Speculative Building and Build to Suit Leasing

We are well into one of those hot cycles in the Seattle commercial real estate market where it may make sense to develop a spec project. Obviously, your ultimate goal is to turn a speculative building into a build-to-suit lease and/or a fully occupied building. What factors should you consider, and what are the benefits of spec building? Some benefits are as follows:

  • It may make sense to target a specific user, or category of user, e.g., an Amazon distribution center or warehouse
  • There may be limited competition to build spec, or there may not be sufficient established product to handle large users in the market
  • Location—if you have the perfect undeveloped or redevelopment site, then build it and they will surely come
  • For tenants, you get to design your space just as you like, and you also get a building with new “bones,” which should keep operating expenses lower

Certainly there are also significant risks with spec building, including the fact that the market could turn and/or become oversaturated with supply. Figures from CBRE’s research department tell us there are currently 6.6 million square feet under construction in downtown Seattle—2 million is Amazon space, 1.6 million is pre-leased, and 3 million is pure spec building at the moment. Additionally, permitting could take too long and you could miss the cycle. Or your target good-credit anchor tenant could turn out like Circuit City and go out of business in an economic downturn.

So given these risks and an uncertain future, what are some of the important things to keep in mind before embarking on a speculative building and/or a build-to-suit lease development project?

  • Know the market. Talk to brokers, other developers, potential tenants, designers, contractors, lenders, and other professionals in the market to determine what is really happening in the market. How long are their backlogs, and what do they forecast?
  • Determine what kind of financing will be available, and also what percentage of pre-leasing will be required by your potential lenders
  • Engage your design team early, and plan your acquisition, permitting, feasibility, construction, delivery and leasing schedules in detail. Also work with your design team to prepare your permit application. Get your project submitted under current building codes under the vested rights doctrine
  • Identify your construction team early. Many general contractors and developers tell us they have trouble finding the right talent and the right trades and subcontractors to execute in such a hot market

Then, when you identify that anchor tenant to make it a build-to-suit project, spend more time on the Letter of Intent than you usually would, and include more items than you normally would. You should negotiate at least the following deal points in your Letter of Intent:

  • Be precise regarding termination/cancellation rights, and make sure such rights are consistent among your several contracts or agreements—your loan term sheet, your construction and design contracts, and your letters of intent for tenant leases. If you have to pull the plug or postpone the project for any reason, you want to minimize your financial exposure to all parties
  • Develop a solid change order process, or identify some contingencies or options for potential addition, because the project may change, or the target tenants may change, as the economy and the market evolves over the next 2-3 years. If your tenant is considering certain amenities, specify them and also a timeline for deciding on these options
  • Make sure you have approval rights regarding subcontractors, and that your general contractor requires stringent insurance obligations for subcontractors, including additional insured status for the Owner
  • Be sure all contracts are assignable, as any lender will likely require this, and it would be essential if you were able to sell the property/project mid-stream.
  • Delivery Standards—Make sure they are addressed in your construction and design contracts so there are no inconsistencies with respect to your leases.
  • Delivery Dates—Define factors that constitute a delay and impact substantial completion. Be precise regarding rent commencement and rent abatement periods that will hinge on these delivery dates.
  • Consider flexibility with Tenant’s financial incentives package—Can the TI Allowance be used for other purposes, such as converting to free rent?
  • Parking and Signage—both may be important to negotiate in the LOI due to local regulations
  • LEED considerations—Set the LEED standard. Most tenants are impressed with this, especially smaller tenants who will help you round out your building
  • Assume confidentiality will be important, particularly to potential tech-related tenants
  • Use clause parameters will also be important—be as specific as possible as the nature of your tech tenant’s business may change in a short time period
  • Rules and Regulations—You will need to make sure that you are protecting potential neighboring and future tenants and common areas if your anchor tenant is only taking half of your building.
  • If the Tenant wants to manage its own tenant improvements, be specific about delivery and handoff issues, overlapping work, and access issues
  • Re-measurement of premises upon completion will be important. Have a clear process for this, as the square footage may turn out differently from your LOI rent projections

More and more, the LOI is becoming the most important document in this process. Even though it is legally non-binding, it still represents the business deal. You don’t want to be on the eve of lease execution, lack leverage, request an important item, and have the other party tell you, “We did not agree to that in the LOI, so we are not going to do so now.” Speculative building can be very remunerative if your timing is right, but there are obviously many things to think about first.

John McDowall chairs the Business Group and co-chairs the Real Estate Group at Carney Badley Spellman. His practice focuses on lease, loan, and purchase and sale transactions. He recently spoke at the annual Law Seminars International Seattle Commercial Leasing seminar on the topic of Speculative Building and Build to Suit Leasing. The foregoing is a summary of his presentation at that seminar.

Lease Option Terms Are Worth Paying Attention To In Letters Of Intent

An experienced commercial real estate broker once asked me, “Is there really much to negotiate in these lease agreements other than the operating costs?” Of course, the answer is “yes,” but his point was not lost on me. To wit: “You lawyers should not screw up our deal with a bunch of wordsmithing and should focus on the items that have an actual monetary impact to the client.”

Our firm frequently negotiates leases for both landlords and tenants in various contexts and industries, and lately I have seen a few interesting trends in one of the most often overlooked provisions of a lease and the letter of intent—the renewal options, and specifically the methods for determining fair market rent for renewal terms.

Landlords have become more sophisticated in attempting to set the market in advance, so as to minimize negotiations and down-side risk when a renewal term strikes. Probably the best way for landlords to do this is to narrow the market of “comparable” properties. Some downtown Seattle landlords with low vacancy specifically define the Class A buildings that are a “comparable” property in the Central Business District (“CBD”). Obviously, the market has evolved over the last several years thanks to Amazon—there are now Class A buildings at the north end of the CBD; conversely, some buildings at the south end of the CBD are no longer considered Class A.

We have also seen this in retail or restaurant leases in certain Seattle neighborhoods—trying to define certain “hot” neighborhoods as the universe of comps, e.g., Ballard, Pike/Pine, or South Lake Union.

I even recently saw one industrial lease in Kent where the landlord confined the comparable market to his other buildings!

More alarming for tenants are limitations based on the term or nature of the lease. For example, landlords might limit the renewal comps to other recent renewals. This is usually a very narrow category, which likely does not reflect the market. When the renewal term rolls around in three to five years, the tenant will likely have choices of at least a few other properties on the market, and it is not a stretch to say that other new leases should be considered as comparables, i.e., what has happened recently in the market.

Landlords are also wise to limit the types of concessions that can be considered for purposes of analyzing market comps for renewal purposes. For example, exclude moving costs on the theory that the moving costs would not be a consideration if tenant renewed in the current space. This is probably a reasonable position.

Some landlords are increasingly refusing to consider free rent or tenant improvement allowance concessions in evaluating comparables, and are sticking only to the “face rent” as the only comparable factor. These factors, which yield the “net value” of the “total lease package,” are usually part of the market analysis when the tenant is considering whether to renew or move, and it does not seem appropriate to exclude them.

I rarely see increases based on the Consumer Price Index (“CPI”) anymore, given the sluggish economic growth. Now the parties are more content to simply go with a market analysis, with an arbitration provision to employ experienced appraisers or brokers to decide the fair market rent if the parties cannot agree. A fair compromise I often see with two option periods is to have 2-3% annual increases during the first 5-year option period, and to go with market rent during the second period. Again, this is where itemizing all of the factors to be considered in calculating the “fair market rent” becomes important.

Does this really matter to tenants? Not much in a tenant’s market, where there is significant vacancy and tenants have multiple other options in the market. A tenant can simply decline their option and then negotiate new terms with the landlord. If the market stays tight, however, this definitely makes a difference to the tenant, and there is no down side to the landlord if they can define or further narrow the market years in advance.

The moral of the story? The letter of intent is more important than many think, even if it always contains that “non-binding” legalese in the last paragraph. This does not mean every letter of intent now must be 10-15 pages and essentially replace the lease. The letter of intent should still be 3-5 pages, depending on the issues presented but it is worth some time for both sides to haggle over what will represent a true comp in an option renewal period 5-10 years in the future.