Build-to-Suit Leases in Industrial Real Estate
In the industrial sector, some properties are built by developers for specific tenants under build-to-suit, or BTS, leases. These agreements enable a business to occupy an industrial (or other commercial) asset that is customized for its specific purposes.
What Are Built-to-Suit Leases?
In the industrial real estate sector, it is very common to see properties which are built by developers for specific tenants under build-to-suit, or BTS, leases. These agreements enable a business to occupy an industrial (or other commercial) asset that is customized for its specific purposes, while providing the developer with a stable tenant it can count on for long-term cash flows.
In a BTS agreement, a tenant will typically put out a request for proposal, or RFP, to a number of developers to source various bids in an effort to find a best fit. Once these bids come in, the tenant can compare options to ensure it will find an asset with the right specifications, which encompass a broad range of items including clear heights, truck court sizes, column spacing, land size, and many others. Of course, many of the largest industrial occupiers — think Amazon — may simply leverage existing relationships with property developers to construct something to meet specific needs.
Built-to-Suit Benefits
Build-to-suit leases are generally win-win deals for both the owners and the occupiers. On the tenant side, it reduces financial barriers to getting a new facility. Developing a new asset can be very expensive, but most of the costs — and most of the risk — are borne by the actual developer. This, then, can free up capital to build a business in other ways.
On the developer side, BTS leases can mitigate risk that can be associated with speculative development. While it’s relatively unlikely that a newly constructed distribution center in, say, the Inland Empire would remain vacant long after completion, but with a build-to-suit agreement, a tenant is in place before a single shovel hits the dirt.
Built-to-Suit Drawbacks
Of course, these types of leases come with some level or risks and drawbacks, too, both for tenant and developer. For developers, the main concern is the cost of building the project. With no income coming from a build-to-suit lease until the building is actually delivered, the real estate developer will likely face a loss during the construction phase — and likely for some time afterwards. Another downside can occur further down the road, should the tenant of a built-to-suit property opt not to renew the lease. Depending on the building’s configuration and characteristics, it may be difficult to fill the space.
For the tenants, the main drawback is time. If a company has a more immediate need for space, a build-to-suit agreement may not deliver swiftly enough — after all, the development will likely need to be tailored to certain specifications and then constructed, which could take more than a year, depending on the property. Another potential tenant concern relates to costs. Generally, BTS tenants begin paying rent once an asset is substantially complete, but depending on finalizing work, there could still be a few months when a company is paying rent for a space it cannot yet occupy. Additionally, often tenants may need to put a significant deposit down to guarantee they will honor an agreement.
Financing a Built-to-Suit Development
Many developers use traditional financing vehicles, like a commercial construction loan, to fund a project, often refinancing after completion with a longer-term loan from a bank or credit union, life insurance company, or even a CMBS lender. Additionally, some credit tenant lease and other specialized lenders may be willing to offer construction financing that automatically converts to long-term permanent financing once a property comes online. The more specialized loans tend to offer more advantageous interest rates and longer amortization periods, which can be critical in building cash flow for the developer.
Related Questions
What is a build-to-suit lease in industrial real estate?
A build-to-suit lease in industrial real estate is a long-term contract between a tenant and a developer, in which the developer builds a property specifically for the use of one tenant. Generally, a tenant will locate a developer who is willing to purchase or ground lease land (or already owns land), and is willing to engage in a built-to-suit transaction. However, in some cases, a tenant will purchase land themselves. In this situation, they might finance the construction of a building, sell it to an investor and lease it back from them in a sale-leaseback transaction. In either scenario, built-to-suit leases are generally long term contracts, often lasting between 20 to 30 years or longer. This gives the developer enough time to recoup their initial investment in the development of the property.
Due to the additional time and risk of a built-to-suit transaction, there are additional considerations that must be factored into the process. In particular, potential built-to-suit tenants generally need to have strong financials and great credit in order to qualify (similar to credit tenant leases). Additionally, there will sometimes be significant negotiations between the tenant and the developer as to how the building will be designed and constructed. Tenants will generally want a building to conform to their exact specifications, while developers will want to make sure to limit costs, as well as to ensure that the building’s design is generalized enough that they will be able to rent it to other tenants after the original tenant’s lease expires (or, alternatively, if the original tenant defaults on their lease). However, expectations vary from deal to deal; some tenants may be happy with a basic structure that they will enhance (i.e. a dark shell), while others will want a fully finished interior with high end lighting and expensive floors.
Built-to-suit lease agreements often include the ability for tenants to make change orders, but these will generally need to get the landlord/developer’s approval as to ensure they do not cause unreasonable cost overruns.
What are the advantages of a build-to-suit lease in industrial real estate?
Built-to-suit leases in industrial real estate have a variety of advantages for both tenants and investors/developers. For the tenant, built-to-suit transactions are ideal, because they transfer much of the development risk from the tenant to the developer, freeing up capital that the tenant can use to grow and operate their business. For investors/developers, built-to-suit deals reduce the cost and uncertainty of finding a tenant, as the tenant has already signed a long-term lease on the to-be-developed building.
Additionally, built-to-suit leases often include the ability for tenants to make change orders, but these will generally need to get the landlord/developer’s approval as to ensure they do not cause unreasonable cost overruns.
What are the disadvantages of a build-to-suit lease in industrial real estate?
The main disadvantage of a build-to-suit lease in industrial real estate is that it requires a significant amount of time and risk for both the tenant and the developer. For the tenant, they need to have strong financials and great credit in order to qualify, and there will be significant negotiations between the tenant and the developer as to how the building will be designed and constructed. Additionally, tenants may need to get the landlord/developer’s approval for any change orders to ensure they do not cause unreasonable cost overruns.
Sources:
What are the key considerations when negotiating a build-to-suit lease in industrial real estate?
When negotiating a build-to-suit lease in industrial real estate, there are several key considerations that must be taken into account. Firstly, potential tenants must have strong financials and great credit in order to qualify for the lease. Secondly, there will be significant negotiations between the tenant and the developer as to how the building will be designed and constructed. Tenants will generally want a building to conform to their exact specifications, while developers will want to make sure to limit costs, as well as to ensure that the building’s design is generalized enough that they will be able to rent it to other tenants after the original tenant’s lease expires (or, alternatively, if the original tenant defaults on their lease). Additionally, built-to-suit lease agreements often include the ability for tenants to make change orders, but these will generally need to get the landlord/developer’s approval as to ensure they do not cause unreasonable cost overruns.
In addition to the design and construction considerations, there are also time-related considerations that must be taken into account. In particular, the lease agreement must detail the projected move-in date, as well as the point at which a building is complete enough for the tenant to begin paying rent. Leasing agreements may also include a lease renewal option, which may need to be exercised a certain number of months or years before the end of the initial lease. Finally, certain tenants may want their leasing contract to contain an option to buy the property before their lease is up.
What are the common terms and conditions of a build-to-suit lease in industrial real estate?
In a build-to-suit lease in industrial real estate, the tenant generally needs to have strong financials and great credit in order to qualify. The lease agreement often includes the ability for tenants to make change orders, but these will generally need to get the landlord/developer’s approval as to ensure they do not cause unreasonable cost overruns. The lease is generally long term, often lasting between 20 to 30 years or longer. The process will usually begin with a RFP (request for proposal), in which a tenant requests bids from multiple contractors in order to compare and contrast their options. This will contain various details of the tenant’s desired building, including the size, design, desired move-in date, acceptable rental cost, and other, similar requirements.
What are the financing options for a build-to-suit lease in industrial real estate?
Financing a build-to-suit industrial property can be daunting — and expensive — but there can be less risk for a developer than building speculatively. Most developers tend to finance build-to-suit projects with commercial construction loans from more traditional sources, like a bank, life insurance company, or credit union. However, depending on the strength of the borrower and the tenant, better financing options may be available.
Some specialized lenders offer financing packages that include a construction component followed by a longer-term, permanent loan upon completion. With build-to-suit developments, it is essential to keep your debt service costs as low as you can, for as long as you can. After all, a developer won’t begin collecting rental income until after the building is done. Depending on the leasing contract, it might not be considered “done” until after a tenant completes all necessary tenant improvement, or TI, work.
For more information, please visit industrialproperty.loan/investor-glossary/build-to-suit-leases and industrialproperty.loan/blog/new-jersey-tightens-up.
Not sure which option is best for your project? Looking to get matched with the best financing partners? Fill in your details in the form below — we’re here to help.