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.