Just how good was that tenant attorney?

One of our earliest blogs was about the landlord’s standard lease being the best case scenario. Changes that are made to that standard lease are being done at the tenant’s request because the tenants have seen, over and over, how not changing those clauses has impacted their financials. Tenants are dealing with tens or hundreds of different landlords’ standard lease forms. They can see the differences.

But, unless you are a prolific big box developer with the same cadre of tenants at each property, the landlord does not have the opportunity to see the nuances in a tenant “standard” lease form. It is “standard” to the tenant, but not so much to the landlord.

This week, we were working on a regional mall in Florida where a big box tenant had taken an anchor position in a former department store space.

How many flags went off in your head reading that sentence? There should be quite a few.

Regional mall  – While regional malls have historically had junior anchors, with some exceptions, even junior anchors in regional malls have been on landlords’ standard form leases. Department stores have almost always used their own leases or other types of documents, but landlords have been able to rest a bit using their own standard leases. We’ll see many changes to that over the next few years in this evolution of shopping centers. Big boxes used to using their own leases in power centers will expect the same in regional malls.

Former department store – If you are even marginally aware of cotenancy language in leases, you should be wondering about whether replacing a traditional department store with some other sort of big box will satisfy “acceptable replacement” language for tenants with cotenancy clauses in their leases. If you replace a tenant like a Penney or Sears with a theater, a sports big box, a soft goods retailer, a gym – will that be deemed an acceptable replacement?

Florida – There are a couple of things I think of when I think Florida retail leases – hurricane language (Can we include hurricane clean up in CAM? Is there a limit on levels of insurance a landlord can bill to a tenant? Does the lease require business interruption insurance?) and sales tax (most lease related occupancy charges in Florida require a tenant to pay sales tax). The other thing I think of related to Florida leases, but primarily for open air centers, is that landlords of Florida properties are much likely to give up percentage rent than in any other state. In fact, smaller landlords with properties primarily in Florida may even have standard leases without percentage rent requirements.

Typically, if a property is in Florida, there will be a clause somewhere in the lease that addresses the tenant’s obligation to pay sales taxes on rent. Usually, the sales tax will be collected by the landlord. But, if a tenant has a large enough presence in the state, there may be a clause allowing the tenant to pay sales taxes directly to the state – not often, but it happens – and that language will also be addressed somewhere in the lease.

Did you ever pay attention to a clause in your lease that might reference “Headings and Captions”?

It is essentially a “don’t come crying to us if you didn’t pay attention to something because the caption made you think you didn’t have to read it” clause. It’s there because both landlords and tenants get burned when a clause is buried where you do not expect it.

Finally, back to just how good that tenant attorney was. When you read the definition of Real Estate Taxes in the lease, it will typically define that taxes include all taxes, general and special assessments, perhaps personal property taxes on the common area and whether consulting and challenge fees may be included, among others. It will also address what is not included – typically things like franchise, estate and income taxes. It may specifically exclude special assessments. A tenant may have negotiated that they do not have to pay increases in taxes due to a sale of the center (often more than one time every x years). But, in both the definition of inclusions in, and the definition of exclusions from, the definitions almost always are limited to real estate taxes.

Almost always! For this particular lease, the tenant attorney buried in the tenant’s own standard lease form, in the definition of real estate taxes (specifically in exclusions from real estate taxes) a line that the tenant did not have to pay sales taxes on minimum rent. Sales taxes on minimum rent! That has nothing to do with real estate taxes. Those “headings and captions” were not accurate. And, it was not that the tenant would pay sales taxes directly to the state. No – the tenant did not have to pay sales taxes AT ALL.  Sales taxes have to be paid. The state doesn’t care whose responsibility it is. Sales taxes have to be paid. If the tenant doesn’t pay, who does? The landlord!

Bottom line? The tenant’s minimum rent was just over $1.5m per year. The landlord was forced to use this as the gross collection, meaning total of minimum rent and sales taxes together. So you take the $1.5m and divide is by (in this case) 1.075 – that’s 100% plus the 7.5% sales tax. That means $1.395m in minimum rent and $105k in sales taxes.

Buried language and a brilliant tenant attorney once again costing the landlord.

Depending upon the cap rate of the center, that simple little bit of buried language cost the landlord somewhere between $1.4m and $1.8m in value.

Consider the facts behind the stories

As a company, we spend our time making sense of the cash flows presented by sellers. Find where the seller may have overstated the cash flow. Find where they had missed opportunities. Basically, sort out the facts.

There were a couple of articles this week that made their way around Twitter an LinkedIn because they had sort of Clickbait headlines. The first was:

Landlords, brands brace for less shopping at the mall

The premise of the article is that e-commerce will account for one-third of all shopping by 2030, so considering that it currently accounts for 10%, the losses will be coming from bricks and mortar –  so a loss of 23% of sales. What the article does not present is that total sales – online and physical – will continue to grow. If those sales grow by 2.5% per year, total sales in 2030 will be 35% higher than they are today. If physical retail is “just” two-thirds of total sales in 2030, physical sales will have suffered no loss – physical sales will be essentially what they are today. However, as we continue to see, shopping centers are evolving. Restaurants, residential, office, entertainment, health and other non-retail uses are being brought in to bring the properties to their current highest and best use. If 10% of retail is converted to non-retail uses but in the same retail environment, then that two-thirds of sales in 2030 is being achieved with 90% of the space. That accounts for real increases in sales – just over 11%.

I do realize that I can poke holes in these numbers I have just presented. But the point is, the “sky is falling articles” have similar holes. They can ignore realities as did the second article:

Malls hope to get back in shape by adding gyms

This article ignores two facts. The first is that, through their evolution, malls (an open air retail) have had gyms and other non-retail uses as part of their tenant mix. Shopping centers have been constantly evolving. It’s back to that highest and best use. It must always be considered.

Quick little story – In 1991/1992, we were doing some work for Faison in North Carolina. It’s namesake founder, Henry Faison, had been developing retail properties since the early 1960s, and Henry happened to be one of those one generation of developers of regional malls, alongside of the Simons, DeBartolos, Taubmans, Hahns, Congels, Pasquerellas, Aronovs, Karps, Bucksbaums and handful of others that truly changed the landscape of the US. I was under 30, sitting down the hall from someone I considered a rock star of our industry (they weren’t online war rooms at the time. You had to physically be where the records were). Henry clearly loved what he did. Despite his successes, he was in the office early and stayed late (and drove a series of Ford Tauruses). He was all business. His assistant, Candace, had been working with him for years. I wanted to know the man celebrated a little. I asked her what he did when he signed anchors and knew he had a mall ready to come out of the ground. Did he do a little private happy dance? No, she said. He just immediately said, “Who are we going to put next to them? Is fashion going to be on the first floor or second?” It was all (in capital letters, ALL) about the tenant mix. It was, is, and will be all about the highest and best use.

The second fact ignored, or implied, is that mall (and open air centers) are not in financial shape. It ignored another article this week:

Shopping center rents, income and occupancy rose in 2017

Retail is not in the tank as the media constantly presents. Much of what has been going on, with bankruptcies and closures, has long (let’s do caps again, LONG) been expected. There is no landlord with a Sears or Macys or Penneys or Bon-Ton that is the least bit surprised about an announced closure. They have anticipated and planned for these closures for years. In some cases, for more than a decade.

That planning is no exaggeration. There are 10+ year old leases that address replacing department stores with lifestyle centers. There are 10+ year old leases that address replacing retail with non-retail.

There are malls and strip centers that should no longer be retail. At the time they were developed, retail may have been the highest and best use. But, the evolution of retail has been a constant, and that evolution has been considered.

While less shopping and dead malls may cause clicks, there is much more to the story.

Unintentionally losing 19 months of the term

This week, we were working on a small (six tenant) retail acquisition. There were only two different “standard” lease forms in place at this center, but each of the leases had very significant changes to the lease.

One of the ways these leases were so different from each other was in the definition of the term of the lease. Several defined the Commencement Date as the date of the lease and then a Rent Commencement Date as the earlier of opening or the Commencement Date plus xxx days. Others did not define a Commencement Date but defined a Rent Commencement Date only.

Lease Year definitions also varied – some defined from the Commencement Date while other defined from the Rent Commencement Date.

There were numerous changes. One defined rents as increasing each Lease Year, with Lease Year defined as from the Rent Commencement Date. In this case, the Rent Commencement Date was 5/24/15. The Lease Year was ultimately 6/1-5/31. However, the Offering Memorandum reflected the rent as increasing on 8/1. Why? The seller had inadvertently used 8/1 because the tenant had been granted a 60 day rent abatement at the beginning of the term. 60 days from the Rent Commencement Date. That abatement did not change the Rent Commencement Date and did not change the definition of Lease Year. A two month (every year) acceleration of rent bumps.

But, out bigger issue was another lease executed 4/24/14, which happened to be the defined Commencement Date. Lease Year was also measured from this Commencement Date – so the first Lease Year was 4/24/14-4/30/15. However, the Rent Commencement Date was ultimately not until 11/24/15. The Term was defined as 10 Lease Years from the Commencement Date. The seller had inadvertently measured from the Rent Commencement Date (both the Lease Year and the Term). The seller was, therefore, presenting the Term as 11/24/15-11/30/25. However, the reality was that the Term actually ran from 4/24/14-4/30/24 – a difference of 19 months!!!

I would venture to guess that the intent was the seller’s presentation. However, without a letter agreement or amendment, the buyer can only count on a Term ending 4/30/24, not 11/30/25.

One funny (to someone who appreciates lease language) was that the bump date of minimum rent did not change. While the term was measured from the Commencement Date and by Lease Year, the rental periods were defined by “Years” from the Rent Commencement Date.

All of these problems were clearly unintentional. But, unintentional or not, lease language has consequences.