Financing Focus

Financing Fusion

The lease-own hybrid model provides fuel for property transactions.

Many areas of the U.S. have an oversupply of office and industrial property, tight access to capital, and fewer and shrinking local businesses to sustain property absorption. During this turbulent period, the ownership-leasing hybrid approach may provide an attractive, profitable alternative to steep rent concessions or condominium sales to only the most creditworthy prospects.

The ownership-leasing hybrid is ideally suited for properties in major metropolitan areas and those catering to professional-services firms and light-industrial users. Privately held companies and partnerships are ideal prospects since their principals tend to find the profit-making potential of the program attractive and are more amenable to longer lease terms. Finally, the ownership-leasing model is flexible and suits a variety of marketing objectives and developer preferences.

Hybrid Advantages

In April 2008, the owner of a new 130,000-square-foot medical office building in a major metro adopted the ownership-leasing model after 18 months of attempting to lease the building, followed by unsuccessful efforts to sell the property as office condominiums. Within the first 90 days of using the hybrid model, 30 percent of the building leased up. At present, the developer is experiencing an absorption rate of 5 percent to 10 percent of space per month — even as the economy has continued to deteriorate — and it expects to lease 95 percent of the building within 18 months of adopting the hybrid program.

As a financial tool, the ownership-leasing hybrid combines the advantages of leasing and selling commercial property. In its simplest form, a tenant company leases space in a building and, in turn, the tenant (or its principals) receives an ownership stake in the landlord entity with an opportunity to participate in the company’s annual profits and long-term appreciation. As consideration for this ownership interest, the tenant agrees to a long-term lease and pays strong market rents with few concessions. The tenant also may provide personal guarantees to ensure lease term fulfillment.

Developers and owners also gain from the ownership-leasing model. The hybrid approach accelerates tenant occupancy and allows the developer to quickly transfer the financial burden of owning and operating the building to rent-paying tenants, thereby eliminating the need to inject additional capital into the project. The developer also retains control of the property and landlord entity and pays itself a monthly managerial fee. In addition, the developer typically reserves to itself a fixed return on its original equity investment. Taking advantage of the building’s strong market rents and long-term leases, the developer may choose to realize its profits by refinancing or selling the property as early as the initial lease-out of the space.

The Agreement

With the assistance of skilled legal counsel, the developer documents the tenancy relationship using a standard commercial lease with a few modifications. First, the lease is modified to include a special stipulation that incorporates the terms of the landlord’s corporate documents by reference and provides the method of determining the tenant’s ownership interest in the landlord entity (for example, by square foot proration).

Second, the lease default terms should define particular defaults and reasonable notice and cure periods that result in a rescission of the tenant’s ownership interest. Typically, an uncured default during the initial lease term automatically triggers a buy-out right of a tenant’s interest in the landlord entity for nominal consideration. This approach provides an incentive to ensure tenant compliance with the lease terms and avoids underperforming tenant-owners.

Finally, the tenant’s right to transfer its ownership interest in the landlord entity frequently vests after the initial lease term. Should a tenant decide to vacate the premises after its initial lease term, the tenant may retain its ownership interest in the landlord or decide to cash out.

The ownership-leasing hybrid’s corporate documentation is slightly more difficult and requires careful attention to federal and state securities laws. Assuming the landlord entity is a limited liability company — although other entity types may be used — the developer is a member owning one class of interests (for example, class A interests) and is the landlord entity’s sole manager. Except for certain major decisions reserved by law, the developer unilaterally makes all decisions for the company. The LLC operating agreement also provides for the developer’s preferred return on its original equity investment in the project and may provide compensation to the developer for managing the company’s daily affairs.

The tenant-owners also are members of the landlord entity, but own a different class of interests (class B interests). Their only substantive interest in the company is the right to receive net income, as defined in the LLC operating agreement. Initially, the developer is the sole class B member and distributes its class B membership interests as qualified leases are executed. The developer probably will retain some class B membership interests as a result of common areas in the building and any short-term leases that may not qualify for this tenant concession.

Finally, the LLC’s operating agreement addresses the developer’s right to repurchase a tenant’s membership interest for nominal consideration in the event of a tenant’s default. It also may provide for no capital calls on the class B members and restricts the class B members’ right to transfer their membership interests. Related to this point, tenants may decide to hold their class B membership interests in a separate company comprised of its principals, which allows the tenant greater flexibility in adding and removing principals over time and in obtaining preferable accounting and tax treatment of future income distributions.

Securities Considerations

The sale of stock or membership interests by the developer is considered the sale of securities and must be registered with the Securities and Exchange Commission or satisfy an applicable exemption. Most developers try to achieve safe harbor protection by satisfying Regulation D rules. Moreover, each prospective tenant (or its investing affiliate) must qualify as an accredited investor under applicable law; most commercial tenants tend to meet this investment standard. Finally, the developer should make a Form D filing with federal regulators to document the offered transaction.

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