The most dreaded lease clause – Most Favored Nations

This week, I was working on an office acquisition and came across a clause I had never seen applied in office before – a most favored nations clause. The clause essentially read:

Notwithstanding anything in the lease to the contrary, no other tenant in the Property shall have a more favorable rental rate (which was further defined to include base rent, tenant’s share of operating expenses and tenant’s share of taxes).

It reads fairly simply – no other tenant shall have a more favorable rental rate – but the consequences of administering that language can have a material impact on cash flow and value. Most typical in retail leases, I would estimate that we see this language once out of every three malls (so figure 1 in 400-450 leases) and perhaps once out of every 10 open air centers (maybe 1 in 200 leases).

When I first got into the industry 30 years ago and saw this language, I remember thinking that the tenants that had the language in the lease were the laziest leasing agents around. Essentially, 「Yes. I will agree to this, but if someone was better than me and negotiated a better deal. I get that.」 It did not take me long to realize that the tenants that negotiated this language had the absolute best leasing agents in the country because of the same exact statement, 「Yes. I will agree to this, but if someone was better than me and negotiated a better deal, I get that.」

They not only have their own skills and experience to draw from, but they have the collective skills and experience of every other leasing agents with space at that property.

It is so dreaded for many reasons, but the most obvious are the amount of administration it takes to properly bill a tenant and the financial implications. Imagine, you have finished the final review of the year end settlements of CAM or taxes and are ready to post the billings. But, you find that the tenant with the most favored nations clause is required to pay $4.00/sf, another tenant has a $3.00/sf rate. You now have to go back and change that first tenant’s rate to $3.00/sf. Now, imagine that tenant was an excluded area for other tenants in the center. That change from $4.00/sf to $3.00/sf could affect every other tenant. Now, take it a step further. You have a struggling tenant. You agree to put that tenant on a percentage in lieu of minimum rent and all other charges. All of the sudden, that $4.00/sf goes to $0/sf.

A truly awful clause for the landlord and a truly wonderful clause for the tenant.

Often I am asked about how can you be sure if the landlord is administering the clause properly. Honestly, you can’t – unless it comes out in discovery during a lawsuit. However, what I can share is that the tenants with most favored nations clause are often anchors or other highly desirable tenants that landlords have (or want) a solid relationship with. In 30 years, I have seen hundreds of these. And, in all but one instance, when the landlord was made aware of the clause, they properly administered the clause (prospectively).

One way landlords can all but eliminate the impact of this clause (through attrition as leases turn over) is to include 「allocation language」 in their standard lease form which essentially gives the landlord the right to allocate base rent, percentage rent, or any other charge to another lease required charge. In that case, when you see the $3.00/sf charge, or the $0/sf charge, if those leases have allocation rights, the landlord can allocate $1.00/sf or $4.00/sf from one charge to another and have no tenant with a rate lower than $4.00/sf.

While you may want to put your head in the sand and hope you don’t have them in your portfolio, they are probably buried in your leases. So, be proactive and address them head on.

Extracting value from an exclusive

There is no question that a tenant benefits from being granted an exclusive use in a shopping center. More often than not, an exclusive ensure that no other tenant in the shopping center shall have the same use as tenant granted the exclsuive. (Occasionally, an exclusive shall read something to the effect of 「There shall be no more than two other jewelry stores…」 Still something of an exclusive, it is a little less burdensome on the landlord.)

Traditionally, the tenant benefits from the exclusive, and the landlord has yet another restriction, limiting its leasing options. It 「costs」 the landlord. However, there is language that we see occasionally that does, to a certain extent, assign a value to the exclusive.

It will read something to the effect of:

As long as tenant is operating as a ______, there shall be no other ______ in the shopping center. If landlord wishes to lease to another _____, landlord will notify tenant. Tenant shall have 10 days to notify landlord whether it wishes to enforce the restriction against another _____ from operating in the center. If the tenant elects to enforce this restriction, tenant’s Base Rent will immediately increase by $5.00/sf for the remainder of the term and landlord will not lease to the another _____. However, if the tenant does not respond within 10 days, or the tenant elects not to require the landlord to enforce the restriction, this exclusive shall no longer apply and the landlord shall be permitted to lease to another _____.」

Beautiful language turning a typically non-financial covenant into a financial covenant!

Why should you care about the definition of the 「Shopping Center」 in the lease?

This past week, we were working on a sizable shopping center acquisition in the Southeast. Part of the center had been a mall that was 「de-malled,」 while the balance was developed in two additional phases. The original mall became a series of big boxes, some traditional small shop retail, a few restaurants and a bit of service type retail now often found in shopping centers (dental, doc-in-in-a-box and the like). The second phase added a discount department store and some other big boxes, and the third phase added a supermarket and small shop retail. More recently, some big box space was converted to a nice health club, a theater was added and a group personal training facility lease had been executed.

We knew 「shopping center」 was going to be an issue for this acquisition. We just did not realize how much. Many of the leases defined shopping center as 「(Name) shopping center as reflected on the Exhibit A site plan.」 Others defined the center as Phase II or Phase III, or Phase II and III. Other defined the center as 「(Name) shopping center as described on Exhibit A,」 with Exhibit A being a two page metes and bounds description. There were about 10 different iterations of the term 「shopping center.」

Why would that matter? Because some lease prohibited health clubs or theaters. Others granted exclusives in the shopping center defined in their lease. While yet others extended the exclusives and restrictions to adjacent parcels controlled by the landlord or its affiliates. This mish-mosh of definitions caused our client to wisely have the seller seek waivers on certain existing uses prior to closing, and created the need for an almost Venn diagram type site plan for what can go where. Without the waivers, without a clear picture of restrictions and exclusives, a new owner could have some exposure.

There are other financial implications of the definition of shopping center that we will hit in a future blog, particularly as it relates to whether a particular space is included in the definition of the shopping center and then defined as an excluded area, or whether it is excluded from the definition of the shopping center to begin with. But, be clear about how you define the shopping center in your leases!

Are your tenants open or closed today? The value of lease required operating hours.

As I write this blog, the rest of my family is getting ready for Easter Sunday Mass. I can be ready in five minutes so I have a little time. There is the major religious significance of today, but there are also secular, lease-related consequences of retailers and retail venues operating today.

Sometimes ignored in leases are the tenant’s required operating hours. Often, it will be presented simply as 10 am to 9 pm Monday through Saturday and 11 am to 6 pm on Sunday. It will usually address that the center will not be operating on Thanksgiving and Christmas. This clause does get negotiated, but not nearly as often as you might think. This is where tenants will negotiate their right to close two days per year for inventory. This is where the Chick-fil-as of the world state that they will not be required to operate on Sundays. This is where you might see a tax preparation firm negotiate their right to operate only certain months of the year. This is where supermarkets address their right to operate 24/7, and where restaurants and theater negotiate their late night operating hours.

It is also where you will see language to the effect of 「and other hours as landlord may require.」 Sophisticated tenants will respond to that language with a sort of cotenancy (not a true cotenancy) language that states 「only if at least two department stores and 70% of the inline tenant」 are also operating.

These clause are in the lease to provide a united front. To ensure that a customer does not come to the center and find currently operating retailers essentially not operating. While the required operating hours may be pretty easy to find in the lease, the consequences of not operating are often sprinkled throughout the lease.

In minimum rent, you may find language that provides for one or two day’s minimum rent as a penalty for each day that the tenant is not operating. Sometimes in percentage rent or in the definition of reported gross sales, you may find that the breakpoint is reduced for each day that the tenant does not operate, or that reported gross sales gets 「grossed up」 (proportionately increased) for each day that the tenant does not operate. The bottom line is that there are financial implications to a tenant not operating when required.

And, it actually goes the other way too. If you have a supermarket that had been a 7 am to 9 pm operation convert to a 24 hour operation, your concession allowing for the conversion of the operation should also address the new 「after hours」 charges. You will now have parking lot lights running an additional 8-10 hours. Typically, a tenant will be required to pay after hours charges proportionately with other tenants also operating after hours. If your theater or restaurant is required to pay fixed CAM, but then requests to operate additional hours, that landlord concession should also include an increase in the fixed CAM to account for increases in lighting, security, janitorial and other similar variable expenses.

One other thought related to hours and landlord supplied utilities. If your lease contains a base charge for either electricity or tenant HVAC, it is usually based upon a standard expectation for operating hours similar to those addressed above (10-9 and 11-6). If you have tenants operating outside of those hours (think about a food court tenant that opens early to cater to mall walkers or a salon or optician that opens early for appointments, there may be a need to adjust the tenant’s charge. And, though it is a rare occurrence, there are still counties throughout the US with blue laws prohibiting many retail locations from opening on Sundays. When those laws are lifted and a center begins operating, adjustments are needed to account for these additional hours.

– Just once instance where a non-financial covenant of a lease has a financial impact

(And, I did finish before my family was ready to leave!)

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!

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