"Our focus to pursue build-to-suit is new," says Lance Collins, vice president for development, Cabot Industrial Trust (CBT). "It's a good additional dimension."
As a developer of industrial properties, CBT over the last two years has completed several build-to-suit projects, but it hasn't been until recently that the REIT's management made the decision to expand that segment of its business to meet client needs. "Few existing buildings can meet the new user requirements such as higher ceiling height, greater power requirements and additional parking," Collins says. "Many existing facilities can't accommodate those needs, or they may not be able to be retrofitted."
"When you own or control over 50 million square feet of industrial space and you continue to do speculative projects you're going to be in the right place at the right time to do a build-to-suit project," Collins says. "We have done them either because existing tenants need more space or because we have a speculative development coming out of the ground at the right time."
Since speculative construction is by nature risky, Cabot and other developers find that increasing their build-to-suit work adds a conservative piece to the portfolio puzzle.
"Build-to-suit projects have lower yields than speculative development, but are offset by the reduced risk of not having to lease the property once it's built," Collins says. "You don't start a project without a tenant."
As tenants seek facilities of size and scope that don't often exist in the marketplace, they are working with developers to build the type of structure that meets their business needs. "Five years ago a million square foot warehouse was unheard of," Collins says. "Now it's not unusual for a major tenant to ask for 800,000 or 900,000, or even a million square feet, and sometimes in excess of that. There aren't many people putting up a million square foot building on speculation."
Growing with Build-to-Suit
"With the economy in the state it is today, there seems to be a focus more on profitability than growth," says Koll Development Co. president Steve Van Amburgh. "This means speculative development is not a formula for success."
In the last three years, Koll has done just over $1 billion in build-to-suit projects nationwide and will continue to pursue those projects.
"The purpose of my joining [Koll] was to start a corporate build-to-suit facility development division. Over the last 11 years we have built that division to where it now holds a majority of the revenues and profits of the company," Amburgh says. "We've been averaging 300 million to 400 million square feet a year. So, we do more build-to-suit than speculative."
Amburgh attributes Koll's success working with clients such as Federal Express, Nortel Networks and CitiGroup to its unique management style, which includes assigning multiple managers to each project. "Most of the jobs we pursue require two to three people from our company to oversee the project, stick to the schedule and meet the expectations of our client," Amburgh says. "Because of today's high-tech and telecom demands we have anywhere from three or four people that bring different skill sets and expertise to the job. We think that by adding those experts in the field it makes the project run smoothly and efficiently."
The formula has proven successful with Koll's clients. "We've been quite pleased with the Koll development team," says Dick Guerreri, senior project management specialist at FedEx. "I'm always in favor of build-to-suit in lieu of a spec building. You design into it what you need as a customer so you know what you're getting on the front end."
After failed negotiations with its landlord in Irving, TX, FedEx management contracted with Koll Development to build a 170,000 square foot office complex including a cafeteria, fitness center and software development labs. "We talked to Koll about a design-built facility and we were able to build it for about $4 a square foot less than what the market was asking," says Guerreri.
Build-to-suit projects have proven to be a profitable venture for both the customer and the developer. Jim Kammert, vice president at Goldman Sachs, says, "From the public company perspective it's profitable. By definition, in build-to-suit you have most of the financial detail worked out prior to the contract. It's either build-to-suit for a fee, or there might also be a simultaneous purchase. There's no capital committed to it, you collect the fee and move on. It's a good marketing tool, people know you're a full-service solution."
Alternatively, since build-to-suit projects are usually not owned by the real estate developer they typically do not generate ongoing cash flow as a leased property would. "Many investors question the viability of that earnings stream," Kammert says. For instance, he noted that a 10-year property that was built, owned and leased by a developer generates revenue for 10 years whereas a build-to-suit project only generates a one-time fee. "It's the 'What are you going to do for me next year?' mentality," he says, adding, "I think the pros far outweigh the cons."
A Strong Business Model
Duke Realty Corporation is one of the developers that believes in the pros of build-to-suit. "We're not out there trying to invent any new business," says Rich Horn, president of Duke Realty. "We do [build-to-suit projects] just because customers ask for them. We're trying to satisfy the needs of existing clients and potential clients. It's a very big part of our business."
In 2000, build-to-suit projects accounted for more than half of Duke Realty's new development, according to Horn. "If you look at our total investment and development in third-party construction jobs last year of $900-plus million, more than half was build-to-suit. It happens because part of our business strategy is to go into cities and get a very strong foothold in industrial and office buildings. As a result of that, we develop relationships with customers, and [build-to-suit] is a logical outgrowth of owning real estate and having development expertise."
From the outset, developers work with clients to create the working environment that best meets their needs. "You have to help a client determine what their needs are because many times, even though they know they want to own a building, they're not quite sure what it ought to be," Horn says. "We listen to them describe how they utilize their current space and based on that information, we design a footprint and exterior skin system, an electrical and HVAC plan, parking or trucking requirements, storage requirements, all those kind of things. There's a lot of consulting that goes along with it."
During this process, clients may often look for building design alternatives. "We give them various choices and price scenarios, list pros and cons of each system based on our experience and then we let them decide. We're constantly giving our customers value engineering choices, helping them to determine what's in their best interest," says Horn. "This is a part of our value creation in our business model."
One client, Nationwide Insurance approached Duke Realty with the task of developing an office building in Columbus, OH. Typically, customers who want office buildings are looking for amenities such as increased electrical and HVAC, high-speed Internet access and enlarged parking amenities. In this instance, Duke Realty met their occupancy and cost specifications by using large floor plates. "Bigger floor plates make for more efficient space where more office cubicles and rows can be arranged in an efficient manner," Horn says.
On the industrial property side, Duke Realty's staff was able to integrate a customer's personal property such as conveyor belts, racking systems and other material handling equipment into the construction of the building. "There's a lot of new technology in material handling equipment," Horn says. "There are some very complex systems that handle inventory for our warehouse users. Many times that material is a higher cost than the underlying real estate."
Joint Ventures Reduce Costs, Risks
Other developers are splitting the costs by forming joint ventures with tenants to build and develop real estate. Cousins Properties, Inc.'s Gateway Village is an example of a successful partnership. With nearly 34 acres under roof, it is the largest private mixed-use urban project under construction in the U.S., according to the firm. Bank of America, the venture partner, has moved into the completed Phase I building and the entire project is scheduled to be completed by late 2002. As partner, Bank of America, besides participating in property appreciation, can either pay full rent or choose to reduce its rent instead of taking a return on its share of equity.
"In the first phase, Bank of America is the tenant," says Tommy Shealy, senior vice president, Bank of America corporate real estate, Charlotte, NC. "It was around [our] requirements that we crafted a building that would satisfy our needs over the 15-year term of the lease. And, by the same token, we wanted to build a property that could be marketed to third-party tenants at the end of our 15-year term if we didn't renew our lease commitment."
Over the years, Cousins Properties has joint ventured with IBM Corporation, Coca-Cola Company, American General Corporation and more, utilizing the architectural design talents of well-known firms such as I. M. Pei Associates, now Pei, Cobb, Freed & Partners.
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"If a major company is having difficulty and they're contracting, they’re going to be less likely to contract in a building they own rather than rent." |
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"There is no company that I'm aware of that's done more institutions than Cousins Properties," says Shealy. "To paper a joint venture is quite daunting. It takes a patient, very detailed, and very professional development company to make transactions like Gateway Village happen. As a partner, Bank of America benefits two ways. Cousins' experience saves everyone a lot of time and a lot of energy and ultimately a lot of money. They could quickly look at our criteria for occupancy and meet our tenant needs as well as effectively wear a joint venture partner hat."
Cousins also guided Bank of America in their lease agreement. "When signing a long-term lease, there's a strong tendency to not worry about what's going to happen 15 years out," he says. "That's one of the things Cousins kept our eye on. They helped us look at an exit strategy so that if Bank of America chose not to extend its lease, we'll have an asset that will be marketable to third-party tenants."
Building a Property, and a Relationship
Joint ventures aren't just about raising capital, they're about forming long-term relationships. "The joint ventures we're in are not entered into for the sole purpose of finding capital," explains Daniel M. DuPree, former Cousins president and chief operating officer. (DuPree left the company on March 31, 2001 and was replaced by R. Dary Stone.) "They really are more about creating relationships with our lead tenant on an equitable basis. One thing a tenant gets in a relationship like that is considerably more flexibility for growth and contraction."
For instance, in the early 1990s, IBM Corporation, also a venture partner and tenant, was forced to cut its office space in the Wildwood Plaza by 50 percent. Cousins' staff worked with IBM to bring in new tenants to rent the extra space. "[Their downsizing] allowed us to greatly diversify the park," says DuPree, adding, "[Diversifying] was a silver lining [to their downsizing] for them and for us as landlord."
Robb Mayo, IBM's director, asset management and finance, notes, "They've kept the buildings fully leased. The tenant satisfaction is extremely high in the park."
While all downsizing may not have the same positive outcome, it is more likely if the tenant is also a part owner. "If a major company is having difficulty and they're contracting, they're going to be less likely to contract in a building they own rather than rent," Mayo says. "One of the things we've been successful at is looking to the future, anticipating rollover, and renewing leases in advance."
But, that's only one side of the joint venture coin that has caused Cousins to produce a 22 percent total return to its shareholders over the last 25 years. As a developer, the REIT creates non-taxable retained earnings in the value of the assets it builds.
"If we are building an office property in San Francisco at a cost of $100 million that will be, on completion, worth $130 million [the company historically makes a 30 percent gross profit margin on its building assets], we have created earnings that aren't taxable at that point," DuPree says. "We can then put debt on that building, take our money out and have that $130 million worth of equity."
As a joint venture partner, The Prudential Insurance Company of America provided the financing for Cousins to harvest the value of its assets for additional development without triggering a tax payment.
"The Prudential deal was a retail valuation of the assets. It is a venture that values the assets at retail, instead of wholesale," DuPree says. "We'll use those funds to develop other projects. Because of that, and the value we create in those assets, we are not really reliant on the public capital markets. The only reason we have had the number of equity offerings that we've had—three—was to create a little more size quicker so we could structure our balance sheet the way we were most comfortable doing it."
While REITs such as Cousins find success in joint ventures, still others continue to pursue the competitive business of build-to-suit on their own. Cabot Industrial's Collins notes that build-to-suit business will continue as long as customers continue to save money.
"What will really drive [build-to-suit] is those companies that have done it successfully," Collins says. Noting that Kellogg's is developing approximately 1 million square feet of distribution centers in a few key cities and is achieving substantial savings, he expects the build-to-suit trend will continue. "Other companies are going to say 'we need to do that, too.'"
Deidra Darsa, a freelance writer based in Rockville, MD, is a frequent contributor to Real Estate Portfolio.
Once happy with the standard fare of commercial properties, potential building users now are increasingly approaching real estate developers with specific design requirements to meet their operational needs. As a result, real estate developers are profitably constructing buildings or entering into joint ventures to suit the requirements of the next generation of owner-tenants rather than merely building projects on spec.