Due diligence before the due diligence?

happy dance

When we perform acquisition due diligence on behalf of a buyer, we find two types of issues. The first is where the seller has presented information that overstates the income or conditions. The seller may have presented that a tenant’s minimum rent is $10,000 per month, but the lease states $9,000. Or, perhaps the lease does state $10,000, but we find that the seller has been billing only $9,000 (with the seller having agreed to take less based upon some side agreement). The buyer can then go back to the seller and accurately claim that the income had been overstated. Or the seller did not present that a tenant has a right to terminate at the end of the fifth lease year in a ten year term if sales are less than $x, and we can see that sales are less than $x. These type of adjustments may require a purchase price adjustment because the seller had presented information that was not accurate, and was more positive that the situation actually is.

The second type of adjustment is one where the seller presented information that understates the cash flow, or may be more negative than the true scenario. Perhaps rent is presented as $10,000 per month with annual CPI increases, but the CPI increases have never been applied. Or, a tenant is being billed based upon the leasable area of the property, but the lease requires that the tenant be billed upon the leased area of the property. These, for us, are the more exciting issues because they represent the buyer’s upside.

With the first type of adjustment, where the seller presented overly optimistic information, the buyer goes back and, appropriately, asks for a purchase price adjustment. However, with the second type of adjustment, the buyer learns that they may be able to immediately increase the cash flow upon closing.

Occasionally, but not often enough, a seller will conduct its own “due diligence” on a property that they intend to sell. And, almost always, it pays off. This past week, we did a little pre-sale due diligence on a small center – 87,000 sf, grocery anchored, with 19 tenants. A number of issues came up provided a really nice pop to cash flow – a few tenants had gross up clauses that were not being administered; a few leases required expenses to be billed based upon leased not leasable; quite a number of tenants were allowed to be billed based upon “less separately assessed”; and, the best, was the grocery store had a cap reset at the beginning of each option period. Ultimately, a $49k increase to cash flow per year.  Had we found those doing the acquisition due diligence on behalf of a buyer, we would play the music for a happy dance. In this case, doing this pre-sale due diligence on behalf of the seller, the seller is now able to increase the cash flow by that $49k per year. At a conservative cap rate of 8%, that more than $600k in additional value the seller will realize from the property. We also identified a “no increase in taxes due to a sale of the property more than one time in any five year period” clause that a buyer would be sure to pick up, but we were also able to pull that language that it was during the Initial Term. With that particular tenant now in a renewal period, the language no longer applies.

The moral – take some time before you put a property on the market so you, the seller, realize all of the value from your property. Otherwise, you’ll hear the buyer doing its “found equity” happy dance upon closing.

Let’s eat, Grandma! Let’s eat Grandma!


A comma can change the meaning of a sentence fairly drastically. And, for lease administration purposes, it can have an unexpected impact on cash flow. The clause below was from a center we worked on last week:


“Tenant’s Proportionate Share” shall be equal to the number of rentable square feet included in the Premises divided by the total number of square feet included in the Building multiplied by ninety-five (95%) percent.

Yes. We do have the order of operation. If you were lucky or unlucky enough to have Sr. Julia Mary for seventh grade pre-algebra, you might have learned “Please Excuse My Dear Aunt Sally.” Parentheses – do what is in the parantheses first. Exponent – apply the exponents next. Then Multiply and Divide. Finally, Add and Subtract.

Why bring up Sr. Julia Mary (affectionately, by some, known as Scary Mary)? Because (1) if we take the premises divided by the center square footage and then multiply by 95%, we get a completely different answer than (2) taking the square footage divided by (the center square footage x 95). Take, for example, a 10,000 sf premises in a 100,000 sf shopping center. The straight prorate share would be 10,000/100,000 = 10%. But, we have a 95% factor to apply. In example 1 – we get 9.5% – 10,000/100,000 = 10%; 10% x 95% = 9.5%. In example 2, we get 10.53% – 100,000 x 95% = 95,000; 10,000/95,000 = 10.53%. That’s almost an 11% difference.

This one needs a letter agreement to correct it!

Leased vs. Leased and Occupied


A few months ago, we had a blog that addressed a difference in lease language where an excluded area was defined as any premises greater than 15,000 sf vs any occupant greater than 15,000 sf – a subtle change in lease language having a material impact on a lease’s or even a property’s cash flow.

This week, we had a similar situation related to different wording. The expenses of the property were to be “grossed up” to what they would be if the property were 95% occupied. This gross up language is most commonly associated with office leases where a tenant’s prorate share is determined using the rentable area of the building. If the building has 100,000 sf and the tenant is 10,000 sf, their prorata share is 10%. That 10% may even be fixed in the lease. If the building was only 50% occupied, and janitorial in the office building was $50,000, without a gross up, the tenant would pay $50,000 x 10% = $5,000. However, a gross up recognizes that the $50,000 in expenses were attributable to a half full building. To keep it simple, if we “grossed up” expenses to what they might be if the building were 100% occupied, we would essentially calculate:

gross up

So, using the grossed up share of $100,000 x 10%, the tenant’s share of the expense would be $10,000. So, if the 50,000 sf of occupied tenants all paid using the grossed up expenses, they would pay a total of $50,000, and the landlord would be whole. If the expenses were not grossed up, the tenants would have only paid $25,000, with the landlord absorbing the other $25,000 in expenses. (This example used straight prorate. In office, tenant’s shares are often couple wit base years as well, but I was trying to keep the example straightforward).

Simply, the purpose of the gross up is to make sure the tenants are paying their share of variable expenses based upon the square footage of the property occupied, really the square footage causing that expense. (Notice, only variable expenses get grossed up. If landscaping cost $25,000 per year, that expense would likely not vary if the property was 50% or 100% occupied so would not get grossed up.)

This week’s issue that caused some debate was the wording of an inline tenant’s lease in a retail property. As discussed, gross ups are typically associated with office leases. Therefore, office landlords are pretty detailed with the gross up language – they know what is needed. The tenant’s lease required the tenant to pay a prorata share of expenses based upon its square footage over the square footage of the center (there were some issues as to whether outparcels were included or excluded from the definition of the center, but that’s another story!). The expenses were also to have been grossed up to what the expenses would have been if the center had been 95% leased.

As the examples show, the purpose of a gross up is to determine what the expenses would have been had the center be 95% occupied. But, that’s not what the lease said. It said 95% leased. Subtleties! Subtleties!

In the property, there is a 25,000 sf premises which had been vacant for a number of years. In mid 2016, a lease was executed for that particular premises. The tenant took possession of that premises on the day the lease was executed. Because some approvals were needed from other tenants, the tenant received permits in March 2017.  The rent commencement dated was the earlier of open or permits + 180 days. As of March 2018, the tenant is still not open.

Based upon the “intent” of a gross up clause, we would treat the premises as un-occupied, and we would still be grossing up. However, based upon the terms of that particular lease, the Commencement Date of that lease was possession – mid 2016. Therefore, as of mid 2016, that particular premises was actually leased.

Two words often used interchangeably – occupied and leased – making a difference as to whether we have the ability to gross up expenses. The intent was clearly to gross up if the center was less than 95% occupied, but we are stuck with the word “leased.” The premises was, in fact, leased.

Pay attention to the language!

Just how good was that tenant attorney?

One of our earliest blogs was about the landlord’s standard lease being the best case scenario. Changes that are made to that standard lease are being done at the tenant’s request because the tenants have seen, over and over, how not changing those clauses has impacted their financials. Tenants are dealing with tens or hundreds of different landlords’ standard lease forms. They can see the differences.

But, unless you are a prolific big box developer with the same cadre of tenants at each property, the landlord does not have the opportunity to see the nuances in a tenant “standard” lease form. It is “standard” to the tenant, but not so much to the landlord.

This week, we were working on a regional mall in Florida where a big box tenant had taken an anchor position in a former department store space.

How many flags went off in your head reading that sentence? There should be quite a few.

Regional mall  – While regional malls have historically had junior anchors, with some exceptions, even junior anchors in regional malls have been on landlords’ standard form leases. Department stores have almost always used their own leases or other types of documents, but landlords have been able to rest a bit using their own standard leases. We’ll see many changes to that over the next few years in this evolution of shopping centers. Big boxes used to using their own leases in power centers will expect the same in regional malls.

Former department store – If you are even marginally aware of cotenancy language in leases, you should be wondering about whether replacing a traditional department store with some other sort of big box will satisfy “acceptable replacement” language for tenants with cotenancy clauses in their leases. If you replace a tenant like a Penney or Sears with a theater, a sports big box, a soft goods retailer, a gym – will that be deemed an acceptable replacement?

Florida – There are a couple of things I think of when I think Florida retail leases – hurricane language (Can we include hurricane clean up in CAM? Is there a limit on levels of insurance a landlord can bill to a tenant? Does the lease require business interruption insurance?) and sales tax (most lease related occupancy charges in Florida require a tenant to pay sales tax). The other thing I think of related to Florida leases, but primarily for open air centers, is that landlords of Florida properties are much likely to give up percentage rent than in any other state. In fact, smaller landlords with properties primarily in Florida may even have standard leases without percentage rent requirements.

Typically, if a property is in Florida, there will be a clause somewhere in the lease that addresses the tenant’s obligation to pay sales taxes on rent. Usually, the sales tax will be collected by the landlord. But, if a tenant has a large enough presence in the state, there may be a clause allowing the tenant to pay sales taxes directly to the state – not often, but it happens – and that language will also be addressed somewhere in the lease.

Did you ever pay attention to a clause in your lease that might reference “Headings and Captions”?

It is essentially a “don’t come crying to us if you didn’t pay attention to something because the caption made you think you didn’t have to read it” clause. It’s there because both landlords and tenants get burned when a clause is buried where you do not expect it.

Finally, back to just how good that tenant attorney was. When you read the definition of Real Estate Taxes in the lease, it will typically define that taxes include all taxes, general and special assessments, perhaps personal property taxes on the common area and whether consulting and challenge fees may be included, among others. It will also address what is not included – typically things like franchise, estate and income taxes. It may specifically exclude special assessments. A tenant may have negotiated that they do not have to pay increases in taxes due to a sale of the center (often more than one time every x years). But, in both the definition of inclusions in, and the definition of exclusions from, the definitions almost always are limited to real estate taxes.

Almost always! For this particular lease, the tenant attorney buried in the tenant’s own standard lease form, in the definition of real estate taxes (specifically in exclusions from real estate taxes) a line that the tenant did not have to pay sales taxes on minimum rent. Sales taxes on minimum rent! That has nothing to do with real estate taxes. Those “headings and captions” were not accurate. And, it was not that the tenant would pay sales taxes directly to the state. No – the tenant did not have to pay sales taxes AT ALL.  Sales taxes have to be paid. The state doesn’t care whose responsibility it is. Sales taxes have to be paid. If the tenant doesn’t pay, who does? The landlord!

Bottom line? The tenant’s minimum rent was just over $1.5m per year. The landlord was forced to use this as the gross collection, meaning total of minimum rent and sales taxes together. So you take the $1.5m and divide is by (in this case) 1.075 – that’s 100% plus the 7.5% sales tax. That means $1.395m in minimum rent and $105k in sales taxes.

Buried language and a brilliant tenant attorney once again costing the landlord.

Depending upon the cap rate of the center, that simple little bit of buried language cost the landlord somewhere between $1.4m and $1.8m in value.

Consider the facts behind the stories

As a company, we spend our time making sense of the cash flows presented by sellers. Find where the seller may have overstated the cash flow. Find where they had missed opportunities. Basically, sort out the facts.

There were a couple of articles this week that made their way around Twitter an LinkedIn because they had sort of Clickbait headlines. The first was:

Landlords, brands brace for less shopping at the mall

The premise of the article is that e-commerce will account for one-third of all shopping by 2030, so considering that it currently accounts for 10%, the losses will be coming from bricks and mortar –  so a loss of 23% of sales. What the article does not present is that total sales – online and physical – will continue to grow. If those sales grow by 2.5% per year, total sales in 2030 will be 35% higher than they are today. If physical retail is “just” two-thirds of total sales in 2030, physical sales will have suffered no loss – physical sales will be essentially what they are today. However, as we continue to see, shopping centers are evolving. Restaurants, residential, office, entertainment, health and other non-retail uses are being brought in to bring the properties to their current highest and best use. If 10% of retail is converted to non-retail uses but in the same retail environment, then that two-thirds of sales in 2030 is being achieved with 90% of the space. That accounts for real increases in sales – just over 11%.

I do realize that I can poke holes in these numbers I have just presented. But the point is, the “sky is falling articles” have similar holes. They can ignore realities as did the second article:

Malls hope to get back in shape by adding gyms

This article ignores two facts. The first is that, through their evolution, malls (an open air retail) have had gyms and other non-retail uses as part of their tenant mix. Shopping centers have been constantly evolving. It’s back to that highest and best use. It must always be considered.

Quick little story – In 1991/1992, we were doing some work for Faison in North Carolina. It’s namesake founder, Henry Faison, had been developing retail properties since the early 1960s, and Henry happened to be one of those one generation of developers of regional malls, alongside of the Simons, DeBartolos, Taubmans, Hahns, Congels, Pasquerellas, Aronovs, Karps, Bucksbaums and handful of others that truly changed the landscape of the US. I was under 30, sitting down the hall from someone I considered a rock star of our industry (they weren’t online war rooms at the time. You had to physically be where the records were). Henry clearly loved what he did. Despite his successes, he was in the office early and stayed late (and drove a series of Ford Tauruses). He was all business. His assistant, Candace, had been working with him for years. I wanted to know the man celebrated a little. I asked her what he did when he signed anchors and knew he had a mall ready to come out of the ground. Did he do a little private happy dance? No, she said. He just immediately said, “Who are we going to put next to them? Is fashion going to be on the first floor or second?” It was all (in capital letters, ALL) about the tenant mix. It was, is, and will be all about the highest and best use.

The second fact ignored, or implied, is that mall (and open air centers) are not in financial shape. It ignored another article this week:

Shopping center rents, income and occupancy rose in 2017

Retail is not in the tank as the media constantly presents. Much of what has been going on, with bankruptcies and closures, has long (let’s do caps again, LONG) been expected. There is no landlord with a Sears or Macys or Penneys or Bon-Ton that is the least bit surprised about an announced closure. They have anticipated and planned for these closures for years. In some cases, for more than a decade.

That planning is no exaggeration. There are 10+ year old leases that address replacing department stores with lifestyle centers. There are 10+ year old leases that address replacing retail with non-retail.

There are malls and strip centers that should no longer be retail. At the time they were developed, retail may have been the highest and best use. But, the evolution of retail has been a constant, and that evolution has been considered.

While less shopping and dead malls may cause clicks, there is much more to the story.

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