|August 5, 2014|
Previously published on August 4, 2014
A Solution to the Problem of Rent, Schedule and Design Control
A build-to-suit (BTS) project often puts the corporate real estate department in a challenging position. The project must conform to an approved budget, while also facing a very tight schedule with a series of milestones that must be met in a perfectly orchestrated fashion. To meet the Project Schedule, the project must move forward even before the building is designed or a rental rate is set. The sooner the tenant can bring its developer partner on board, the better the chances for success.
Rent is always a key concern. The tenant favors certainty and wants to know what its rent will be. But a developer will not agree to a fixed rent until all project costs have been determined. This cannot be done until the land is selected, the building has been designed and priced, and site improvement and infrastructure costs have been determined. Also, if the tenant insists on rent certainty, it will not be able to select its developer partner until the project is fully designed and priced so that multiple developers can bid based on a fixed rent.
Project design not only impacts the rent and the Project Schedule, it also raises the issue of design control. While the tenant has a notion of the desired project, the plans and specifications are likely very preliminary. Perhaps the site, which impacts building design, has not even been selected. The tenant feels it owns the project and can make design decisions as the project progresses. On the other hand, the developer partner will also feel that it owns the project and will expect design control. If the building is not “market standard,” but is unique or high cost due to tenant’s specialized design, the building will be less attractive for investors and future users.
Rent, schedule and design control create an inherent tension in a BTS lease. The tenant should not expect the developer to fix a rent for a building that is not yet designed, but the deal structure should assure the tenant that it will get a fair rent. The developer cannot expect the tenant to cede all influence over building design, but a tenant has to respect the developer’s fundamental interest in the project design. If the developer is not selected until the building is designed and the project is priced, the desired schedule will not be achieved and the tenant will not have the assistance of its developer partner during the crucial design and pricing stages.
Use of the Rent Constant pricing approach to determine the initial annual rent relieves this inherent tension in a BTS lease. In this structure, the developer and tenant agree on a factor (Rent Constant or sometimes called a Lease Constant) to be multiplied by the total development cost of the project (Rental Base) to determine the initial annual rent. For example, if the Rent Constant is 9% and the Rental Base is $10,000,000, then the initial rent would be $900,000.
The developer will propose a Rent Constant based on multiple factors including credit of the tenant, current interest rates, geographic market, type of building, lease term, annual rent escalations, and special lease provisions such as early termination or expansion rights. If tenant credit is investment grade, the building is generic or market standard and in a good location, the Rent Constant will be lower. If the building is specialized, the lease term is short, or the tenant has early termination rights, the Rent Constant will be higher. For a tenant selecting a developer, the Rent Constant can be a point of competition among prospective developers. This approach also allows for earlier selection of the developer partner so that the tenant can get the benefit of the developer’s expertise as soon as possible.
The Rental Base will include all hard and soft costs for the development of the project including land, site improvements, design, building construction, and construction financing. The Rental Base will also include a developer’s fee and an amount for contingency. The amount of the developer’s fee and the amount and use of contingency can also be points of competition among prospective developers.
The Rent Constant approach may seem risky to a tenant focused on a fixed rental rate. What if costs go up making the rent higher than expected? But the reality is that the developer will not accept cost risk unless the project is fully designed and the developer has received final construction pricing. The process of waiting for final design, final construction pricing, and then a final rent number could delay the project for months, making completion on schedule impossible. Also, once the developer fixes its rental rate, the tenant will no longer have the right to influence the design of the project. Finally, a fixed rent lease will create a more adversarial relationship between tenant and its developer partner as cost and design issues inevitably arise. A collaborative approach where the developer and the tenant work together to address pricing and design issues as early as possible is much preferred.
The Rent Constant approach yields multiple benefits to the tenant and the tenant need not accept unlimited rent risk. Rather, costs can be controlled by forcing developers to bid on the Rent Constant, their development fee and the budgeted contingency. The BTS documents should require that a competitive bidding process be used for each contractor in an “open book” approach, allowing both the tenant and developer to have some control over contractor selection and pricing. Once construction pricing is finally established, the risk of contractor default and construction completion can be shifted to the developer and the general contractor. The Rent Constant approach allows the tenant meaningful influence over building design. Finally, the tenant can select its developer partner before the building is designed and even before final site selection is made, so that the tenant benefits from the developer’s expertise early, when it is most needed. Early selection of the developer helps the tenant achieve timely completion of the project.
While no single approach is right for all build-to-suit transactions, I encourage tenants to consider the Rent Constant approach because it gives them fair pricing, the ability to influence design and the best chance for on-time completion. It also allows for earlier developer selection, enabling better use of their developer’s expertise and creates a more collaborative relationship with their developer partner.