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Life Science Conversions in Real Estate

Among the key legal issues to be considered when converting office to life science space are credit enhancements, expansion/contraction options, use segregation, and zoning.

Q2 2023
One of the hottest topics discussed in real estate circles today pertains to whether life science conversions can save the perceived imminent obsolescence affecting large swaths of the office sector. Obsolescence is nothing new. Obsolescence, however, in the real estate world, prior to COVID, typically took years to achieve. The prospect of remote work was, no doubt, a growing trend for years. COVID, however, acted as an accelerant the likes of which the real estate sector and, in particular, the office sector had not observed in the career of most real estate professionals.

While architects and engineers have for years aspired to design the holy grail of buildings with unlimited flexibility, the fact of the matter is that few office buildings can instantly convert to life science uses. While the focus of real estate professionals has gravitated toward addressing design issues in office conversions, and they are undoubtedly important, such design issues are not the only issues to be considered in a life science conversion project. As will be discussed in this article, there are a number of legal issues a typical office lease may not contemplate that should be assessed and addressed in life science conversions.

For purposes of this article, life science space comprises laboratory space, research and development space, and cGMP space. While there may be an office component as well, the requirement of the life science portion of the premises is the true design driver, and, as such, creates unique issues not otherwise found in traditional office leasing.

It is important to change a developer’s thought paradigm when contemplating life science space such that it is viewed as its own asset class of real estate rather than a subclass or derivative use of office space. By way of example only, while floor load may be a factor in office leasing (particularly in server rooms, file rooms, and library areas, such as they exist in the digital age), floor loads of office space have been assumed in the design of a traditional office building. However, a typical life science space may house heavier equipment which increases the floor load, resulting in the need for additional reinforcements. An office building with industrial bones (e.g., an old newspaper building or quasi-industrial site) may facilitate an easier and more cost-effective life science conversion. Below is a discussion of several of the key legal issues surrounding office to life science conversions.

There are a number of legal issues a typical office lease may not contemplate that should be assessed and addressed in life science conversions. Credit Enhancements
Life science conversions are more expensive than a simple office build out. Whether it be landlord work or tenant improvement allowance, the amount of funds designated to potentially stripping the building, upgrading base building facilities, and related expenditures creates quite a bit of increased costs. The willingness of landlords to fund such costs or of a lender to loan funds toward a conversion may be dependent on the financial viability of the tenant. As many life science tenants are startups or early-stage companies, the need for a credit enhancement is necessary in many cases. Some companies will elect to put up a cash deposit and many more will elect to cause the issuance of a letter of credit.

Until recently, the main reason to request a letter of credit pertained to the tenant’s creditworthiness. However, with the recent string of bank collapses, particularly Silicon Valley Bank and other lenders with considerable life science and tech exposure, the astute landlord will now need to underwrite the liquidity of the bank issuing the letter of credit. The ability to cash out the letter of credit and swap the letter of credit with another bank should be considered. The parties should consider more than simply a tenant default as a trigger for a landlord being permitted to draw on a letter of credit. This is particularly important as many lenders look to the continued existence of a line of credit in underwriting a loan with a landlord.

Expansion and Contraction Options
The success of life science companies is more volatile than are traditional office tenants. While much focus is on the possibility of a collapse of a life science tenant, there should also be emphasis on the success of life science tenants. This plays into the conversion processes specifically. A more holistic, cradle-to-grave analysis is necessary with a life science tenant.

Life science conversions are more expensive than a simple office build out. For example, a traditional law firm or bank tenant can project their needs and organic growth over 10 or maybe 15 years based on historical growth. Life science companies have no baseline. There is a need for flexibility in the conversion of the building to ensure enough floors and/or the entire building is converted or can readily be converted to life science use such that the life science tenant can grow into its needs. Whether it be expansion options, rights of first refusal, or rights of first offers for additional space, or even relocation rights to new space, landlords and tenants need to have an honest discussion about potential growth and take into account those needs as necessary.

While developers and life science tenants may aspire to continuously expand their size, the reality is that many life science companies fail, move, or simply require less space in a particular building. As important as contemplating possible expansion of a life science space when assessing conversion related issues, the concept of contraction and how such a reduction in space may affect partial buildings and partial floors must also be addressed by the parties. While it may be more incumbent for a tenant rather than a landlord to raise the possibility of a contraction, it is important that both parties have an honest discussion about space needs going forward and when designing the re-use of converted space, taking into account how a reduction in space may impact building systems.

Use Segregation
Conversions of an entire building allow for an upgrade of entire systems, particularly when the entire property is stripped and rebuilt; however, partial building conversions (e.g., street level retail, life science, and residential floors) require unique considerations. From a design perspective, there may be a need for elevated HVAC requirements in life science spaces, fire safety considerations, elevator usage requirements, soundproofing, and vibration mitigations that are not necessary in other uses.

There are costs for such uses that may not be allocable in a simple operating expense proration. The developer may need to look at “condominiumizing” the building in a multi-tenant and multi-use building to address the asymmetrical use of facilities and to ensure that costs are properly allocated between the various uses. While there will certainly be quite a bit of discussion among the design professionals as to how that use segregation will occur, how that will occur legally (e.g., condominiums, cross easements, and similar items) will require quite a bit of advance legal planning.

The rules and regulations may similarly need fine-tuning to account for the different uses in the building. By way of example, a new pet policy makes sense in a traditional office setting or even a residential setting (or at least limiting the building to certain domesticated pets). Such a restriction does not work when housing a vivarium. The presence of animals of all types must be permitted in the premises (and disposal must also be addressed). So too, gyms or other vibration-creating uses may not be permitted within life science areas as they create noise and vibration issues that can affect the calibration of equipment. While such an amenity for residential tenants may be a plus, the proximity of such amenities to life science space can create issues.

While developers and life science tenants may aspire to continuously expand their size, the reality is that many life science companies fail, move, or simply require less space in a particular building. Zoning
Office use is not necessarily zoned the same as life science usage. Certain cGMP and other uses may fall into industrial and light manufacturing zoning uses that, in turn, may require the converted property to obtain a variance or special exception rather than be permitted to operate as of right. Prior to embarking on the life science conversion journey, the legal team must ensure that an audit of the zoning for the project is thoroughly vetted. Single-use buildings and multi-use buildings may trigger different facets of the zoning code. Additionally, issues regarding subtle differences between industrial, manufacturing, and warehousing uses as part of the life science premises may be as of right or need a variance which can add time, cost, and additional work in connection with a life science conversion.

The above conversion-related legal concepts are not intended to be exhaustive. This area of law is dynamic, with new issues and challenges arising on a monthly, weekly, and — at times — daily basis. Just as architects, civil engineers, and developers are modifying their proformas, preconceptions, and thought processes as they contemplate whether and how a building can be converted, so too will legal professionals need to adjust to the vibrant life science asset category as they contemplate future conversions.

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