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A few more issues related to excluded area contributions

Last week we addressed a few of the issues to consider related to excluded area contributions, but two properties that we worked on this week made me realize I missed discussing two very significant issues – refunds/credits and recaptures as they relate to excluded area tenants.

At one of the properties, an excluded area tenant audited its CAM and tax charges for several years. While the landlord had tried to bill everything in accordance with the terms of the leases, the tenant was entitled to credits of just over $75,000. While painful to issue such a significant credit, since the credit was issued to an excluded area tenant, this actually should have triggered other adjustments. Every tenant in the center with a lease that defined that particular tenant as an excluded area had previously had its CAM and taxes calculated based upon the original contributions. As the credits were issued reducing those contributions, the other tenants were underbilled.

Often, it is impractical to go back to bill the other tenants for their respective share of what may have been $25,000 per year for three years. The typical application of this would be to apply the credit in the ensuing year, without applying the same credit to those tenants who were not there in the years the credits applied.

(This is a bit more advanced, so skip it if you need to. The method just addressed may have a negative impact if some of the tenants have caps that would be affected by a material reduction in any given year. In that case, even though it would be an administrative burden, it would be best to go year by year so as not to set the caps artificially low for any given year.)

The second property had a standard lease for that specifically addressed deducting contributions from majors (definition varied tenant to tenant) where the major did not have the right to “recapture” the contribution against other charges. I will do a blog in the future to specifically address recaptures. But briefly, some tenants (typically majors or the most desired tenants) have requirements to pay a share of CAM or taxes, but then have a right to offset these payments against percentage rent or some other charge. As an example, if a tenant was required to pay $100,000 in taxes, but had $65,000 in percentage rent due, and then tenant was allowed to offset taxes paid against percentage rent, then, with this clause in a lease, instead of a $100,000 contribution from the excluded area tenant reducing allocable taxes, the contribution used would be $35,000 ($100,000 paid less $65,000 “recaptured”).

We usually see tenants granted recapture language perhaps one time out of every three to four retail properties (so maybe .5-1% of leases). In this case, while the standard lease does address recapture language, none of the current majors have recapture rights (we haven’t completed the outparcels which could potentially have recapture rights). Therefore, at this property, it may not even apply.

These two issues are a little more convoluted. Feel free to comment if you have any specific issues needing clarification.

Excluded area contributions

When a tenant pays a prorata share of taxes or CAM, there are often defined excluded areas. Most typically, those defined excluded areas are either directly assessed, self-maintaining or insured, or are paying at a rate significantly less than full prorata. By defining those areas as “excluded areas,” the landlord reduces it absorption of CAM or taxes not paid by those areas. And, again, most typically, the contributions made by those defined excluded areas are deducted from the total allocable expenses prior to calculating the specific tenant’s share of CAM or taxes.

Most typically.

However, there are instances where a lease will read “without deducting contributions from excluded areas” (this is most often seen in the northeast part of the country and Florida). This specific language allows the rare “double dip” by the landlord. It happens infrequently but it does happen.

Occasionally, we’ll see the opposite. Where the previous example includes very specific language that does state “without deducting,” the opposite is often an error. A lease will read something to the effect of “after deducting contributions from Majors,” but the lease does not allow the same Majors’ square footage to de excluded from the denominator. This gives opportunity for the rare “double dip” by the tenant.

One not uncommon issue is where a lease requires Majors or some other defined excluded excluded area to be excluded from the denominator, but subject to a cap on how much square footage may be deducted, or to some certain number of tenants that may be considered excluded areas. For example, a lease may read that “the denominator used to allocate CAM shall be the Gross Leasable Area of the center excluding any tenant greater than 15,000 sf. However, in no event shall the denominator ever be less than 200,000 sf.” In this scenario, if the denominator would have been 175,000 sf after deducting all excluded areas, the landlord would still be required to use 200,000 sf as the denominator. But often, the landlord would have deducted the contributions from all tenants that would have otherwise taken then down to 175,000 sf. In that particular (again, not so uncommon) instance, the landlord would have “overdeducted” contributions.

Our very insightful client recognized that, if not considered, the balance of the tenants would be getting a contribution from an anchor for taxes that they, themselves, were not required to pay.

Why this issue this week? We worked on a property this week where a portion of the property was subject to a material tax abatement. Two of the anchor tenants were required to pay taxes based upon what they would have been absent 50% or 75% of the abatement. So, in this instance, the two tenants were paying on taxes greater than total taxes billed. However, the balance of the tenants did not have the same requirement and were being billed based upon actual taxes. Our very insightful client recognized that, if not considered, the balance of the tenants would be getting a contribution from an anchor for taxes that they, themselves, were not required to pay.

While excluded area contributions are usually straightforward, this is clear evidence that they are not always so!

Dealing with new realities in “retail” rents

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Back in 1996, I was serving as an expert witness in a mediation related to HVAC billing methodologies in regional malls. The tenant brought in their own expert witness to address water rates. Over the course of two days, the two of us had plenty of time to talk. At that time, in most municipalities, water rates ran 2-3 times sewer rates. He shared that over the next few years, sewer rates would creep up to the same levels as water rates – possibly higher.

I absolutely wanted to discount his prediction because an increase in sewer rates would ultimately affect base rents. But, over the next decade, I saw those sewer rates creep up. He was sharing a new reality, and I did not want to listen.

Though we are fighting tooth and nail, I think we are in the midst of a reality shift for retail rents – much more so for enclosed, regional mall type centers than for open air, community centers. To a certain extent, we all try to apply a kind of ratchet to rents – they can increase but never decrease.  But, tenant mixes are changing significantly. I have a tendency to resist using buzzwords almost out of spite because they are buzzwords. However, a few of them are not just buzzwords anymore and are contributing to this new reality of retail rents – experiential retail and showrooming.

chip cheese

I have quotes above around the word retail in the blog’s title. I have seen so many memes where quotes are used in a way that makes you question whether the user knows how or why to use them. In this case, I am air-quoting the word because, to a certain extent, retail is no longer retail. The language that used to be so prevalent in retail leases about other permitted uses in a shopping center, “… and other similar uses found in first class shopping centers …” no longer has relevance. The days of having specific restrictions against health clubs, schools and other educational facilities, residential, sales and rentals of vehicles, a limit on the number of square feet of office space, gambling, distilleries or even supermarkets (in regional malls) and theaters are going away.

As “retail” changes, many of these formerly restricted uses are becoming desired uses. Vacancy or: A Lifetime or Equinox Fitness? A Tesla dealership? A Whole Foods?  A well conceived multi-family  project? A Main Event or Dave & Busters type attraction? A WeWork coworking office space?

One of my idols in our industry. Henry Faison, passed away a few years ago. I had the opportunity to start working with him in 1990 – a few years into my career but nearly 30 years into his. He developed many successful strip centers before adding regional malls in the mid-1960s. His successes could be attributed to the relationships he developed with anchor tenants over the years. I sincerely wanted to believe that the man did a happy dance when he had gotten commitments from a few anchors and knew he had a center coming. But, what I learned was that his own happy dance was not a physical display but the joy he got from the ability to create that successful center by perfecting the tenant mix. Which tenant would go next to which anchor? How would certain categories be grouped and on what floors? Ultimately, perfecting the tenant mix would optimize sales which would, in turn, optimize rents.

The need to focus on tenant mix has not changed at all. Ultimately, perfecting the tenant mix will optimize the tenants’ successes and the center’s own financial performance. However, the components of the tenant mix have been changing drastically, and the  sales per square foot of a tenant is no longer the exclusive measure of a tenant’s success.

I think it may have been 10+ years ago, I sat at a roundtable at ICSC’s RECON led by Bill Taubman, COO of The Taubman Company. He never came out and used the word showrooming (because it may not have existed as a word attributed to retail at the time), but Taubman was starting to address the concept at the time. They had recognized the need to capture the rental value attributable to a tenant’s increases in online sales in markets where they had a physical location. If you look at the sales of a tenant made at a bricks and mortar location, and let’s say those are $500 per square foot, that might equate to a minimum rent of $40 per square foot. However, if there is a direct correlation to a 30% increase in online sales in a market where there is a physical location, the value is much greater than $40 per square foot. From personal experience, I had not purchased from UNTUCKit until I had the opportunity to visit a bricks and mortar location but have now become a regular customer.

In the case of showrooming, there is value far beyond the sales made in the bricks and mortar location – an opportunity for increased rents.

However, in the case of experiential retail, the flipside may be true. The new reality. The rent ratchet may (or maybe even can) no longer exist. As we rethink tenant mix, we have to rethink the appraisal concept of “highest and best use.” We cannot run our proformas assuming all vacancies will be tenanted at $40 per square foot with a $20 per square foot tenant allowance. We have to consider that these new “retailer” have many different measures of their own successes. We have to understand what types of rents these “retailers” can afford. There may be a sizable spread between what we would like and what a tenant can pay to ensure their long term success.  We have to take time to understand these new types of tenants’ measure of profitability. It may be that, if we want that experiential tenant, we have to accept $15 per square foot instead of the $40. But, ultimately, if that experiential tenant is a key component to our desired tenant mix, we are maximizing value in the long run.

Regional mall values (and the companies that own those regional malls) have already taken their value hits. It’s time to rethink that tenant mix and mine for the new values that can be achieved in this new “retail” reality.

Real estate tax resources

brick

Back when I first got into the industry in the late 1980s, if I needed information on a property’s real estate taxes, it was not unusual to actually have to go to physically go to a county assessor’s office and access the data on microfiche. Fortunately, those days are long gone. For the most part, municipalities’ tax records can be accessed online.

A friend was looking for information this week related to some of their properties’ land vs improvement value and was lamenting the lack of data on certain municipalities’ websites. As it has been a few years since I could not get everything I needed (tax related) for a property remotely, I was surprised. But, he was not checking all of the available resources.

When I shared my methodology, he, too, was able to get everything he needed. First, determine the county. Then search three terms – 1. (county) tax assessor, 2. (county) tax collector, and (county) GIS. Obviously, you may have to add the state as well if it is a common county name. But, seriously, one of those three sites will typically get you the information you need – even the property’s assessor cards where there are multiple cards for one tax parcel. Use that search methodology for a property you are familiar with and see just how much information is available. My first search is typically the (county) GIS search because I can find a property without even knowing the owner name, tax parcel number or even specific address – you search using a map.

The information is there. You just may need to dig a little.

Real estate tax timing issues

When reconciling operating expenses, timing is often pretty straightforward. The tenants make monthly escrow payments throughout the year. The landlord reconciles the calendar year and applies those payments. An additional billing or credit is applied to a tenant’s account.
However, taxes are a different story. While some municipalities bill taxes for calendar years, many bill for fiscal years – often a July – June period. We have worked on properties where there have been multiple types of taxes with multiple fiscal periods. County, school, village using calendar year, fiscal year 7/1-6/30 and fiscal year using 5/1-4/30. As you can imagine, that can really complicate a reconciliation. There are endless numbers of ways to deal with this type of scenario with the most common being to blend to a calendar year. Essentially, you calculate what taxes would be for say 2018 – 6 months of one fiscal year, 6 months of another – using escrows and occupancy for that same calendar year. Consistently applied, this methodology can work really well.
However, there are certain states and municipalities that really throw a wrench into the calculations – where taxes are sometimes billed either a full year in advance or a full year in arrears. In 2018, in some areas, the tax bill being paid could be for 2019, while in other areas, the tax bill could be for 2017!
What does that mean? If a tenant’s lease commenced on April 1, 2018 in an area where taxes are paid a full year in advance, the taxes for 2018 would have been paid in 2017. Therefore, on the day the lease commences, the tenant should be billed for essentially a full year of taxes – the eight month remaining in 2018 and the first four months of 2019 – and then immediately start making additional escrow payments. When their lease terminates, they would essentially be entitled to a full year’s escrow refunds.
If a tenant’s lease commenced on April 1, 2018 in an area where taxes are paid a full year in arrears, the taxes being paid in 2018 are really for 2017, so there would be no tax obligation for that first partial year. When the lease terminated, they would still owe a year plus of taxes.
To combat this timing complexity, many sophisticated landlords will change the lease language to specifically address timing to something along the lines of “taxes for the year will be taxes paid during the year without regard to the period to which they apply.” With that language, for that lease that started on April 1, 2018, regardless of whether it was in a pay for the prior year, pay for the current year or pay for the next year municipality, the tenant would pay its share of taxes paid during that particular year – using the occupancy information and escrows for that year.
The bottom line on this whole timing issue is absolute consistency – in both understanding the periods being billed and how the escrows are being applied – and sticking with that methodology.
Why this issue this week? We are working on a property where taxes are paid a full year in arrears – so the taxes paid in 2018 are for 2017. But there is a lack of consistency. Some of the anchors are billed taxes based upon the period to which they apply while others are billed taxes using amounts paid during the year, while the inlines and outparcels have similar issues. Some escrow, some don’t. And there are material changes in GLA and occupancy among the years. It’s pandemonium!
Do yourself a favor. Shoot for consistency! (And, spend some time really understanding tax periods and how a seller has applied escrows when you are considering a property for acquisition!)

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