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Office leases – Are taxes part of operating expenses?

The short answer? The lease should specifically address whether taxes are reconciled as part of operating expenses or are reconciled separately. But, why should this matter?

This week, we were working on an office tower acquisition in the southeast. The majority of the leases had the typical 「tenant pays a proportionate share in excess of the base year」 language. Both Operating Expenses and Real Estate Taxes (both capitalized) were defined very well by the leases. However, this was a situation where the leases were poorly written and rather than addressing a year end reconciliation of Operating Expenses as well as a year end reconciliation of Rea Estate Taxes, the leases addressed a reconciliation of Operating Expenses and Real Estate Taxes – so addressed only one time instead of two separate times.

The leases read, 「The tenant will pay its proportionate share of current year Operating Expenses and Real Estate Taxes over Base Year Operating Expenses and Real Estate Taxes.」 What made the scenario critical was that current year Operating Expenses were much higher than Base Year Operating Expenses, while current year Real Estate Taxes were much lower than Base Year Real Estate Taxes. Reconcile separately, the landlord bills excess for Operating Expenses and gets nothing for Real Estate Taxes. Reconcile together and the landlord leaves money on the table.

Take the following simple example:

  • Tenant’s proportionate share – 10%
  • Base Year Operating Expenses – $1,000,000
  • Base Year Real Estate Taxes – $1,000,000
  • Current Year Operating Expenses – $1,100,000
  • Current Year Real Estate Taxes – $900,000

combined

As you can see, there can be a real difference between reconciling together or separately. In the case of the acquisition, considering this scenario affected a number of tenants and has a material impact on cash flow, our client has requested that the seller obtain letter agreements from the tenants clarifying that the charges are reconciled separately. If the seller fails to obtain the letter agreements, cash flow for purposes of the purchase price will be reduced to reflect a combined reconciliation rather than two separate reconciliations.

Another example of somewhat innocuous lease language affecting the cash flow and value of a property.

Co-participation and similar obligation

It is not uncommon to have co-participation clauses in retail leases – a clause which states that a tenant will be obligated to pay a certain charge at a specific rate with annual increases to that charge, but 「only if at least 70% of the other tenants are similarly obligated to pay such charge.」

The percentage of other tenants is a negotiated percentage, often ranging from 60-85%. Further, there will often be exceptions to what types of tenants get considered when calculating this percentage, such as 「excluding department stores, outparcels and theaters.」 Sometimes the co-participation may be based upon absolute the absolute number of tenants, while in other cased it may be based upon the square footage. (In the case of the former, a 1,000 sf tenant’s participation carries the same weight as a 15,000 sf tenant’s participation, while in the case of the latter, the 15,000 sf tenant carries 15 times the weight.)

Where the clause gets dicey and ambiguous is when 「similarly obligated」 is not defined. If a tenant is required to pay $2.00/sf increased by 5% per year, do other tenants have to pay similar rates per square foot with similar increases, or is it based upon absolute amounts? If another tenant pays the same $2.00/sf, but has 3% increases, does that eliminate the similar obligation? If a tenant is paying a $1,000 per year marketing charge, but another tenant sponsors two celebrity autograph events in lieu of a contribution, are they not both obligated?

Ambiguity typically goes against the writer, and it is typically a tenant requesting/offering the co-participation clause. With ambiguity, it is fairly easy to present a supportable position for or against 「similarly obligated.」

So, take the time to eliminate the ambiguity in advance!

Retail – the fatalists and the opportunists

This past week, Sears announced another 42 closures. As usual, we see even retail real estate executives posting or re-posting about the 「Dying Retail Sector.」 But, what I see regularly, not from these fatalists, is successful real estate companies take a different approach – 「How do we take advantage of these opportunities?」

One particular client this week looked at an opportunity to expand one junior anchor’s presence at a property. In this case, the junior anchor has several other concepts not yet present in the market. The opportunity was to consider relocating the junior from its current big box to a prominent anchor position which would give it the ability to house multiple concepts under one roof.

Why relocate the existing box to a future vacancy? Besides the ability to have the concepts under one roof with the ease of passing through from store to store, the landlord realized it would be easier to backfill the smaller big box. Additionally, there is the potential opportunity to eliminate cotenancy issues that might have otherwise arisen.

Our exercise was to determine if one or more relocated/new concepts in an anchor space satisfied the definition of 「acceptable replacement.」 This is an issue that I have addressed in previous blogs, but it truly is one of the most pressing issues facing the industry today. In a property with 150 tenants, you might expect 60-90 of those tenants to have cotenancy requirements. Of those 60-90, there could be as many as 40-60 different definitions of cotenants and their respective replacements.

As an example, anchors could be defined as 「department stores (may be further defined) operating in more than 60,000 sf.」 Just considering that one definition, a theater operating in 85,000 sf would not be considered an anchor. Depending upon how department store is further defined, a discount department store in 100,000 sf or a sporting goods store operating in 70,000 sf may not be department stores. And, if it is vacant (not operating) it may not be a department store. Another lease might define department store as the building labeled as 「A, B, C and D」 as reflected on Exhibit A. In that case, the building, whether vacant or occupied, is the anchor. There are hundreds of variations, each with potential exceptions (things like 「operating under one trade name,」 「not a theater,」 「must have multiple departments with both soft goods and hard goods,」 and so on).

To further complicate the issue, an 「acceptable replacement」 for the anchor may be defined differently. It could be as simple as another tenant must begin operating in the premises, but could address issues such as the number of floors in the vacant anchor and the need to have an opening on each floor. As addressed in an earlier blog, many more recent (over the past 3-5 years) leases now address alternative uses or a lifestyle component as acceptable replacements.

As we adapt in the industry to the new reality of fewer true department store anchors, we have to take the opportunity at every instance to amend or revise the definitions of acceptable replacements.

Since I got into the industry in the late 80s, appraisals have always addressed the highest and best uses for properties. While the appraisals did address these other uses, the reality was (and to a certain extent, still is) that we could not truly adopt these uses because existing leases restricted any use other than retail. But, we now see that something other than a department store, whether still retail or not, may be a better use. Malls are evolving and will continue to evolve. The fatalists may continue to call out for the death of malls and shopping centers. But, those that recognize the opportunity will help direct the future of our industry.

Visits to malls in India

This is not the typical lease admin blog that I write because I do not have any Indian retail leases to review. For ICSC, I have taught in the US, Canada and China, and I have had students from countries around the world. Many of them have provided me with their standard lease forms so that I could learn about their lease requirements and incorporate that info into the ICSC classes.

As a true shopping center geek, I really do enjoy visiting centers when I am on vacation. So, I was excited to visit a couple of properties in Ahmedabad, India. The first one I visited was Alpha One (or Ahmedabad One) Mall about 2-3 miles outside of the main part of the city. No freeways in site with easy access for cars. Rather, this opened around 2009 in a very dense area. I don’t know the history of the site, but I have to imagine demolition of existing structures was involved. I was in a rickshaw getting there and, as easily as they manuever, it was still very difficult getting there just to the volume of people and cars and motorcycles and scooters and rickshaws and carts and trucks clogging the roadways immediately around the center.

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Once there, you pass through security to get in to the center – metal detectors followed by a wand pass while standing on a raised platform. Women to the left (with modesty screening) and men to the right). My immediate impression was, yes it’s a mall. A mall that could have been in the US. But, what immediately hit me was the presence of so many doors. There were a handful of stores that had disappearing storefronts, but that vast majority had doors to enter the space. Air conditioning is a very precious commodity here in India, so I can only imagine they do not have the 「tenant shall ensure that the air pressure of the premises will be balanced with that of the common area」 type language. (When I mention AC being precious, my son is shadowing doctors over here, and AC is switched on for surgery, or just portions of surgeries, and restaurants add an AC charge).

The other thing that really caught my attention while walking through the mall was their use of kiddie carts. They looked similar to what we might find in the US, but without a handle for pushing. Rather, the parents have a radio control and steer the kids through the center! I believe that must have been the reason for posting guards at the top of escalators!

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I would have loved this for my kids when they were younger.

And, related to that guard at the top of escalators. From what I have seen, escalators are motion detected. If no one is around, they are stopped – in keeping with precious commodities.

The other mall I visited was CG Central Mall, not far from where I am staying. No different that multi-level malls in the US that have just one anchor, this mall may have seen better days as the first level was probably 60% full, dropping by 10-15% per floor as I went up.

So, while there appeared to be a successful mall launch in 2009 while we were deep in a recession in the US, it appears that, from my sample of two, C malls are suffering the same fate in India as our C Malls are suffering in the US.

I hope to be back to the normal lease administration blog next week.

So a cow walks up to a drive thru… Operating hours and liquidated damages

This week’s (and next’s) post will be a bit shorter as I am in India with my son. This picture reminded me of Chick-fil-a which reminded me of a clause I ran across earlier in the week.

Most retail leases have operating hours requirements which provide for default if the tenant does not maintain the required hours. However, some leases have liquidated damages specifically identifying a penalty to be applied if the tenant fails to operate all hours and days. The liquidated damages can often run in to 100% of the daily rent for failure to operate – so the tenant has paid rent, but then there is a 100% penalty agreed to in advance because the tenant’s failure to operate affects the landlord and the other tenants in the property.

Therefore, sophisticated tenants will specifically address not opening on Sundays, or not opening on weekends, or not opening certain months of the year (think tax preparers in the off season or my favorite purveyors of water ice (a Philly thing) during the winter or even the ability to close once or twice a year for inventory.

If you are a tenant, don’t just hope the landlord doesn’t bill you for liquidated damages – negotiate. And, if you are a landlord, put some teeth in your operating hour requirements.

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