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Deductions and exclusions from reported gross sales

October 19, 2020

ICSC published a brief summary of a handful of timely legal issues discussed during its 50th U.S. Law Conference. Among the topics were a few percentage rent concerns. They are all relevant in the current environment and worthy of addressing the “whys” of the topics and expanding on them a bit.

Before hitting those issues, I want to make a quick distinction. There are two general categories that negotiated changes fall into for the definition of Gross Sales – Exclusions and Deductions. Both reduce Gross Sales, but it is important to see the difference. Exclusions are types of revenues that do not get included in reported Gross Sales. If a revenue is generated, it must be included unless an Exclusion is negotiated. (For exclusions, think along the lines of alteration income for a clothing store, or lottery tickets sales for a supermarket or liquor store. These would be expense categories that might be negotiated as exclusions from Gross Sales.) Deductions, however, are more typically expenses that can be deducted from reported Gross Sales. (For deductions, think along the lines of credit card charges. This would be a retailer’s expense that might be negotiated as a deduction.) This might seem like semantics, but it is important to understand the distinction. Why? Because there are no Exclusions or Deductions from reported Gross Sales unless they have been specifically negotiated.

Now, finally! On to the issues raised by ICSC:

Pop-ups within stores raise questions about percentage rent leases, and (Ruth) Schoenmeyer advised landlords to make sure lease language defines the sales on which percentage rent is based to include anything sold within the leaseholder’s space. That covers products sold by a pop-up retailer within another retailer’s store.

“Gross Sales” are typically defined as sales made “in, at, on, or from the Demised Premises.”  Therefore, based upon this most common starting definition of Gross Sales, the Pop-ups’ sales are required to be included in reported Gross Sales. Required – doesn’t mean they are. So, unless the tenant has negotiated the exclusion of sales from pop-up stores (or concessions), these sales must be included by the tenant when reporting its Gross Sales. (We are sticking to sales for this blog, but, hopefully, you are thinking of a few other issues reading this. Think along the lines of perhaps a Sephora in a JC Penney, or a Starbucks in a Barnes & Noble. Are they permitted to have a pop-up in the store? How might that affect existing exclusives in the center? How might that affect my ability to lease to another cosmetics store or coffee shop in the center?) Often, if the landlord concedes to the tenant’s request to exclude the sales from permitted concessions within the premises, the tenant will be required to include the rents received from the concessionaire/pop-up/subtenant. It will often just be a small fraction of the sales themselves, often keeping a tenant from achieving a breakpoint.

Retailers want to minimize gross sales as accounted by the landlord. However, landlords nowadays want to know if the property in question was “touched” at any point during the transaction. Did the consumer pay for the item at the store or pick it up there? Perhaps the item was stored there if the retailer is fulfilling online purchases from the store.

Back to that “in, at, on or from the Demised Premises,” if the premises is involved in any way, the sales are required to be included in gross sales unless an exclusion is negotiated.  Last week, my wife went to the local running store for a new pair of Hokas. She made the purchase in the premises, and must be reported. If the shoes were not available and they shipped them to her, the sale was made at the premises and must be reported. In June, I walked a great property in North Carolina with a cupcake store. They had beautiful wedding cakes on display. If the cake was ordered elsewhere but baked on the premises, it must be included in gross sales.  And, if I go on to Amazon to order from Whole Foods and pick up my order two hours later, that sale was made from the premises and must be included in gross sales. All of these are examples of sales made in, at, on or from the demised premises that must be included in reported gross sales unless an exclusion has been negotiated.

Ulmer & Berne managing partner Scott Kadish said negotiations should occur around deducting payments to third-party delivery services from restaurant sales for lease purposes.

“Deducting” in the paragraph above says enough. If you place a $20 restaurant order using a delivery service, the sale made at the restaurant is $20. The restaurant then pays a percentage of the order, say 20%, to the delivery service. The sale is $20, the expense is $4. The restaurant tenant must report $20. If it has negotiated a deduction for third party delivery charges, it may deduct $4, ultimately reporting Gross Sales of $16. This is comparable to a tenant negotiating a deduction for credit card fees. A $20 sale made by credit card is $20. The 3% fee paid to a credit card company is an expense of the retailer that cannot be deducted from reported gross sales unless a tenant has negotiated a deduction of credit card fees. (Again, just a brief distinction between exclusions and deductions – retailers often negotiate the exclusion of employee sales (often with a landlord-imposed limit) because the retailer gives a substantial discount to employees. Theaters will often negotiate the exclusion of certain box-office receipts when the royalty on a movie exceeds 35-40%.)

Schoenmeyer also noted that lease drafters should consider the impact on gross sales of buy-online-return-in-store programs.

There are certain “givens” related to sales that do not have to be negotiated (yet some retailers will still add them to their negotiated deductions and exclusions just to play it safe). Sales taxes collected by a retailer on behalf of a state or municipality are not sales. You buy a $10.00 item and you pay $10.70 with sales tax. The sale is $10.00, not $10.70. And, returns of purchases made automatically reduce sales. That same $10 purchase returned reduces sales by $10, for a net $0. But, as Ruth Schoenmeyer pointed out, landlords really need to consider the impact of Buy Online Return in Store. For most retailers, a $10 purchase online is not credited to a store, yet that same purchase, returned to a store will be treated as a return, reducing sales when the original sale was never included! The typical “standard” lease definition of gross sales does not sufficiently address the reality of online sales returned in store. An adequate way to address this prospectively might be to state in the standard lease form that “only returns for sales previously included in reported gross sales may be used to reduce sales.”

In any event, these are just a few of the hundreds of exclusions, deductions and other considerations keeping sales audit firms busy.  While many landlords reserve sales audits for tenants and periods where sales approach 90% of a tenant’s breakpoint (because there would be a greater likelihood of additional percentage rent due), the current effects of coronavirus actually create a more pressing need for sales audits (as some tenants have been temporarily converted to a percentage in lieu of minimum rent (and every adjustment results in a percentage rent change) or tenants request rent relief).

If you are puzzled by the value of a specific exclusion or deduction that you have seen in any of your leases, comment below and we’ll be happy to address it here.

Comments | Posted in Commercial Real Estate, Malls, Retail Leases, Shopping Center, Uncategorized

Lease language food hack?

September 20, 2020

Last week, I read an article about a nineteen year old who used one email address and an Excel spreadsheet to get free food every day of the year. He gave a different birthday to every restaurant that he could find that would give free food for your birthday, and then used his spreadsheet to see where he was eating that day. Right or wrong, it reminded me a handful of acquisitions we did about 7-8 years ago in the Southeast for a few different owners.

The common thread to these acquisitions was that they were all purchased from one small developer. Since they were strong, grocery anchored centers, the institutions loved them. We are doing the first acquisition and everything is as expected. And, then I start abstracting a Chinese restaurant lease. The final negotiated clause added to the lease was that the developer was entitled to one free lunch special, once a week, with a drink. Seriously, negotiated into the lease! Geek that I am, I estimate the cost of the special and a drink at $8, then do the math for 52 weeks ($416) and then apply a cap rate to it (I think at the time, the center was going to have traded in the low 7s), so it was worth about $5k! Pretty funny and creative. We move on from that acquisition.

A few months later, another institution, same seller/developer. AND ANOTHER LOCAL RESTAURANT WHERE THE DEVELOPER HAD NEGOTIATED THE SAME DEAL!!!! About a year later, we found one more for another buyer.

This local developer had at least three of his weekly lunches covered! No doubt there were more.

You never know what you’ll find in a lease.

Comments | Posted in Retail Leases, Shopping Center, Uncategorized

Property Management Systems Can’t Handle This Clause – And if you have them, they will be critical for 2020

September 14, 2020

We have been seeing a clause for years that is both brilliant and fair to both landlords and tenants – a CAM cap carryforward. The concept is fairly simple. You calculate and apply a cap as required by the lease. However, if there is any excess CAM that the landlord could not bill and collect because of the cap, the landlord can carry that excess forward and bill it if the tenant’s share of CAM in a future year is less than that current year’s cap. (And, as we have addressed in previous blogs, we have to be aware of whether the lease addressed the cap as cumulative or non-cumulative.) Here is an example of what this could mean for 2020 and beyond:

As the example points out, with a CAM cap carryforward, we may be able to pick up amounts not previously billed. And, perhaps even more importantly in the case of a non-cumulative cap, we may be able to prevent the reset to a much lower cap for future years.

This carryforward language is not uncommon. I would venture to say that it exists in about 15% of leases that have cap language. However, it is very landlord-specific, meaning there are numerous landlords out there that use this language while the majority do not. If you are a landlord that does not use this language, keep in mind that it may exist in properties that you have acquired over the years.

And, that blog title, “Property Management Systems Can’t Handle This Clause”? It is true that this is a brilliant, fair clause. However, we have not encountered a “stock” property management system that can handle this clause – tracking the carryforward and applying the carryforward. Please share if yours does.

But, for 2020, and the value of your portfolio, it is worth starting the search and prepping the manual calculations now.

Comments | Posted in Commercial Real Estate, Malls, Office Properties, Retail Leases, Shopping Center, Uncategorized

Remember that premises services (utilities/trash) are not common area expenses!

September 7, 2020

It is not uncommon for a lease to require a tenant to pay quite a few different monthly recurring charges (minimum rent, taxes escrows, CAM escrows or fixed CAM, insurance escrows, perhaps a marketing charge, or storage, or signage to name a few) as well as certain charges to be paid or reconciled annually (those same tax, CAM and insurance charges, percentage rent ). Couple those with so many other clauses that need to be administered for each lease, it is not surprising that landlords try to simplify the administration whenever possible.

One of the more common practices across the industry is to bill certain services provided to tenants for their premises as CAM. In an open air shopping center, these services we see billed most often through CAM include trash removal and water and sewer. Your immediate reaction might be that common area trash and water and sewer for landscaping (hopefully you have separate meters for landscaping so sewer is reduced!) are definitely CAM, and, no doubt, they are.

However, suppose you have just one water main coming in to the center and the tenants do not have individual meters (or maybe some heavy users do). A portion of that water is for the common areas, but a material portion is for water and sewer for the individual tenant premises. That later portion – the water used in each tenants’ leasable areas – in a tenant utility, not a common area expense.

Similarly, premises’ trash is not a common area expense. Yes, we absolutely have common area trash, but if our tenants are using dumpsters that we as landlord pay for the service, that usage is premises’ usage. On the mall side of our business, other expenses treated similarly might also include tenant HVAC (as opposed to mall area HVAC) and, in some cases, electricity.

In most leases (there exceptions even within a center), tenant premises utilities and tenant’s own trash removal services are tenant responsibilities. The tenant is required to pay for these services even if the landlord elects to supply the services.

There are a few reasons you should be thinking about this (you can add your own in the comments as well).

  • If you are billing tenant services through CAM, but competitive centers are either billing the separately or third parties are providing those services, your CAM rates per square foot and your occupancy cost ratio will appear higher.
  • Caps – While the majority of negotiated caps have exceptions from the caps that often include utilities, not all caps have those exceptions, and those exceptions rarely address a service like trash removal or pest control. By billing through CAM, you might be absorbing expenses you don’t have to because of a cap. (Conversely, there is a possibility you may be artificially inflating a cap if these additional services remain flat – but that’s enough for another blog).
  • Denominators/Allocable Square Footage – The square footage provided with these tenant premises services is rarely the same as the square footage used for the CAM denominator, so you might be absorbing expenses for areas not provided with the service. Think about something as simple as trash removal. If you have a 100,000 sf center with a 60,000 sf supermarket that provides its own trash, and the tenants pay CAM on the GLA of the center with no excluded area, billing premises trash as CAM could have you eating 60% of the bill.
  • This final one came up quite a few times over the last few months from different owners – if you convert to a fixed CAM charge or to a gross lease, the tenants are still required to pay those charges (unless otherwise negotiated) because they are not CAM.

We are all for simplification of lease administration whenever possible. However, we never want to oversimplify if it will affect cash flow and value.

Comments | Posted in Commercial Real Estate, Malls, Office Properties, Retail Leases, Shopping Center, Uncategorized

The throwaway lease clause that cost more than $10m in value

August 30, 2020

You may be thinking this is clickbait. It’s not. This past week, we had a truly “throwaway” lease clause that had cost the owner more than $10m in value on the property. Not one clause in every lease at the property, but one clause in one lease. The clause –

“The tenant may offset percentage rent, if any, against real estate taxes.”

That “if any” is what made it a throwaway clause. Percentage rent, if any… So, the landlord was not counting on any percentage rent.

The quick facts – the anchor pays a full prorata share of real estate taxes. Their share? Over $800,000. Tenant pays stepped percentage rent (ex. 2% over $17m up to $20m; 1.50% from $20m-$25m). The lease commenced in the 70s. Tenant’s sales were running nearly $50m. Percentage rent (remember “if any”) would be north of $600k. Not $600. Not $60,000. But north of $600,000!!!

So, the tenant would be paying over $800k in taxes and over $600k in percentage rent. But, this throwaway clause allowed them to offset (recapture) percentage rent against taxes. Cap that $600k (that you lose on an annual basis) and you get over $10m in value (on this type of property at a 6% cap).

We might not have given up that much in value if the balance of the leases in the property excluded the anchor from the denominator AND had recapture language in the leases. It would read something to the effect of:

“Majors (premises greater than 50,000 sf) shall be excluded from the denominator when calculating Tenant’s Prorata Share provided that landlord shall deduct contributions (net of any permitted recaptures) from any excluded area prior to calculating Tenant’s Share.”

In that case, instead of deducting an $800k contribution from the excluded area, we would have deducted a $200k contribution ($800k calculated less $600k recapture). That would have increased the inline tenants’ shares, and we would have been able to pick up much of the $600k (we wouldn’t have gotten it all because more sophisticated tenants would have negotiated out the recapture language.

But, one clause. One lease. $10,000,000 in value.

Back when I was I was 7, in 1972, I thought I was going to get “rich.” There were news stories all the time about the US Mint making a mistake and accidentally double stamping some 1972 Lincoln Pennies. There was a slight shadow on the pennies where you could see this “double die.” I honestly forget what I was told they were worth at the time – I think $55. For the next few years, I searched and searched. Friends and relatives let me search their coin jars. The deal was, if I took a penny, I had to replace it. This applied to nickels, dimes and quarters. I never did find a 1972 double die (likely because it was too subtle for me to find). But, in the end, I had a complete set of Lincoln pennies, most Indian Head pennies, most Jefferson and Buffalo nickels, and so many pre-1964 (silver) dimes and quarters. I found value.

Recapture provisions are not nearly as rare as 1972 double dies. We’ll come across 25-30 per year. But, honestly, if you get to know the leases and lease language in your portfolio, you’ll find value.

Comments | Posted in Uncategorized

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