In going over the outline of an airport project with Mr. John Yarberry, Senior Vice President-Real Estate for Wells Fargo, it became clear that for a bank like Wells Fargo to even consider project financing for an airport project they would want to see the following:
- Ideally a term of at least 50 years. If not that then a term that extended at least ten years beyond the end of the amortization period of the loan. If it’s a 25-year loan then they would want a 35-year lease.
- Defined land rent escalations. This can take several forms, but doesn’t include at the sole discretion of the airport.
- Relocation provisions that ideally would provide enough compensation to retire the loan, even if the developer lost all equity.
Additionally Wells Fargo would expect to underwrite the loan based on standard requirements like a 1.25 debt coverage ratio (income after expenses that is 1.25 times the debt service payment); a maximum of 70 percent loan to cost in the beginning (on a land lease 70 percent might be a stretch), and the maintenance of 70 percent loan to value over the life of the loan. A lot would depend on the bank’s relationship with the developer, his track record, other assets, etc.
In other words, not an encouraging start since many airports want as short a term as possible, and the more equity one has in the project the harder it is to realize an acceptable rate of return.
There are many important provisions in any land lease such as access, signage, offsite work, construction standards, and many others, but the following seem to be the potential deal killers ...
Item #1: Length of the lease
Probably the single most important item in the entire deal is the length of the lease. Some airports seem to have a goal of keeping the term as short as possible, and the developer, of course, wants it to be a very long term; at least 50 years or more.
On my first airport project we started by pushing for a 99-year lease and wound up settling for 20 years with no renewals (never again!).
I watched a large airport go to market with a request for proposals (RFP) that required a $3.5 million structure to be built by the successful responder. The airport required well over one dollar per square foot for land rent, 10 percent of gross revenue, and a 15-year lease with no renewals.
(The developer is thinking: WHAT? They expect me to build the building, finance it over 15 years, get it paid off, and then GIVE it back to the airport. So they can do what? Go out with another RFP and let me compete for my own building and pay for it all over again. Forget it!
The airport may be thinking: This sneaky developer wants to tie up our land for a long period of time while paying minimal rent and making a lot of money because of the traffic we are bringing to the site. Forget it!)
And in this case that is what both parties chose to do — forget it. There were no responses that met the airport’s terms. Interestingly enough, even though it was a good and unique use, the airport dropped the entire thing instead of considering a modification of the RFP.
The developer has to build the building; lease it for enough to cover the loan, expenses, risk of tenant failure/vacancies, etc.; and still achieve a decent return on equity. This basically requires the end-user to pay rent that is higher than if they were able to build the building themselves and lease the land directly from the airport.
How do the lenders look at this? They really want to look the other way and do business somewhere else. Finance something where there is a residual value to the project and it may be more valuable over time as opposed to it becoming less and less valuable as the lease years go by. There is nothing to like from a lenders point of view.
The lender is probably wondering why the developer is even trying to do this deal when its on an un-subordinated land lease, vague language regarding land rent escalations (if it’s that good), no renewals, and relocation provisions that altogether makes one want to faint.
The developer also gets to deal with the fact that virtually all commercial real estate loans have call provisions. Meaning that even though the loan may be amortized over 25 years, and everything is going well, at the five- or seven- year mark they get to take a peek and see if they still like you and everything that’s going on. The bank basically calls the loan due. The bank will underwrite the loan all over again. This may result in a change in terms, or a requirement to buy down the principal amount of the loan if the ratios are out of line.
Land rent, percentage rent, and escalations
When there is a developer between the tenant and the airport, it is a virtual certainty that the tenant will have to pay more to be in business than if the airport did the project itself (assuming costs are the same). The developer needs to be reasonably confident that it can make a profit over the holding period by leasing up the project, and either keeping it or selling it to a long-term investor.
The developer will most likely include land rent in its CAM (common area maintenance) charges to the tenants in multi-tenant buildings. A typical retail layout may have a floor area ratio (FAR) of .25, meaning the rentable building square footage covers one-fourth of the land area. Therefore if land rent is one dollar, the tenant is paying four dollars per square foot plus all other common charges.
It’s always interesting to know how an airport sets the land rent per square foot. Is it a result of some formula that generates an amount to recover costs; is it arbitrary; or is it market value? If its market value, how is that determined? A range might be six to eight of the value of the land per year. But then the trick is to determine what that value is. One could obtain an appraisal or a broker’s opinion to determine the value. Whatever the rate the airport charges the developer, the developer will most likely want to increase that rate to the end-user to recover improvement costs and to make a profit.
Percentage rent could be applied to gross revenue received by the developer (which they really hate), or more typically require each end-user to pay the percentage rent directly to the airport, since different uses may result in different rates.
Escalation provisions in a short-term tenant’s lease can generally be dealt with by the end-user agreeing to pay a fixed stair step of increases, or base it on increases in the consumer price index (CPI) or a fixed percentage. This leaves the risk of undefined rent escalations imposed by the airport with the developer. Fixed increases on a long-term lease can sometimes get out of hand, and it may make sense to negotiate a “market rate” reset periodically during the lease.
Some airports want somewhat open-ended language regarding escalations due to their own requirements. This requires some real explaining to the bank and the developer as to why this won’t be a problem. And that is always the position taken. No problem. The bank, developer, and long-term tenants do have a problem with this. The developer wants to pass it straight through to the tenant, but the bank wants to be sure the tenants are strong enough to handle undefined future rent increases.
In a nutshell the bank needs default language that allows it to step in and take over the project if the developer fails. And do it without taking any kind of title to anything, and be able to then transfer everything to a new developer without a whole lot of interference from anybody. It needs to be able to step in and cure any money defaults, but perhaps not be required to perform all non-monetary obligations the developer was required to do under the lease. This is a major over-simplification of the issue, as there are many elements that go into the default provisions, but if there is a default the lender needs to be able to act in a timely manner to preserve the asset.
We developers know the airport needs a relocation provision whereby they can terminate the lease, as unlikely as it is that it should be required. Developer and lender will need some formula for this. Does the airport agree to pay an amount equal to the remaining balance after straight-line depreciating the project over the term of the lease? It may or may not even be enough to pay off the loan. Is there any compensation at all?
Another approach is to pay the fair market value of the project. An appraiser would likely determine this using a discounted cash flow approach. Naturally the fewer years that remain on the lease, the less valuable it becomes. I am a part owner in airport projects that grant no compensation whatsoever, and two projects that the airport will pay fair market value.
So, what’s the best way to work with a developer? Once the tenant and airport have identified a site:
- Is an RFP issued for a developer for that site with no specific use? Or
- Is an RFP issued based on what has been identified as a use or uses to be developed on the site?
Both approaches have their pluses and minuses. In both cases one might be well served to be very open to what the local development, planning, and brokerage community thinks the target market is, what to build, and how to phase it.
Does the airport have personnel with the real estate knowledge to negotiate this kind of transaction, or should it consider a consultant to assist? One can get great input from developers, real estate agents, architects, planners, and consultants.
I think a very good case can be made for the airport doing the project itself. Determine what is wanted to see developed, plan the site, and market the parcels within the site to end-users or for a developer to build the multi-tenant building(s). All of the issues are the same, but the risk to the developer is substantially reduced because each parcel is a much smaller transaction. This would help open the process to a wider range of local developers who would be qualified for a smaller project that’s part of the larger site.
If a developer contacts the airport with an idea for a project, how is that handled? Is there a process for evaluating an unsolicited proposal? Will the airport select an appropriate location for the proposed use, qualify the developer, and negotiate a lease? Or, does it, by regulation or policy, always go out to the market with an RFP. Certainly a thorough and complete process of vetting the proposer and the project would be necessary to prevent criticism and second-guessing. However, being open to, or soliciting, ideas from the private sector may be a good way to discover some great ideas.
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Many developers would not want to hold this kind of asset for a long term. What they do is develop. Their idea of a good time is to build a project that leases up at good rates and then sell it to a long-term investor. They make fees and then a profit when they sell, and then apply those resources to the next project. Some others may keep it in their portfolio for many years.
I believe airports are in the best position to develop a multi-tenant project. The airport should do the land planning and site development, unless the project is large enough to attract a national class developer with the ability to use non-project specific financing. The good news is that airports do bring in a lot of people and that will always get the interest of tenants and developers.
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Bill Prather has been involved in commercial real estate for more than 40 years. With L.C. Fulenwider Inc., Prather assisted in the development of 7,500 acres around Denver International Airport, including the development of WorldPort at DIA.