Appraisers are often tasked with determining the prospective future value of a proposed improvement when complete. That is, the site is currently vacant today, but the owner/developer has site plans, building floor plans, and costs to complete the proposed development.
Although the report is issued on June 1, 2022, for instance, the future value analyzed may be as of December 1, 2023 – the anticipated date of project completion.
In some cases, these developments may be proposed owner-occupied buildings or proposed buildings for third-party occupancy.
This article focuses on the latter which are most often represented in our market by free-standing medical office and retail buildings, respectively, but can be literally any type of building.
The build-to-suit agreement typically begins with a desirable piece of land which is marketed to third-party tenants. Similar to the trade-off between renting and owning your primary residence, prospective tenants of these buildings may be able to owner occupy for a lower occupancy cost [1] relative to renting; however, many companies would rather expend resources in core operations than real estate ownership and will gladly transfer time, effort, and risk to a developer-owner.
While there are many examples of companies owning their real estate, there is no definitive trend one way or the other as the goals, direction, and competitive advantages of every business vary.
Leasing may be preferable to companies that want to keep their options open for relocation, downsizing, or upsizing and do not want to make a long-term commitment to a site or building that may not fit their needs years down the road. With this in mind, many companies are more than happy to pay a slight premium for the transfer of risk to a developer who will incur short - term risk by coordinating development and maintain long - term risk of ownership.
Although many build-to-suit properties are not appealing to the general market from a financial feasibility perspective, the term of the proposed lease typically reduces risk of the property in the short-term.
Build-to-suit leases typically range from at least 10 years to as many as 20 years (with options to extend). [2] This is intentionally required by the landlord because they acknowledge the long - term risk of securing a second-generation user for the specialized space.
For instance, as the end of the base term approaches, the in-place lease may have less of an effect on value depending on the likelihood of extension. Therefore, as the lease approaches the end of its base term, analysis of physical characteristics and their adaptability or appeal to second - generation users will be more influential on value.
Once a tenant and landowner are connected, a site plan, floor plan, and contractor-provided cost estimates will be developed.
Change orders may result in higher overall project cost – which may or may not be passed onto the tenant based on negotiations prior to the project breaking ground. A predetermined yield on cost rate will be applied to the overall project cost by the developer to “back into” the annual feasibility rent. [3]
Take the following medical office development for example:
The spread between the market capitalization rate and yield on cost is the premium, or reward, to the developer for undertaking project risk.
The tenant is willing to accept this based on the transfer of risk. While the above project makes sense to a developer based on a predetermined, build-to-suit lease structure, the actual market rent for similar space is typically much less.
This can be for a few reasons, but the primary factor is that build-to-suit spaces are specific to the desires and intended functionality for a specific user - much different than speculative (spec) space which is generically designed to accommodate a wide range of potential users.
The intended functionality of build-to-suit space is often inconsistent with what the balance of the market desires. This scenario is understood as a “superadequate” building improvement in real estate valuation. The concept of a superadequate building improvement arises when the cost of constructing a building component – or components – increase the property value at a lower rate than the cost of constructing that component.
For example, if an executive wants to construct a lavish bathroom in their office suite at a cost of $50,000, but the typical market desires only a simple bathroom at a cost of $20,000, in its simplest terms, the building now has $30,000 ($50,000 - $20,000) in functional super adequacy.
This concept can be applied to many different custom features inherent in a build-to-suit development.
You may be asking: Why would a prospective tenant agree to an above-market lease structure?
It’s because the build-to-suit development has characteristics that specifically accommodate that tenant’s business operations and/or brand-image needs.
In other words, this proposed development is not simply a real estate decision, it’s a business decision.
Therefore, the above-market rent – in most cases – is directly attributable to business value, or goodwill. [4] It follows then that the effect of excess rent, if any, should be carefully considered in a real estate market value appraisal.
So, is this type of project ill-advised?
Absolutely not.
A prospective tenant's financial return for the above-market rent is theoretically realized in enhancements to corporate image, employee morale, and overall productivity due to the specialized space. Therefore, in the event a given project is not financially feasible from a real estate perspective, only, conversations about this concept are incredibly valuable to clients considering a build-to-suit agreement.
It may even help get the transaction across the finish line.
[1] Occupancy cost for owner-occupants includes mortgage and operating expenses; occupancy costs for tenants includes rent and operating expenses
[2] Base terms are typically less than 29 ½ years in PA due to tax ramifications
[3] The difference in yield on cost and market capitalization rate is known as development spread. The development spread measures the “development pop”, or value-added by taking on the construction and lease-up risk. The greater the development spread, the more likely a development project will be deemed financially feasible.
A real estate investor has the option to either a) acquire a fully-built and stabilized asset at a preferred cap rate or
b) construct and lease-up a brand new property at a preferred yield-on-cost. In order to make the latter worthwhile, a benefit commensurate with the risk must be gained, otherwise there is no incentive to take on the development risk.
One way the developer and its capital partners measure the potential benefit is by looking at the difference in yield between the two options, or the development spread (https://www.adventuresincre.com/glossary/development-spread/).
[4] Also known as transferred value. This concept is expanded upon in a prior blog which can be found here.
Michael J. Rohm, MAI, CCIM, R/W-AC, is a fee appraiser and real estate agent working throughout Pennsylvania.
He is president and owner of Commonwealth Commercial Appraisal Group and is director of valuation advisory and senior associate with Landmark Commercial Realty. Contact him at mrohm@commonwealthappraiser.com.
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