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Common area taxes and liability insurance

In the majority of retail leases (and in a smaller portion of office leases), we have sections in the leases that address how to calculate the tenant’s prorata share of real estate taxes as well as tenant’s share of property insurance. This can be a little confusing if you do not read leases regularly because often, when reading the Common Area or Operating Expense definitions the lease will define taxes and insurance as part of reimbursable CAM or OPEX.

This is not giving the landlord the right to 「double dip,」 billing those expenses twice. Rather, when this language exists in leases, it is requiring that the common area portion of real estate taxes and liability insurance be billed through CAM or OPEX. This insurance issue is typically simple and straightforward (but occasionally does require what we will describe in taxes next). When there is a separate insurance section describing a tenant’s prorata share, this separate section is for the property insurance – insurance covering damage and destruction to the physical building (think something like a fire). The portion that most typically goes in to operating expenses is for the liability portion of the insurance (think something like a slip and fall). Confusing the issue a little further is that most leases require tenants to carry insurance – both property and liability on their premises. In the majority of instances, the insurance required to be carried by the tenant is for damage to its improvement and inventory within its premises, as well as liability within its premises. (In the other instances, the tenant may be on a ground lease, or constructed its own building improvements, and is required to insure no only the interior improvements, but the building itself).

With real estate taxes are addressed both in CAM or Operating Expenses as well as in a separate tax section, it is the common area portion of real estate taxes to be billed through CAM, and the taxes on the leasable areas of the property billed separately. In honor of National Donut Day this past Friday, picture a Krispy Kreme donut sitting on a plate. The plate itself is the property. The donut is the leasable area. The portion of the plate not covered by the donut is the common area – so outside of the donut may be the parking area and the hole inside the donut may be interior mall walkways and corridors. So the donut gets billed separately, and the uncovered portion of the plate gets billed through CAM.

There are countless justifiable ways to calculate the common area portion of taxes – enough to cover multiple blogs. So we won’t cover that at this time. However, there are a few thoughts to leave you with if you have these types of leases in your portfolio:

  • When caps on increases in expenses exist in leases, it is much more common to see a cap on CAM than a cap on real estate taxes. If the landlord is not billing taxes as required, they may have some exposure for overbilling if the tenant has a cap on CAM but not taxes.
  • The donut issue can sometimes be required for insurance.
  • As leases are converted to fixed CAM, the conversion must address the common area portion of real estate taxes. It may be the landlord’s intent to bill all taxes as a separate charge, but if common area taxes are still defined as part of CAM and CAM is fixed, only the taxes on the leasable areas may be billed.

Percentage rent using different partial year methodologies

Percentage rent is where a tenant pays a percentage of its sales once it has exceeded a certain base level of sales. The better a tenant does, the better the landlord does. If the tenant does not exceed the base level of sales, or the breakpoint, the landlord does not receive percentage rent.

In most cases, the tenant reports sales and pays percentage rent based upon its Lease Year. Lease Year is defined within the lease, most often defined one of three periods: 1. A Calendar Year (1/1-12/31), 2. A period running 2/1-1/31, and 3. A period ruining 12 full months from the commencement date (if it is the first of the month) or from the first day of the month following the commencement date (if the commencement date does not fall on the first of the month).

Calculation of percentage rent for full lease years is simple and straightforward. Take sales for the full lease year less the breakpoint for the full lease year, and multiply that excess times the percentage rent rate to determine percentage rent. However, when a partial lease year (a period less than 12 full months) is involved, a lease must specifically address how percentage rent is calculated because the methodology applied could provide wildly different amounts due.

Consider why partial years would be an issue. With exceptions for certain categories of retail and certain types of properties, most retailers will do a disproportionate amount of sales in November and December. Typically, we set an expectation of about 12% of sales in November (weighted toward the latter part of the month) and 19% in December. Think about that. If a tenant opens on 12/1, they are going to do about 19% of their annual sales in just over 8% of the year. Depending upon how the lease addresses percentage rent for that period (if the lease year end were 12/31), the tenant could pay wildly different amount of percentage rent.

While there is no limit to the number of ways that percentage rent for a partial period can be calculated, there are three 「typical」 methods applied in the industry – 1. True partial lease year, 2. Extended lease year, and 3. Extended partial lease year.

A true partial lease year requires that sales for the partial lease year be compared against a breakpoint calculated using the annual breakpoint prorated for the number of days in the partial period. Opponents of this method argue that the tenant is unfairly penalized higher amounts of percentage rent because the tenant opened during the busiest time of year. Proponents of this method argue that the tenant did not pay rent during the slowest times during the year and got the benefit of opening during the busiest time of year. An extended lease year combines the initial partial lease year with the first full lease year. To a certain extent, this method allows for the fact that there is often an artificial bump in sales when a tenant first opens. The final method, the extended partial, still bills for the partial period, but uses sales for the first 12 months against a breakpoint for the first 12 months, and then prorates the percentage rent that would be due for this so-called reference year by the number of days in the partial lease year. This method began surfacing around 20 years ago and is slowly becoming the standard in regional mall leases. It can be found in strip centers, but the first two methods are still much more common in open air centers.

Reflected in the following slides, I have calculated percentage rent for an initial partial lease year and a first full lease year using the same exact sales figures and a requirement that the tenant pays 6% of sales aver a $1,000,000 annual breakpoint.

Sales

blog 5 rent sales used

True partial lease year

blog true partial

Extended lease year

blog extended.JPG

Extended partial lease year

blog extended partial

As you can see, percentage rent for the periods using the exact same set of numbers can range from a low of $69 to a high of $11,096. Therefore, whether you are a landlord or a tenant, it is imperative that you understand how percentage rent is required to be calculated for partial lease years.

Retail evolution and the need for lease language changes

Experiential retail. Bricks and mortar stores as distribution points. Online sales returns. Showrooming. We are continuously bombarded with articles about the death of retail, the evolution of retail, stores closures, the death of retail being exaggerated, announced stores closings, announced store openings. While there seems to be little agreement about the future of retail, there is little doubt that retail continues to evolve. And, with that evolution, changes are needed to leases and lease language.

  • Many leases and most operating agreements (Reciprocal Easement Agreements (REAs), Construction, Operating and Reciprocal Easement Agreements (COREAs) and other similar documents) typically have restrictions against uses which may be found in a shopping center such as:
    • Residential
    • Education
    • Entertainment (movies, theaters)
    • Vehicle sales and rental
    • Office
    • Health clubs and exercise facilities

These restrictions often run with the land (meaning they are perpetual with no expiration). Often, these restrictions existed to limit the impact on parking. However, some existed to ensure 「a first class」 shopping center. But, outstanding properties live Oak Brook Center outside of Chicago and Avalon (pictured in the photo) outside of Atlanta have Tesla dealerships. Some of the best centers in the country, Ala Moana Center, Natick Mall, Phipps Plaza, have residential incorporated or immediately adjacent. As retail evolves, these restrictions have to be eliminated, or altered. Without changes, a developer’s ability to allow a center to evolve will be limited. I used to laugh when I would read a restriction against a distillery. Who would ever consider something like that? Today, breweries and distilleries are desired tenants in mixed use properties – that experiential retail. Do you really want to be denied an Equinox Fitness or Soul Cycle due to a use restriction. Use restrictions must evolve.

  • Retailers trying to marry e-commerce with bricks and mortar often use their store locations as distribution points. However, if you take a look at a gross sales definition, reported gross sales include sales generated 「in, at, on or from the demised premises.」 While a sale may have been made online, in certain instances, the sale is finalized 「from」 the demised premises. On the other hand, if a retailer makes a sale online, but allows the consumer to return it to a retail location, the sale may have never been reported, yet the return is used to reduce reported gross sales for the location. The definition of gross sales must evolve.
  • Also affecting the definition of gross sales will be the concept of showrooming – where the store may be a showroom only. Touch, experience, try on. The order may be placed at the retail location, or subsequently online. Leases have to evolve to recognize the value of the sale which, in some part, is attributable to the physical location.

From the late 1950s to the early 1970s, it was very common for department stores in regional malls to have absolute approval rights over other tenants which would be permitted to operate in the mall (or at a minimum, in their respective entry court). Right around 1973, due to anti-trust lawsuits which were being brought at the time, most department stores issued unilateral agreements rescinding their approval rights.

For the health and survival of the industry, we may need to see some unilateral rights, restrictions, and language definition rescissions granted from tenants to landlords and vice versa so that centers can evolve.

The most dreaded lease clause – Most Favored Nations

This week, I was working on an office acquisition and came across a clause I had never seen applied in office before – a most favored nations clause. The clause essentially read:

Notwithstanding anything in the lease to the contrary, no other tenant in the Property shall have a more favorable rental rate (which was further defined to include base rent, tenant’s share of operating expenses and tenant’s share of taxes).

It reads fairly simply – no other tenant shall have a more favorable rental rate – but the consequences of administering that language can have a material impact on cash flow and value. Most typical in retail leases, I would estimate that we see this language once out of every three malls (so figure 1 in 400-450 leases) and perhaps once out of every 10 open air centers (maybe 1 in 200 leases).

When I first got into the industry 30 years ago and saw this language, I remember thinking that the tenants that had the language in the lease were the laziest leasing agents around. Essentially, 「Yes. I will agree to this, but if someone was better than me and negotiated a better deal. I get that.」 It did not take me long to realize that the tenants that negotiated this language had the absolute best leasing agents in the country because of the same exact statement, 「Yes. I will agree to this, but if someone was better than me and negotiated a better deal, I get that.」

They not only have their own skills and experience to draw from, but they have the collective skills and experience of every other leasing agents with space at that property.

It is so dreaded for many reasons, but the most obvious are the amount of administration it takes to properly bill a tenant and the financial implications. Imagine, you have finished the final review of the year end settlements of CAM or taxes and are ready to post the billings. But, you find that the tenant with the most favored nations clause is required to pay $4.00/sf, another tenant has a $3.00/sf rate. You now have to go back and change that first tenant’s rate to $3.00/sf. Now, imagine that tenant was an excluded area for other tenants in the center. That change from $4.00/sf to $3.00/sf could affect every other tenant. Now, take it a step further. You have a struggling tenant. You agree to put that tenant on a percentage in lieu of minimum rent and all other charges. All of the sudden, that $4.00/sf goes to $0/sf.

A truly awful clause for the landlord and a truly wonderful clause for the tenant.

Often I am asked about how can you be sure if the landlord is administering the clause properly. Honestly, you can’t – unless it comes out in discovery during a lawsuit. However, what I can share is that the tenants with most favored nations clause are often anchors or other highly desirable tenants that landlords have (or want) a solid relationship with. In 30 years, I have seen hundreds of these. And, in all but one instance, when the landlord was made aware of the clause, they properly administered the clause (prospectively).

One way landlords can all but eliminate the impact of this clause (through attrition as leases turn over) is to include 「allocation language」 in their standard lease form which essentially gives the landlord the right to allocate base rent, percentage rent, or any other charge to another lease required charge. In that case, when you see the $3.00/sf charge, or the $0/sf charge, if those leases have allocation rights, the landlord can allocate $1.00/sf or $4.00/sf from one charge to another and have no tenant with a rate lower than $4.00/sf.

While you may want to put your head in the sand and hope you don’t have them in your portfolio, they are probably buried in your leases. So, be proactive and address them head on.

Extracting value from an exclusive

There is no question that a tenant benefits from being granted an exclusive use in a shopping center. More often than not, an exclusive ensure that no other tenant in the shopping center shall have the same use as tenant granted the exclsuive. (Occasionally, an exclusive shall read something to the effect of 「There shall be no more than two other jewelry stores…」 Still something of an exclusive, it is a little less burdensome on the landlord.)

Traditionally, the tenant benefits from the exclusive, and the landlord has yet another restriction, limiting its leasing options. It 「costs」 the landlord. However, there is language that we see occasionally that does, to a certain extent, assign a value to the exclusive.

It will read something to the effect of:

As long as tenant is operating as a ______, there shall be no other ______ in the shopping center. If landlord wishes to lease to another _____, landlord will notify tenant. Tenant shall have 10 days to notify landlord whether it wishes to enforce the restriction against another _____ from operating in the center. If the tenant elects to enforce this restriction, tenant’s Base Rent will immediately increase by $5.00/sf for the remainder of the term and landlord will not lease to the another _____. However, if the tenant does not respond within 10 days, or the tenant elects not to require the landlord to enforce the restriction, this exclusive shall no longer apply and the landlord shall be permitted to lease to another _____.」

Beautiful language turning a typically non-financial covenant into a financial covenant!

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