Build to Suit Facilities Gaining Favour in China

For Captain Ahab it was the great white whale that drove him ever onward, and for China's industrial real estate developers in 2010 the obsession seems to be with great, big build to suit projects. While not challenging as hunting down a sixty ton white mammal, finding the right client and executing a profitable build to suit project still represents a significant challenge.

China Industrial Market Favours Build to Suit

As 2009's downturn fades into memory, most industry observers will tell you that for China's industrial and logistics real estate markets, transactions are rapidly rebounding to their pre-crisis levels. At the same time, however, clients are favoring a more asset-light approach, and developers are tending to avoid speculative development.

The ramification of these trends is that developer-led build to suit projects with a lease-back arrangement have become the watchword for industrial real estate transactions in 2010. Experts from China's top property consultancies have also noticed the trend and believe that this emphasis on build to suit, particularly for companies involved in manufacturing and other occupiers of industrial facilities, is part of a post-financial crisis asset-light approach to business.

According to Tammy Tang, head of business parks and consulting for Jones Lang LaSalle in Shanghai, “That has to do with asset strategy. If it's leased you won't have it depreciating on your books.” Tang also notes that this approach allows more flexibility.  “To lease they don't want to go through the headache of going through the land sale, development, applications, and development risks, but they also want to have their own building for their specific use.”

How Build to Suit is Being Implemented in China

While build to suit deals exist in several forms, the simplest approach is for a developer, or project management company to create a facility designed specifically for a client's requirements, for the client to use on a long-term basis. This approach can provide the occupier with a purpose-built facility without the uncertainty and upfront expense of undertaking construction themselves.

Sale-Lease Back

To provide more flexible terms to the occupier and to provide an attractive product for developers to market, build to suit deals are often packaged with lease agreements, and are often referred to as “lease-back” deals. Usually, a lease-back is an arrangement where a property is sold to a buyer and then leased to the seller. The lease takes effect after the sale, but is considered part of the same transaction.

However, when coupled with a sale-lease back arrangement, the build to suit approach can provide a cooperative financing model which is proving particularly appealing following the world financial crisis. Rather than purchase an existing property as in a traditional sale-leaseback, the developer finances the construction of a new facility or the expansion of an existing one.  Under this arrangement, the developer finances the construction of the new facility and builds it to the design requirements of the occupier. However, the occupier retains long-term operational control of the new facility.

And it is these developer-led build to suit with a sale and lease-back arrangements that are on the rise in China this year.

By working with a developer in a developer-led build to suit/sale-lease back arrangement, the occupier can avoid the large capital investment required to put up their own facility. At the same time, the developer gains a guaranteed client and avoids the risk and additional marketing costs required when developing a building on a speculative basis.

Reasons for the Trend

Another industry expert who has noted the trend toward build to suit projects is Jeremy Chapman, Director of Industrial and Investment at Colliers International in Shanghai. Chapman believes that the trend toward developer-led build to suit deals is due primarily to financial concerns, with risk management by occupiers also a major factor in a move away from self-financed and built projects.

Asked about the financial reasons for companies to move away from self-financed and built projects,   Chapman said, “There are a number of sound financial considerations that make build to suit an attractive alternative in 2010. There is opportunity cost for the occupier (they could be using their capital for other purposes rather than tying it up in real estate). Also, internal borrowing costs of typically plus 12 - 15% versus market yields of sub 10% for real estate are leading many occupiers active in China to look at real estate as an unsustainable investment.”

At the same time, Chapman sees significant incentives for occupiers to pursue build to suit deals. “For occupiers, build to suit with a  lease-back means the facility is off their balance sheet and therefore requires less internal approvals for capital expenditure. Also many companies are attracted to the lower risk involved in a leasing arrangement. If something goes wrong they can return the property at anytime and walk away.”

Changes in Land Transfer Regulations

In addition to the financial forces moving the market toward build to suit projects, there are also legal changes and a shift in government attitudes that have helped to make build to suit more popular. 

One of the major reasons for the rising popularity of developer-led sell and lease-back arrangement are changes in China's Property Rights Law that went into effect in 2007 which restrict the ability of industrial zones to transfer land directly to the industrial clients who are setting up facilities within the zones.

In the past, when foreign investors intended to acquire land for industrial construction, they would usually sign an initial letter of intent with the economic development zone’s local management committee. After these letters were signed, foreign investors would then secure the necessary  government approvals for their projects, and finally execute an agreement with the local land bureau  for the grant of state-owned land use rights in return for a fee. This method of obtaining industrial land is called “grant by negotiation”.

However, when China's Property Rights Law went into effect in October 2007, in an effort to promote transparency in the real estate market, it did away with all grant by negotiation transactions.  Now the law requires that all land use rights be assigned through auctions, bid invitations or other competitive pricing methods. 

One result of this has been to complicate investment in China's industrial zones and parks so that for transactions in government owned zones, build to suit/sale-lease back transactions have become a favored method for companies securing land directly from government developers.

Changes in Government Attitudes

While government owned industrial parks and development zones have offered pre-built standard factories for lease for many years now, as well as doing build to suit arrangements in some cases, occupiers that were leasing property were often excluded from some of the most attractive incentives.

According to Jones Lang LaSalle's Tang, “In the old days the government didn't give you a choice.”  Before the “government thought that a build to suit with a lease meant less commitment by the company.” Now that the development zones themselves are doing build to suit with lease deals, they are looking at these arrangements in a much more favourable light.

Competition Presents Challenges for Developers

For developers, however, the build to suit approach may present some challenges that make 2010 another challenging year for corporate profits.  Although build to suit projects help to free developers from some of the risk and marketing costs involved in speculative development, the competition to develop industrial facilities for large multinational companies in China is set to become increasingly fierce.

Tang points out that, “This is a very competitive market on the developer side. A financially healthy MNC that people believe in is likely to have 4-8 developers, local and foreign to bid on that project. That would mean everyone is squeezing their yield.

Tang also anticipates that there will be potential market battles between international developers with imported expertise and state-owned developers who are often owned and subsidised by local governments. “Normally the yield expectation from a domestic developer is lower than for a foreign developer, because of the expectation of the appreciation of the value of the building.”

“A foreign developer will mainly look at cash flow and internal rate of return (IRR). Government developers will set up a facility at a lower price point because they'll get revenue streams from tax contributions and employment of their citizens. A foreign developer only wants to build the building and make money on the real estate transaction.”

Will Occupiers Wait for Build to Suit Projects?

Another major challenge of successfully implementing a build to suit facility is the longer timeline involved in such projects.

According to Chapman, “Occupiers who are consolidating existing facilities driven by market growth and drive to reduce costs, will tolerate the additional months involved in getting a build to suit deal completed. However, if it is an immediate need driven by an alignment of contract work, then this approach is much less appealing.”

Tang points out that in deciding between built-to-suit, buying a property and building your own facility or buying or leasing a property that's immediately available, occupiers should be aware of the different timelines involved in each approach.

Tang presents the following timetable for the three approaches:

The reason for the extra time involved in build to suit projects is that the negotiations between developer and occupier involved in such projects frequently takes around one year. Most of the time is spent negotiating the details of the construction and converting the requirements of the occupier into plans, engineering specifications and construction approaches.

So like searching for the great white whale it may take time for developers to hunt down the build to suit with lease deals that they are seeking in 2010.