Build-to-Suit Net Lease: When the Cap Rate Misleads You

TL;DR

A build-to-suit (BTS) deal is when a developer constructs a building specifically for a tenant, who agrees to a long lease at terms tied to the developer's cost basis plus profit. The OM presents it as a clean "new construction, long lease, credit tenant" story — and it is. But the rent has an embedded developer profit margin that flows into the cap rate calculation, and the underwriting question is whether that rent is sustainable on a market-rent basis if the tenant ever vacates.

The right underwriting framework for a BTS deal isn't just "cap rate vs comps for similar tenant credit." It's also "rent per sq ft vs replacement cost per sq ft" and "rent vs market rent in this submarket for this asset class." Get those wrong and you're underwriting a deal where the rent is structurally supportable only as long as the tenant stays.

How a Build-to-Suit Gets Built

The mechanics, briefly:

1. Tenant selects a site (often the tenant's own site selection team finds it, sometimes a developer brings it).
2. Developer purchases or controls the land, then negotiates a lease with the tenant before breaking ground.
3. Lease terms are calibrated to support the developer's pro-forma: rent = (land cost + construction cost + soft costs + developer profit) × cap rate target.
4. Developer constructs the building to tenant specs.
5. Tenant takes occupancy and starts paying rent under the lease.
6. Developer sells the completed asset to a long-term net lease investor — often within months of stabilization.

The key insight: the rent number isn't set by market dynamics for the asset class. It's set by the developer's cost basis plus required profit. A developer building a 14,000 sq ft Walgreens at a $4.5M total cost basis (land + hard + soft + profit) needs $315,000 of annual rent to hit a 7% yield-on-cost. That's $22.50 per sq ft NNN — which may or may not be market rent for general retail in that submarket.

The Cap Rate Distortion

Here's how the cap rate gets compressed in a BTS deal vs an equivalent older asset:

Scenario A — Existing asset, same tenant

• 14,000 sq ft Walgreens, built 2008
• Current rent: $18 per sq ft NNN ($252,000 annual NOI)
• Asking price: $4.0M
• Cap rate: 6.30%

Scenario B — Brand-new BTS, same tenant

• 14,000 sq ft Walgreens, just delivered
• Rent: $22.50 per sq ft NNN ($315,000 annual NOI)
• Asking price: $5.6M
• Cap rate: 5.625%

The buyer of Scenario B pays a 70 bps tighter cap rate. The OM justification is "brand new, longer lease, less near-term capex risk."

The underwriting question they're not asking: what is the rent supportable at if the tenant vacates?

Suppose Walgreens vacates after 10 years. The next tenant is unlikely to pay $22.50/sf for a 14,000 sq ft former-pharmacy box in a submarket where general retail trades at $14-16/sf. The re-leasable rent might be $14/sf — a 38% drop. Apply a 7.5% market cap rate to the re-leased NOI ($14 × 14,000 = $196,000), and you get $2.6M of value vs your $5.6M cost basis.

In Scenario A, the original buyer paid $4.0M. The same vacancy scenario reaches the same $2.6M value — a 35% loss. Bad, but less catastrophic than the BTS buyer's 54% loss.

Three Disciplines for Underwriting BTS Deals

1. Compare Rent to Replacement Cost

The right starting metric for a BTS deal is rent yield on replacement cost — i.e., the rent the developer is collecting divided by what the building actually cost to build (land + hard + soft, no developer profit).

Industry rule of thumb: developers target a 6-8% yield on cost for a stabilized BTS deal. If the rent supports an 8% yield on cost, the developer is making roughly 100-200 bps of profit margin (selling at a 6-7% cap = 14-25% premium to cost basis).

Underwriting implication: if the deal is priced at a 6% cap rate and the rent supports an 8% yield on cost, you're paying ~25% above replacement cost. That's the implicit developer profit you're inheriting.

2. Compare Rent to Market Rent for the Asset Class

Not the rent for "another Walgreens" — the rent for general-purpose retail of the same size in the same submarket. This is the rent you'll re-lease at if the tenant ever vacates.

Sources for this:

• CoStar / Reonomy lease comps (for office and large-format retail)
• Local broker market reports (often have retail rent ranges by submarket)
• Sub-market broker conversations (the most reliable source for a specific asset class in a specific area)

If the BTS rent is more than 25-30% above market for the asset class, you're underwriting a deal that has no organic rent support — it works only as long as the tenant stays.

3. Calculate the "Tenant-Stays-Forever" Premium

The cap rate spread between Scenario A (existing) and Scenario B (BTS) above is 70 bps. That spread compensates the BTS buyer for: longer lease, no near-term capex, brand-new construction.

What it does not compensate for: the embedded developer profit, or the gap between BTS rent and market rent for the asset class.

A useful exercise: calculate two cap rates for the BTS deal:

• Headline cap rate at the BTS rent (what the OM shows)
• Re-leasable cap rate at market rent for the asset class (what the deal would yield on a worst-case re-lease)

The spread between these two is the tenant-stays-forever premium — i.e., the value the buyer is paying that's contingent on the tenant continuing to pay above-market rent.

For investment-grade tenants on long-term BTS leases (15-20+ years), this premium is reasonable to pay — but it should be quantified, not buried.

What Makes a BTS Deal Actually Worth the Cap Rate Compression

Not all BTS deals are structurally weak. Three factors that make the premium pricing reasonable:

Factor 1: The Building Is Truly Generic

A BTS Walgreens is harder to re-lease than a BTS Chick-fil-A drive-through, because the Chick-fil-A box is purpose-built (small footprint, heavy drive-through orientation, specific kitchen layout) but it's also a desirable QSR box that other QSR operators (Wendy's, Taco Bell, Popeyes) can lease as-is.

A BTS deal where the building is generic enough to be re-leased to any retailer in the asset class commands a tighter cap rate fairly. A BTS deal where the building is purpose-built for one tenant's specific operating model carries more residual risk.

Factor 2: The Rent Is Anchored to Market

Some sophisticated BTS structures use a rent-to-market test at certain trigger dates — e.g., "at year 10, if FMV is more than 110% of contract rent, landlord can reset." This protects the landlord from being stuck below-market if rents inflate. The opposite (rent reduction at FMV reset) is rarer but exists.

Read the lease for any market-rent reset provisions. They change the math materially.

Factor 3: The Submarket Has Real Demand

BTS rent above market is sustainable if the submarket has demand absorption that pulls market rent toward the BTS rent over the lease term. In high-growth metros (Phoenix, Charlotte, Tampa, Austin), 10 years of rent inflation can close a 20% rent-to-market gap. In stagnant or shrinking markets (parts of the Rust Belt, certain Midwest secondary markets), the gap stays open.

The submarket fundamentals matter for whether the embedded BTS premium will erode or grow over the hold period.

Where the BTS Pricing Holds Up

There are deal structures where BTS premium pricing is genuinely justified:

• Investment-grade tenant + 20+ year lease + corporate guarantee: the tenant-stays-forever assumption is supported by credit and term, so the embedded premium has a long runway to amortize.
• Specific-use building in a constrained market: e.g., a BTS Chick-fil-A in a high-growth Sun Belt suburb. The location commands premium rent regardless of which QSR is in the box.
• Contractually escalating rent that compounds at GDP+ over the term: 1.5-2% annual escalators on a 20-year lease close most rent-to-market gaps over time.

Where It Doesn't

• Short term remaining (less than 10 years) on a BTS asset with above-market rent: high residual risk, cap rate should be wider than comparable older assets, not tighter.
• Tenant in a contracting industry: a BTS pharmacy in 2026 with above-market rent is structurally exposed if the chain announces store closures during the lease term.
• Single-purpose buildings in soft submarkets: a BTS bank branch in a market where bank branches are being closed industry-wide is a structural problem.

Practical Underwriting Checklist for BTS Deals

For any BTS deal under offer:

1. Pull replacement cost data for the asset class and market (Marshall & Swift, RS Means).
2. Calculate yield on cost at the contract rent. Compare to the prevailing developer hurdle (6-8%).
3. Pull market rent comps for general-purpose retail of the same size + submarket. Calculate the rent-to-market premium.
4. Stress-test the residual assuming the tenant vacates and you re-lease at market rent for the asset class.
5. Quantify the tenant-stays-forever premium explicitly in your IC memo. The deal may still be a buy, but you should know exactly what you're paying for.

The BTS structure is a perfectly good way to invest in net lease — it's just one where the cap rate alone won't tell you the deal's risk. Replacement cost and market rent are the two reference points the OM probably won't include but the underwriter has to.