Friday, December 2, 2016

When Should a Build-to-Suit be Considered

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We just sold a building located out of the state of California. Our client is an investor who purchased the Texas building to affect a tax deferred exchange.

Cash flow, ease of management, and the multi year lease had appeal to the buyer. For the next 10+ years, our client will enjoy clipping the coupons of rent payments. 

The building is leased long term to a Fortune 500 company. A build-to-suit was accomplished for the tenant four years ago.

So, what is a build-to-suit and when should one be considered? I believe one or more of the following circumstances would dictate building new versus buying or leasing an existing building.

Lack of availability. Industrial vacancy in Orange County, California is the lowest in history. 98 of every 100 manufacturing and warehouse buildings are occupied. If your company needs to grow into a larger building, chances are you'll be hard pressed to find one. The lack of available buildings should suggest a good climate for a build-to-suit. The trouble is - there is very little undeveloped land in the county. Even if you wanted to build a building, no vacant land exists to accommodate the build. In the case of the Texas building above, there were NO vacant buildings within the desired city - but a surplus of affordable, available, buildable land sites. Thus, the choices were - build or consider another city.

Special purpose building. This is similar to the circumstance of "lack of availability" yet very different. If you are patient, and occupied buildings are present in your market, eventually one will lay fallow, create a vacancy, and need a new occupant. A special purpose building contains features that don't exist in the market - a warehouse with 40' ceilings, or a building with acres of excess land for outside storage, maybe one constructed to store highly combustible or explosive contents. Our Texas building required tow of these - VERY high ceilings and acres of excess land for expansion and trailer storage.

A unique deal structure. Recently, a grocery distributor required a class A constructed warehouse building in a size that didn't exist in the city they desired. Additionally, the occupant wanted to own but couldn't afford to purchase land, build the building and carry the debt on a building under construction they couldn't occupy until completion. The solution was to interject a developer who purchased the land, built the building, leased the building to the grocery distributor and granted the occupant an option to buy the building once completed.

But, be wary of the following issues.

Lotsa lead time. Few if any occupants can predict their space needs two to two and one half years in advance of a move. However, you must allow this much time to complete a build-to-suit.

Complete understanding of the mechanics. The basic structure is - land is owned or purchased, new construction is planned and permitted, building is built, new construction is occupied. Easy, right? Yes, if you own the land, already have the plans drawn and permitted, have a bucket of cash to spend on the construction, and don't need the building for several months. Complexity is added with each un-checked box.

Financeability. You need to understand how the financing of a build-to-suit works. I could write an entire post on this subject, however, some of the highlights are - vacant land will generally need to be purchased for cash, a construction loan will precede the permanent loan, a couple of appraisals may be needed, land owners won't allow their loan (if seller carried) to be junior to a construction loan - are you yet confused? Exactly - not a simple transaction!

Understanding you will pay more. I discussed this in detail in a previous post entitled Build CRE and They will Come - Seven Reasons they Won't. I would encourage you to take a look at the reasons you will pay more to occupy a new build vs. an existing building. In short the reasons are - land prices, soft costs, entitlements, time value of money, financing, economies of scale, and market forces.