REAL ESTATE CAPITAL markets are presently flush with cash, ready to underwrite build-to-suit (BTS) projects for creditworthy investment-grade tenants in long-term (preferably 20+ years) single-tenant net leases. If structured properly, a BTS transaction may enable a developer to leverage its position to attract eager capital, potentially funding the total project costs and maximizing proceeds in the subsequent sale of the project.
Often, developers compete to secure BTS opportunities for a fee, as a percentage of total BTS project costs. The total project cost includes all hard and soft costs associated with acquiring, developing and financing the construction of the project. The tenant improvement allowance may also be included in the total project costs.
The following example illustrates one scenario through which the developer accessed funding for the total project costs and sold the BTS development upon completion for a premium. In the sale, the premium the developer received was the difference between the lease constant applied to the total project costs and the cap rate at which the developer was able to sell the completed facility.
A developer proposed a 350,000- square-foot build-to-suit warehouse for Company A, an investment-grade company. Company A agreed to the developer’s BTS proposal and entered into a 20-year triple-net lease. The company hired the developer to develop the facility at a predetermined lease constant of 8 percent of the total BTS project cost. In other words, Company A and the developer agreed on a factor (8 percent lease constant) multiplied by the total BTS project cost to determine the year-one annual rent under the lease. The developer’s total cost to complete the BTS facility was $25 million. Therefore, Company A’s year-one net rent was $2 million ($25 million x 8 percent lease constant).
Upon lease execution, the developer secured a purchaser who funded the construction and purchased the completed BTS facility for a premium. The developer sold the completed BTS facility, subject to the long-term lease, for $28.5 million ($2 million/7 percent cap rate = $28.5 million), 100 basis points less than the 8 percent lease constant off cost, resulting in a $3.5 million windfall to the developer.
If the developer had already secured construction funding, it might have wanted to consider mitigating interest-rate risk during the construction term by obtaining a precommitment to sell the completed BTS development in the capital markets at a predetermined cap rate applied to the year-one net rent paid by Company A.
Some developers may prefer to hold the completed BTS project rather than sell it. Multiple capital financing alternatives may exist to leverage the long-term lease with an investment-grade tenant to potentially reduce the developer’s equity requirements and enhance profits while enabling the developer to retain ownership of the completed BTS development. A nonrecourse credit tenant lease (CTL) loan could be used to fund a BTS project involving a properly structured long-term net lease with an investment-grade tenant.
A CTL loan could fund up to 100 percent of the total BTS project costs, at competitive long-term fixed rates, potentially enabling developers to maximize profits. Depending on the situation, it is not uncommon for a developer to secure proceeds in excess of the total BTS development costs, based on the annual net rent. In this case, the developer would profit from the difference between the CTL financing proceeds and the “all-in” BTS project costs.
If using a CTL loan structure to finance the project, the developer should also explore the impact of a subsequent sale of the BTS leased property in the zero-cash-flow market to a zero buyer in the net-lease sector to generate an additional 10 to 15 percent in proceeds above the debt as part of the overall economics. Buyers in the zero-cash-flow market are looking to recharacterize their taxable income into debt by acquiring highly leveraged assets subject to long-term leases with investment-grade tenants. Rather than pay the taxes at the higher rate, zero buyers may pay a 10 to 15 percent premium over and above the debt on the asset they acquire.
In real estate, every deal is unique, and constituents are motivated by a diverse set of considerations. Developers who recognize the opportunities that may exist and can navigate BTS project financing scenarios will likely realize the best outcomes and maximize profits.
By Turkia Mullin, first vice president, CBRE Capital Markets, email@example.com