By Heidi Lee, MAI, MRICS, AI-GRS. Copyright © 2014, All rights reserved.
I am shifting my focus today to something that even appraisers can get wrong: build-to-suit properties. Part of the reason for their confusion is that appraisal literature does not contain a definition of this term. Banks need to be aware of the risks associated with lending on build-to-suit properties, particularly as some of that risk can come from appraisers who confuse build-to-suit properties with those that are not.
In a nutshell, a build-to-suit property always involves a developer and an end-user. A good example is Walgreens. Say Walgreens wants to build a new store in a particular town or specific portion of a city, but does not want to hire a staff of real estate development experts. Instead, Walgreens will work with a developer to locate a parcel of ground that meets their size and location requirements. The developer purchases the property, enters into a lease with Walgreens, and develops the site to their specifications. Walgreens moves in and starts paying rent, after which the developer sells the property and moves on to the next project.
What will be of particular importance in such situations are the terms and conditions of the negotiated lease. Build-to-suit leases are of sufficient duration for the developer or his successor to collect all of his capital outlay for construction, plus a profit for his time and whatever risk is involved. Build-to-suit leases differ from other leases because the rental rates are based solely on acquisition and development costs.
In a perfect world, the cost of creating a specific improvement would drive a contract rent exactly equal to market rent for that same property. However, that is rarely the case. Just as cost does not equal value, rent driven by costs is most often different than general market rents for an equivalent property. Since build-to-suit rents owe little to market conditions and everything to site acquisition and construction costs, they tend to exceed market rents. And since the sale prices of leased properties are most often driven by the income stream produced by the lease(s), it should be clear that build-to-suit sales and rents may be different – probably higher –than for properties that are leased at market terms or are owner occupied.
There are two ways that build-to-suit properties can be problematic for appraisers, and of course the banks that use their services. The first problem arises when appraisers associate a build-to-suit status with particular property types: fast food restaurants and national pharmacies to name a few. For the most part, this association is a short-cut that serves the appraiser well. When he bids on a proposed CVS, he understands that build-to-suit rents and sales should be involved and bids accordingly. A problem arises, however, in the few instances when such a property type that is typically encumbered by a build-to-suit lease is not leased at all.
When a property is not leased it must be valued assuming it could be readily leased at market rent or sold to a prospective user or to an investor who will lease the property at market terms. All appraisals relied upon by banks must be based on a specific market value definition. This market value definition assumes a sale of the subject property on the effective date of the appraisal report, which sale must involve exposure on the open market. The market value definition mandates a value conclusion for the property “in exchange” and not tied to its current use and user.
And so, a fast food restaurant or a pharmacy or any other property type that is typically leased at rents based on cost, becomes a problem in the few instances when no lease is involved. In such cases, banking regulations require a market value of the fee simple estate – market value at typical restaurant or retail market rents, not at higher build-to-suit rents. Whenever a non-leased property is valued using build-to-suit rents, the value concluded in the report does not meet the specifications of the regulatory market value definition and should not be the basis for a real estate loan.
On the other side of the equation, a problem can arise when the appraiser recognizes that the subject is not build-to-suit but fails to notice that one or more of the sale or rent “comparables” used in the report are build-to-suit that are only minimally reflective of current market conditions. I have seen this most often with restaurants. The following may be signs of build-to-suit restaurant comparables:
- Sales of leased restaurants; double-check the lease rates with the market rent conclusion in the income approach
- Rent comparables where the tenant is the first occupant of a fairly recently completed restaurant
- Rents or sales that are outliers that set the high end of the indicated range
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