Although most developers of single-tenant, net-leased retail properties still carry the construction costs on their own balance sheets, it is becoming more common to find a take-out buyer at the very beginning of the process. This, apparently, is due to the relative scarcity of favorable construction debt and higher levels of equity required from the developer.
On a build-to-suit project for a single-tenant, net-leased property, such as Walgreens or FedEx, developers have traditionally pulled from their own balance sheets as the source of equity, plus construction debt sourced from a dependable team of lenders. Many developers will hold onto the property once it is completed, accumulating a net-leased portfolio. Others will build on the assumption that they will find a take-out buyer once the building is operational and rent is flowing.
In either case, prior to the debt crisis of 2008, most developers could highly leverage the construction and proceed with the development with little cash outlay. In some cases, construction loans could cover nearly 100 percent of the cost. Today, however, lenders are wary of covering more than 75 percent to 80 percent of a new development’s costs, and many developers would become illiquid very quickly if they had to provide 20 percent to 25 percent in equity for each project.
However, we have found that developers have other alternatives, in the form of investors who will make early-purchase commitments. These investors will come on the scene at any of three points:
- Some will supply the construction equity at the very beginning of the process, intending to purchase the finished asset and hold it in their portfolio long-term. They are taking escalated risks by funding construction and committing to purchase the property before completion, but in return the investor will get a discounted price and a higher-than-market cap rate.
- Another type of equity provider will enter into a joint venture with the developer to get the project built and then seek a third-party buyer upon completion of the project.
- The third type will not necessarily fund construction, but will give the developer a pre-construction purchase commitment, whereby the developer can go to lenders and present a reliable buyer that has contractually promised to purchase the property at the end of construction. This scenario might persuade the lenders to provide more favorable financing and it also protects the developer from unfavorable movements in market cap rates during construction.
The cap rates on these transactions are typically higher than if the building were already constructed and the tenant paying rent but the developer will have peace of mind and the capacity to grow their development pipeline with an equity solution along the way.
The fraternity of investors who will do these forward take-outs is fairly small. Most are institutional players, in addition to high net-worth individuals who have the capacity to take on these related risks. Some are taking a programmatic approach, intending to do several of these deals over a few years with the same developer. By going into a joint venture with an equity investor in the early stages of development, a developer can count on steady portfolio growth and have the ability to win more projects.
Brad Pepin is a director on the Hughes team at Stan Johnson Co., providing advisory and brokerage services to developers, investors and institutional buyers and sellers.