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Don’t overcomplicate the lease language

Every few weeks, someone in the office will let out a scream of frustration. The frustration comes from reading lease language that is so involved, but could have been accomplished with incredibly simple lease language.

For example, it is fairly common to see Consumer Price Index (CPI) increases applied to rents, or used as caps for certain reimbursable expenses in a lease. Applying a CPI increase is fairly simple and straightforward, but there are hundreds of variations of the CPI – for all Urban Consumers (CPI-U); for Urban Wage Earners and Clerical Workers and Wage Earners (CPI-W); either one of the using a 1982-84=100 base or a 1967=100 base, or even a 1957=100 base; any one of those for a specific city; any one of those for specific items, or excluding specific items. Along with those increases, it is common to have a negotiated cap on the increase – say 3%. Often, that cap is negotiated to be non-cumulative rather than cumulative. Sometimes there is language that states if the increase is greater than the cap in any given year, the amount over the cap can be carried forward to a future year when the increase is less than the cap. Sometimes, there are minimum increases applied in addition to the cap.

So, if you find yourself writing or negotiating a lease clause where

「the tenant pays a prorate share of CAM based upon the leased area of the shopping center, calculated on a weighted average basis, excluding major tenants greater than 25,000 sf and any tenant above or below ground level, where controllable costs are capped by 5% per year with any excess being carried forward to a future year, and where the first year CAM costs (including both controllable and uncontrollable costs) are capped at $2.00/sf, with the overall cap being increased by the CPI-W, 82-84=100 for New York, with a maximum increase of 3.5% and a minimum increase of 2.5%, also giving the tenant the right to audit CAM」

Do yourself (and your lease administration, lease accounting, asset management, billings and collections staff) a favor, and just simplify it to:

Tenant shall pay $2.00/sf for CAM, increased by 3% each 1/1 starting 1/1/18.

Think about what you are really trying to accomplish, and keep it as simple as possible.

Negotiate your leases wisely!

In any given year, we (my company, Meridian Realty Consultants) will read and abstract 8-10,000 leases. We get to see what landlords and tenants spend their time negotiating. It is not uncommon for someone in the office to say, 「Can you believe someone took the time to negotiate this?」 It might be something as simple as a tenant negotiating that common area maintenance expenses shall not include the cost of improvements to the leasable area of another tenant.

Why would we make that statement? Because excluding tenant improvements from CAM is a 「given.」 I am not saying it has never happened, but landlords do not include tenant improvement costs in CAM. Therefore, spending time negotiating that 「exclusion」 is a waste of time. It was going to have been excluded regardless of whether than negotiated language was included in the lease. It is amazing how many of these worthless (seriously) exclusions are negotiated. Is it really necessary to negotiate that the landlord shall not include in CAM a charge that has been recovered elsewhere in the lease? No. Again, it is a given.

At the same time, lease language that has a really material impact on expenses often is not as highly negotiated.

What has the single greatest impact on a tenant’s expenses? Is it the inclusion of roof repairs? Is it the inclusion of capital repairs or replacements? Is it the inclusion of seasonal décor? While they all impact a tenant’s rate, it is the METHOD used to bill CAM or taxes that has the most significant impact. If we have a 1,000,000 shopping center with four 200,000 sf anchor tenants each paying $2.00/sf for CAM and $5,000,000 in expenses, a tenant required to pay operating expenses based upon the leasable area of the shopping center would pay $5.00/sf ($5,000,000/1,000,000), while a tenant required to pay based upon the leasable area excluding anchors would pay $17.00/sf ($5,000,000 – $1,600,000 (4 anchors x 200,000 sf x $2.00/sf))/200,000 sf (1,000,000 sf – 4 anchors x 200,000 sf).

As we continue to show in out weekly review of lease language, it is imperative to understand how lease language and changes in lease language impact the cash flow from a property. So, if you are going to negotiate the lease language, spend the time negotiating language that will materially impact the cash flow.

“… the breakpoint shall likewise be abated…”

“… the breakpoint shall likewise be abated…”

This clause is almost a throwaway clause – one landlords and tenants give much consideration to – and it is the majority of retail leases.

So, what does it mean? If the tenant is struggling, and the landlord agrees to reduce minimum rent by 50%, then the 「breakpoint shall likewise be abated.」 To keep things simple, assume a tenant pays $100,000 per year in minimum rent and 10% of sales over a natural breakpoint ($100,000/10% = $1,000,000). If the landlord reduces minimum rent by 50% and 「the breakpoint is likewise abated,」 the tenant pays $50,000 in minimum rent and 10% of sales over $500,000. The intent is almost to ensure that the landlord doesn’t give too much.

But, its true impact is not always considered. Let’s consider a tenant with a lease commencing 10/1/17. They have the same $100,000 minimum rent and 10% of sales over the $1,000,000. They pay percentage rent on a 12/31 lease year end (including the true partial lease year*** ending 12/31/17). Now, let’s assume that in lieu of a tenant improvement allowance, the landlord gives a three month rent abatement. So, for October-December, 2017, the tenant pays no minimum rent. If that innocuous little statement (「the breakpoint shall likewise be abated」), the tenant is the required to pay 10% of sales over a 「likewise abated」 breakpoint, or $0. Therefore, the tenant pays 10% of all sales for 10/1-12/31/17.

The tenant was expecting essentially a $25,000 allowance as a three month rent abatement, but, it is possible, they actually got nothing because they end up paying the full amount in percentage rent.

This comes into play anytime there is a reduction is rent – a pure rent abatement, an abatement for a tenant improvement allowance, ant type of rent concession, alternate rent due to a cotenancy failure, alternate rent due to an exclusive violation and so on. Therefore, it is critical to understand this little bit of throwaway language and how it may impact a tenant’s percentage rent requirements.

*** – See a previous post on true partial lease years.

Co-participation and similar obligation

It is not uncommon to have co-participation clauses in retail leases – a clause which states that a tenant will be obligated to pay a certain charge at a specific rate with annual increases to that charge, but 「only if at least 70% of the other tenants are similarly obligated to pay such charge.」

The percentage of other tenants is a negotiated percentage, often ranging from 60-85%. Further, there will often be exceptions to what types of tenants get considered when calculating this percentage, such as 「excluding department stores, outparcels and theaters.」 Sometimes the co-participation may be based upon absolute the absolute number of tenants, while in other cased it may be based upon the square footage. (In the case of the former, a 1,000 sf tenant’s participation carries the same weight as a 15,000 sf tenant’s participation, while in the case of the latter, the 15,000 sf tenant carries 15 times the weight.)

Where the clause gets dicey and ambiguous is when 「similarly obligated」 is not defined. If a tenant is required to pay $2.00/sf increased by 5% per year, do other tenants have to pay similar rates per square foot with similar increases, or is it based upon absolute amounts? If another tenant pays the same $2.00/sf, but has 3% increases, does that eliminate the similar obligation? If a tenant is paying a $1,000 per year marketing charge, but another tenant sponsors two celebrity autograph events in lieu of a contribution, are they not both obligated?

Ambiguity typically goes against the writer, and it is typically a tenant requesting/offering the co-participation clause. With ambiguity, it is fairly easy to present a supportable position for or against 「similarly obligated.」

So, take the time to eliminate the ambiguity in advance!

Retail – the fatalists and the opportunists

This past week, Sears announced another 42 closures. As usual, we see even retail real estate executives posting or re-posting about the 「Dying Retail Sector.」 But, what I see regularly, not from these fatalists, is successful real estate companies take a different approach – 「How do we take advantage of these opportunities?」

One particular client this week looked at an opportunity to expand one junior anchor’s presence at a property. In this case, the junior anchor has several other concepts not yet present in the market. The opportunity was to consider relocating the junior from its current big box to a prominent anchor position which would give it the ability to house multiple concepts under one roof.

Why relocate the existing box to a future vacancy? Besides the ability to have the concepts under one roof with the ease of passing through from store to store, the landlord realized it would be easier to backfill the smaller big box. Additionally, there is the potential opportunity to eliminate cotenancy issues that might have otherwise arisen.

Our exercise was to determine if one or more relocated/new concepts in an anchor space satisfied the definition of 「acceptable replacement.」 This is an issue that I have addressed in previous blogs, but it truly is one of the most pressing issues facing the industry today. In a property with 150 tenants, you might expect 60-90 of those tenants to have cotenancy requirements. Of those 60-90, there could be as many as 40-60 different definitions of cotenants and their respective replacements.

As an example, anchors could be defined as 「department stores (may be further defined) operating in more than 60,000 sf.」 Just considering that one definition, a theater operating in 85,000 sf would not be considered an anchor. Depending upon how department store is further defined, a discount department store in 100,000 sf or a sporting goods store operating in 70,000 sf may not be department stores. And, if it is vacant (not operating) it may not be a department store. Another lease might define department store as the building labeled as 「A, B, C and D」 as reflected on Exhibit A. In that case, the building, whether vacant or occupied, is the anchor. There are hundreds of variations, each with potential exceptions (things like 「operating under one trade name,」 「not a theater,」 「must have multiple departments with both soft goods and hard goods,」 and so on).

To further complicate the issue, an 「acceptable replacement」 for the anchor may be defined differently. It could be as simple as another tenant must begin operating in the premises, but could address issues such as the number of floors in the vacant anchor and the need to have an opening on each floor. As addressed in an earlier blog, many more recent (over the past 3-5 years) leases now address alternative uses or a lifestyle component as acceptable replacements.

As we adapt in the industry to the new reality of fewer true department store anchors, we have to take the opportunity at every instance to amend or revise the definitions of acceptable replacements.

Since I got into the industry in the late 80s, appraisals have always addressed the highest and best uses for properties. While the appraisals did address these other uses, the reality was (and to a certain extent, still is) that we could not truly adopt these uses because existing leases restricted any use other than retail. But, we now see that something other than a department store, whether still retail or not, may be a better use. Malls are evolving and will continue to evolve. The fatalists may continue to call out for the death of malls and shopping centers. But, those that recognize the opportunity will help direct the future of our industry.

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