Title two lines - Pepper€¦ · demand has all but disappeared in the Australian commercial office market. ... In many instances, these types of fitouts have been delivered via an

Pepper Property

Delivery Risk Whitepaper

2 Pepper Property Delivery Risk Whitepaper | 2016 |

1.0 EXECUTIVE SUMMARY 3

2.0 PARADOX OF LEASING 4

3.0 COUNTERPARTY STRENGTH 6

4.0 COUNTERPARTY ENGAGEMENT & MARKET PROCESS 9

5.0 FITOUT DELIVERY – RISKS & OPPORTUNITIES 11

6.0 SUMMARY OF THESIS 13

3 Pepper Property Delivery Risk Whitepaper | 2016

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1.0 Executive Summary

Since the 1990’s, speculative development to meet forecasted demand has all but disappeared in the Australian commercial office market.

More stringent lending policies have curtailed the traditional developer-led speculative supply trends. With the break in the speculative supply side, the risk - reward equation between a tenant and developer has reset. Subsequent market transactions meant that large tenants seeking contemporary building design, floorplates and building services were only able to procure these contemporary products via pre-lease arrangements.

The purpose of this paper is to analyse current market practices and the “below the line” elements associated with pre-lease arrangements to deliver either a new development or major refurbishment of an existing building.

In a macro sense, Pepper’s analysis is the property market is imperfect. Traditional leases are not cost effective and transfer risk to tenants without equitable reward. Consequently, a tenants lease commitment and covenant strength can be valued and traded by the owner in the open market with little to no personal benefit to the tenant.

Pepper’s assessment is that a tenant’s commitment via a Lease or Agreement for Lease commitment underpins a developer’s ability to source funding, commence construction and create asset value via the delivery of new building. The tenant does not share in this value creation even though they underpin it.

This paper will examine in more detail the “below the line” risks associated with pre lease arrangements and the “industry standard” practices imposed on tenants and the strategies which can be used to mitigate the same.


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2.0 Paradox of Leasing

Intuitively most corporate tenants view a leasing transaction as the lowest risk scenario.

The above assumption can be compared to alternate financing and delivery methods where the tenant/occupier takes a more direct contractual position with a delivery and construction partner.

The perception that a leasing transaction presents less risk than other forms of project delivery are incorrect. The prevailing standard practice of leasing pre-commitment places significant constraints, costs and risk onto tenants compared to having more direct contractual involvement and greater control over the project delivery. This particularly relates to the building contracts for base building and the tenant’s fitout where significant cost efficiencies can be achieved.

The limited supply and conservative risk position of traditional landlords is causing tenants to accept a transfer of risk without equitable reward. More significantly, traditional tenants have little or no control over the contractual arrangements between the landlord and builder. This situation causes the tenant to then proceed in an exposed and captured position, resulting in a higher risk position than if the tenant had more direct involvement or control. In Pepper’s experience, there can be a price premium of up to 20% in this captured position.

Assuming a typical pre commitment of circa 30,000m2, using the above figures a fit out construction contract represents a capital expenditure of circa $75 million (nominal).

In many instances, these types of fitouts have been delivered via an integrated method designed to improve efficiencies and deliver savings back to the tenant. Logically, integrating the base building and tenants fit out contracts should achieve these efficiencies.

However, in practice the system has been manipulated with numerous instances of third party contractors pricing the Landlord/Developers base building contract at zero margin, in the knowledge that an integrated fit out is guaranteed. As a result, the tenant is exposed to a monopolistic position with increased preliminaries/margins and sub-contractors nominated by the base building contract. This structure results in the tenant not being able to achieve parity in the pricing and delivery of the tenancy fit out.

Table 1 Construction Costs: *Includes demo/construction costs and builders margin/preliminaries **Assumes a mid – tier open plan legal fitout

Base Building Construction*

Tenancy Fitout Construction**

Construction Cost ($/m2) (2016) $4,800/m2 $2,500/m2


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Recent examples of this structure have resulted in additional cost premiums of circa 15-20% on the tenancy fit out contract value. Using the figures references in Table 1, this would equate to an unforeseen overspend of circa $11.25 million - $15 million. Any financial benefit delivered through the commercial lease structure is undermined by not having control or parity in contract pricing.

Even in circumstances where a third party fitout contractor is to complete the fitout works, the base building contractor will typically be instructed to perform base building modifications, at a premium. For example, if the instruction is a different layout of the same number of light fittings it should be nil cost but in practice it never is. If it is not laying carpet tiles, the tenant should get full credit for no carpet but is often offered merely the savings on the install as “the carpet has already been ordered”.

The most successful recent example of time and cost mitigation in this situation is the purchase and refurbishment of 50 Martin Place by Macquarie Group Limited.

The circumstances presented a tight timeframe with risk attached to approvals. More significantly, design variations were required to be implemented through the $150m construction and tenant fitout contract.

Macquarie assessed that the risk was too great to pass onto a traditional landlord/developer and the best mitigation strategy was to control directly. The base building and fitout contract were let as one and resulted in a 15-20% saving in fitout costs compared to budget.

Observation: Consider alternative fit out methodologies to ensure price parity and captured pricing is avoided, one example would be to let the base build and tenant contract simultaneously.

Case Study 50 Martin Place


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3.0 Counterparty Strength

Market Practice

The current market practice of tenants entering into an Agreement for Lease (“AFL”) prior to the delivery of either a new development or the major refurbishment of existing premises results in the unequitable transfer of risk from asset-owners, as developers, to the tenant.

Institutional landlords and fund managers no longer have an appetite or capacity to accept traditional property development risk. Typically a developer will establish a separate Development Entity or Special Purpose Vehicle (“SPV”) and therefore will resist providing a corporate or commercial guarantee to support contracted performance. This presents difficulties to large scale corporate occupiers seeking to understand the strength of counterparties with the aim of minimising delivery risk or in underwriting continuous occupation. Furthermore, as a means of minimising a risk, developers often seek “Fund Through” partners, which results in the developer acting more as a manager than a principal stakeholder. The “Fund Through” partner provides an end take out of the building, however also provides the upfront construction financing. This structure is graphically articulated in Section 3.0.

Typical Development Structure

Conferring ownership of an asset in a limited liability SPV is the preferred method by which asset owners seek to minimise their risk exposures. In this regard, the SPV provides a convenient method of parcelling up assets whilst retaining the ability to enter into contracts, particularly relating to the financing, management and/or development of the asset. While convenient for landlords, this ownership structure introduces complexities for tenants in determining their risk exposure in entering into leases, particularly in circumstances where they pre-commit.

Chart 1, below, articulates how far removed a tenant can be from a Parent Company, illustrating the importance, from a tenant’s perspective, of ensuring appropriate guarantees are in place for security of delivery. The relationship between the tenant and the Landlord/Builder, under this structure is characterised by a lack of control over the contractual arrangements between the parties, which results in increased risk exposure for tenants, particularly in comparison to a structure that affords more direct involvement in project delivery and greater control.


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Perth (2006)

• Tenant entered into an AFL with counterparty of no financial substance (“SPV”)

• Rent was set at below market without building contract in place or priced

• Developer provided continuous occupation including agreement to underwrite exercise of Option Terms in existing premises

• Counterparty failed to perform partly because of an escalation in construction cost which caused the rental to become economically unviable

• Counterparty entity was of no substance and was unable to fund the option exercised due to delay

• Tenant ‘stepped in’ to finalise the delivery

• Counterparty developer fell away

Case Study Commercial Bank


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Brisbane (2011) • Tenant entered into an AFL for a new commercial development

• Bank proceeded to sell and lease back its existing head office. Lease expiration

co-incided with expected delivery of new development

• Developer counterparty failed to secure finance and consequently was unable to perform its contractual obligations.

• The bank then had to negotiate fresh lease terms with the sale and lease back owner of its existing premises to provide security of tenure and continuous occupation.

Observation: As shown in Chart 1 a typical development structure is complicated and counterparties willingness to accept traditional property development risk is limited as they seek to transfer this through contractual arrangements involving multiple parties. It is critical that tenants understand the parties and associated risks involved, in a ‘disaster’ scenario as detailed in the case studies above. A well advised tenant should consider what enforceable contractual obligations exist and are there sufficient guarantees and step in rights to resolve matters if third parties do not perform.


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4.0 Counterparty Engagement & Market Process

The relationship between Tenant and Landlord (predominantly A REIT’s and institutional owners) is a critical element that is often overlooked and in some instances mismanaged by both parties. For a large scale corporate tenant to avoid being marginalised, strategic engagement and sequencing of discussions with counterparties is paramount.

Market engagement should be progressive & collaborative and avoid unnecessary time and cost exposures. All parties should recognise that there is reputational and financial risk associated with negotiations. Notable recent examples have demonstrated that an overly prescriptive and opaque process, has resulted in counterparties publicly stating they will not treat with certain tenants again. This has stemmed from the amount of capital and resources expended throughout the negotiation process with no indication of probability of success.

In addition to reputational damage, given the inherent risk associated with large scale pre-commitment negotiations and the relatively small pool of institutional landlords this approach can compromise risk mitigation strategies and future negotiations to the tenant’s disadvantage if preferred outcomes are not achieved.

In Peppers experience, counterparties respond more effectively to an approach whereby they are well informed of their suitability and the process.

A process which provides market participants the opportunity to be actively involved and put forward opportunities will ensure that if dissatisfaction arises, the process has allowed all parties to be actively involved. Subsequently, any potential counterparty dissatisfaction can be dealt with through a transparent, fair and equitable selection criteria preserving relationships.

Further to the elements outlined in Section 3.0, ensuring that each counterparty is dealt with in a bespoke manner is crucial by understanding their corporate structure. For example, a typical Fund Manager will have trustee limitations and as a result ensuring adequate parent company guarantees are in place is paramount.


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2014-

• Shortlisted development sites for a CBD pre commitment were submitted as part of a market engagement process and counterparties made representations concerning delivery risk profile

• Pepper undertook due diligence to understand ownership, timing risk and implications for non-performance

• A preferred counterparty was unwilling to provide a parent company guarantee despite assurances on delivery

• Investigations established that the developer in question had proposed to operate under a construction management agreement, as such the control of the land would not transfer until completion of the development

• This meant that ultimately if there was non-performance by the developer the pre-committed tenant would have no legal right to pursue the counterparty and as a result no security of tenure

• Ultimately the site was discounted by the prospective tenant due to the risk profile that was uncovered

Case Study Professional Services Client


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5.0 Fitout Delivery – Risks & Opportunities

The traditional view is that an integrated fitout when moving into a new building or one undergoing major refurbishment is advantageous to tenants as the works are completed once, to the specification of the tenant, which intuitively should result in cost savings and the works are completed in parallel with the base building works providing the earliest possible completion date. However, unfortunately this is not always the case. While time benefits are clear, the tenant can in fact pay more for their fitout as their fitout is being priced in an uncompetitive environment.

Commonly the Landlord or Developer will ask the base building contractor to deliver the fitout works. The Base Building Contractor is in a monopolistic position and could seek to charge excessive preliminaries and margin. In addition, each subcontractor is in a monopolistic position as other subcontractor are unlikely to price against an incumbent. Therefore, the tenant is hit twice with inflated costs, first from the subcontractor then from the base building contractor applying an inflated percentage to an inflated subcontract price. This also extends to any base building variations.

When a base building contractor is pricing Preliminaries on a fitout contract they should take into account the economies of scale of already being on site and the multiple ‘hats’ many of their employees will undertake. This is often countered by the argument that there will be a dedicated fitout team. In practice, the same foreman installing the base building services and finishes will also be installing the fitout services and finishes, so there is a double dip and the tenant is asked to pay for a full additional resource.

When modifying base building designs, all parties should seek to agree with the following principle:

Principle: if base building light fittings have not yet been installed and the tenant wants to locate these same type and number of light fittings in different positions on the floor, there should be no cost. The real cost of integration can be zero.

Unfortunately, this principle is not always agreed. The same principle applies to other building services but is rarely applied.

Once the issues of integrated fitout are understood mitigation strategies can be put in place. There is not a single solution and many factors, in particular the point in time in both the development program and leasing timeline, will determine which mitigation strategy to support.

Mitigation strategies are typically based around the extent of Landlord’s works that are completed. By negotiating out base building works prior to these works being undertaken can produce a saving on fitout costs for the tenant. Project delivery options include:

• Capped Price Fitout cost negotiated with AFL – the Landlord and developer take on the risk of integration of base building services and/or fitout works by negotiating an upper limiting cap on fitout costs


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• Tender fitout with base building – this is possible where the fitout design is completed prior to the base building tender, which for a new building is very rare

• Integrate Building Services only – commonly called a ‘warm shell’, this limits a tenant’s exposure to incumbent contractors for building services only. However, the tenant is also seeking to negotiate credits for uninstalled base building finishes in an uncompetitive environment

• Cold Shell – the tenant will complete the fitout post-completion of Landlords works, however will need to negotiate credits for base building works not completed.

It is clear there is not a single solution for all tenants and a bespoke solution will need to be developed depending on where the tenant sits in both the development program and leasing timeline.

From our experience what we do know is that being prepared early, having an understanding of the tenants preferred procurement method early and spending the time in the initial phases of Agreement for Lease negotiations resolving these issues will be to the benefit of the tenant when negotiating fitout contracts or credits for incomplete works. Moreover, commencing design at the earliest possible opportunity to maximise the time in which to identify works that can be integrated and negotiating a realistic and acceptable costs for these works will be to the benefit of the tenant.


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6.0 Summary of Thesis

This report seeks to identify a number of elements of risk which may not fully be understood or appreciated by market participants. It seeks to discuss a number of the major cost implications of perceivably “below the line” issues. As the market evolves, elements or industry standard practices which were perceived to provide a benefit to tenants are now resulting in unforeseen cost and risk premiums. Corporate tenants considering the delivery of new premises via pre-commitment lease structures need to assess carefully what are the risks, can these be mitigated and is there an equitable reward for taking on these risks?

E: [email protected]

W: pepper.com.au/property

T: +61 2 8913 3013

mailto:[email protected]


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Title two lines - Pepper€¦ · demand has all but disappeared in the Australian commercial office market. ... In many instances, these types of fitouts have been delivered via an