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“We see the retail business is getting busy again”

Not my typical lease administration post. Just sharing an email that I received this morning.

Personally, when I have to do something I don’t want to. I tell myself, “There is nothing I can’t do for X amount of time.” X amount of time has always been a wide variable – in some cases, it could be seconds, minutes or hours while in others, it has been days, weeks or months. I tell myself I can get through it because there is an end in sight.

Like so many of us, my own level of anxiety has been driven quite a bit higher over the last couple of weeks. I realized when I received an email this morning, it was because I couldn’t see an end.

I have stayed in touch with some of the wonderful people I met in Shanghai while teaching classes for ICSC. Selfishly, I hadn’t thought to reach out while they were in the early stages of it. But I did this week and this is the response I received this morning:

jeff

Hi Jack

Great to hear from you again!

Both Catherine and I are doing very well. Thanks for greating. Yes, the virus outbreak almost comes to its end in China but we are still very alert and get fully ready for any possible comingback. Most of people here are still wearing masks.

But the city is regaining its momentemum right now and we see the retail business is getting busy again and actually I miss the days of empty roads and malls. The lockdown or social distancing is safe for everyone while the number of infected cases goes up like crazy. You don’t have to feel horrified if you do what you are told to do by the real experts there, like washing hands.

Jack, do stay well and healthy. Hope the pandemic becomes history soon and looking forward to meeting you in Shanghai again.

All the best.

This simple email has shown me there is an end. While I may not know what the X amount of time is in this case, there is some X. I can get through this. WE can get through this.

Remember at the end of It’s a Wonderful Life, when George comes bursting through doors and runs through the house like a mad man. At that moment, he truly appreciates the finial on the stairs that he had never fixed and had been a troublesome thorn in his side.

Its

While we may not know exactly when, that email from Jeff in Shanghai has given me both hope and a new found appreciation for my broken finials.

 

Real estate tax timing in a purchase

A little more than a year ago, we addressed the timing/matching of real estate periods. Perhaps it was taxes reconciled for a calendar year, but taxes were paid on a fiscal year. Some landlord would take six months of one fiscal period and six months of another to match those fiscal periods to the calendar year. In other cases, another landlord would use the taxes paid during the calendar year as the taxes for that calendar year. As long as there was consistency, we could justify the methodology.

However, we have a practical application issue at this time. One client is purchasing two properties in Illinois from two separate sellers. Central to this scenario is the fact that the properties are in Illinois. Why? Because taxes are actually paid a full year in arrears in Illinois. Taxes for 2019 will be payable in the March and August of 2020.

So we have to consider the taxes from two different perspectives – the financial accounting perspective and the lease accounting perspective.  Let’s say we are closing on the sale on 1/31/20, and let’s tackle the closing statement first. The seller owned the property for all of 2019. Therefore, since the buyer will be paying the taxes later in 2020, the buyer should be credited with a full year’s taxes. And, considering that the seller owned it for one month into 2020, the buyer should also be credited with another 31/365 days for 2020 taxes – that the buyer will not even pay until the 2021. A bit more of an issue than most other states, but still fairly straightforward. (Maryland is at the other extreme. Taxes are paid in advance, so in that case, it may be the seller getting a larger credit.)

But, now we move on to the tenant side of the equation. Tenants are escrowing taxes throughout the year (unless they are big boxes where they may pay as taxes are paid or have negotiated annual or semi-annual payments) for taxes applicable to their occupancy. Here we have a material divergence in methodology between the two sellers. The first matches taxes and escrows for the period to which they applied. So the tenant made monthly escrow payments during 2019. Those escrows will be used in  2020 when 2019 taxes are reconciled. Let’s say a tenant left in May 2019. In that case, the buyer will be reconciling taxes in later 2020 for a tenant that was never a tenant under their period of ownership and may have exposure if there is additional tax due and they cannot collect. In this case, at closing, the buyer should be collecting 100% of the escrows for 2019, plus one month of escrows for 2020. (Consider if you had a big box leave in May 2019, and that big box is only billed when taxes are paid. The new owner has to go back and bill the tenant 100% of taxes for its occupancy because there were no escrows!)

The second seller, however, uses taxes paid DURING the year as taxes  FOR the year, and the escrows BILLED during the year as the escrows FOR the year.  In this case, when the seller reconciled in 2019, it had just paid 2018 taxes, and the taxes paid were used as the taxes FOR 2019. The seller also used the escrows billed DURING 2019 as the escrows for 2019. Therefore, escrows due from the seller, technically, are just one month’s escrows for January 2020, because the 2019 escrows have already been applied.

ONE FULL YEAR’S WORTH OF ESCROWS OFF!!! It could have been two different sellers of the same exact property, and we would need to have two sets of expectations for escrows at closing.

This second method – the cash method – could create a separate issue. The seller (in the Purchase and Sale) has suggested that because taxes paid during the year are used as taxes for the year that they do not have to credit all of 2019 taxes plus one month’s of 2020 taxes. Rather they suggest that they should only be crediting one month of 2019 taxes (payable in 2020) for its one month of ownership in 2020.

I have not presented the “proper” proration to be made at closing. I am very fortunate as with every lease that we administer or calculate – the lease sets the rules for billing. The lease will state to use either taxes for the year, or taxes to be paid during the year.  The lease itself must be administered in accordance with its requirements. But, from a financial perspective, there may be a full one year cost (or benefit) when a seller using one method is selling to a buyer using the other.

Applying the K.I.S.S. method in leases

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“Keep it simple, stupid!” That hits home so often as I am reading leases.

I have taught classes for ICSC for nearly 25 years. One of my favorite example has been base rents or fixed CAM charges increased by the CPI. That in and of itself is pretty simple. But, you often see caps on these increases, and in many cases where there are caps there are also floors. So the lease might read something to the effect of:

Minimum rent as reflected in Section x.x will be adjusted at the beginning of each Lease Year by the increase in the Consumer Price Index (CPI) from Index published as of the Commencement Date through the Index in effect as of the adjustment date. The increase applied shall never be less than 2% nor more than 4%. The Index shall be the CPI, Clerical Workers and Wage Earners, 1982-84=100 for the SMSA of which the property is apart.

This adjustment is not difficult to calculate, but it has so many different factors to consider.

  • What is the Commencement Date? You might hone in on the Rent Commencement Date, but the Commencement Date might defined elsewhere as the Date of the Lease.
  • What is the definition of Lease Year? Is it from the Commencement Date? Is it from the Rent Commencement Date? Is it 1/1-12/31? Is it 2/1-1/31?
  • What is my SMSA? A property is midway between Philadelphia and DC? Do I go with Philly or DC? Do I go with Eastern Region?
  • What is the “as of date”? It may sound silly, but “as of” Commencement Date is different that “for” the month of Commencement, which is different that Published “during” the month of Commencement. The possibility of three different months. And, the right index could change if the lease commenced on the 10th or 20th of the month (the Index is usually published mid-month, but it can be the 13th-17th).
  • Are my floors (minimums) or cap (maximums) cumulative or non-cumulative?

Honestly, there are a handful of additional considerations.

However, with the idea of K.I.S.S., you can ask, what are we hoping to accomplish? Your minimum is 2%. Your maximum is 4%. Do we think maybe both parties are shooting for 3%? Is it possible they both have an idea of when each year they would like the increase to be applied?

So, instead of each year having to do the drawn out computation, it can be eliminated with:

Minimum rent will be increased by 3% each January 1 of the term, with the first increase effective 1/1/20.

No arguing of any component of a computation. Simple. Straightforward.

Why this post this week?

We are working on a portfolio acquisition and the seller has created some of the most complicated pools for one of these open air centers that I have ever seen. Grocery and discount store anchored. 11 different groupings for allocations. A similar number of pools within these  groupings. Multiple denominators within each of these groupings. Caps. A Most Favored Nations clause or two.

And, there was one particular pool, with one particular denominator that had been created for one particular tenant. The total allocable expense in that pool? $158. Seriously, $158. The incremental pickup of creating the separate pool and the unique denominator? $1.30. That is not $1.30/sf. That is $1.30 total.

My life, and the lives of the professionals in our company (Meridian Realty Consultants), is about making sure that landlords do not leave any cash flow on the table. I can appreciate efforts to reduce a landlord’s absorption. But, the number of factors going in to that calculation – the expense coding, the allocation among the groupings, the denominators within the pools, the explanations necessary – all for $1.30?

I have a really bad tendency to associate scenes from movies or lyrics from songs to my current situation. As I wrote that $1.30, it brought back a scene from a movie I haven’t even thought about in probably 35 years. https://www.youtube.com/watch?v=e9mf3Bypyk8

Focus on what matters. And, K.I.S.S.

Could this be worse than a Most Favored Nations clause?

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We have addressed the Most Dreaded Lease Clause a few times over the past couple of years. We have also addressed another lease language concept – co-participation. But what happens when you combines the concepts? That combination was evident in an acquisition we were working on this week.

If you have time, take a minute to read those more detailed blogs, but briefly: A most favored nations clause states that a tenant will pay certain amounts (or could have certain restrictions on their occupancy) unless another tenant gets a better deal, in which case the tenant will get the other tenants deal. A co-participation clause states something similar – a tenant will pay, be subject to an increase or have restrictions as long as xx% of other tenants are similarly obligated.

Both clauses are fairly onerous and require some work to properly administer them. You must calculate or consider every other tenants’ obligations and then consider the specific tenant’s obligation.

This week, this was the beauty we came across in a big box lease:

“…provided that all in line tenants of the Shopping Center except (Shadow Anchor 1) and (Shadow Anchor 2) are obligated to pay an equivalent amount (on a per square foot basis) of such costs…”

The tenant was obligated to pay its share of CAM as defined in the lease “…provided that all in line tenants of the Shopping Center except (Shadow Anchor 1) and (Shadow Anchor 2) are obligated to pay an equivalent amount (on a per square foot basis) of such costs…”

The lease did not provide for any remedies if those parameters were not met. Therefore, it became an “I don’t have to pay at all if someone pays less” situation. Go back and read that language. It requires 100% participation from the inlines and an equivalent amount on a per square foot basis.

Consider the scenario: The tenant with this language in the lease is required to pay $4.00/sf. Another tenant is required to pay $3.25/sf. The other tenant is not paying an equivalent amount on a per square foot basis. Therefore, the “provided that” kicks in, and the tenant is no longer obligated to pay. It is not reduced to $3.25/sf as it might be in the case of a Most Favored Nations clause. We can’t argue “similar obligation” as we might in the case of a co-participation and state each is required to pay a prorata share, or a fixed share, or even just a share.

The fallout could be severe. As I mentioned, it was a big box. Figure 35,000 sf at $4.00/sf. $140,000 per year!!! Now apply a cap rate to that (as I also mentioned, it was an acquisition). At a 7% cap rate, that is $2,000,000 in value!!! That might be the worst case scenario (unless there was another most favored nations clause in the center which rarely ever happens). However, it could have other consequences (and be mitigated a bit) if the big box were a defined excluded area for other tenants in which case the other tenants might see an increase in their rates per square foot because that $140,000 contribution would be going away.

Two weeks ago, the blog was that Always and Never cannot exist in real estate. Perhaps I have to rethink my use of the word “Most” as in Most Dreaded Lease Clause from now on.

Two words that STILL don’t exist in commercial real estate (this time related to sales reporting and percentage rent)

always

Last year, upon returning from ICSC’s John T. Riordan School of Professional Development in Minneapolis, I felt the need to write a blog entry on the use of “ALWAYS” and “NEVER” when referring to commercial leases. In short, the only absolute that may exist in commercial real estate is that there are no absolutes.

This year, the JTR school was back in its former home in Scottsdale. There are tracks for Management I and II, Leasing I and II, Development, Marketing and Leadership. While the entire program is exceptional, one particular highlight is Case Study day. The students in the various disciplines are paired together with other disciplines to develop game plans for a particular property – grocery anchored for Level I and a more complex lifestyle center for Level II. The information provided to the students is thorough, with some of the most insightful geofenced data available for each property (provided by David Lobaugh of August Partners).

But, in the Level I program, we unfortunately did not provide tenant sales data. Wanting to determine how the tenants were performing, whether there might be percentage rent, and to help shape future rental rates, a few of the students asked if we could provide it.

The immediate response to the students was disappointing for two reasons. It used an absolute and it was incorrect. The students were told that tenants in grocery anchored centers NEVER report sales or pay percentage rent.

There are certain parts of the country where landlords are a little more likely to concede to tenants’ requests to delete percentage rent requirements. But, even in those areas, the landlord still makes every effort to keep the sales reporting requirements in the lease – perhaps not at the same monthly level, but quarterly or annually.

“Whether you have Percent-In-Lieu (Gross Deals), Early Termination Rights clauses, POP-Up Stores, Rent Relief, Specialty Leasing or other ‘Risk Sensitive’ leasing financial exposure, industry ‘Best Practices’ dictate you keep Sales Reporting and/or Percentage Rent requirements at a minimum.”

According to Ken Lamy, president and CEO of The Lamy Group, an international retail sales assessment and consulting firm, “Whether you have Percent-In-Lieu (Gross Deals), Early Termination Rights clauses, POP-Up Stores, Rent Relief, Specialty Leasing or other ‘Risk Sensitive’ leasing financial exposure, industry ‘Best Practices’ dictate you keep Sales Reporting and/or Percentage Rent requirements at a minimum.”

Lamy states that “These two provisions (percentage rent and sales reporting) currently appear in leases 65-70% in “Open-Air” properties and 99% in mall / outlet / lifestyle properties. As a 21st century industry professional, transparency along with quality data sharing is the norm.”

Even in those instances where the specific sales reporting requirement is deleted, there may be another useful clause buried elsewhere in the lease – Landlord’s right to request financial information. This clause requires the tenant to submit financials (income statements and balance sheets) upon request – often no more than once a year, or in conjunction with a sale or refinance of the center.

Because thorough sales data is critical to the health and operation of a center, landlords are firm in their resolve to keep the sales reporting clause in their leases.

And, to reiterate, always and never really do not exist in commercial real estate.

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