CONSTRUCTION ALTERNATIVE
By David E. Vieweg
The "Reverse Build-to-Suit": An Option for Landlords & Tenants
The term "reverse build-to-suit" means, for the purposes of
this article, that the tenant, rather than the landlord, constructs the
building which the tenant will then occupy pursuant to the terms and conditions
of the lease. Rather than construct the tenant's space with its own funds
(up to an agreed-to maximum), the landlord instead contributes the agreed-to
amount to the tenant in connection with the construction.
This article will provide a general overview of the reverse build-to-suit process, from both landlord's and tenant's point of view, and point out a number of changes to be made to the lease to accommodate the fact that a buildable pad is being delivered to the tenant rather than a finished space awaiting only tenant's fixtures and furnishings. It will then address the potential financial problems facing the tenant involved in a "reverse build-to-suit."
The Advantage of Control
For an increasing number of national "big-box" retailers, the
idea of constructing the building which they will then lease for a substantial
period of time from their landlord has appeal. For one thing, their own
construction departments will, in large part, be running the show, and
the concept of control is critical for retailers. Control brings added
assurance that timetables for bringing stores on-line will be met.
This is especially important when the retailer plans to expand into a new market and wants to coordinate the simultaneous opening of a group of stores, with an associated grand-opening media blitz.
The Advantage Regarding
Custom Stores
A related advantage, from both a time and cost perspective, stems from
the fact that numerous retailers operate stores with unusual features,
which even regional developers may not have encountered before. For example,
constructing a pet supply store which may have an aquarium, grooming center
and veterinary clinic is similar to constructing a space which has features
of a warehouse, supermarket, car wash and hospital. A landlord frequently
will take a tenant's preliminary plans and specifications and mark them
up to conform to the landlord's development as well as its traditional
way of doing things, not realizing the extent of the design (and cost)
requirements. A retailer may find the process greatly simplified when
its architect and its construction department coordinate with the landlord's
team to fine-tune the tenant's plans and specifications.
Landlord Concerns:
Date of Rent Commencement
From the landlord's perspective, the idea of a reverse build-to-suit presents
an obvious concern in terms of establishing the date of rent commencement.
This is not an insurmountable issue, however, as rent commencement can
be set at the end of a specified time period following delivery of possession
of the building pad, over which the landlord retains control. One benefit
of this approach is the streamlining of the construction exhibit to the
lease. Tenant submits its plans and specifications to the landlord (which
landlord should be required to approve so long as they call for tenant's
prototypical building).
Once final plans and specifications have been created, the tenant should be required to obtain the landlord's approval for material changes. The landlord will also require the tenant to apply for all building permits and licenses by a certain date following the creation of the final plans and specifications, as well as to pay all utility and development fees (to the extent required) and obtain temporary permits for demolition, excavation, grading or other site work, and any other required licenses, permits or consents in connection with the construction of its building.
The Bidding Process
The bidding process also follows the creation of the final plans and specifications.
The bidding process is very important for both the landlord and the tenant,
for the structure of the construction component of the lease as a reverse
build-to-suit does not change the overall economics of the transaction.
The landlord typically will have committed to contribute a specified amount
toward the cost of construction, and both parties will be interested to
see that the bidding process yields a general contractor that is both
good on price and competent to build the type of building required. The
tenant should reserve for itself the right to terminate the lease in the
event that even good-faith efforts to reduce construction costs through
the value engineering process do not reduce the per-square-foot cost of
the building below a specified amount.
Other Lease Changes
Neither landlord nor tenant should resist the idea of a reverse build-to-suit
structure on the basis that it would require too many changes to the lease
form being used for the transaction. We have already touched on a number
of changes which would be required-e.g., a substitute mechanism for determining
rent commencement; a revised construction exhibit; the tenant undertaking
to provide its preliminary plans and specifications to the landlord by
a specified time; and the tenant undertaking to obtain all building and
other permits required in connection with the construction of its building.
In addition, a few changes may be required throughout the lease related to the fact that a building pad, rather than a structure, will be delivered by the landlord. For example, certain prerequisites to building delivery and rent commencement in the lease form, such as the landlord's delivery of a leasehold title policy to the tenant and the landlord's completion of the common areas, may not be prerequisites to pad delivery. Care should also be taken to modify the alterations provision of the lease to allow the tenant to make structural, as well as non-structural, alterations, at least prior to the tenant's initial occupancy of its building.
Adequate Assurance
of Payment
A primary concern of the tenant, unaddressed so far, is the manner in
which the tenant is to be assured that the landlord will be good for the
funds which it is agreeing to contribute toward the cost of construction.
The tenant has now committed to build its building, subject to the landlord's
obligation to reimburse construction costs up to a mutually-agreed amount.
The tenant should be wary about proceeding without any stronger assurance
than the landlord's contractual agreement to make payment. Perhaps the
key point of this article is to recommend that a tenant in a reverse build-to-suit
situation require the landlord to post adequate assurance that the landlord
(or its lender) will fund the obligation incurred by the landlord under
the lease.
Proper assurance of payment may take one of several forms:
· A construction escrow account held by a third-party bank, trust company, title insurance company, etc. into which the landlord will deposit the full amount of the construction allowance, providing for disbursement as construction progresses in accordance with mutually-agreed disbursement conditions;
· An irrevocable letter of credit in favor of the tenant issued by a bank in the full amount of the construction allowance and providing for disbursement in accordance with the disbursement conditions; or
· A "set-aside" agreement or letter, binding upon a third-party bank, approved by the tenant, to disburse to the tenant the construction allowance, in accordance with the disbursement conditions, regardless of any default by the landlord under any loan or other agreement between the landlord and the lender.
The idea of putting the total amount of funds into an escrow account in advance of construction is anathema to landlords, if only because of the difficulty in convincing their lenders of the advisability of this approach. On those occasions where lenders are agreeable, they will require the escrow agreement to be very strict regarding compliance with suitable conditions to disbursement. Letters of credit add transaction costs to the deal, are tedious to negotiate and even more tedious to attempt to enforce-clearly, a second-best alternative. The set-aside agreement may well be a little-known device deserving of wider use.
So what are the essential characteristics of the set-aside agreement? Fortunately for all concerned, the set-aside agreement can take the form of a two-page letter from the bank. The key provisions of the letter are that the bank:
(1) Acknowledges the lease between the landlord and the tenant;
(2) Acknowledges that the bank has agreed to loan the landlord a specified amount as its contribution toward the construction costs of the tenant's building; and
(3) Agrees to disburse funds to the tenant directly (and independently of any default by the landlord under the loan agreement) in accordance with the disbursement conditions, provided that the tenant apply the proceeds in accordance with the terms of the lease. As between the bank and the landlord, any and all amounts so disbursed to the tenant will constitute loan proceeds and be applied against the bank's lending obligations under the loan agreement.
For a lender to simply acknowledge the lease and agree to cut joint checks is not sufficient from the tenant's perspective. The crucial aspect of the set-aside agreement is that the lender undertake to the tenant to disburse loan proceeds earmarked for the tenant's building directly to the tenant, regardless of the landlord's default or bankruptcy. Joint checks provide no benefit to the tenant if the landlord is legally impaired.
The consideration
for this undertaking by the lender is the lease itself. Consequently,
the requirement that the landlord post adequate assurance of payment,
together with a list of acceptable means of so doing, must be included
in the lease.