: the land cost, the developer’s fee, the cost of any work performed by the developer’s employees or affiliates which is not being bid out, project administration handled by the developer’s in house team and any markup for overhead and profit if the developer is acting as the general contractor.  Finally, what costs should not be included in the rent?  What if the developer discovers excessive rock beneath the building, previously unknown hazardous materials that need to be remediated or the developer needs to expend money to correct defective work performed by a bad subcontractor?  Certain costs should be the developer’s risk not the tenant’s.

Although this model sounds simple at first blush, it is not without its complications and risks.  To proceed on this basis requires a lot of discipline and a lot of checks and balances in the lease document. It also requires a lot of faith in the design team to be able to come up with a project that satisfies the tenant’s needs while also remaining true to an established budget.  Goldilocks may well conclude that this model is too uncertain to be a comfortable fit.

The Hybrid model.  The foregoing structures represent the two extremes in a situation where the building is not yet designed yet the tenant needs to make a decision.  Many variations of these two alternatives exist and components of each structure can be combined to create a hybrid approach.  In the ideal scenario for a build to suit, the deal structure and lease should include the following key components:

1.       The essence of the building should be described in the Lease by schematic drawings, specifications, or references to other, similar buildings constructed by the developer with an exhibit that identifies material deviations from the comparison building.

2.      The Lease should include an estimated project budget for the building, provided by the developer, based on his contemplated base building.  This, combined with number 1 above, will help define for the tenant whether it is getting (and whether the developer is committing to build) a Chevy or a BMW and provide some early indication as to the ballpark rent.

3.      If time permits, the tenant should have its design team (including engineering professionals) scrub the items in 1 and 2 to make sure the quality and scope is acceptable for the tenant’s needs and expectations.

4.      A specific description of where the landlord’s work ends and the tenant’s work begins so the tenant can establish a realistic capital budget.

5.      Provisions which ensure that the work will be competitively bid to multiple contractors and/or subcontractors with guaranteed involvement by the tenant and its project managers.

6.      Clear definitions of and agreed pricing for project components and work controlled by the developer (i.e., land cost, developer fees, profit).

7.      A lease constant to be applied to the bid project costs in deriving the rent.  At a minimum, this constant can be used to price change orders that impact pricing after the lease is signed.

8.      A critical path schedule that ensures that things move at the pace necessary to achieve the tenant’s move date so that problems are identified and addressed before it gets too late.

9.     Adequate remedies to put teeth in the obligations of the developer/landlord. Without effective remedies, the parties’ respective covenants in a lease document are merely empty promises.  Remedies can include self help, liquidated damages and even termination.

Structuring a lease for a new building is not for the faint of heart.  In our region, few are executed; probably because few people know how to handle them.  As our existing stock of commercial buildings continues to age, it is likely that more companies will find they want something newer or something that uniquely addresses their specific needs.  Therefore, tenants need to be aware of how to handle these types of transactions.  Only by being an educated consumer can a tenant create a structure that “is just right”.

For more information contact Glenn Blumenfeld

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