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Looking behind the retail curtain at the holiday

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Way back when in high school, I was on stage crew for the school’s productions. What I realized was that after doing that for several years, whenever I went to a Broadway show or musical, I would be at least as interested in how the crew handled the sets and lighting and sound as I was with the show itself.

Similarly, at this time of year, as I walk around a mall or shopping center, I pay probably more attention to the centers’ operations as I do to the merchandise (that actually is part of the operations). What actually triggered this line of thought was an article this week on Business Insider:

“The end-of-the-year retail bump is a lie we’ve been told for decades”

It is worth a read, but, for those of us operating in this industry, there is no lie. Year after year. With the exception of a few retail categories that remain steady throughout the year, or some retail properties that are destinations at certain times of the year, we can consistently see that many of the mall and strip center “goods” type tenants experience this retail bump, doing 19+% of their annual sales in December and a little more than 12% of their sales in November. Throw in 8% for October, and you are pushing 40% for one quarter. If you do 40% in the 4th quarter, that leaves 60%, or an average of 20% per quarter for the other three quarters. Nearly a 100% increase over the other quarters is real, and critical.

But, what else do I think about as I walk through the malls and strips? That despite the fact that it may be the coldest part of the year, the HVAC units and central plants may be working their hardest as the heat generated by the sheer volume of people makes it work overtime. (Christmas shopping is not Christmas shopping for me without sweating in a mall because the HVAC can’t keep up and I have a winter jacket on!) And, speaking of overtime, what is happening with the additional hours that the centers operate? In the days when the majority of tenants were on prorata CAM in malls, the extra hours were paid prorata by the tenants. But, with the majority of mall tenants on fixed CAM, if the initial CAM did not consider the additional hours, the landlord will absorb the expenses. I think about the tenants that are opening late in the year and getting the benefit of a disproportionate amount of sales early on – how are they paying percentage rent. As we experienced the past two days here in Atlanta, I think about the costs of snow removal and whether it will be a disproportionate year. Do the properties leases allow, despite fixed CAM, a billing of snow related expenses for exceptional expense years? I think about the properties, mostly strips, that are still on prorata CAM and whether the holiday décor is defined as part of CAM, or whether it is purely a landlord expense, or whether they may be making a marketing contribution and it’s covered by that. I think about the Santa displays and the holiday village displays and where they are stored throughout the year, and whether the landlord owns the displays or leases them, or whether the temporary tenant that operates the Santa village owns the displays and that is part of their cost of doing business. I think about the gift cards being purchased, and that the sale of those gift cards is not a reportable sale until they are redeemed. But then, what portion are never redeemed, and does the tenant turn the unclaimed dollars over to the state as they may be required. And, I do think about the impact that online sales has on our industry – that the strongest properties will continue to get stronger and that the media will focus on the weakest properties that maybe should never have been built in the first place and their struggles supposedly indicating the death of retail.

In any event, you probably don’t want to go Christmas shopping with me because my mind will clearly be wondering. But as you go yourself, think about the time and effort the property managers and the marketing managers and the leasing staff and the temporary leasing staff have put in to making a great holiday shopping experience.

And, give a special shout out to the operations managers and HVAC engineers trying to keep you cool!

“I need to call my friend Pete to get some more information about this lease…”

pawn-stars

I love the shows Pawn Stars, American Pickers and Mysteries at the Museum. With these shows, they find an item that interests them, authenticate it and then give a bit of history on the piece. As geeky as it may sound, there can be identifiable histories to leases and lease language.

Did you ever pick up a lease and you have to turn it sideways to read the inserts? If you have one of those, or a lease that references a porters wage index instead of the consumer price index, it likely is for a property in New York. If it is not, the attorney that negotiated it probably worked in New York at some time.

Does you lease have a carryforward of any excess share of taxes or CAM over a cap? The leasing agent probably came from one of two major mall developers. How about an inserted, photo copied page addressing exclusions from gross sales? Many of us came name the developer.

A few years back, we were working on a mall portfolio acquisition. After abstracting the first few leases, we had joked that you could tell that the seller did not participate in ICSC events because the leases that were then being negotiated were similar to the ones that they had executed 30-40 years earlier – they never witnessed and benefitted from the evolution of lease language.

This week, we had a lease where the tax denominator had a handful of excluded areas and, contrary to industry standard, taxes were defined as “without deducting contributions from excluded areas.” We knew exactly which law firm had drafted the lease. Sure enough, the notice address confirmed it.

I guess in their own sort of survival of the fittest way, leases and lease language have evolved over the years to adapt to the then-current circumstances. Co-working and e-commerce, even things like autonomous vehicles, will likely be bring more big changes to lease language in the near future!

The percentage rent unicorn

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There are a few percentage rent calculation issues that make me happy (from a landlord perspective. If you are a tenant, you hate these!). True partial lease years – where a sales for a portion of a year are compared to the breakpoint for a portion of the year, and the tenant pays sales on the excess. National and regional tenants typically no longer have true partial years, negotiating the extended partial (12 months of sales from commencement over a 12 month breakpoint, calculate any percentage rent on the excess and then prorate the result). True partials typically result in much higher percentage rent, but since the tenant is there for the busiest months of the year and did not have to pay rents during the slower months, it actually is a fair method.

Next is when there is a change is percentage rent rates during the year. While breakpoints can be blended when there are changes mid lease year (and no change in percentage rent rates), percentage rent rates cannot be blended. Therefore, you end up with two partial lease years.

Another is where there is an abatement of rent and the boilerplate breakpoint language remains – if minimum rent is abated, the breakpoint shall likewise be abated. Think about a lease commencing 1/1 and the tenant has 9 months of abated minimum rent. If the lease year ends 12/31, you have 12 months of sales over a three month breakpoint. Landlord’s recapture a good bit of that free rent. Along those same lines, when, for one reason or another, a tenant goes to percentage in lieu for a portion of the year, that has the same exact effect as minimum rent abating and the breakpoint likewise abating.

But, there is one percentage rent method that outshines them all (again, from a landlord perspective!) – monthly breakpoints with no annual reconciliations. These are few and far between, but unlike unicorns, they really do exist. We have actually worked on properties where the majority of tenants have this requirement. In these cases, in months where the tenant is over the breakpoint, the tenant pays percentage rent, but there is no annual reconciliation, meaning the tenant’s percentage rent is not reduced for months when sales are less than the breakpoint. As an example, a tenant pays 5% of sales over its breakpoint of $100,000 per month (the equivalent of $1,200,000 per year). In 9 months, the sales are $80,000. In three months, the sales are $150,000. For the three months of $150,000 sales, the tenant pays $2,500 per month, or $7,500 for the year ($150,000-$100,000= $50,000 x 5% = $2,500; $2,500 x 3 = $7,500. For the other months, the tenant has sales less than the breakpoint and they pay no percentage rent. They paid $7,500. Had there been an annual reconciliation, the tenant would have not have paid percentage rent ($80,000 x 9 = $720,000; $150,000 x 3 = $450,000; $450,000 + 720,000 = 1,170,000; sales would then be less than the $1,200,000 annual breakpoint).

This is a tame example. We have seen tens of thousands of dollars due from tenants when there are extreme monthly variances, where percentage rent may not have been due if an annual reconciliation was required.

They are few and far between, but these percentage rent unicorns will provide a material boost to your cash flow if you find one.

Gross sales/percentage rent considerations when backfilling a department store/big box

Site plan of King of Prussia Plaza from the early 1960s with an Acme Supermarket:

02_KOPP_1963 plan

Since the 1970s, it has not been common to see certain types of tenants in regional malls as department stores enforced certain types of use restrictions that existed in their leases (often to protect parking).  However, as closures of former destination tenants have occurred and regional malls are becoming the community centers and all-in-one centers they once were, we are seeing a resurgence of these categories back into regional malls. As it has been so long that mall developers have had to deal with these categories, today’s blog addresses a few of the sales-related issues in those categories that can have a material impact on percentage rent.

Health Clubs – Most gross sales definitions include sales, whether on cash or credit. When an individual signs a contract for a year, paid monthly, the sale is for the entire amount. If the customer does not follow through with the contract, it is a bad debt. Unless a health club has specifically negotiated a deduction for bad debts, the full amount of the sale must be included. Also, if a health club allows personal trainers to operate out of their facility, the revenues generated by those personal trainers must also be included.

Supermarkets – There are quite a few gross sales issues related to supermarkets. Manufacturers’ coupons (like the ones you get in the Sunday paper) are reimbursed by the manufacturer. Therefore, the use of these coupon should not decrease the sale (whereas store coupons are a true discount by the supermarket chain and are not reimbursed). Slotting fees are significant fees paid by manufacturers for shelf space in supermarkets. Often, the slotting fees can be more than the profits supermarkets realize on the actual sale of product. Consideration must be given to the fact that supermarkets often sell lottery tickets. Depending upon the lease language, it is usually the commission realized on the sale of lottery tickets that must be included rather than the sale of the tickets itself. However, it is possible that the sale itself should be included. Among the many other considerations are whether the sales of goods and services by subtenants or the rents paid by those tenants should be included in reported gross sales, and whether the tenant specifically negotiates the exclusion of alcohol or tobacco sales from reported gross sales.

Theaters – Theaters will often try to negotiate either one of their two biggest sources of revenues from reported gross sales – tickets sales or concessions. Theaters are charged a material portion of their ticket sales as royalties, sometimes approaching 100% for blockbuster/Oscar winners. If the theater can make a good case for the exclusion of a specific type of revenue, the breakpoint and percentage rent rate should be adjusted appropriately (no longer a natural breakpoint).

One other quick note – There was an article in Globe Street earlier this week about Amazon being surprised by some of the restrictions that they were discovering in their Whole Foods’ leases that are affecting what Amazon could sell in Whole Foods (due to other big boxes’ exclusives), and specific restrictions against Amazon’s locker delivery system. Many supermarket leases are excepted from other big box exclusives or allow the incidental (typically defined as less than 5% of sales or less than 500 sf) sales of restricted goods, so these issues may be fewer and farther between than the article may have presented. However, there is a sales/percentage rent issue not addressed in the article. Typically, gross sales is defined as sales “in, at, on or from” the demised premises. If Amazon does install the lockers in their own Whole Foods stores, the “locker-delivered” sale will have occurred “from” the demised premises and will, therefore, have to be reported as part of reported gross sales. A potential boon for landlords!

How many expense pools are required?

Over the years, we have worked on 150+ tenant regional malls where the sellesr had been using 3-4 expense pools per prorata expense category, and we have also worked on 20 tenant open air centers where the seller had been using 20 different expense pools.

What’s right?

As new variables are introduced into leases, the number of pools required grows. For example, your standard lease requires the tenant to pay a prorata share of taxes based upon the leased area of the shopping center excluding tenants greater than 15,000 sf. If every tenant comes in and agrees to that methodology, you may have one pool. But another tenant comes in and changes the definition to 20,000 sf, and yet another, 25,000 sf. All other things being equal, you now have three pools. Other tenants come in, and rather than leased, they negotiate leasable. With no other variables, you could possibly have 3 additional pools, for a total of 6 (leased less 15k, leased less 20k, leased less 25k, leasable less 15k, leasable less 20k, leasable less 25k). Part of it will also be determined by how you have set up your property management software and you cash flow analysis software. Now suppose you develop an outparcel and you want that outparcel to be excluded, so you change your standard lease to leased less tenants greater than 15,000 sf and outparcels. All of the sudden, there are the possibility of 6 more. Then you have tenants request (and your leasing people agree to) minimum occupancies (ex. Leased less tenants > 15k sf, with the denominator never less than 80% of the leasable area excluding tenants > 15k). The number of possibilities grew again. Consider that the property is sold and the new owner’s standard lease includes personal property taxes in the tax definition whereas the original lease did not.

Seriously, as variables are added, the number of pools grows. We have worked on properties that on the day they have opened, there have been nearly the number of pools as there are tenants.

Why this post this week? Working on a regional mall this week with about 140 tenants, I had just reviewed the owners set up of taxes. There were about 12 methods while about 20/21 were needed. Then I got to CAM. They had nearly 40 methods set up for CAM, many with changes in the inclusions or exclusions from expenses (before even considering changes in methodologies). I settled in for the long haul, but soon found that all but one tenant was on fixed CAM. Still not sure why they had not cleaned up the CAM pools.

So, how many expense pools are required? Unfortunately, as many as necessary. Trying to use too few pools to ease the administrative burden will lead to numerous errors, which can often lead to money left on the table. No one wants that!

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