So a cow walks up to a drive thru… Operating hours and liquidated damages

This week’s (and next’s) post will be a bit shorter as I am in India with my son. This picture reminded me of Chick-fil-a which reminded me of a clause I ran across earlier in the week.

Most retail leases have operating hours requirements which provide for default if the tenant does not maintain the required hours. However, some leases have liquidated damages specifically identifying a penalty to be applied if the tenant fails to operate all hours and days. The liquidated damages can often run in to 100% of the daily rent for failure to operate – so the tenant has paid rent, but then there is a 100% penalty agreed to in advance because the tenant’s failure to operate affects the landlord and the other tenants in the property.

Therefore, sophisticated tenants will specifically address not opening on Sundays, or not opening on weekends, or not opening certain months of the year (think tax preparers in the off season or my favorite purveyors of water ice (a Philly thing) during the winter or even the ability to close once or twice a year for inventory.

If you are a tenant, don’t just hope the landlord doesn’t bill you for liquidated damages – negotiate. And, if you are a landlord, put some teeth in your operating hour requirements.

The value of radius restrictions

This week, we were working on a mall in the Rocky Mountain States. One of the food court tenants had a precipitous drop in sales – from north of $2m to under $1m from 2014 to 2016. I looked at the monthly sales, and sales had been running about $200k per month almost regardless of time of year. Then in May 2015, sales dropped to under $100k and never recovered. I did a search for the tenant name and the town and May 2015. Lo and behold, less than a mile down the road, the tenant opened a freestanding location on April 30.

It’s not often that obvious. But in this case, a tenant that was well in to percentage rent, had a sales drop of $1m due to opening another location. The landlord lost all of its percentage rent. And, to make matters worse, the tenant had a cap on CAM based upon a percentage of sales.

A real life example of the value of a radius restriction! A radius restriction specifically prohibits a tenant from opening another location within a certain radius of a property. The radius can be down in terms an 「as the bird flies」 distance, or a driving distance, or often even specifically prohibiting a certain competing location (「Shall have no other operations within 5 miles or at Maggie Mall…」). The negotiated distances can range from as little as a half mile to as much as a full 100 miles. With strip centers, 1-3 miles is typical. With regional malls, 3-5 miles is typical. With outlet centers, 25 to 50 miles is fairly typical. (There may be exceptions to outlet center or regional mall leases allowing the operation of the other category within the radius – Something like an outlet center lease stating that 「the tenant shall have no other outlet locations within 25 miles. However, this restriction shall not prohibit tenant from operating its regular, non-outlet operation provided the location is more than 3 miles …」

It may seem odd to think a tenant would agree to a hundred mile radius restriction, but, in cases where a landlord is providing significant financial incentives to a tenant (perhaps bringing a new anchor not currently in the region and fully building out a space, requiring little to no rent, and perhaps even offering something like the first round of inventory), the landlord must know that its investment is protected – at least for a while.

That 「for a while」 means that tenants will sometimes negotiate an expiration of the radius restriction – essentially enough time for a landlord to recoup its investment.

Radius restrictions will often exclude 「then-existing」 locations (i.e. already operating within the radius at the execution of the lease) or those locations a tenant subsequently acquires via something like a merger. And, the clause will typically address remedies other than just default – most typically a requirement that the sales from the violating location be included in the reported gross sales for the landlord’s premises (but in cases where there is no percentage rent requirement, it may address an increase in minimum rent).

Not to be one sided, radius restrictions are not always just limited to tenants. It is not unusual for a supermarket or theater lease to restrict a landlord from allowing another supermarket or theater on property controlled by the landlord within some negotiated distance.

Believe it or not, we worked on one trophy regional mall where the operating agreement between the partners actually restricted one partner from developing or acquiring another property within a 25 mile radius of the property.

A radius restriction can be a very powerful tool to protect a retail investment.

(Unfortunately, the lease in the Rocky Mountain States Mall did not have a radius restriction!)

Common area taxes and liability insurance

In the majority of retail leases (and in a smaller portion of office leases), we have sections in the leases that address how to calculate the tenant’s prorata share of real estate taxes as well as tenant’s share of property insurance. This can be a little confusing if you do not read leases regularly because often, when reading the Common Area or Operating Expense definitions the lease will define taxes and insurance as part of reimbursable CAM or OPEX.

This is not giving the landlord the right to 「double dip,」 billing those expenses twice. Rather, when this language exists in leases, it is requiring that the common area portion of real estate taxes and liability insurance be billed through CAM or OPEX. This insurance issue is typically simple and straightforward (but occasionally does require what we will describe in taxes next). When there is a separate insurance section describing a tenant’s prorata share, this separate section is for the property insurance – insurance covering damage and destruction to the physical building (think something like a fire). The portion that most typically goes in to operating expenses is for the liability portion of the insurance (think something like a slip and fall). Confusing the issue a little further is that most leases require tenants to carry insurance – both property and liability on their premises. In the majority of instances, the insurance required to be carried by the tenant is for damage to its improvement and inventory within its premises, as well as liability within its premises. (In the other instances, the tenant may be on a ground lease, or constructed its own building improvements, and is required to insure no only the interior improvements, but the building itself).

With real estate taxes are addressed both in CAM or Operating Expenses as well as in a separate tax section, it is the common area portion of real estate taxes to be billed through CAM, and the taxes on the leasable areas of the property billed separately. In honor of National Donut Day this past Friday, picture a Krispy Kreme donut sitting on a plate. The plate itself is the property. The donut is the leasable area. The portion of the plate not covered by the donut is the common area – so outside of the donut may be the parking area and the hole inside the donut may be interior mall walkways and corridors. So the donut gets billed separately, and the uncovered portion of the plate gets billed through CAM.

There are countless justifiable ways to calculate the common area portion of taxes – enough to cover multiple blogs. So we won’t cover that at this time. However, there are a few thoughts to leave you with if you have these types of leases in your portfolio:

  • When caps on increases in expenses exist in leases, it is much more common to see a cap on CAM than a cap on real estate taxes. If the landlord is not billing taxes as required, they may have some exposure for overbilling if the tenant has a cap on CAM but not taxes.
  • The donut issue can sometimes be required for insurance.
  • As leases are converted to fixed CAM, the conversion must address the common area portion of real estate taxes. It may be the landlord’s intent to bill all taxes as a separate charge, but if common area taxes are still defined as part of CAM and CAM is fixed, only the taxes on the leasable areas may be billed.

Percentage rent using different partial year methodologies

Percentage rent is where a tenant pays a percentage of its sales once it has exceeded a certain base level of sales. The better a tenant does, the better the landlord does. If the tenant does not exceed the base level of sales, or the breakpoint, the landlord does not receive percentage rent.

In most cases, the tenant reports sales and pays percentage rent based upon its Lease Year. Lease Year is defined within the lease, most often defined one of three periods: 1. A Calendar Year (1/1-12/31), 2. A period running 2/1-1/31, and 3. A period ruining 12 full months from the commencement date (if it is the first of the month) or from the first day of the month following the commencement date (if the commencement date does not fall on the first of the month).

Calculation of percentage rent for full lease years is simple and straightforward. Take sales for the full lease year less the breakpoint for the full lease year, and multiply that excess times the percentage rent rate to determine percentage rent. However, when a partial lease year (a period less than 12 full months) is involved, a lease must specifically address how percentage rent is calculated because the methodology applied could provide wildly different amounts due.

Consider why partial years would be an issue. With exceptions for certain categories of retail and certain types of properties, most retailers will do a disproportionate amount of sales in November and December. Typically, we set an expectation of about 12% of sales in November (weighted toward the latter part of the month) and 19% in December. Think about that. If a tenant opens on 12/1, they are going to do about 19% of their annual sales in just over 8% of the year. Depending upon how the lease addresses percentage rent for that period (if the lease year end were 12/31), the tenant could pay wildly different amount of percentage rent.

While there is no limit to the number of ways that percentage rent for a partial period can be calculated, there are three 「typical」 methods applied in the industry – 1. True partial lease year, 2. Extended lease year, and 3. Extended partial lease year.

A true partial lease year requires that sales for the partial lease year be compared against a breakpoint calculated using the annual breakpoint prorated for the number of days in the partial period. Opponents of this method argue that the tenant is unfairly penalized higher amounts of percentage rent because the tenant opened during the busiest time of year. Proponents of this method argue that the tenant did not pay rent during the slowest times during the year and got the benefit of opening during the busiest time of year. An extended lease year combines the initial partial lease year with the first full lease year. To a certain extent, this method allows for the fact that there is often an artificial bump in sales when a tenant first opens. The final method, the extended partial, still bills for the partial period, but uses sales for the first 12 months against a breakpoint for the first 12 months, and then prorates the percentage rent that would be due for this so-called reference year by the number of days in the partial lease year. This method began surfacing around 20 years ago and is slowly becoming the standard in regional mall leases. It can be found in strip centers, but the first two methods are still much more common in open air centers.

Reflected in the following slides, I have calculated percentage rent for an initial partial lease year and a first full lease year using the same exact sales figures and a requirement that the tenant pays 6% of sales aver a $1,000,000 annual breakpoint.


blog 5 rent sales used

True partial lease year

blog true partial

Extended lease year

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Extended partial lease year

blog extended partial

As you can see, percentage rent for the periods using the exact same set of numbers can range from a low of $69 to a high of $11,096. Therefore, whether you are a landlord or a tenant, it is imperative that you understand how percentage rent is required to be calculated for partial lease years.

Retail evolution and the need for lease language changes

Experiential retail. Bricks and mortar stores as distribution points. Online sales returns. Showrooming. We are continuously bombarded with articles about the death of retail, the evolution of retail, stores closures, the death of retail being exaggerated, announced stores closings, announced store openings. While there seems to be little agreement about the future of retail, there is little doubt that retail continues to evolve. And, with that evolution, changes are needed to leases and lease language.

  • Many leases and most operating agreements (Reciprocal Easement Agreements (REAs), Construction, Operating and Reciprocal Easement Agreements (COREAs) and other similar documents) typically have restrictions against uses which may be found in a shopping center such as:
    • Residential
    • Education
    • Entertainment (movies, theaters)
    • Vehicle sales and rental
    • Office
    • Health clubs and exercise facilities

These restrictions often run with the land (meaning they are perpetual with no expiration). Often, these restrictions existed to limit the impact on parking. However, some existed to ensure 「a first class」 shopping center. But, outstanding properties live Oak Brook Center outside of Chicago and Avalon (pictured in the photo) outside of Atlanta have Tesla dealerships. Some of the best centers in the country, Ala Moana Center, Natick Mall, Phipps Plaza, have residential incorporated or immediately adjacent. As retail evolves, these restrictions have to be eliminated, or altered. Without changes, a developer’s ability to allow a center to evolve will be limited. I used to laugh when I would read a restriction against a distillery. Who would ever consider something like that? Today, breweries and distilleries are desired tenants in mixed use properties – that experiential retail. Do you really want to be denied an Equinox Fitness or Soul Cycle due to a use restriction. Use restrictions must evolve.

  • Retailers trying to marry e-commerce with bricks and mortar often use their store locations as distribution points. However, if you take a look at a gross sales definition, reported gross sales include sales generated 「in, at, on or from the demised premises.」 While a sale may have been made online, in certain instances, the sale is finalized 「from」 the demised premises. On the other hand, if a retailer makes a sale online, but allows the consumer to return it to a retail location, the sale may have never been reported, yet the return is used to reduce reported gross sales for the location. The definition of gross sales must evolve.
  • Also affecting the definition of gross sales will be the concept of showrooming – where the store may be a showroom only. Touch, experience, try on. The order may be placed at the retail location, or subsequently online. Leases have to evolve to recognize the value of the sale which, in some part, is attributable to the physical location.

From the late 1950s to the early 1970s, it was very common for department stores in regional malls to have absolute approval rights over other tenants which would be permitted to operate in the mall (or at a minimum, in their respective entry court). Right around 1973, due to anti-trust lawsuits which were being brought at the time, most department stores issued unilateral agreements rescinding their approval rights.

For the health and survival of the industry, we may need to see some unilateral rights, restrictions, and language definition rescissions granted from tenants to landlords and vice versa so that centers can evolve.

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