If you're a business owner looking for a facility to run your operations, you have several options. You could buy or lease an existing commercial property. You could choose to build your own. Or, you can choose an arrangement known as a build-to-suit lease.
A build-to-suit lease is a common arrangement used when businesses want a newly built freestanding property but don't want to come up with the initial capital themselves. Here's an overview of what build-to-suit leases are and why they can be preferable to the alternatives.
What is a build-to-suit lease?
In simple terms, a build-to-suit lease is a type of commercial real estate leasing arrangement under which a developer or landlord agrees to construct a property according to the lessee's requirements, and the lessee agrees to lease the property from the developer upon its completion.
The developer finances the entire construction cost of a build-to-suit commercial property, and instead of building with the intention to sell the property as many commercial developers do, the property is built for the sole purpose of being held to generate income. Once the building construction is completed, the developer becomes the landlord and receives a steady stream of rent payments.
How does a built-to-suit lease work?
Tenants typically commit to leasing a built-to-suit property for a certain length of time (10 to 20 years is common), and they often have the option to extend the lease beyond its initial term. Most build-to-suit properties are freestanding, meaning that they only have one tenant. Build-to-suit leases are typically triple net leases. This means that the tenant is responsible for property taxes, building insurance, and most maintenance and repair costs for the duration of the lease.
The general process starts by the tenant selecting a site for their property, usually in cooperation with a developer. Many developers have a portfolio of undeveloped land that build-to-suit tenants can choose from, or the business owner can find an available piece of land on their own.
Then, the business owner and the commercial real estate developer will agree on terms of the lease, such as how long the lease term will last, how much the rent will be, and when lease payments start. Typically, the rent will be determined by the developer applying a desired percentage return to the costs of the project. These costs include land costs, site improvements such as grading and utilities, the costs of the actual building, legal costs, and several other common expenses and are important for the tenant to know (since they will determine the rent).
For example, let's say that it costs a developer $2 million to construct a building, and that current market conditions have created an expectation for a 7% yield on cost. This would translate to rent of $140,000 per year, or $11,667 per month. Note that there are several factors that could make the rent higher or lower, other than real estate market conditions.
For example, if a tenant has a particularly high or low credit rating, its rent could be significantly lower or higher than the market average. Or, it's not uncommon for a tenant to get a favorable rent in exchange for agreeing to a longer lease term.
Once the landlord-tenant relationship is clearly defined and agreed upon, the developer prepares building plans, obtains permits, and starts construction. Typically, the lessee doesn't start making lease payments until construction is substantially completed.
Advantages of a build-to-suit lease
From a tenant's perspective, there are some good reasons why a build-to-suit lease could be a favorable arrangement. As mentioned earlier, a build-to-suit lease results in a highly customized and brand-new property and doesn't require a massive capital commitment from the tenant. Plus, a build-to-suit lease has an interesting tax advantage over real estate ownership.
This is the biggest advantage of using a build-to-suit lease arrangement. A build-to-suit property is constructed to a tenant's particular specifications, which can be an especially strong advantage for businesses with unique real estate needs. A tenant can ask the developer to build a property of the exact size they want and with the exact layout that allows them to conduct their business as efficiently as possible.
It's capital-light for the tenant
If a business needs a property built to certain specifications, using a build-to-suit lease can be more affordable than building the property themselves. There are other ways to develop a customized property without having to own it long-term, such as doing a sale-leaseback transaction, which involves paying to develop the property, selling it to a landlord after construction is finished, and then making lease payments to the landlord, but this route requires far more upfront capital than a build-to-suit lease does. In a nutshell, this gives the tenant more money to invest in its business, as opposed to it being tied up in real estate assets.
When a business makes lease payments, 100% of the payment is deductible as a business expense. On the other hand, when a property owner makes a mortgage payment, only the interest portion is deductible. To be sure, there are certainly some other tax advantages of being a property owner (such as depreciation), but this still often works out in the lessee's favor.
A new facility
By definition, a build-to-suit lease will involve a brand-new property. From a business' perspective, this can certainly be preferable to a building that has been around for many years. You can select the colors and materials to suit your needs, you can hand-pick the location for your business instead of limiting your choices to existing inventory, and the property will have modern equipment (such as the HVAC system) in good condition.
That last point could be especially desirable -- since most build-to-suit leases are triple net in nature and require the tenant to cover maintenance expenses. Fewer maintenance issues and less uncertainty when it comes to repairs is a big perk of setting up shop in a brand-new business.
The Millionacres bottom line on build-to-suit leases
A build-to-suit lease can be a preferable arrangement for business owners. Not only does it result in a brand-new, custom-designed facility, but it requires minimal upfront capital to get started, leaving more money for the business to invest in its growth and success.