Excluded areas – reducing or eliminating absorption

For purposes of prorata shares, leases will often define excluded areas as greater than some specified square footage. 「The tenant will pay a prorata share of real estate taxes based upon the leasable area of the center excluding premises (or occupants) greater than 25,000 square feet.」 You will see language like this in almost all regional malls and in many open air centers. Those areas that are excluded typically pay less than a full prorate share – whether it is taxes, CAM or insurance. By excluding them from the denominator, the landlord is able to reduce their own absorption of the shortfall and collect that shortfall from the other tenants in the center.

If you have a 1,000,000 square foot center and $1m in taxes, if the center was fully occupied and all tenants paid a full prorata share based upon the leasable area of the center, all tenants would be paying $1.00/sf. But imagine, as it typical, you have an anchor paying less than a full prorata share. A 200,000 square foot tenant is paying a fixed $.50/sf. In that case, we would have the balance of the center, 800,000 sf, paying $1.00/sf, and the anchor paying $100,000. Instead of having collected $1,000,000 from our tenants, we would have collected $900,000 (800,000 x $1.00 plus 200,000 x $.50). We as the landlord would absorb $100,000 not collected from the tenants. At a 7.5% cap rate, the $100,000 absorption costs us $1,333,333 in value ($100,000/.075). So, recognizing that not all tenants will pay a full prorate share, the landlord writes its standard lease to exclude premises (or occupants) greater than xx,xxx square feet.

With that type of language, the landlord then takes the $1,000,000 in takes, deducts the contribution from the anchor ($100,000) and allocates the net taxes ($900,000) over 800,000 square feet (the 1,000,000 square foot center less the 200,000 square foot anchor). The remaining tenants then pay $1.125/sf for their share of taxes ($900,000/800,000 sf). The landlord has then collected the full $1m in taxes (800,000 x $1.125 plus 200,000 x $.50/sf). No absorption. No $1,333,333 reduction in value.

This week’s blog was originally going to go down a path of excluding 「premises greater than 25,000 square feet」 vs. excluding 「occupants greater than 25,000 square feet,」 but that was a lot to hit for a short blog. But, imagine the 200,000 sf anchor in the above example closes. Use the comment section to take a shot at what happens to absorption and value if the lease reads occupant vs. premises. One word can be worth a lot!

When Sloth from the Goonies is your leasing agent

You really never know what you are going to find in a lease when you are doing acquisitions. About three years ago, we did two shopping center acquisitions in the Southeast for one of our institutional clients from a local developer. In one restaurant lease in each of the centers, the developer had negotiated a specific clause – 「During the term of the lease, Landlord shall be entitled to one special (including a drink) each week.」 The developer had others centers not being sold. I can only imagine that there were similar clauses at each of the other centers to cover the developer’s meals during property visits.

Yes. It’s kind of funny. But, as someone who loves to address the cash flow and value impact of lease language, this somewhat silly clause had real value. Imagine – with a drink, each special (yes, I did look up the menus!) had a value of about $10 per week. Multiplied by 52, it was worth about $520 per year. At a 7.5% cap, that is actually about $7,000 in value. From a nonsense clause!!!!

So, what does Sloth from the Goonies have to do with any of this? You remember the scene from the Goonies where Chunk is tied up in the basement? All of the sudden, Sloth smells chocolate and starts saying 「Chocolate? Chocolate! Ruth! Ruth! Baby! Ruth!」 It had to be a Sloth-like person who came up with this language –

「Tenant shall not be responsible for the payment of Minimum Monthly Rent or Additional Rent until January 1, 2012. In lieu of said rent, Tenant will credit Landlord Three Thousand Seen Hundred Fifty and 00/100 Dollars ($3,750.00) per month in chocolate products selected by Landlord at Tenant’s retail price from the Commencement Date until January 1, 2012.」

Who else would have negotiated such a great clause? And, the tenant did open in September – so more than 11,000 in chocolate.

While not all leases have the personality of these – offering you a meal and dessert – there is value hidden in every lease!

Buried language can burn you

I am sure I sound like a broken record to anyone who has ever taken more than one of my classes because I always (seriously always) bring up how language can be buried deep within a lease that can change the cash flow from a tenant. The best example I can give is one landord’s prorata tax section requiring that tenant pay a full prorate share of taxes based upon the 「Gross Leasable Area of the Shopping Center.」 The lease continues with other excluded area definitions. But, the bottom line is that you read the requirement as 「Gross Leasable Area.」 That’s not a typo in how I used 「Gross Leasable Area」 with all caps.

When something is capitalized mid-sentence in a lease, it typically means that it is defined elsewhere in the lease. In the case of this particular landlord’s standard lease, Gross Leasable Area is defined elsewhere, and it is defined to exclude vacancy. So, if you go to the tax section only, you think you are paying based upon leasable, but you are really required to pay based upon leased.

Remember that. If it is capitalized, it is typically defined. Go look for it.

So, as someone who preaches about buried lease language, I should not have issues with it myself, right? But, this week, I got burned myself by buried language.

One particular retailer had negotiated changes to the definition of anchors to specifically exclude anchors that are a use competing with their own use. So the anchor definition essentially reads that anchors are Occupants greater than 50,000 square feet, except for Occupants selling x, y and z (a use competing with theirs). I wasn’t burned on the 「Occupants.」 (The use of Occupant vs. Premises is a major distinction in and of itself. It means that we can only consider a tenant in more than 50,000 sf. A vacant 50,000 sf space is a vacancy rather than a defined anchor. That makes a difference if a tenant does pay based upon leasable, or if a tenant pays based upon leased with a minimum occupancy.)

No – I was burned in a cotenancy section. The lease stated that a cotenancy condition only existed if there were less than three anchors. The property had three department stores, another tenant greater than 50,000 sf that was a competing use (so not an anchor), and a 75,000 sf theater. So, I had four anchors (the three department stores and the theater) when one of the department store closed. I had three remaining anchors – two department stores and the theater. But, five paragraphs into the cotenancy section, in a paragraph defining acceptable replacements was a stand-alone line. For purposes of cotenancy, a theater shall not be considered an anchor. Sure enough, I had abstracted this requirement, but essentially saying that you could not replace an existing anchor with a theater (which is a very typical limitation). However, that wasn’t the requirement. For cotenancy purposes, I did not have four department stores when I lost one. I had three when I lost one. So, a cotenancy condition existed.

Buried language burning someone who preaches not to get burned by buried language. I have to give props to the retailer’s attorney. It was intentionally buried, and it worked.

It can happen to you.

It can happen to you too!

Retail vs. office leases

Last month, we worked on a beautiful, relatively new lifestyle retail property in California. It was developed by company that traditionally develops office. We did not know that they were office developers when we started the project. It became obvious after abstracting the first two leases.

How could it be obvious by reading lease? By seeing three of the primary differences between retail and office leases. Typically, in retail, tenants pay a full prorata share of expenses. In office, tenants will often pay a prorata share of the increase in expenses over base year expenses. Second, in retail, the leasable area of the premises (and the property) is typically used for all calculations while in office, distinctions are made between the rentable and usable areas (with rentable including a common area factor applied onto the usable). Finally, to minimize the absorption of expenses due to vacancy, retail will bill based upon the 「leased」 area of the property (leasable less vacancies) while in office, we 「gross up」 expenses to what they would be if the property were fully leased (or leased to some other level).

Personally, I prefer retail leases. To me, the calculations always seem absolute. If the property has $1,000,000 of recoverable expenses, the tenants will pay their full share of the $1m. In office, they pay excess over their base year. Therefore, the excess amounts will vary from tenant to tenant. And, if a tenant audits, it almost becomes necessary to audit the current year and the base year to determine the proper excess. Related to square footage, in retail, once a premises has been measured as 1,000 square feet of leasable area, it will always be 1,000 square feet. However, in office, a premises that has been measured as 1,000 square feet of usable area will have a rentable area that will vary over time based upon the then-current common area factor of the property.  A 10% common area factor would make for an 1,100 sf rentable area, while a 20% common area factor would make that same space 1,200 square feet of rentable area.

And, finally, in office, we gross up the variable expenses. If we are at 80% occupied, we determine what expenses would be if we were at 100% (or some other negotiated percentage) occupied. Some calculations are simple math. 100/80 x the expense. Others are determined by contract. An elevator contract is $x if we are at 80% occupied and $y if we are at 100% occupied. Others are more subjective. Would we have to add another day porter if we went from 80% to 100% occupied? Still others can be argued endlessly. Do we gross up taxes – possibly if we are in a municipality where the assessments are determined by an income approach and they factor in vacancies. But, we do not get to gross up expenses that are not variable. We end up with some degree of absorption. But, in retail, billing based upon leased, we essentially get to 「gross up」 (algebraically) all the expenses based upon that simple math. All expenses – fixed and variable.

You can always find retail-type clauses in office leases and vice versa, but when you see those concepts above, you will know where they came from.

The landlord’s best case scenario – Its standard lease

It doesn’t get better than the landlord’s standard lease. Seriously. The language in the standard lease is typically the best the landlord can possibly do because changes negotiated from its standard almost always favor the tenant.

A landlord doesn’t have a standard lease form and then have the ability to say 「We are going to add a clause that increases minimum rent by 10% when we add an anchor.」 A landlord doesn’t have the ability to say 「While the lease requires the payment of taxes based upon leasable area, but we are going to change it to leased.」 A landlord doesn’t have the ability to add management fees to the definition of operating expenses if it is not already in the standard lease form.

When the landlord presents its standard lease form, the tenant starts chipping away. There are no 「adds」 for the landlord. (One exception to this rule is that if the tenant does negotiate a change and the landlord has a firm concept of the value and meaning of that change, other language favoring the landlord can be added in response. For example, the tenant negotiates a change in the definition of excluded area from greater than 15,000 sf to greater than 40,000 sf. A landlord can then respond with the addition of 「Notwithstanding anything in the lease to the contrary, the premises currently operated as a Barnes & Noble shall be an excluded area for purposes of calculating tenant’s share of CAM and taxes.」)

What that means is that you as the landlord have to put your best (most aggressive) foot forward in the standard lease form. Have the standard lease describe a monetary default as 0 days without notice. Specifically include items like parking lot resurfacing, roof replacement, management fees, manager’s compensation and admin fees in CAM. Included relocation rights and radius restrictions. Don’t give operating expense audit rights as part of the standard lease. Have the definition of excluded areas include any tenant not paying a full prorata share. Include an increase to minimum rent for the addition of an anchor or a renovation where the landlord spends more than $5m.

Remember, the lease language can be negotiated down, not up.

(While we tend to look at the industry from a landlord’s perspective, this same issue applies to department stores, supermarkets, big boxes and other tenants using their own form leases rather than the landlords. It doesn’t get better for you than your own standard, so make it as tenant- friendly as you can.)

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