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“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?

The economics of a lease

Over the next week, I will be putting together a new class for ICSC’s John T Riordan School for Professional Development. The class will be offered as an elective for the Management, Marketing and Leasing tracks at the school which is being held September 23-27, 2018 in Minneapolis.

A previous version of the class focused primarily on discounted cash flow from the lease which I intend to incorporate into the class. However, I plan to also address:

  • The relationship of one lease and its impact on the balance of the property (and possibly the portfolio)
  • Premise by premise considerations for lease rates
  • Category by category considerations for lease rates
  • Building tenant improvement costs/allowances into the lease
  • How to protect yourself when you do give a sizable allowance (Security Deposits/Letters of Credit/Radius Restrictions)
  • Cotenancies
  • Termination rights (landlord and tenant)
  • Gross leases vs triple net vs modified gross leases
  • The cost of giving up certain standard lease clauses

If you have read this far, perhaps you were thinking another topic or two would be addressed in the class. Well, now is your chance to help shape the curriculum.

Please comment with any additional items you think you be valuable for inclusion.

Here is the link to the John T. Riordan School for Retail Real Estate Professionals. The School offers tracks for Leasing, Management, Marketing and Development, Design and Construction, as well as a new Leadership Institute.

https://www.icsc.org/attend-and-learn/events/details/john-t.-riordan-school-for-retail-real-estate-professionals5

Hope to see you there!

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!

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