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A need for a holistic approach to leases

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When coming up with a blog topic for the week, I typically reflect back on one issue that stood out for the week. My guess is that it almost appears as if each of the issues are stand alone. But, this is never the case. Within one lease, you can have hundreds of potential changes, and then multiply that by the number of tenants in a property, and the combinations are exponential.

However, there are certain types of lease related issues that you truly only expect to see once every 5/10/15 properties. But, this week, we had a “perfect storm” – one property that had so many of these one off type issues.

This was a power center with two smaller specialty centers actually incorporated into the center, giving almost the feel of a lifestyle center. When the property was originally developed, the parcel for one of the two specialty centers was sold off and developed by another owner. They did a beautiful job on this 40,000 sf portion of the entire development. One of the big issues was that there is not an REA/OEA for the entire development. Therefore, the restrictions that apply to the balance of the center – exclusives, prohibited use, signage, height – do not apply to that center. Which makes the opposite true as well. Any time a property is going to be operated as one integrated center, there really needs to be an overall declaration.

One tenant at the center had co-participation language. They were only required to pay taxes if 90% of the other tenants were similarly obligated. You might imagine that we immediately had to focus on that particular lease’s definition of the shopping center. It was an “as reflected on Exhibit A,” with the Exhibit reflecting the entire development, including the separately developed center which the master landlord had absolutely no control over.

Then, there were two absolute minimum denominators. We had talked about this over the last couple of weeks. The denominator for prorata shares could never be less than xxx,xxx sf. However, a few portions of the development, including the separate center, were separately maintained. And, a few more parts of the center were being sold off (to realize some immediate value).

These were just a few of those big ticket lease clauses (or documents in the case of the Declaration) that exist at this particular property. While it is very easy to focus on the particular lease that you are working on/negotiating at the moment, it is critical that we take a holistic approach – looking at the property (and even in some cases, the entire portfolio) as a whole.

Why might it go beyond the property? It is a great topic for another week. However, one really quick example. Another client put a small grocery anchored center under contract this week. What makes this small acquisition unique is that it is immediately adjacent to another of their own centers. The first item we tackled was not a lease on the new acquisition, but the list of restrictions and exclusives on the existing center, and whether there might be landlord radius restrictions. (While radius restrictions exclude “then-existing” more often than not, there are those that are the exception.)

Bottom line, there are consequences/impacts to every change made to a lease – often going beyond that single landlord/tenant relationship.

building vs. Building

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No. It’s not a fight in the ring between two skyscrapers. It’s one of those capitalized/non-capitalized issues that can have a material impact on the cash flow of a property.

Though many tenants may beg to differ, the majority of landlords do actually consider the financial health of their tenants. I cannot tell you the number of times that I have heard “We did not bill that because the tenants do not have the ability to absorb it.” Specific inclusions in CAM or taxes, or, in a few cases, even a CPI increase on a minimum rent charge (this did happen multiple times during the last and previous recessions). For their own long term financial health, landlords want their tenants to succeed and often make decisions toward that goal.

There is also this “conscience” thing that landlords have. And, every organization has one – the vast majority are good. But, there have been a handful… One of the most obvious, recurring examples of the landlord conscience relates to management fees as part of CAM. Not admin fees, but management fees. Back when most mall leases were still on prorata CAM, landlords were starting to include management fees in the definition of CAM expenses. Not all were billing them, but they were including them in defined expenses. However, it had always been much more common for management fees to be included in CAM expenses for open air centers – many times specifically called out, and other times grouped together as the “cost of managing, repairing, replacing, maintaining, operating,…” the common areas or shopping centers. But where that conscience has kicked in is when management fees have actually been permitted to be and have been billed through CAM, it is not uncommon for a landlord to exclude those fees when calculating the required admin fee.

I know. I know. My tenant brethren are up in arms. You can’t have both. Actually, if the lease is negotiated with both, you can absolutely have both. We all have to live with (and properly administer) the terms of an executed lease.

In any event, back to the building vs. Building conscience and the ultimate financial ramifications. The past week, we worked on an open air center that had two distinct sets of prorata CAM requirements. The tenants were to pay a prorata share of “Center” expenses and a prorata share of “Building” expenses, with the sole difference between the two being a freestanding, self-maintaing, self-insuring, separately assessed supermarket. For example purposes, we  will say the denominator for Center expenses is 125,000 sf with the supermarket and 55,000 sf for Building expenses. Personally, I liked the set up and the clarity of the definitions.

However, where the issue came up was that the 55,000 sf of Building square footage was actually two separate buildings (notice the lower case “b”) – for example purposes, one 30,000 sf and one 25,000 sf. There was a significant repair (truly a repair, not a capitalizable expense) of $100,000 to the 30,000 sf building. And here is where the conscience kicked in. The landlord billed the expense only to the tenants in the 30,000 sf building where the expense actually applied, but used the lease required Building denominator of 55,000 sf. This caused the landlord to absorb a full 46%, or, in our example, $46,000 of this expense.

You can understand the conscience issue here – bill it only to those affected. But, to truly and properly reflect the expense, the amount should have been allocated over just the 30,000 sf in the building (again, lower case “b”), but the landlord did not have that option.

Surely, the landlord would have done the same if another expense been on the 25,000 sf building – once again causing material absorption, in that case of 55% of the expense.

While they tried to do the “right” thing, they really hurt themselves and had set themselves up for future failure. The proper direction was (and is) to administer the leases in accordance with the terms of the respective leases – specifically as negotiated. It eliminates any question whatsoever with how to administer the leases.

One final thought. Had this been a recurring annual expense administered “in good conscience” rather than as required by the lease, that $46k that was absorbed would equate to well over $500k in value.

As we have discussed many times, it is imperative to understand the value of a change proposed to a lease before agreeing to it. Once executed, both parties must live with the outcome.

CAM, tax and insurance reconciliations during due diligence

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More often than not, when acquiring a property or portfolio, prospective purchasers are focused on future cash flows. When it comes to CAM, taxes and insurance, it is future reconciliations that will have the most impact on the buyer’s cash flow.

However, when acquiring a property, it is critical to get as many years of CAM, tax and insurance reconciliations from the seller as possible. While a purchase and sales agreement may put the burden for retroactive adjustments on the seller, a tenant doesn’t care where the credits are coming from – seller or buyer.

But, often, there is another need for these historical reconciliations. If a tenant has a cap on any charge, a buyer may need to substantiate prior billings in order to justify current caps – especially in the case of a non-cumulative cap where you may need to show actual charges on a year to year basis.

Just this week, we had a tenant in a center that our client had acquired two years ago. CAM charges were fixed for this particular tenant. However, every five years, the fixed charge was to have been reset based upon the actual CAM charges for the prior five years.

Without the historical billing files, there would be no way to reset the tenant’s charge, leaving significant amounts of cash flow on the table.

So, whenever possible, even though you may do nothing with it, get as many years of historical reconciliations as possible!

Squeeze another 353 sf out of that space!

This past week, we had a call with a long term client to review the results of a lease audit. Typically, it is the accounting people, perhaps some accounts receivable people and occasionally asset management. We review additional historical billings and expected increases to cash flow. But, this week was a little different, it was a group that, in addition to property and asset management, also included leasing. It was outstanding to be able to get all of the disciplines on the same page.

The following day, it really hit me just how valuable that approach was to an owner of shopping centers.

As you know, cotenancy is becoming more and more of a hot topic as the industry evolves. We regularly perform analyses to determine the immediate and long term impact of changes to the anchor and tenant mixes in a center – what is the one year financial impact, what percentage of square footage will have a right to terminate, do the leases also require a sales drop for cotenancy to kick in, can we replace a department store with a hotel? A theater? A restaurant/video/bowling combination? A health club?

On one of the properties we were analyzing this week, the landlord was able to bring in a health club to take some vacant inline space – just under 19,650 sf. It is actually a great addition to the center. But, unlike the first client that pulled all disciplines together, this one did not have the same level of communication. Therefore, when the deal was approved, no one considered that an additional 353 sf would have gotten that particular premises over the “major” definition for a number of tenants at the property. 20,000 sf was the magic number that would have made the health club count as an additional major – that would have provided an additional level of insurance against a cotenancy condition kicking in for a group of tenants that also happened to include two tenants that also fell in to the “major” category themselves.

That additional 353 sf would have … provided an additional level of insurance against a cotenancy condition kicking in …

The cotenancy condition at the property is currently not an issue. However, a meeting of minds across disciplines within the organization would have allowed someone to say “too bad it’s not 20,000 sf,” and another person to say “well, could we add 353 sf to the lease and just not charge them for it?”

As our industry evolves, it is more critical than ever to involve all disciplines within an organization to ensure that all aspects of a deal are considered.

Time for an interdepartmental group hug!

Distorted sales and sales audits

Over the past 2 months, there have been a number of stories about tenants “distorting” sales including this one in Shopping Centers Today –

https://www.icsc.org/news-and-views/icsc-exchange/tenants-should-include-more-internet-returns-in-reported-sales-simon-says

It is almost presented as a “breaking news” type item, but this issue, including internet returns and its technological predecessor, catalog returns, has been an issue as long as tenants have been reporting sales and consumers have been returning items ordered outside of a store location. The issue occurs when a consumer makes a purchase that was not made in the store where they are returning the item. It that particular location was either over its breakpoint or approaching its breakpoint, a $150 return could mean a $9 loss in percentage rent (at 6%).

Just this past week, while doing a cotenancy analysis, we came across a cellular provider in a center that had reported sales of $600k for 2015, $625k for 2016 and then just over $150k for 2017. Something was off. We reviewed the lease language specifically to determine if cellular contracts were excepted/excluded from reported gross sales. They were not. The breakpoint was just $650k.

Landlords have been aware of these and other issues and trying to combat them for years. Just a few things that keep companies like The Lamy Group Ltd. and Freed and Associates busy – firms providing tenant sales audits to ensure that tenants are fully reporting sales made at the premises. And, while you may think that the sole purpose of these audits is to generate additional percentage rent, there are many other reasons. One example is that a tenant’s lease is set to expire within the next 18 months and you will soon be negotiating a renewal. Knowing the tenant’s true sales will help you set rents for the renewal or extension term (using an occupancy cost ratio). Another would be that the tenant has requested rent relief and a sales audit helps to create an accurate picture of true sales. Or perhaps, you have provided a significant tenant allowance and the tenant’s lease provides a sales kickout/termination. A sales audit will help determine the risk of the exercise of the kickout, or whether you should devote marketing dollars to promote the tenant to protect your own investment.

While a headline of “Internet returns being used to distort sales reports” might make for good clickbait, the “issue” is not a new one and has always been part of the impetus behind a strong sales audit program.

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