In addition to our series about several commercial real estate topics focusing on retail real estate, like our Comprehensive Guide to Triple Net Leases, we’ve put together a set of questions and answers regarding build-to-suit developments.
N3 Real Estate’s retail real estate experts compiled inquiries that clients had regarding build-to-suit development properties and provided answers to help clarify these concepts.
What is Build-to-Suit Development?
For businesses that are looking to expand to new locations, finding real estate and planning the construction of new buildings can tie up a lot of operating capital. This is particularly true for owners of franchise businesses who need to construct similar or identical buildings but in multiple locations. Using a commercial developer to facilitate a build-to-suit arrangement can protect business owners from the pitfalls of trying to manage their own developments by handling all the details, including the purchase of the property. Build-to-suit developments offer business owners and landowners many benefits.
What is a Build-to-Suit Option?
A build-to-suit arrangement is a mutually beneficial and legally binding agreement between a landlord or real estate developer and a lessee or tenant. The landlord takes on the role of the developer and agrees to construct the building according to the tenant’s specifications and the tenant agrees to lease the property from the landlord when the building is complete. Additionally, the landlord buys the land and retains ownership of it throughout the terms of the lease agreement while the tenant pays all property taxes, insurance, and repair and maintenance costs.
Advantages of Using a Build-to-Suit Agreement
A BTS agreement can help business owners and developers in several ways.
- The tenant can continue to invest income toward the growth of the business because the developer provides the money for the land purchase and assumes all the financial responsibilities for the project.
- The tenant has input into the design of the building and can be sure that it is constructed to meet the specific needs of the business.
- The developer can use energy efficient, environmentally friendly, cost-effective materials and up to date technologies to lower the building’s operating and occupancy expenses.
- Rent expenses might be tax deductible. A CPA and an attorney may be needed to provide guidance regarding tax laws.
Franchise owners especially benefit from these arrangements because the development phases are handled for them with no additional financial burdens.
Disadvantages of Build-to-Suit Agreements
A business owner or tenant may be hesitant to enter a build-to-suit arrangement for a few different reasons.
- Long terms leases can be seen as drawbacks unless the renter will have the option to reduce or increase the amount of space designated in the lease. The renter may want to stipulate the ability to increase or decrease payments to the developer as the economy changes and the business grows or fails.
- New construction is expensive and both parties pay for it, the developer by purchasing the land and funding the construction and the renter by compensating the developer by paying a higher lease rate.
- A BTS agreement can take time to fulfill, as much as 24 months or longer depending on the project.
- The tenant must have exemplary credit worthiness to qualify.
- Accurate forecasts of future growth are essential for tenants to be sure that the new property will meet the needs of the business.
In the meantime, the landlord receives a steady monthly income and the security of maintaining ownership of the property.
What is a Reverse Build-to-Suit?
A reverse build-to-suit is like a build-to-suit in that the landlord still buys the land and retains ownership of it, but the tenant fills in the role of the developer. The landlord still pays for the construction but the tenant uses his own real estate and development resources. The end result is the same in that the tenant rents a customized building from the landlord who still owns the building and the property.
How Does a Build-to-Suit Differ from a Sale Leaseback?
A sale leaseback arrangement is perfect for a business owner who does not want to own the property. The tenant acts as the developer in that the tenant buys the land, provides financing, and supervises the construction of the building. After the construction is complete and the business is ready to open, the tenant sells the property to a landlord and moves forward by leasing the property. The main advantage for the tenant is the ability to recoup all expenses and possibly make a profit because the final sale price should be greater than the development costs.
A build-to-suit agreement is different because the tenant never owns the property at any time during the construction process or lease period.
Is a Reverse Build-to-Suit the Same as a Ground Lease?
Basically, a reverse build-to-suit agreement is the same as a ground lease. The only differences are subtle. For example, a ground lease will extend for much longer periods of time and a tenant may be required to demolish all buildings and improvements at the end of the lease.
How Does a Ground Lease Work?
The terms of a ground lease involve mainly the property, hence the term “ground” lease. The property is an undeveloped piece of commercial land that is leased to a tenant typically for decades at a time. The tenant is allowed to build any structures and develop the property as needed for the duration of the lease agreement. In addition to paying for all construction, the tenant is also bound to pay all insurance costs, property taxes, and maintenance expenses. At the end of the lease, the land and everything on it belongs to the landlord and the tenant walks away. In some cases, the tenant is required to demolish all buildings and improvements to ready the property for the next tenant.
Ground leases are beneficial for business owners who can’t or don’t want to buy the property but need the ability to customize their buildings. The arrangement is equally beneficial for landowners because they don’t have to pay for any of the improvements on the property and the land is worth more at the end of the lease than it was at the beginning.
For business owners who don’t want to own property and need to direct their operating capital toward growth and expansion, build-to-suit arrangements can be an ideal solution.