The Challenges of Financing Buildings for Startup Firms

Cori Shropshire has a good article in today's Post-Gazette about the difficulties of matching supply and demand for office/lab space for biotech startup firms in Oakland and how new building development at the Pittsburgh Technology Center and former LTV Coke Works site could help fill the gap. As she says in the article:

The bottom line for many fledgling life science firms in the region is
this: Flexible affordable lab and office space is hard to come by, particularly
in high demand neighborhoods such as Oakland where rents are higher and
landlords typically require long-term leases to recoup dollars spent to
build customized labs.

It isn't just biotech firms that face the problem; many types of startup firms do. The founders of FORE Systems said that one of the biggest problems they faced during their meteoric growth in the 1990s was that every time they grew, they had to move. The problems are just worse for the biotech firms because of the need for "wet labs" and other facilities which are more costly to develop.

Why is it hard to get private developers to build buildings with affordable rents for startup firms, and is this something the Pittsburgh Region should be trying to address?

To understand this, you need to start with the basic economics of building a multi-tenant building. The developer has to invest equity and borrow enough money to buy or lease the land, pay for the costs of construction, taxes, initial maintenance, and utilities, and pay for debt service on the loan during the period when there is no revenue coming in to pay all of those costs. It's only when tenants begin occupying the building that revenue starts to come in to pay the operating and debt service costs. The longer it takes to lease up the building, the longer the developer is losing money. If the developer has to pay extra money for the interior space to accommodate a particular tenant (what is called "TI" -- tenant improvements -- in real estate jargon), then the profitability of the building declines. Every time a tenant leaves, the developer's revenue goes down until another tenant is found. The developer's goal is rapid leaseup and low turnover.

And this assumes that the developer can get a bank or other lending institution to make a loan in the first place. If the developer doesn't make money on the building, the lender may not get paid. So lenders like to have developers line up tenants in advance of building construction, and not just any tenants, but "credit tenants" (tenants not likely to go out of business or default on a lease) who will sign long-term leases (ideally at least as long as the term of the loan).

It's hard to convince a lender to finance a "spec building" (i.e., a building built purely on the speculation that there will be enough tenants to fill it), and it can only be done with a good market study "proving" that there is high demand for the space.

OK, given those realities, suppose a developer wanted to build a building dedicated to high-tech startup firms.

Problem #1: It's hard to get a loan at all. Startup firms need the space now, not a year or two from now when the building is built. Even if there were startup firms willing to commit to occupy the space, they aren't likely to commit to 10 year leases (if the business fails, it won't need the space, and if it's successful, it will likely grow out of it), and they aren't credit tenants -- they might default on a two-year lease and there would be no assets left to recoup from. The bank won't like that.

Let's suppose the developer gets past this problem. If they do, they still face:

Problem #2: The revenues for the building will be lower than for a "regular" multi-tenant building, even if the tenants are paying market-rate rents. Why? It may take a while for there to be enough startup firms to occupy the space (so the leaseup takes longer) and when they do, they are unlikely to occupy the space for many years (so the vacancy rate is higher). As a result, the developer needs to borrow more to cover the longer period of time that it takes to start getting revenue, and the developer needs to charge higher rent or take lower profits in order to accommodate the lower revenue due to higher vacancy rates. The developer could reduce the problem by taking tenants other than startup firms who will occupy blocks of space for long terms, but that defeats the purpose for which the building was being developed.

This all applies to any kind of startup firm. Now if the developer wants the building to be dedicated to biotechnology firms, they face:

Problem #3: It costs more to prepare the kind of space needed by biotech firms. They need extra plumbing for water and chemicals, they need enhanced ventilation systems to handle emissions, they need hazardous waste disposal systems, etc. It's not just equipment in the lab, but the actual systems built into the building. The floor heights will likely need to be bigger to accommodate this. In other words, it costs a lot more per square foot to build this kind of space than the typical office building, and so the developer has to charge more rent to cover that cost. Yet the tenants are startup firms scraping for every penny, so higher rents exhaust their limited capital even more quickly.

The Post-Gazette headline suggested that "fatter wallet" universities would be more likely to occupy space in these buildings than startups. But R&D projects at universities can have the same characteristics as startup firms. Until a research grant comes along, neither the researcher nor the university can commit to lease the space, and most research grants aren't committed for more than a few years, so they can't easily sign long-term leases. So there are problems getting space for both R&D jobs at universities and startup firms trying to commercialize university R&D.

The bottom line on the supply side: a developer can make more money with less risk by building a traditional multi-tenant office building for traditional tenants than trying to create multi-tenant spec space for startup firms and university research projects. On the demand side: a startup firm may lose valuable time looking for space when it should be concentrating on developing products, raising capital, and making sales.

So what's a region that wants more startup firms and R&D to do? There need to be special financing programs that will offset the problems described above. Things like master leases and lease guarantees, gap loans with flexible terms, and grants can address the problems.

Unfortunately, the Commonwealth of Pennsylvania doesn't have any programs specifically designed to provide these kinds of solutions. The state has recognized the need, and has provided grants for some spec building projects from the Redevelopment Assistance Capital Program (RACP). But RACP funds can be used for a wide array of projects, ranging from industrial sites to cultural facilities, and it's hard for "spec tech buildings" to compete. A dedicated program is needed to aggressively address this issue.

If the state is going to accelerate business and job creation in technology fields, it needs to help accelerate the creation of buildings to accommodate those businesses and jobs. Two years ago, Governor Rendell recognized the financing problems involved in developing industrial sites and created the "Business in Our Sites" program to address them. It may be time now to create an additional program: "Space for Our Entrepreneurs."