- Laying the Foundation for a Build-to-Suit Lease
- December 4, 2012 | Authors: Natalia Iamundo; Savvas Kotsopoulos
- Law Firm: Miller Thomson LLP - Toronto Office
A build-to-suit (or design-build) lease is essentially a landlord/developer’s agreement to construct a purpose built building, usually for a single tenant. The landlord will typically own or ground lease the lands (and once constructed, the building) and has the option of re-letting the building to a new tenant upon the expiry of the term of the build-to-suit lease to the original tenant. Build-to-suit leases typically are for a longer term than a normal lease in order to permit the landlord to recoup its investment over the duration of the lease term.
A build-to-suit arrangement is essentially comprised of two agreements: (i) a development or construction agreement, the result of a request for proposal ("RFP") process, which defines the relationship between the landlord and tenant from the design through to the construction of the building; and (ii) a lease agreement, which stipulates the terms of the occupancy post-construction. In some cases, the provisions regarding the construction of the building are included in the lease itself or captured in an accompanying "work letter". The construction aspect of this arrangement is usually the key issue and the most complicated, warranting close attention to the landlord’s and the tenant’s responsibilities in this regard.
Given the interplay of traditional lease issues with design, construction, timing and financing concerns associated with making a project a reality, build-to-suit leases present a unique set of obstacles that parties must face and which require careful drafting and attention. This article highlights some of the key issues to be considered in this respect.
A build-to-suit lease has the potential to bind the landlord and tenant for an extended period of time and the design-build process is typically a lengthy process requiring significant commitments of capital, time and effort by each of the parties at the outset. Accordingly, the question as to the exact role each party will play warrants more than a superficial evaluation. A landlord will need to carefully evaluate the credit-worthiness of the tenant and be cognizant of the nature of the tenant’s business and its specific needs to help guide the design and construction of the building. Quite often such analysis will result in the landlord requiring a parent guarantee and/or cash security for the tenant’s obligations under the build-to-suit agreements. From a tenant’s perspective (and as part of the RFP response process), it should assess whether the landlord has the expertise and financial wherewithal to deliver the building within the required time period and as specified. Much of this will be contingent upon evaluating the landlord’s previous build-to-suit experience, local and industry reputation and organizational structure. In some cases (where, for instance, there is a significant tenant improvement allowance payable by the landlord or where the landlord is a special purpose entity), it may be appropriate for the tenant to require the guarantee of a parent entity, the securitization of an amount owing via a letter of credit and/or self-help/set-off remedies. Who will finance the project and on what terms also merits some analysis. A construction lender will likely have its own requirements with respect to the project and will introduce its own parties, such as inspectors, insurers and guarantors, into the mix.
The landlord and tenant will also each want to weigh in on the selection of the architects, contractors, and engineers for the project and competing priorities will need to be balanced. A landlord will want to ensure that the design of the building allows for a lease to a new tenant upon the expiry of the term, while a tenant will want the design to best suit its particular needs. The choice of contractor is also important, with factors such as experience, existing relationships with the developer, reputation, and the bid amount weighing differently for the landlord and the tenant.
Designing, Describing and Allocating the Work
A build-to-suit project typically starts with an RFP in which the tenant sets forth its projected needs and seeks presentations from a number of developers. The RFP will usually set out the types of uses, amount of space required, timeline for occupancy, range of acceptable rent, general design parameters and other specifics that the tenant wants addressed in the RFP response. Once the successful proposal is selected, the lease negotiations begin in earnest and the landlord and its architects will begin to exchange design plans and specifications with the tenant’s space planners and construction consultants. The landlord and tenant may very well envision the finished project differently, in that the tenant will want the design to perfectly suit its needs, while the landlord will try to balance the tenant’s requirements with the necessity of designing a building where the construction costs are financeable and such that the building is capable of being leased to as wide a market as possible once the initial tenancy has ended. Given that the design specifications and parameters are of critical importance in establishing the cost of the project, the rent and the timing for completion thereof, it is important to provide as much detail as possible in the build-to-suit agreements as to the known aspects of the design and the work to be completed. Similarly, there also should be a detailed description of the parties’ construction duties and approval requirements concerning the premises to be built and the allocation of obligations (for example, will the landlord fit-out the premises to a "turn-key" specification or is the landlord simply providing a "cold dark shell"?).
A commonly-encountered issue in a build-to-suit lease is the natural tension between multiple contractors in the same building. Most timetables will require that the tenant improvement contractor is working in the building at the same time as the general contractor is putting the finishing touches on the base building. The practical concern centres around meeting the needs of two contractors simultaneously and balancing their demands for the overall benefit and completion of the project in a timely manner. To address this, many landlords will suggest that the tenant avoid this issue altogether by contracting with the landlord for the construction of the tenant improvements or with its contractor directly.
Timing for performance is a critical issue in a build-to-suit lease and a timetable with clearly identified deliverables is imperative and must be incorporated into the agreements. Usually the parties will establish a fixed move-in date (often motivated by the tenant’s need to move out of its existing premises by a date certain) from which all players involved must work backward and harmonize their deliverables. The timeline will likely include milestones for the design, construction, and occupancy phases around which a schedule will be built, such as securing of financing and permits, ground breaking, pouring of the foundation and completion of the structural steel.
Since so much hinges on whether the project can be completed on time, the parties must consider what will happen if there are delays. From a tenant's perspective, it is important to have the right to walk away from the project if it becomes apparent that the project is not financeable, that obtaining permits is unduly problematic, or that the project will otherwise be significantly off-schedule. Conversely, the landlord will seek to limit this right to narrow circumstances, particularly after construction has reached a critical point. One approach to balance these competing concerns is to tie the termination right to delays in meeting certain critical milestone dates in the project schedule, including an outside date for the substantial completion of the project itself. Nevertheless, after a certain point, walking away from the project will not be a practical or satisfactory remedy for a tenant where it is faced with the prospect of very few, if any, suitable occupancy alternatives and significant business interruption losses as a result of the delays. As a result, tenants will often seek to fix liquidated damages amounts for delays that will make any delay very uncomfortable for the landlord and incentivize timely completion. The enforceability of liquidated damages can be a thorny issue and accordingly where the actual damages are very difficult to estimate, the parties will need to carefully consider the quantum and the factors influencing same. In addition, the tenant may seek the right to take over the work itself (including an assignment of construction contracts) and set-off the costs of completion against the rent that would be due under the lease, although the practical application of this remedy has significant real world limitations. The practical inadequacy of these remedies for the tenant underscores the importance of undertaking a thorough program of legal and business due diligence very early on (and ideally as part of the RFP response analysis) so as to assess as thoroughly as possible any risk factors that could impact the project timelines.
Another key timing concept is establishing the date on which the building is sufficiently complete so as to trigger, amongst other things, the commencement of the payment of rent (or rent free periods, as the case may be). This date is typically described in build-to-suit leases as the date of "substantial completion" or "substantial performance", frequently with reference to the provisions for determining substantial performance set out in the Construction Lien Act (Ontario). While the landlord will want a definition broad enough to oblige the tenant to move in and start paying rent despite some incomplete details, the tenant will want to ensure that such details are minor and will not interfere with its occupation in any material respect. In order to balance this disparity in approach and avoid potential problems, the aforesaid provisions of the Construction Lien Act (Ontario) may need to be supplemented with greater specificity.
Basic rent calculations for build-to-suit leases involve different considerations than do leases of constructed premises where the basic rental rate can be easily fixed at the commencement of negotiations. Such basic rental rate will often be calculated based on a stated rate of return on imputed land value plus a reasonable estimate of the hard and soft costs of construction incurred by the landlord. In some cases, the basic rental rate may be subject to adjustment based on actual construction costs (subject to agreed upon construction budgets set out in a guaranteed maximum price contract and accepted change orders). Should the tenant seek to retain the fixed rate of basic rent as initially negotiated and resist any of the landlord’s attempts to adjust it, it is imperative to have established a mutually acceptable budget and detailed scope of work. This ensures the tenant is receiving a building of a specification and value which is proportionate to the basic rent that has been fixed and agreed to at the outset.
The requirements of each of the tenant and the landlord to make changes to the approved construction documents must be balanced. Typically, this will include a right in favour of the landlord to approve any change orders submitted by the tenant, particularly if they will result in cost increases, in which case the landlord will seek to have the tenant pay for such costs. Similarly, the tenant will want to reserve the right to approve any changes proposed by the landlord which alter in any material respect the proposed development and/or which could, amongst other things, have a negative impact on the timing for completion of the project.
Other Lease Considerations
Although not unique to build-to-suit leases, the following issues and concepts also warrant particular consideration in this context and should be considered carefully:
Commencement vs. Construction Date: Build to suit lease forms often make the distinction between “construction” and “commencement” dates. While the landlord may seek a steadfast commencement date so that the commencement date for the payment of rent is established at the outset, a tenant would be wise to defer any payment of rent until the project has been substantially constructed.
Tenant Rights re: Purchase: Given that build-to-suit projects are generally purpose built for the original tenant, such tenant may seek options in its favour to purchase the project at some point during the term of the lease, a right to be first to the table in the event of a proposed sale (a right of first offer), and/or a right to match an offer received by the landlord from a third party for a proposed purchase (a right of first refusal). Establishing these rights in favour of the tenant will typically require that a balance be struck such that the tenant has the benefit of some or all of these options without unduly limiting the landlord’s ability to deal with the project and get the best price in the market. 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.
Space Mitigation Strategies: Where the project is part of an existing commercial park, the needs of the tenant for expansion flexibility into adjacent buildings and, alternatively, exit and space mitigation strategies (in particular, flexibility in larger buildings to sub-demise and sublet excess space) should be addressed.
Warranty Items: Allocation of risk and the responsibilities for the costs of defects or deficiencies covered under warranty or which result due to faulty design, construction or defect should be expressly addressed in the lease, including as part of the landlord’s and tenant’s repair and maintenance obligations and the operating cost recovery provisions.