Karbank Blog

A successful real estate development project is based on many factors: a good location, suitability of the site for the intended use, availability of utilities, traffic patterns, a logical site plan, a functional and attractive building design, permits,  a high quality contractor and sub-contractors, sensible financing, effective marketing, and many other factors.  Problems with any of these factors can negatively and severely impact a project.  Yet sometimes real estate projects are so ill conceived that a good real estate developer or broker can quickly spot a real estate development train wreck.

We recently reviewed a Request for Proposal for a build-to-suit development of a 100,000 sq.ft. office project for a large international pharmaceutical company (we’ll call it “Pharma” in this posting).  Pharma’s RFP, which was given to numerous developers and contractors, was unnecessarily complex and onerous and must have taken months to put together.  A quick glance at the RFP raised red flags: this project was a real estate development train wreck in the making. 

The RFP was clearly drafted by lawyers, in coordination with Pharma executives and engineers, who had little or no practical knowledge of real estate development, financing or construction.  The proposed deal structure was comically unrealistic.  The first red flag. 

The location was “C-” quality, at best.  Pharma owned the ground, which was part of a large manufacturing complex of oddly designed and inefficiently positioned buildings.  Though Pharma had invested hundreds of millions of dollars in buildings and equipment over the years to support its manufacturing at the complex, from a real estate point of view, the complex was a hodgepodge, a collection of peculiar decisions.  The second red flag.  

The RFP stated that Pharma would provide a 35-year ground lease to the developer for the portion of the property on which the developer was to build the building.  Even though the company was willing to lease the building for 15 years, the combination of the inferior location and the (relatively) short ground lease meant that financing would be difficult and unfavorable and the rent would need to be unnecessarily high.

Pharma, despite being very profitable, apparently wanted to avoid owning the building because the capital expenditure would have to show on its balance sheet and presumably limit its corporate borrowing capacity.  However, the deal structure stipulated by Pharma was based a false assumption that Pharma could classify the proposed building lease with the developer as an operating lease rather than a capital lease (the latter of which, according to accounting rules, must be shown on a company’s balance sheet).   A brief telephone conversation with a savvy real estate developer, a knowledgeable lender or an accountant could have cleared up that misconception.  Months and months and tens or hundreds of thousands of dollars were spent (and wasted) on preparing an ill-conceived RFP.

Another problem with the project was that Pharma had hired an architectural firm to draws plans and specs for the project, but the plans and specs were far from complete when the RFP was provided to the developers and contractors.  This was another red flag.  Architects may understand design and engineering, but not necessarily real estate development and construction.  Not having a developer and contractor involved from the beginning of the design and development process, when their knowledge and input matter most, usually results in higher costs, time delays, problems during construction and liability issues.

The project timetable outlined in the RFP indicated a fast-track project...yet another red flag.   Under the right circumstances (when the developer, contractor, architect and client are working cooperatively together), fast-track projects can have very good results.  Under the wrong circumstances, such as in Pharma’s project, with an ill-conceived deal structure and a disorderly development process, fast track projects compound problems.

With so many red flags in the project, one can only hope that Pharma’s decision-makers are not color-blind and mistake the red flags for green flags.  Pharma would be much better off to raise the white flag, throw away the dangerously flawed RFP and rethink the project with the help of an experienced developer, lender and contractor.  Otherwise, the real estate development train wreck is inevitable.

Steven Karbank