By: Victor McConnell, MAI, ASA, CRE, Frank Fehribach, MAI, MRICS, and Grace McWatters
*This is Part 1 in VMG Health’s series on transaction structuring considerations for new developments. The other parts in this series can be found here: Part 2, Part 3, Part 4.
Are you constructing a new building, on or off of a hospital campus? If so, there are unique considerations that investors, joint venture (“JV”) partners, developers, hospitals, physicians, and other parties to a new development should evaluate. For instance, if a hospital and/or a physician partner are developing a building and then leasing it to a JV entity, the associated lease rate and overall development terms will likely need to be documented as being commercially reasonable[1] and within fair market value (“FMV”) parameters. For investors constructing build-to-suits, primary concerns may revolve around analyzing the risk associated with a particular tenant. For hospitals and physician partners who are joint venturing on a development, the key analyses may involve appropriate allocation of risk, responsibility, and capital vs. non-capital contributions that each party is making to the development. If parties are sharing in development responsibility and risk, then a careful analysis should be undertaken to ensure that parties receive appropriate return given their risk, as well as their various capital and non-capital contributions.
This article, which is presented as a four-part series, will provide an overview of key issues to be considered prior to, during, and subsequent to construction of a new building. For assistance with transaction advisory, cost benchmarking, FMV analysis, commercial reasonableness opinions, or other consulting services, please contact VMG Health.
PART 1: Overview, BTS Economics, and Development Risk & Responsibility
Build-to-Suit – What is It?
The term “build-to-suit” (“BTS” or “built-to-suit”) is not formally defined within The Dictionary of Real Estate Appraisal; however, the Commercial Real Estate Encyclopedia defines it as “a type of real estate transaction where a property owner or developer will construct a building for sale or lease that will be built to the tenant’s or buyer’s specifications.” Within healthcare settings, developers commonly develop buildings for tenants who will then lease the building subsequent to construction. In some cases, a hospital (or JV between a hospital and a physician group) may develop a new building and then master lease it to an operating entity. In other cases, the building may be constructed by a third party (developer, REIT, private equity, etc.) who will then lease the space to a healthcare tenant.
Economics of a Build-to-Suit
In a typical build-to-suit arrangement that is to be 100% leased by a single tenant, a developer will construct a property that the tenant will lease at a percentage multiplied by the developer’s “all-in” [2] cost. Market participants differ in the terminology utilized to refer to this “build-to-suit rate”; common terms include return-on-cost (“RoC”) rate, initial yield rate, rent constant (or factor), development constant, or developer’s yield.
In these arrangements, a developer receives a return via the rent collected over the course of the lease term, as well as via reversion upon project sale (unless there is no residual, in which case a developer achieves their targeted return via rent collected during the holding period). The developer will generally anticipate selling the property at an overall capitalization rate (“cap rate”[3]) that is below the build-to-suit rate. Factors which can affect the RoC rate are similar to factors which affect cap rates. These factors include, but are not limited to: a) tenant creditworthiness; b) financing terms associated with the transaction; c) length of lease term; d) lease escalations; e) a property’s location and physical characteristics, such as design and construction quality; f) expense structure between tenant and landlord; g) renewal probability; h) anticipated reversion; i) trends in the capital markets; j) industry specific trends; k) landlord and tenant motivations; and l) a property’s construction cost and implied lease rate relative to market.
Some developers build and hold projects over a long period, while other seek to sell projects based on a shorter forecasted hold period [4]. Furthermore, the developer is likely borrowing money both during the construction period (an interim construction loan) as well as subsequent to construction (permanent financing). In these cases, the developer will likely anticipate borrowing at a rate that is a certain number of basis points below their build-to-suit rate. Similarly, if a landlord is providing funding for tenant improvements in an existing building, the landlord will typically provide those funds to the tenant at a rate above the landlord’s cost of borrowing. When offering tenant-specific tenant improvement (“TIs”) allowances, a real estate investor will evaluate how much residual value, if any, will remain at the end of the lease term. If the TIs are highly specialized and tenant specific, an investor may seek to amortize the full cost of the TIs into the lease term, as the likelihood of residual value to another tenant is low. In some cases, a landlord may offer an amortization schedule which exceeds the lease term, although the tenant may be required to pay the unamortized cost of the TIs if they choose not to renew the lease.
In structuring a lease associated with a build-to-suit, the overall economics must be carefully considered in order to ensure that each party is receiving a return commensurate with their risk and responsibility.
Evaluating Build-to-Suit Rates
Build-to-suit rates (i.e. rent constants) are highly correlated with cap rates and other capital market indicators. However, specifics concerning lease structure (such as absolute net vs. triple-net) can also affect an appropriate rent constant. For instance, in an absolute net lease structure, a tenant will bear more ongoing capital expenditures during the lease term, which decreases the risk profile for the landlord. Term length also affects an appropriate build-to-suit rate, as longer terms are generally more favorable to landlords due to lowering risk profiles (which can translate to lower cap rates or superior financing options).
VMG has conducted extensive research into cap rate trends across various healthcare real estate asset classes. In the course of our valuation and consulting work pertaining to proposed projects, VMG Health has also interviewed multiple investors, developers, and brokers active in the healthcare real estate market regarding cap rate and build-to-suit data for various assets. While return-on-cost rates offered by build-to-suit developers generally compress along with overall capital markets trends, historical averages for a particular sector, as well as forecasted risks for a particular tenant (and their associated industry) will affect the build-to-suit terms available at any given time.
Cap rates and RoC rates are different, though correlated. As previously noted, when developers build specialty healthcare assets for tenants on a build-to-suit basis, the developer’s profit is often a function of the “spread” between their RoC rate and their exit cap rate. For instance, as noted previously, if a developer constructs a project at a 9.0% RoC rate and then immediately sells the project for an 8.0% cap rate upon completion (a 100 BPS spread), the developer will have made a 12.5% unlevered profit (without considering timing and other certain factors). A project built at a 7% RoC and sold at a 6% cap rate would represent a 16.7% unlevered profit for the developer.
In addition to the project-specific or tenant-specific risk factors which can affect risk and profit expectations, the size of the development can also affect the spread sought by the developer, as developer profits tend to be smaller on a percentage basis for a $50 million project as compared to a $5 million project.
Ultimately, build-to-suit rates and development profit are largely affected by the risk associated with the tenant, as well as with the risks and responsibility allocation between developer and tenant.
Tenant risk will be discussed later in this article, whereas an overview of development risk and responsibility is presented in the following section.
Development Risk and Responsibility
In constructing a new real estate development (or performing significant renovations on an existing building), a number of different direct costs [5] and indirect costs [6] are required. Furthermore, time and expertise are required to manage various parts of the construction process. Developers also commonly take a variety of risks during the development process, and the overall return achieved by a developer is generally considered to represent compensation for the risk taken on by the developer. There are a wide array of potential risks (and time expenditures) that a developer may incur, including items such as, but not limited to, the following: a) market analysis and feasibility studies to assess demand prior to development; b) site selection and land acquisition, including potential negotiations with multiple sellers to assemble a large development tract; c) environmental assessments; d) site plans, permitting, and building plans; e) zoning analysis and applying for zoning changes or use exceptions; f) infrastructure assessment and improvement; g) construction financing; and h) other factors. A developer must also consider and factor in the potential for project failure at various points in the early stages, which could result in significant financial losses for the developer. The early-stage land development process can be delayed by a variety of factors, including environmental issues, design delays, zoning and entitlement delays, appeals (and/or litigation) from nearby property owners or other interest parties, and disputes between a developer and the local municipality or other regulatory authorities. During the construction process, a developer may also face risks associated with construction delays, cost overruns, financing issues, pre-leasing risk, and other factors. Subsequent to completion, a developer may continue to have various risks in a project, depending on lease-up, potential exit strategy, tenant default, property management, ongoing capital expenditures, and other considerations.
Given the extended timeline in which development risk is incurred, the timing of an equity investment in an LLC which owns a new building affects the way in which the ownership interest is valued. Assuming an investment is made at very beginning, when the proposed project is just a plan, then the pricing for an equity buy-in into the real estate ownership entity may correspond more closely to direct cost and indirect cost of the development. This is because all investors paying for the construction of the project are sharing in the risks of the project’s development. This assumes that project risks are shared evenly and equitably among JV partners; in these cases, a project’s entrepreneurial profit/incentive would generally align accordingly.
When a project is complete, the sale of a minority equity position (or the sale of a 100% ownership position) in the project will generally no longer correspond as closely to the aggregate construction costs, as the development risk has already been incurred. Thus, post-completion, equity positions should generally be based upon their fair market value (because the equity investor post-completion is no longer taking on development risk and thus would not reasonably be expected to participate in the entrepreneurial profit/incentive associated with the development).
A real estate development can involve a developer and a variety of individuals or companies responsible for managing or overseeing components of a project. Within commercial real estate development, developers are sometimes hired on a fee for development basis, with developer’s fees often included within a project’s budgeted soft costs; this generally represents a lower risk profile for a developer. Developer’s fee is defined as follows: “typically, a payment by a property owner to a third party for overseeing the development of a project from inception to completion, included among the direct and indirect costs of development. Sometimes, the term is used to describe the time, energy, and experience a developer invests in a project as well as a reward for the risk undertaken.” [7] Developer’s fee is distinct from “developer’s profit”, which is defined as “The profit earned by the developer of a real estate project.” Developer’s profit is also sometimes referred to (by appraisers and real estate analysts) as entrepreneurial profit, and the two terms can represent the same concept, though certain market participants may apply the terms differently.
Entrepreneurial profit is defined as: “A market-derived figure that represents the amount an entrepreneur receives for his or her contribution to a project and risk; the difference between the total cost of a property (cost of development) and its market value (property value after completion), which represents the entrepreneur’s compensation for the risk and expertise associated with development.” Entrepreneurial incentive is defined as: “The amount an entrepreneur expects to receive for his or her contribution to a project. Entrepreneurial incentive may be distinguished from entrepreneurial profit (often called developer’s profit) in that it is the expectation of future profit as opposed to the profit actually earned on a development or improvement.”
It should be noted that, over a large enough sample, entrepreneurial profit and entrepreneurial incentive should be roughly equivalent. However, as illustrated by the definitions, entrepreneurial profit is a historical fact (based on the actual profit achieved), whereas entrepreneurial incentive is based on profit that is anticipated.
Entrepreneurial profit (or developer’s profit) and developer’s fees are separate and distinct from certain other soft costs, such as “contractor’s overhead” and “contractor’s profit.” Contractor’s overhead is defined as “The general and administrative costs, over and above the direct costs of material and labor, that are estimated by a contractor on any construction work.” Contractor’s profit is defined as “The amount by which the fee received by a contractor for work performed exceeds the total direct costs of material, labor, and overhead. [8]
Developer’s profit can include construction management and project management, as well, though construction management and project management are not defined terms within The Dictionary of Real Estate Appraisal. [9] However, both are required to construct a building and are roles that are often filled by the developer or the general contractor. Pricing for these services can vary and depend, in part, on whether the party providing the service is profiting in other ways from the development (e.g. a developer who is also the owner or landlord). If a developer is overseeing a project but is not contributing equity, then a developer will typically charge a fee for their time and expertise. If a developer is contributing equity or going at risk for other project components, they may price certain fees differently as they will likely evaluate their overall return on a project relative to the risk (and required time, expertise, and capital outlay). Furthermore, as noted, some developers may provide services on a fixed fee basis, while others will provide services as a percentage of costs or as part of their overall project role (e.g. a developer with significant risk and equity in a project may expect to provide a variety of services over the development and construction lifecycle). Thus, in some instances, developer’s pricing and compensation may also implicitly or explicitly reflect brokerage fees [10], site selection [11] services, or other items.
The detailed discussion of various risks and responsibilities involved in the development process is presented in order to illustrate the complexity of allocating risk and responsibilities between parties in a build-to-suit transaction (and ensuring that the transaction structure appropriately accounts for these factors).
If you are evaluating a potential build-to-suit project and require third-party expertise to assist with ensuring that the transaction structure is fair and reasonable to each party participating in the development, please contact VMG Health for assistance.
The next portion (Part 2) of this series will focus on credit ratings and their impact on build-to-suit projects.
Footnotes:
[1] In the December 2, 2020 Final Rule, CMS provided updated and detailed guidance on commercial reasonableness (“CR”). CR is a complex topic, and a detailed CR discussion is beyond the scope of this article. For questions regarding commercial reasonableness in the context of a new real estate development, please contact VMG Health.
[2] “All-in” costs may be defined differently by different developers for different projects in different markets. Developers take different approaches to pricing projects in a competitive bid situation, with some shifting more profit to a projected residual, while others may seek a higher developer fee or higher rent rate. Generally, however, “all-in” costs encompass all of a developer’s hard and soft costs, including land acquisition, building design and construction, site work, project financing, and so forth.
[3] A “capitalization rate” is defined by The Dictionary of Real Estate Appraisal as “a ratio of one year’s net operating income provided by an asset to the value of the asset; used to convert income into value in the application of the income capitalization approach.” Within the single-tenant, net-leased sector, there are slight variances in the methodologies by which investors calculate a capitalization rate. A detailed discussion pertaining to these variances is beyond the scope of this article.
[4] A hold period, or “holding period”, is defined as “the term of ownership of an investment”. Source: The Dictionary of Real Estate Appraisal, 6th Edition (Chicago: Appraisal Institute, 2015).
[5] Direct costs are defined by The Dictionary of Real Estate Appraisal as “Expenditures for the labor and materials used in the construction of improvements; also called hard costs.”
[6] Indirect costs are defined in The Dictionary of Real Estate Appraisal as “Expenditures or allowances for items other than labor and materials that are necessary for construction, but are not typically part of the construction contract. Indirect costs may include administrative costs, professional fees, financing costs and the interest paid on construction loans, taxes, the builder’s or developer’s all-risk insurance during construction, and marketing, sales, and lease-up costs incurred to achieve occupancy or sale. Also called soft costs.”
[7] The Dictionary of Real Estate Appraisal, 6th Edition (Chicago: Appraisal Institute, 2015).
[8] Ibid.
[9] An example of a definition of “construction management fee” sourced from lawinsider.com is noted as the “fee or other remuneration for acting as general contractor and/or construction manager to construct improvements, supervise and coordinate projects or to provide major repairs or rehabilitation on a property.”
[10] When acquiring vacant land for development or buying, selling, or leasing a building, fees are often paid to a third-party broker based upon a percentage of sales or lease price. Brokerage fees (i.e. broker’s “commission”) are defined by The Dictionary of Real Estate Appraisal as follows: “an agent’s compensation for performing his or her duties; in real estate, a percentage of the selling price of property or a percentage of rentals that is received by the agent.”
[11] Some developers perform site selection services in conjunction with other development services. Brokers will also assist in site selection as part of their brokerage services in assisting a client in buying a property. Furthermore, consultants who specialize in site selection and appraisers with expertise in site selection are sometimes separately engaged in evaluating a potential new location, though their services can sometimes include a more comprehensive feasibility analysis. In some cases, the company providing site selection services will also be involved in conducting feasibility studies and/or limited negotiation with the seller of the land.
