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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.

“Absolute” minimum denominators – Yeah! Right!

Last week, we covered minimum occupancies as a percentage of GLA for denominator purposes. But, sometimes we see another type of minimum – absolute minimum denominators. That is where you might see language to the effect of

“The tenant will pay its share of common area maintenance expenses based upon the leased area of the shopping center excluding tenants greater than 15,000 square feet. For purposes of calculating the denominator, the occupancy in the center shall never be less than 80%. Further, in no event shall the denominator ever be less than 225,000 sf.”

The 80% referenced above is the typical minimum occupancy – the minimum occupancy we addressed last week. However, the 225,000 sf referenced above is referred to as an absolute minimum denominator. Under no circumstance shall the denominator used to calculate the tenant’s prorate share ever fall below 225,000 sf.

Why would you have language like that? Consider the current state of regional malls where anchors or inline spaces are being demolished, or earlier periods where older malls were “de-malled.” Tenants wanted (and needed) assurances that if a landlord elected to reduce the GLA in a center, or re-configure the GLA in the center, the burden of those decisions would not fall on the tenant by increasing its ahre of CAM, taxes or insurance (typically, as the denominator goes down, the rate per square foot goes up. Not always, but typically).

However, in the spirits of earlier blogs where I have mentioned that you can never say “always” or “never” regarding certain lease language, even the word “absolute” may have qualifications.

This past week, we worked on a small center with a total GLA in the 47,000 sf range. One of the tenants had an absolute minimum denominator of just over 52,000 sf. Our client had bought this center, developed in the late 90s, just a few years ago. Sure enough, our client had diligently been using the absolute minimum denominator of 52,000 sf.

What does using that minimum denominator do to the center’s cash flow? By using a denominator higher than the actual denominator, the landlord is absorbing the tenant’s prorate share of this phantom square footage. If expenses are $470,000, if the denominator was 47,000 sf, the tenant would pay $10.00/sf. But, with a denominator of 52,000 sf, the tenant pays only $9.04/sf. If the center were fully occupied at 47,000 sf, and every tenant had this absolute minimum denominator, the landlord would eat $50,000. $50,000 at an 8% cap is $625,000 in value.

But, even though this is an “absolute minimum denominator,” there truly are no “absolutes” in real estate. There is typically a good reason for negotiating an “absolute minimum denominator” in a lease. Sometimes, it is a new center that has not been fully constructed. The tenant does not want to pay a prorata share of expenses for a center that will eventually be much larger, but is not there at commencement. So, we looked for that reason – and it was right there on the site plan/exhibit A. When the lease was executed, the center included two parcels that have since been sold off. Those two parcels contained that additional “phantom” 5,000 sf. So, while the center still technically included the additional 5,000 sf, the landlord’s expenses did not include the expenses attributable to that 5,000 sf.

In this scenario, the landlord should have gone to the tenant to amend the lease as those parcels were sold off. But, since they did not, there are two potential solutions. The first is to bill the tenant based upon landlord’s expenses and the actual square footage of the center – damn the absolute. This method represents the true expenses of the 47,000 sf. The spirit of the absolute minimum denominator is still intact. The tenant is not being billed expenses for 52,000 sf using a 47,000 sf denominator. The second method is to determine what the expenses are for that additional 5,000 sf that the landlord is not maintaining and then continue billing using the 52,000 sf denominator.

The latter scenario is fairly simple to administer for tax purposes – obtain the tax information from the local municipality. However, it is much more difficult to administer from a CAM and insurance perspective. The easiest way to do those is to “gross up” the expense to account for the additional 5,000 sf. Algebraically, this has the same exact impact as using the lesser denominator. Or, alternatively, you could approach the adjacent owners to get the true, actual expeses.

Personally, I would opt to approach the tenant to amend the lease to use a new “absolute minimum denominator reflecting the new “absolute.”

But, we know there are no “absolutes” in real estate!

Minimum occupancies

When a tenant’s prorata share is based upon the leased area of a shopping center (rather than leasable), a very common change to the lease language negotiated by tenants is the addition of a minimum occupancy. The language would read something to the effect of:

“The tenant’s prorate share of CAM shall be based upon the leasable area of the premises over the leased area of the shopping center (with the addition of) however, in no event shall the denominator be less than 80% of the leasable area of the shopping center.”

Using the “leased” area of the shopping center, the landlord reduces the absorption it would otherwise experience due to vacancy. The purpose of the tenant’s added language is protect itself from the vacancy getting too high, causing its rate per square foot to get much higher.

A nice, simple example of the minimum occupancy in action would be a 100,000 square foot shopping center with 30,000 sf of vacancies where total reimbursable expenses for the center are $1,000,000:min occ

As you can see, by negotiating this clause, the tenant was able to reduce its expense by $1.79/sf. If vacancy had increased to 50,000 of the 100,000, without a minimum occupancy, the rate would increase to $20.00/sf, but with the 80% minimum occupancy, the rate would still be $12.50/sf.

If all of the tenant is the center were billed based upon the “leasable” area of the center, the rate per square foot in this case would be $10.00/sf ($1,000,000/100,000 sf). With 30,000 sf of vacancy, the landlord would then “absorb” $300,000 due to vacancies (30,000 sf x $10.00sf). However, if all of the tenants were paying based upon “leased,” the tenants would pay 70,000 sf x $14.29/sf = $1,000,000. Therefore, the landlord would have no absorption. But the minimum occupancy holds the landlord accountable for excess vacancy.

That was a simple example. It gets a bit more complicated when there are excluded areas defined. The minimum occupancies are typically calculated after deducting the excluded areas. For example, if there was a 25,000 sf tenant in our example center and that tenant was defined as an excluded area, we would calculate the minimum occupancy on 100,000 sf less 25,000, or 75,000 sf. In that case, actually “leased” area would be 100,000 sf – 25,000 sf (major) – 30,000 sf vacancy = 45,000 sf denominator. But with the minimum occupancy, we would compare the 45,000 sf to a 60,000 sf minimum denominator (75,000 x 80%). (In the case of the excluded area, we would also typically deduct the contribution from the excluded area).

 

Next week, I will give one more example – where there is an “absolute” minimum denominator. It’s a bit more complicated, and causes a few other considerations.

How do YOU determine the value of a negotiated exception to a lease?

Any change made to a lease has a value to one of the parties. Some have very straightforward calculable values – reducing minimum rent from $25/sf to $24/sf or changing the percentage rent rate from 6% to 5%. Others have an absolute calculable value, but take a little effort to determine that value – changing the definition of an excluded major from 25,000 sf to 50,000 sf reduces taxes from $x.xx/sf to $y.yy/sf. However, others can have a material impact on the cash flow and value of a lease or a property, but the values are difficult to determine – giving up an exclusive, cotenancy or termination right.
ICSC is applying a “flipped classroom” concept to the upcoming John T. Riordan School for Professional Development in Minneapolis. The flipped classroom is where you do exercises in advance of the class to make the classroom experience even more valuable. As part of the Economics of the Deal class, students will look at five changes made to the lease for the most recent deal they have completed and attempt to assign a value to those changes. When we discussed this in my office last week, I couldn’t get my co-workers to stop talking about it.
So – just some food for thought for you –
When a tenant requests a change to the lease, what steps do you go through to determine the value impact of that change?

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