May 30, 2019

Evaluating development models for commercial office: landlord or developer?

As the commercial landscape begins to change, developers of commercial office and retail space are asking whether it makes better financial sense to build and hold a property as a landlord over time or to develop the property as a commercial condominium association. There are benefits and detriments to both and important differences to consider in the development process.

A standard commercial project involves finding a location that meets the parameters for the deal, and every developer (and their investors) differ on what makes for an ideal opportunity. Traditionally, developers build and then lease the office or retail units and continue to hold the property over time. As many developers leverage their projects, there can be decent future profits and, eventually, a solid income stream after the lenders are paid. Depending on the structure of the development, this may be a short pay down or it may be a longer term proposition before realizing a strong income stream along with significant profits.

In a leased development, we see an increasing trend towards absolute triple net leases or ever-expanding common area maintenance (CAM) categories. Most developers develop a property and hold the interest in a single entity, most commonly a limited liability company. Using the “one entity per property model” tends to ensure easy accounting as the property is considered a stand-alone business. Normal commercial leases pass on a portion of the CAM to the tenants, yet many leave the landlord responsible for structural maintenance and certain major expenses, not to mention the management and business overhead costs. An absolute triple net lease passes every expense to the tenant, often including an exhaustive lease. Tenants, obviously, do not like the potential risk of bearing all business liabilities under an absolute triple net lease but it can be a very useful position for a landlord with a very predictable risk, so long as the tenants remain financially able to pay for every eventuality and expense in the future.

Some commercial developers are again considering using the condominium model to develop commercial and retail projects. The main benefit to this model is a shorter horizon to gain significant profits, even with a leveraged position. Granted, the income a developer receives happens once—at the time of sale (unless the unit is held as a rental)—but obtaining a smaller profit in a shorter timeframe can be an attractive scenario for many developers.

Developing a commercial condominium usually does not involve much extra legal work compared to a well-documented leasing project; instead of form leases and covenants, the project is governed by a condominium declaration. As sales close, profit is realized and soon the developer is out of the picture. The individual owners form a board that manages the property onward.

For developers who prefer the absolute triple net lease model of passing on all future operating expenses to the tenants, it makes sense to consider whether a condominium model generates a sufficiently-satisfying profit in a shorter timeframe. There are also benefits to creating the development as a condominium and retaining the units for rent; why not invite tenants who will shoulder an absolute triple net or a generous triple net lease while you retain the flexibility to sell of that portion of the property (the condominium commercial unit) in the future should the market be ripe?

Beyond documenting everything correctly, there is no one business model that is “best” for any one or all types of developments, but condominium-style models have some merit to consider as we look at a changing commercial and retail landscape. Leases will always remain a constant in the commercial market as tenants invariably like the comfort of an exit strategy, but there remains some food for thought for developer-landlords to consider having an exit strategy, too.

Contact a Chuhak & Tecson Real Estate attorney for legal counsel regarding the best course of action for commercial property development projects.

This Chuhak & Tecson, P.C. communication is intended only to provide information regarding developments in the law and information of general interest. It is not intended to constitute advice regarding legal problems and should not be relied upon as such.

Client alert authored by James R. Stevens, Principal