Pre-Construction and Construction Issues

Build-to-Suit Leases

Pre-Construction and Construction Issues

Loretta M. Kelly[1]

1. INTRODUCTION

A build-to-suit lease is the transaction structure by which a real estate owner-developer (the “Landlord”) constructs a building to the specifications and needs of a particular tenant (the “Tenant”) with the agreement that the Tenant will lease the building from the Landlord upon completion.[2] Although the term “build-to-suit” can be used to describe any lease in which the Landlord agrees to perform work to ready space to the Tenant’s occupancy, the most comprehensive form of build-to-suit scenario is that in which a Tenant has a business need for the construction of a building from the ground up. A build-to-suit transaction can arise in a number of contexts. A distributor may require a warehouse and distribution center adjacent to major highways and population centers. A growing firm may decide that it needs a distinctive office building to house new headquarters. A retailer who commits to lease a store in a shopping center needs its store to be built. A government contractor may need a building to accommodate staff to perform a long-term contract. All of these are common scenarios, and while each deal is unique, all build-to-suits have basic core issues that are in addition to those that present themselves in a standard lease transaction. In a conventional commercial lease transaction, the Landlord owns a building and the Tenant tours the space and decides whether or not to lease that space. The building was built by the Landlord to commercial standards chosen by the Landlord, such that it would be attractive to lease in the marketplace, capable of being utilized by one or multiple tenants, efficient to operate and attractive in the investment market. The parties agree on the space to be leased and the rent that will be paid. In a ground up build-to-suit transaction there exist several additional, highly interactive, phases in the Landlord/Tenant relationship. The Landlord/Tenant relationship exists well before construction begins, and extends through the construction period before becoming a traditionallandlord/tenant relationship. This discussion focuses on those additional interactions that are unique to a groundup build-to-suit transaction; the pre-construction phase and the construction phase.

A build-to-suit transaction is attractive to a Tenant because the building to be constructed will match its needs and provide an efficient, up to date and attractive place of business. For their part, Landlords who own development sites are extremely happy to eliminate lease-up risk from development pro-formas and turn vacant land into leased, income producing assets. The evolution of a Tenant’s initial conception of its need for a new building to the grand opening of a new facility is a complex transactional journey presenting countless challenges along the way. Many issues present themselves before a shovel is put in the ground. Careful planning is the key to successful execution.

A build-to-suit transaction is unique because of the particular relationship of the parties and because the parties’ contractual relationship evolves during the course of the project from the joint planning stage, to the construction phase, to completion. Generally, the Landlord/developer will own the land and the building built on that property, or will acquire land designated by the Tenant. The building will be designed and built specifically for the use of the Tenant. The architect and contractor are in most cases retained by the Landlord, but may have been brought into the transaction by the Tenant. In either case, the professionals will be obligated by the Landlord to satisfy the needs of the Tenant. The transaction includes, in addition to all of the issues related to the Landlord/Tenant relationship that must be addressed in the lease, all of the problems and challenges of a construction job. In construction, the mantra “measure twice, cut once” illustrates the importance of planning before acting. The concept applies in a larger context in the planning phases of a build-to-suit transaction. The consequences of failure in the process can be costly to both parties, and precision in communication is essential to avoid adverse consequences.

The ultimate success of any such process is a function of whether the developer and the prospective occupant can communicate well and work together effectively, particularly in the early stages, when errors or lapses in understanding can have a domino effect and create bigger issues in later stages of the project. Once the building is built, errors are costly to correct. Extensive planning, effective communication, experienced teams, and patience and discipline all play a role in a successful project.

1. PRE-CONSTRUCTION ISSUES

1. Tenant Team.Businesses that do not frequently engage in real estate transactions will find themselves in unfamiliar territory when embarking on a built-to- suit transaction. Management teams for non-real estate firms, even those with staff familiar with asset or facility management, may find it difficult effectively to provide the interactions and make prompt and informed choices necessary to fulfill the Tenant’s role in the design and construction phases of a building project. For these organizations, real estate planning and expertise are typically outsourced. In addition to legal advice, a Tenant will need specialized advice in many other aspects of the design and construction phases of the job. A Tenant representative (a “Tenant Rep”), in most cases a broker with experience in build-to-suit transactions and familiar with the many aspects of the development process, can be very helpful in acting as the “translator” between the Tenant and the Landlord relative to the planning and construction project. To be effective, the Tenant Rep must have real estate development and leasing expertise while also having the capability to understand the Tenant’s business and its operating needs. A Tenant Rep can be an invaluable presence in the transaction if the Tenant’s real estate objectives are properly and clearly communicated to the Tenant Rep, and if that representative can efficiently work with the rest of the Tenant’s team, including counsel, to accomplish their mutual customer’s needs. A first issue for counsel representing a Tenant is likely to be the negotiation of the Tenant representation agreement pursuant to which the Tenant Rep will be engaged to assist the Tenant in real estate matters surrounding the lease, to assist in the preparation of the Tenant’s overall plans, to review the various options available to the Tenant in the market, to assist in the choice of developer, to assist in the negotiation of the Lease, and to review the plans. It is important that a Tenant Rep agreement reflect clearly and unambiguously the scope of the representative’s authority, the chain of command and communication, and compensation arrangements (a complex topic; the Tenant Rep’s compensation should be structured to incentivize efficiency). Because the relationship between the Tenant and the Tenant Rep is highly interactive and service-oriented, the Tenant must have the right to terminate the agreement at any time while retaining ownership of all files related to the project in the Tenant Rep’s possession. The Tenant Rep should be prohibited from assigning or delegating duties without the Tenant’s consent. The Tenant Rep’s interest must be protected so that it is compensated properly for work performed even if a termination right is exercised. Landlords working with a Tenant who has appointed a Tenant Rep will want to know: (i) the full extent of the Tenant Rep’s authority; (ii) the Tenant business contact to whom the Landlord can address questions the Tenant Rep declines or is unable to answer; and (iii) the timeframes within which the Tenant decision-makers will respond to questions or issues. Once the agreement is in place, an effective Tenant Rep will spend time getting to know his or her client’s business operations, and will need a comprehensive understanding of what objectives will be met by the new building. A sample of a tenant representation letter is attached as Exhibit A.[3]

The Tenant, together with its Tenant Rep, should also include counsel and may include other experts, such as an engineer, architect, space planner, and contractors, depending on the complexity of the building, and the extent and nature of work to be performed by the Tenant on its own behalf once the Landlord has completed its portion of the work.

1. The Request for Proposal. Once the Tenant has appointed its representative and otherwise staffed its transaction team, the processes of choosing a developer and site will then lead to designing, constructing and completing a building to the Tenant’s requirements and specifications. The process can be as long, or as compressed, as the Tenant’s schedule dictates. Regardless of the time available to complete them, there are steps and processes to be completed prior to commencement of construction, the successful and competent sequencing and fulfillment of which are key to the ultimate physical and financial success of the project.

The critical need for Tenant and Landlord to communicate with each other begins at the first stages of the project, before the parties have met. In most cases the process begins with the Tenant, who will work with its Tenant Rep on producing a formal Request for Proposal (“RFP”). An RFP is a document that describes the Tenant’s business and its space needs, and requests information about the qualifications of those developers who are interested in being considered for selection by the Tenant as Landlord. The RFP and is an organized and standardized means, recognized in the industry, by which the Tenant can request information in a standardized fashion regarding potential developers, their sites, and each developer’s vision for the design, planning, financing and construction of the Tenant’s facility. RFPs vary in length and requested detail. Some, particularly those for high-profile projects, can go so far as to include draft documents or lease provisions, with a request for review and comment to allow the Tenant insight into how the Landlord will address issues. Most are structured generally as follows:

• A description of the Tenant and its business.

• A description of the building requirements; its proposed use, approximate size, required schedule for completion, and proposed lease term and other special lease requirements, if any. In some cases a preliminary budget, providing the Tenant’s initial view of what the project will entail, may be included.

• A request for a description of the developer, including relevant experience in similar projects, expertise, staffing and references.

• A request for a description of the developer’s team of experts who could be called upon to participate in the project, including architects, engineers, land planners, and attorneys.

• A request for a general description of how the developer would undertake the project; the main contact person, means of communication, frequency of meetings, and general procedures and protocols to be employed throughout the process.

• A description of the developer’s funding sources.

• A deadline for submission of a response.

Further, an RFP document should contain confidentiality provisions, and an acknowledgement that it is non-binding and may be withdrawn or modified at any time. The preparers of the RFP, the Tenant business representatives and their legal advisors, want to craft a document that will elicit complete and informative responses. The description of the project must be clear. Specialized needs should be highlighted. The RFP should provide an opportunity to respondents to describe how they would address the particular needs of the project, and to make their best case as to their qualifications.

The RFP is the first document that provides the basic outlines of the business deal that is contemplated by the parties; the same agreements that will later be governed solely by the lease document. Legal counsel is not always involved in the drafting of the RFP; that task may be performed by a Tenant Rep or a broker, but counsel for Landlord and Tenant both are well-served to be familiar with the RFP and the responses submitted by developers in anticipation of the lease negotiation process, in order to gain insight into the Tenant’s needs, requirements, and future plans for use of the building, as well as the prospective Landlord’s statements made regarding the project at the “pitch” phase. For counsel drafting the lease, issues of particular import to either party, or circumstances in which a communication failure may have occurred, can frequently be gleaned from the RFP documents and highlight issues that should be discussed at the planning stage rather than mid-construction, or worse, post-completion. A form of a typical RFP is attached hereto as Exhibit B.

1. Review of RFP Responses; Developer and Site Selection. As discussed above, responses to the RFP assist the Tenant in evaluating the available options for the proposed project. After the RFP is exposed to the brokerage and development community, and response packages are submitted, the presentations of each developer will be vetted by the Tenant and its real estate advisors for the closest fit to the Tenant’s requirements. Developers will take care to craft a response that shows its site and development capabilities as best suited for the project. Tenants must evaluate each response package critically and carefully to eliminate sites or developers that do not fit the job’s requirements. The information provided in each response to the RFP must be examined critically by the Tenant in light of its most important goals for the project. If, for example, the Tenant needs the building to fulfill a contractual commitment, such as a government contract, the developer who can promise reliably to meet the schedule will garner interest, while a developer who has not yet acquired the site may be rejected due to the risk of failure of the acquisition transaction. If schedule is less important than the ability to expand the facility in the future, then larger sites that can accommodate additional construction and parking will be attractive. It is rare that any one site would fit each and every one of the Tenant’s needs but rather a balancing test is applied to the eligible sites. To move forward, the field is narrowed to a group of developers each of whom will be invited to meet with the Tenant and its team in order to discuss the project in more detail. This is the time for the Tenant to challenge each developer, ask hard questions and drill down to more specific facts about each proposal. The interview stage of the election process allows the Tenant and its staff of advisors the opportunity to determine which developer is not only the most qualified, but also one with whom they feel most comfortable as the project moves forward. Because a build-to-suit project requires such a high degree of cooperation and communication, and creates a long-term business relationship, it is necessary that a relationship of confidence exist between the developer and the Tenant. A clash of cultures, an inability to communicate, even a clash of personalities can have substantive effect later on in the transaction and are factors to be weighed. The vetting process, aided by the structure provided by the RFP, is the point at which the Tenant can evaluate the best fit for the project.

The examination of specific categories of information about each competing site is a crucial part of the selection process. Side by side comparisons of sites identified as viable prospects will highlight the pros and cons of each possible development site. Tenants and their advisors will at this point conduct one or more visits to each site with their advisors and the Landlord’s planning team to determine if the site proposed in each developer’s response meets its current needs and its expansion plans, if any. Site proximity to highways, public transportation, available workforce, and workplace amenities such as restaurants and shopping areas, among other factors, will enter into the site selection process.

In addition to the ability to establish a cohesive working relationship, other intangibles can be brought to bear at the developer/site selection process. For example, developers who seek to purchase developable land sites that could accommodate a build-to-suit Tenant will, as part of acquisition due diligence, factor in the ease of access to the site from affluent residential areas where C-suite employees are likely to reside. An easy commute for management staff can easily tip the scale in favor of a site.

More substantively, the availability of governmental incentives like tax rebates, enterprise zone incentives, economic development grants and other governmental programs can also have a significant impact on a site selection decision, particularly if the target area includes multiple states or jurisdictions. Local tax structures, such as the existence of wage or business privilege taxes that can impact a Tenant’s bottom line, will be analyzed. Frequently, developers competing for the award of a deal will call on local and state governmental officials to explore the availability of economic development incentives that could benefit the Tenant and its business. Governmental officials tasked with boosting their region’s local economy through job creation will be vitally interested in courting an organization to locate in its area. Incentives can range from tax breaks to low interest loans, to grants. Programs providing tax incentives or loans are typically tied to the achievement of desired levels of job creation or the initiation of other economic drivers such as development of road or utility infrastructure or other capital improvements.[4] Counsel drafting the lease will need to be fully aware of the requirements of incentive programs, since the funding provided by the program is almost always tied to the achievement of levels of job creation or other conditions. The responsibility for meeting the requirements should be expressly set forth in the Lease. Each party must be aware of the ramifications of the failure of a condition to the continued applicability of any such program and the obligations of each for fulfillment, since the budget for the transaction will reflect the availability of the program.