Distribution Centre Leases – Suited for You?
Narrator: You’re listening to season two of WeirTalking Leasing. A podcast series from WeirFoulds LLP’s commercial leasing lawyers in Ontario, Canada. In these first few episodes of the season, our speakers cover topics including co-tenancies, distribution leases, and changes to construction legislation that impact leases and construction projects. Now, onto the episode.
David Thompson: Hi, everyone. It’s Lisa Borsook, Co-Head of the Leasing Group, and David Thompson. Talking to you today about distribution centres. People with the growth in logistics and warehousing, it’s sort of a hot topic. So Lisa, what is a distribution centre?
Lisa Borsook: A distribution centre is a location, usually of an industrial nature, where the tenant uses the premises for the purposes of distributing product. So, they can be distributing product because they’re a logistics company, which means that they’re a company, the sole purpose of which is to distribute product for other entities, or they can actually be leasing the premises for themselves. So, as you can imagine, with the advent of the internet, a number of companies that historically distributed their product through retail locations are now distributing them through distribution centres, directly to consumers.
David Thompson: So are there different types of distribution centre leases? Obviously, depending on if it’s a third-party logistics company or it’s their own product?
Lisa Borsook: I think that the difference between the leases for distribution centres that are for a logistics company or for a tenant themselves aren’t so substantial. There are a variety of different types, depending on really whether or not it’s a build-to-suit distribution centre or an existing industrial premises, but regardless whether it’s a logistics company or a tenant, a tenant that’s actually distributing its own product, but particularly in the latter case, it is likely that they are going to put a lot of money
into the leasehold improvements that they’re putting into the distribution centre. What with an incredible array of new systems that mechanize the process of distributing product.
David Thompson: So build-to-suit, what does that mean? They’re only building the inside or they could even build the entire shell?
Lisa Borsook: Well, build-to-suit is for sure the more complicated type of distribution centre lease that you can do. It involves the landlord usually, not always, but usually building the location for the specific tenant, and usually building it to suit their specific needs. So what happens is you enter into a lease, there’s usually quite a long construction period at the beginning of the lease, and depending on who is doing construction, there’s a package of risks that you need to deal with in the lease relating to that construction. So the build-to-suit, if it’s being done by the landlord, creates certain risks on the tenant. On the other hand, if the build-to-suit involves the landlord handing over the land to the tenant and the tenant doing the construction, then the landlord has a package of risks that it wants to look at as well in the context of the construction process.
David Thompson: So for tenants, often it’s a ground lease rather than a building lease. What does that mean?
Lisa Borsook: A ground lease is a lease of the land. And it’s not a lease of the building. So, if you can imagine, if you go to lease a retail store in a shopping centre, what you’re getting is a lease just of premises. The interior area of a location: not the walls, not the structure. If you’re entering into a ground lease, then what you’re doing is leasing the entire package of land and everything that’s on it. At the beginning of the lease, if it’s a build-to-suit, there may be nothing on it, except for maybe environmental hazards. And then when you build it, if you’re one year in, or you’re two years into the term of the lease, the ground lease is going to include the ground, plus the building and all the other improvements. The parking, the landscaping, everything else.
David Thompson: So then there’d be different costs in that kind of lease than a normal store lease, because you have to deal with the parking lot, you have to deal with structure, you have to deal with things that normal tenants wouldn’t deal with, right?
Lisa Borsook: So within every genre there’s a whole bunch of different options. And in a lot of build-to-suit leases, which are ground leases, the tenant, once the construction’s completed, is taking over responsibility for all of those costs. So these are usually long-term leases. They can run for 30-50 years, longer than that. And during the course of that period of time, the landlord really doesn’t have to do anything except collect the rent and make sure that its property isn’t falling into a state of disrepair. It probably also carries some measure of insurance. But, otherwise the tenant is absorbing all of those costs. It is carrying out the snowplowing. It is making sure that the landscaping’s in place. It is even in a lot of circumstances responsible for effecting capital repairs and replacements to the structures that are built on the basis that that’s a risk that the tenants should be absorbing in a build-to-suit arrangement.
David Thompson: So, this triple-net thing, and basically the tenant is maintaining and repairing everything, what does the tenant get to take at the end of the day? I mean, you talked about the sophisticated equipment they have inside. I’ve heard about conveyor belts that now packages are floating on air. It’s all done by computer. You need two people to run the thing now. Who owns that and who insures that and takes care of all that stuff?
Lisa Borsook: Distribution leases are, by their nature, heavily negotiated documents. Each of the landlord and the tenant is putting a lot of money into this project. So, the ordinary rules relating to who owns what, don’t necessarily apply and they’re negotiated. So if for instance, a tenant is planning on installing a sophisticated system to automate the distribution of their product or a sophisticated racking system into the premises, despite the fact that those items might in other circumstances be considered leasehold improvements, and hence be the property, the landlord, once they’re affixed to the premises. Most tenants of any sophistication will provide that those items are not leasehold improvements, that they’re tenant’s trade fixtures.
And that means that the tenant has all rights in them and can remove them at the expiry of the term. And then, if you want to take it a step further, they may even negotiate to have the option to elect whether or not to remove them or to leave them there.
David Thompson: So you might end up with a shell that’s sort of blank, or you might end up with a shell that has this cool conveyor system in it. But, maybe your next tenant can use it or maybe not.
Lisa Borsook: That’s correct.
David Thompson: Okay. So then outside in the yard with the trucks and the entrance and all of that, there’s sophisticated security and things like that now. So, because it’s a ground lease, would the tenant be in charge of most of that?
Lisa Borsook: In the ordinary course, if it’s a ground lease where the tenant is assuming responsibility for all of those things, then yes, the tenant’s going to create a security system that satisfies their own security needs. And in those provisions of the lease, which usually deal with the right of the landlord to go in and take a look around, make sure that the tenant’s living up to its obligations, it’s likely going to be subject to compliance with the tenant’s security protocols.
David Thompson: So from a financing point of view, I guess, well since you said there’s a lot of investment by each party, there’s going to be two banks involved, but how are they usually financed for the landlords, for example?
Lisa Borsook: Well, if the landlord’s doing the construction, then likely they’re going to go to a lender. And the lender is going to provide to them financing for the construction. There can be different levels, there can be bridge financing, and then permanent financing. These are all going to be identified in the lease. They’re going to be dealt
with sometimes in separate documents. The leases sometimes contain sophisticated construction plans and specifications. They contain sophisticated lender requirements. Lenders have a special package of concerns that they’re going to want to look at the lease, make sure those concerns are appropriately dealt with. And also, these costs of construction, the lender costs that the landlord is assuming are likely going to be a component in the determination of what the rent is that the tenant is going to pay.
David Thompson: So the financing for the tenant, I guess they have to finance, let’s say they’re not building, let’s say it was a shell that was built by the landlord. They have to do all their improvements, so their special security, their special racking, their special conveyor, all of that. How does the bank get that back if they default? I mean, how would they get in the warehouse?
Lisa Borsook: What happens is that the tenant’s lender, if they are just financing those kinds of trade fixtures and other improvements, is going to ask the landlord and the tenant to enter into an agreement with it. We call them tripartite agreements, we call them lender agreements, but basically they’re another agreement whereby the landlord agrees that the lender has a certain package of rights relating to the things that it has financed, so that if the tenant goes bankrupt or if the tenant goes into default under its lending agreement, they have rights to go in and make sure that they can control the improvements that they financed. Or in some cases, even take over the tenant’s responsibility under the lease, arrange to have, for instance, the lease assigned, and somebody else to take over those improvements so that they can find a way to get their money back that they loaned to the tenant for those improvements.
David Thompson: So not only would you have a lease, you’d have construction aspects in the lease or a separate construction agreement, and then you’ve got this lender’s agreement. So it seems like you’ve got a lot of documents in a distribution deal.
Lisa Borsook: You do. I mean, you’ve got the usual documents that you get in conjunction with any major lease. You’ve got the lease itself, you’ve got the non-disturbance
agreement between the tenant and the landlord’s lender. You’ve got a notice of lease document that you want to get registered to make sure that your interests are protected. And then on top of that, you may have a package of construction-related agreements, insurance trust agreements that deal with the disposition of insurance proceeds in the event of damage or destruction to the improvements, either during the course of construction or later during the course of the lease. And those insurance trust agreements are often also looked at by the various lenders that are involved in this.
Lisa Borsook: Suffice to say that because there’s so much money being put into these kinds of facilities, there is a huge package of documents that go with them to satisfy the interests of the landlord, the tenant, the landlord’s lender, the tenant’s lender.
Narrator: You’re listening to WeirTalking Leasing, by WeirFoulds’ commercial leasing lawyers. We’re taking a quick break to tell you about part two of season two. Coming Fall 2020, the episodes will cover the latest updates in the commercial leasing world in Canada. Visit weirfoulds.com/podcasts for more information and to subscribe for updates. Now, back to the episode.
David Thompson: So you brought up before about construction, about the landlord doing it or the tenant doing it, and the specific specifications and sort of terms and conditions that they need in that. Do you want to talk a little bit more about the construction issues that come up?
Lisa Borsook: Whenever you’re doing construction on a property, there’s a package of risks that need to be dealt with in conjunction with the construction. For starters, and likely because it’s a ground lease or maybe if it was any lease, you’d be concerned about environmental issues. So the first thing you want to do is you want to make sure that the land in which you’re investing so much money is clean land. And then you want to think about how you’re going to allocate responsibility for environmental issues if something comes up in the future. Ordinarily, that something would be caused by the tenant, but then there’s always the possibility that contaminants will migrate onto the property from adjoining properties and people like to figure out
who’s going to be responsible for that and how it’s going to impact the carrying on of business in the premises. That’s a really, really important consideration.
Lisa Borsook: People do not want there to be any interference with their ability to carry on business in that premises. You’re going to want to make sure that the property has been properly severed. If it’s part of a larger parcel, you’re going to want to look at zoning-related issues, if the property needs to be rezoned or if you’re planning on backing up huge trucks into that distribution centre, you need to make sure that you’ve got access to public highways, that noise isn’t going to be an issue. You want to make sure that you can use that property for all of those distribution requirements that you need. I mean, some of them even involve gas stations on the property, so that when these trucks back up into the centre, they can actually fill themselves up with gas as well. You’re going to want to talk about who’s getting the permits, and because you’re at the discretion of a third-party, a municipal authority, you need to think in particular about the issues related to timing and permitting that are important.
Lisa Borsook: The construction itself, whether the tenant is doing it or the landlord is doing it, usually both parties want to monitor the construction to make sure that what’s going on is meeting both parties’ expectations. You want to make sure that contractors and subcontractors are taking proper care, that they’re being paid on a timely basis. There’s a package of insurance obligations, bonding and other security that gets put into place. Whenever you’re dealing with a large scale construction project, you want to think about what happens if halfway through the completion of your centre, somebody goes bankrupt. Who could be the somebody? It could be the landlord, it could be the contractor. It’s likely not going to be the tenant, but I guess it could be as well. You want to figure out who’s going to step in and finish this project, what the rights are going to be as a result of somebody going into default. And specifically, you really want to deal with issues relating to delay.
Lisa Borsook: It has been my experience that in conjunction with these distribution centres, the issue is all about time. We want this distribution centre by this date. What are you going to do to make sure I get it by that date? Because, there are other contracts that feed into this contract, that are impacted by that timing. If for instance, you’ve
arranged to get $10 million worth of racking delivered on a certain date, and the building is half-built, you have a problem. Timing, timing, timing. And finally, I would say that post-construction, particularly if it’s going to be a ground lease where the tenant takes over all of those responsibilities, you need to think about what warranties have been provided and whether or not they’re going to be assignable to you. Who’s going to be responsible for latent defects?
Lisa Borsook: I mean, roofs are always never … you’re never certainly going to get a roof that’s going to last as long as the term of some of these leases. Some of them go on for 30, 40, 50 years. Roofs have a shorter life, so you’re going to want to make sure that we get those warranties relating to the roof assigned to whose ever responsible for repairing and replacing that roof. And you want to talk about who’s going to be responsible if an actual replacement needs to take place, in say year 25 of the lease.
David Thompson: Two things I want to comment on there about what you said. One is, I heard, I don’t know if it’s an urban myth, I don’t think it is, but in Oakville there was a warehouse near a residential area and they basically made it a requirement that the trucks couldn’t idle at certain times because it would bother the people in the residential neighbourhood. So that’s one of your points about zoning, right? That you want it to be 24/7, because you want to be on the road maybe in the middle of the night, right?
Lisa Borsook: Have you ever heard a tractor trailer back up?
David Thompson: Yeah.
Lisa Borsook: Have you ever heard the sirens that go off in the tractor trailer itself when it backs up? If you’re next to a residential neighbourhood and it’s backing up at two a.m, You’re going to really upset a lot of people. So you want to make sure that the noise bylaws and the other bylaws in the vicinity aren’t going to inhibit your operations in any way whatsoever.
David Thompson: I was thinking about confidentiality. Let’s say Amazon was building a warehouse, and do they ever ask the landlord to keep it confidential so that FedEx can’t get their plans and specs or anything like that?
Lisa Borsook: A lot of global tenants have very strict requirements, not only relating to confidentiality, which is very important to them, not only with respect to their construction specs, but their ongoing requirements. They also have corruption provisions, codes of conduct that are posted on their international websites and with respect to which they expect their landlords to comply.
David Thompson: Right. The anti-bribery and the anti-terrorism stuff, especially for tenants out of the States. That’s a great point. Okay. So the timing issue. So everybody’s talked about the last mile ad nauseam, but for me, I feel like they’re missing the point now on timing. I mean, Amazon Prime is a great example. Everybody expects that they can get their product almost literally the next day. It’s like click and collect. And you’re sitting at home. It’s unbelievable. So do you think that has impacted the market and the deals that you’re doing in a big way?
Lisa Borsook: I don’t think there’s any question that it has. When somebody thinks about creating a logistics centre, and I should mention that there are two kinds. There are logistics centres and then they’re what are called reverse logistics centres. That’s where you buy a product and then you don’t want it and you distribute it back to the original deliverer. But, sometimes it goes to a different centre. Those are called reverse logistics centres. But, everybody who’s thinking about building logistics centers are trying to do them in a way that they can ensure delivery of their product to meet their clients’ expectations. And certainly for some internet providers, those expectations are 24 hours.
Lisa Borsook: So you can imagine that the rent for a building that’s located within a very short distance of a larger metropolitan centre, and it needs to be very close to easy transportation routes, they’re going to be able to get a much higher rent, because
it’s so important to that provider to get their product out within a short period of time. And we’ve seen rates for those kinds of industrial properties, for instance, for existing industrial premises, go from anywhere from six to seven dollars a square foot to 18 or 19, but a lot of people who are thinking about leasing those premises can rationalize that cost because they’re providing products so quickly and they’re keeping their own transportation costs down because of proximity to these larger metropolitan centres. The costs of transportation are expensive.
David Thompson: So with these long term leases, is there particular legal issues about, let’s say the Planning Act or something like that?
Lisa Borsook: Well, when you enter into a lease in the province of Ontario, if that lease is for part of a property, not a whole of a lot in registered plan of subdivision, any lease really for greater than 21 years is subject to Planning Act consent. And that means that you have to go to a local body and get a specific consent to the lease for being greater than 21 years. Otherwise, at the end of that 21 years, less a day, the lease is void. And if you’re planning on entering into a lease for 30 or 50 years, that would be a stunning development.
Lisa Borsook: You also have to be conscious about the Land Transfer Tax Act. The Land Transfer Tax Act says that any lease that’s for 50 years or greater is considered to be a disposition of the property in respect of what you have to pay land transfer tax. So people look at that pretty closely to try and figure out whether or not they might be subject to land transfer tax. And the lease is not just the term, but it’s the term plus extension periods. So, that’s a factor. Even though you may have a term for 30 years, if you build into your lease, the right to have five or six, five-year extensions, you’re going to bump up against the Land Transfer Tax Act.
David Thompson: OK. The last thing I wanted to ask you was, if you had an existing facility, what to you would be a couple things that would change the value of the facility? I mean, something like the proximity to 400-series highways or a bigger yard that you could have more trailers. I get that, but the building itself, is there anything that has to do
with, I don’t know, height or doors or anything that increases or decreases the price?
Lisa Borsook: Because of the costs associated with distribution facilities can be quite large, people are looking to pack as much as they can into those facilities. And so, if they can do that by having higher ceilings, clearer heights, if you will, then that’s obviously going to be advantageous to potential tenants who want to use that facility for a logistics centre. There are other things that people are building in to their developments that would make it more attractive to lease that development. People like to be able to pull up their trucks and drop off their product, and then at the other end of the building, sometimes they like to be able to take that product and put it onto another truck and send it out to the consumer or whoever it is they’re delivering the product to.
Lisa Borsook: Those are called cross docks, and they’re becoming a little more common. Suffice to say that whatever in your building is going to facilitate the intensification of product, and the easy distribution of that product in and out of the building is going to be advantageous to you.
David Thompson: Thanks very much.
Narrator: Thanks for joining us for this episode of WeirTalking Leasing by WeirFoulds’ commercial leasing lawyers. Please take a moment to rate, review and subscribe. And if you’d like to hear from our lawyers on another topic, send us an email: firstname.lastname@example.org. Tune in again soon.