Shopping Center Remodeling and Expansion: Considerations and Drafting Points

In today's commercial real estate market, with new shopping centers being developed at a rapid pace, landlords and tenants in existing older shopping centers have to work diligently to stay competitive. A factor that should be considered by both parties to stay competitive includes the eventual need to remodel and/or expand the shopping center.

This two-part article explores some of the issues that arise in negotiating a lease form that contains clauses defining the rights of the landlord and obligations of the tenant with regard to remodeling or expanding a shopping center. The first part of the article discusses negotiating points that could benefit, rather than burden, a landlord and tenant, during the administration of the lease. Part two will provide some suggested model language to consider when drafting a lease.

The need for both the landlord and the tenant to maintain a competitive shopping center (and competitive retail base) will arise in those instances in which the surrounding retail base has had a new increase in new shopping center development. A familiar scenario for remodeling may occur when a landlord owns a community shopping center anchored by a grocery store and drug store. At the time it was constructed, the center was considered on the outer edge of the population trade area. The population trade area increased year after year, and new shopping centers were developed in the same trade area to absorb the increased demand for retail goods and services. These new shopping centers incorporate and reflect current shopping center design standards relative to facility upgrades, layouts of inline buildings and outlot parcels, parking lots and access, landscaping, and trade name signs. The newer shopping centers are, therefore, more attractive and desirable to retail tenants and their customers.

The dilemma thus exists between 1) the landlord of the older shopping center who wants to remodel and upgrade its shopping center to stabilize the current tenant base, add value to its asset, and attract new tenants to its existing shopping center, and 2) the tenants of the older shopping center who want to be in a competitive shopping center, but do not want to deal with the potential problems caused by construction-related activities. Considering the overall length of a standard lease term of 10 to 15 years, attorneys should negotiate to include provisions in the lease addressing the landlord's rights and obligations to remodel and expand the shopping center, and the tenant's rights and obligations to participate in the remodeling and expansion, especially in those shopping centers that are more than 10 years old. Any further references to remodeling will also be deemed to include expanding the shopping center.

Negotiation and Drafting Points

1) Scope of remodeling and review of plans. The remodeling of the shopping center could be as simple and easy as applying a new exterior coat of paint to the buildings comprising the shopping center and adding new parking lot striping and a new pylon sign, or as complex as changing exterior architectural features, adding additional retail space by demolishing existing buildings or developing previously unconstructed portions of land adjacent to the existing shopping center.

When the lease is initially negotiated, it is important that both the landlord and tenant have an understanding of the proposed scope of any future expected remodeling. That understanding may be difficult to both qualify and quantify. Some examples of attempts to qualify and quantify the scope of the remodeling would be to use exhibits in the lease, showing: 1) future development phases of the shopping center on the site plan, 2) proposed changes to access points, 3) new architectural renderings for the exterior elevations, and 4) new sign criteria that would be triggered by the remodeling.

At a minimum, the tenant should be allowed to review a copy of the plans. In addition, the tenant may require the right not only to review the plans, but also to approve the plans as a condition precedent to the landlord's right to remodel. The resolution is in part dependent on the relative bargaining powers of landlord and tenant.

2) Rent abatements and rent increases. Frequently, negotiations will include discussions relative to abatement in rent based upon a presumption that there will be an adverse impact to the tenant's business during the remodeling. Most tenants would want a complete abatement of rent and additional rent even if they remain open for business during the remodeling; most landlords do not want to have any decreases to their income stream. There are many possible compromises upon which landlords and tenants can agree. A few compromises include: 1) paying a percentage of sales during the remodeling, provided that the actual amount paid does not exceed the fixed minimum rent payable pursuant to the lease; 2) stipulating to a fixed reduction of fixed rent; 3) agreeing that a certain minimum reduction in sales revenues will equate to a fixed reduction in fixed rent, or 4) equating a percentage reduction of fixed rent based upon a percentage decline in sales revenues as compared to the same time period during the prior year (for example, a 10% reduction in sales revenue during the first quarter will equate to a 10% reduction in fixed rent). Some problems with the calculation of the reduction of sales revenue arise due to the different profit margins associated with different types of retail tenants: A direct percentage ratio of a drop in sales may not equate to a fair allocation of a reduction in rent. Another problem from a sales reduction/rent reduction format is that retail tenants have an expectation that sales will increase from year to year. Thus, a sales comparison that shows the same level of sales revenues during the remodeling period as compared with the same period the prior year, which results in no abatement of rent, fails to consider the impact on business that the remodeling period had on the projected sales increases from the prior year. One other method of calculation would be to consider an equitable reduction in fixed rent based upon a showing of proof by the tenant that includes other factors beyond a reduction in sales revenues, such as the closing of a portion of the premises, temporary closing of the whole premises, interference with access to the premises, short-term reduction in available parking and the adverse impact on the traffic flow.

Further, lease forms may include automatic rent increases of 10% to 20% to the existing tenant's rental rate as a result of the remodeling based upon the presumption that there is a direct benefit to the tenant after the remodeling due to an expected increase in customer traffic. The dilemma that occurs with these types of provisions is that leases that are structured with percentage rent clauses will have the natural break point increase dramatically with the increase to fixed rent. Perhaps a more reasonable negotiating approach would be that, if the presumption is that sales revenues would increase as a result of the remodeling, the landlord would receive more percentage rent by not increasing the fixed rent and by maintaining the original natural break point.

3) Relocation rights. Frequently, lease forms include the landlord's right to relocate the tenant, due to a remodeling of the shopping center, expansion of an anchor tenant, or the construction of a new phase of the shopping center. The landlord's right to relocate the tenant could be considered onerous if the location of the leased premises is one of the most important factors in a tenant's decision to open a store for business in a shopping center. If the relocation provision cannot be negotiated out of the lease form, there are some possible compromises to which the landlord and tenant can agree; a few include 1) the right to identify a relocation area on the site plan so that the proposed new location is clearly identified at the outset; 2) the right to request that the tenant is offered two to three choices for relocation; 3) an agreement from the landlord that the tenant will have no down time with its business so that the relocated premises are available for occupancy prior to having to close for business in the original premises; and 4) having the landlord pay for the cost of moving and the build-out of the new tenant improvements.

4) Signage permits; new laws. The remodeling will likely require that the tenant's exterior signs be removed for some period of time. During such occasions, the tenant would want the landlord to install temporary banners that are approved or provided by the tenant. Further, the tenant would negotiate that the landlord should pay for the cost to remove, reinstall and if need be, repair, any damage to the existing exterior signs caused by the landlord's remodeling of the shopping center. An alternate solution would be either to have the landlord pay for the construction and installation of the new sign or have the tenant do the construction and installation and offset the cost against minimum rent and additional rent. One other difficult issue that the landlord and tenant may encounter is that sign ordinances may have become stricter than those ordinances in existence at the time that the tenant's initial sign was installed. As a result, the tenant will not get the same size, type or look for its signs after the remodeling is finished. A compromise would be to have the landlord, at its own cost, make an appeal to the governmental authority for a variance for all the existing shopping center tenants. This, however, could lead to other problems if the existing tenants are “grandfathered” from the new ordinances, and the new tenants have disproportionate signs that create a motley look to the shopping center. Such an outcome might be contrary to the idea of the remodeling if, for example, the purpose was to achieve a new uniform look for the shopping center.

5) Compliance with laws (ADA) in the common area and premises. Just as with signs, the remodeling of the shopping center may trigger compliance with laws and other related issues in the common areas and the tenant's premises. Common area improvements could include the addition of handicap ramps and access, increased lighting, remediation of pre-existing hazardous materials (because the materials are going to be disturbed), increased landscaping, implementing community-related facilities, such as bus stops and ride-share programs, and contributions for off-site road and utility improvements. The common area improvements have to be funded somehow; therefore, it is important to review, analyze and negotiate the common area expense pass-through sections of the lease to determine if the existing tenants are obligated to contribute their share of such costs and attempt to reach an equitable outcome. Similarly, upgrades to the premises may trigger utility changes and improvements to restrooms and storefront doors. Again, a few possible compromises are either to have the landlord pay for the construction of the required upgrades because they were triggered by the remodeling or have the tenant perform the upgrades and offset the cost against minimum rent and additional rent. The tenant's participation may turn on the issue of whether the upgrade is mandatory (for example, the upgrade is required by the municipality because of the remodeling) or voluntary (for example, the upgrade is not required at the time of the remodeling, but done as a value-enhancing improvement).

6) Commencement and duration of construction activities. The tenant will not want construction-related activities of the remodeling to adversely affect its business, and one potential problem would be that the remodeling would occur during its high seasonal sales cycle. Although the landlord may want to limit the impact on the tenant's business, the landlord will also want to start at an economically advantageous time, for example, when it can secure a good construction loan rate and commence construction before interest rates rise. The sooner the remodeling is completed, the faster new leasing activity can occur in the shopping center and increase the value of the landlord's investment. It is important to try to quantify the duration of the construction-related activities. As a compromise, the parties can agree that no construction-related activities can commence during some seasonal retail event, such as the “going back to school or Christmas season,” which, in any event, should be identified in the lease with specific calendar dates.

7) Impact to access, parking and visibility. Customer access, parking and visibility are all equally important to the tenant, especially if the tenant intends to remain open during the remodeling period. The landlord will want to make sure that the remodeling is performed in an integrated manner and will view the process as a whole. For example, the landlord will want the actual construction work to start at one end of the center and move along to the opposite end. While it is unlikely that the landlord will delay, or skip over remodeling one section of a storefront so a tenant can conduct a sidewalk sale, the landlord and tenant can agree not to close portions of the common area or not to have construction staging areas that would impact on the tenant's access, parking and visibility. This “No Staging Area” can be clearly identified on a site plan to incorporate those specific areas and concerns.

8) Written notice. It is equally important that both parties be able to plan for the remodeling. However, the landlord would probably want to include a short notice period to the tenant before commencement, to account for any logistical problems that may arise in getting the remodeling started, (eg, approval of plans and obtaining permits, executing construction contracts and ordering materials). Conversely, the tenant will probably want a long notice period from the landlord before commencement in order to revise its business plan relative to maintaining inventories, hiring employees or shortening shifts, changing or delaying any promotional activities that would be impacted by the construction.

9) Tax increases. After the remodeling, there is a significant likelihood that the value of the real estate will increase and result in higher property taxes. Thereafter, the tenants would pay their respective proportionate shares of the increased tax base, which, on its face, seems straightforward, fair and reasonable. However, another way to fund the improvements, especially the upgrades or changes to the infrastructure facilities serving the shopping center, would be for the landlord to create a special assessment district for the shopping center and have the cost passed through to the tenant base as a tax increase rather than either a common area expense or as part of the construction loan used for the remodeling. The parties should review, analyze and negotiate the definition of “real property taxes” to determine whether such provisions exist and discuss a fair allocation.

10) Funding the remodeling (new loans, direct common area cost pass throughs, or reserve accounts). The landlord may fund the remodeling by obtaining a construction loan that incorporates the shopping center's existing cash flow and equity. The landlord may thereby recoup the expense by negotiating new rental rates for new tenants and renegotiating longer lease terms with existing tenants. The landlord may also want to have the ability to set up line items in the common area expense portion of the lease either to collect reserve accounts for the remodeling and/or have a direct pass through of such costs as they are incurred by the landlord. In any event, the parties should review, analyze and negotiate the definition of “common area expenses” to determine whether such provisions exist and discuss a fair allocation. For example, the tenant may not be willing to agree to pay its proportionate share of reserves for future construction on a monthly basis as part of common area costs. One possible compromise would be for the tenant to agree to pay for reserves in arrears after notice from the landlord, if and only if, the landlord actually uses the reserve account for the remodeling.

Summary

It is obvious that all potential lease transactions should be thoroughly reviewed and analyzed on a case-by-case basis relative to each party's desires, needs and leverage. A lease that does not address the cost, expense, and administration of the landlord's and tenant's rights and obligations with regard to a remodeling of the shopping center could eventually become an economic liability. To avoid future potential conflicts, therefore, the landlord and tenant should attempt to define the likelihood of remodeling and each party's respective rights and obligations clearly during lease negotiations. Next month's Commercial Leasing Law & Strategy will include sample lease language illustrating the points discussed.

In today's commercial real estate market, with new shopping centers being developed at a rapid pace, landlords and tenants in existing older shopping centers have to work diligently to stay competitive. A factor that should be considered by both parties to stay competitive includes the eventual need to remodel and/or expand the shopping center.

This two-part article explores some of the issues that arise in negotiating a lease form that contains clauses defining the rights of the landlord and obligations of the tenant with regard to remodeling or expanding a shopping center. The first part of the article discusses negotiating points that could benefit, rather than burden, a landlord and tenant, during the administration of the lease. Part two will provide some suggested model language to consider when drafting a lease.

The need for both the landlord and the tenant to maintain a competitive shopping center (and competitive retail base) will arise in those instances in which the surrounding retail base has had a new increase in new shopping center development. A familiar scenario for remodeling may occur when a landlord owns a community shopping center anchored by a grocery store and drug store. At the time it was constructed, the center was considered on the outer edge of the population trade area. The population trade area increased year after year, and new shopping centers were developed in the same trade area to absorb the increased demand for retail goods and services. These new shopping centers incorporate and reflect current shopping center design standards relative to facility upgrades, layouts of inline buildings and outlot parcels, parking lots and access, landscaping, and trade name signs. The newer shopping centers are, therefore, more attractive and desirable to retail tenants and their customers.

The dilemma thus exists between 1) the landlord of the older shopping center who wants to remodel and upgrade its shopping center to stabilize the current tenant base, add value to its asset, and attract new tenants to its existing shopping center, and 2) the tenants of the older shopping center who want to be in a competitive shopping center, but do not want to deal with the potential problems caused by construction-related activities. Considering the overall length of a standard lease term of 10 to 15 years, attorneys should negotiate to include provisions in the lease addressing the landlord's rights and obligations to remodel and expand the shopping center, and the tenant's rights and obligations to participate in the remodeling and expansion, especially in those shopping centers that are more than 10 years old. Any further references to remodeling will also be deemed to include expanding the shopping center.

Negotiation and Drafting Points

1) Scope of remodeling and review of plans. The remodeling of the shopping center could be as simple and easy as applying a new exterior coat of paint to the buildings comprising the shopping center and adding new parking lot striping and a new pylon sign, or as complex as changing exterior architectural features, adding additional retail space by demolishing existing buildings or developing previously unconstructed portions of land adjacent to the existing shopping center.

When the lease is initially negotiated, it is important that both the landlord and tenant have an understanding of the proposed scope of any future expected remodeling. That understanding may be difficult to both qualify and quantify. Some examples of attempts to qualify and quantify the scope of the remodeling would be to use exhibits in the lease, showing: 1) future development phases of the shopping center on the site plan, 2) proposed changes to access points, 3) new architectural renderings for the exterior elevations, and 4) new sign criteria that would be triggered by the remodeling.

At a minimum, the tenant should be allowed to review a copy of the plans. In addition, the tenant may require the right not only to review the plans, but also to approve the plans as a condition precedent to the landlord's right to remodel. The resolution is in part dependent on the relative bargaining powers of landlord and tenant.

2) Rent abatements and rent increases. Frequently, negotiations will include discussions relative to abatement in rent based upon a presumption that there will be an adverse impact to the tenant's business during the remodeling. Most tenants would want a complete abatement of rent and additional rent even if they remain open for business during the remodeling; most landlords do not want to have any decreases to their income stream. There are many possible compromises upon which landlords and tenants can agree. A few compromises include: 1) paying a percentage of sales during the remodeling, provided that the actual amount paid does not exceed the fixed minimum rent payable pursuant to the lease; 2) stipulating to a fixed reduction of fixed rent; 3) agreeing that a certain minimum reduction in sales revenues will equate to a fixed reduction in fixed rent, or 4) equating a percentage reduction of fixed rent based upon a percentage decline in sales revenues as compared to the same time period during the prior year (for example, a 10% reduction in sales revenue during the first quarter will equate to a 10% reduction in fixed rent). Some problems with the calculation of the reduction of sales revenue arise due to the different profit margins associated with different types of retail tenants: A direct percentage ratio of a drop in sales may not equate to a fair allocation of a reduction in rent. Another problem from a sales reduction/rent reduction format is that retail tenants have an expectation that sales will increase from year to year. Thus, a sales comparison that shows the same level of sales revenues during the remodeling period as compared with the same period the prior year, which results in no abatement of rent, fails to consider the impact on business that the remodeling period had on the projected sales increases from the prior year. One other method of calculation would be to consider an equitable reduction in fixed rent based upon a showing of proof by the tenant that includes other factors beyond a reduction in sales revenues, such as the closing of a portion of the premises, temporary closing of the whole premises, interference with access to the premises, short-term reduction in available parking and the adverse impact on the traffic flow.

Further, lease forms may include automatic rent increases of 10% to 20% to the existing tenant's rental rate as a result of the remodeling based upon the presumption that there is a direct benefit to the tenant after the remodeling due to an expected increase in customer traffic. The dilemma that occurs with these types of provisions is that leases that are structured with percentage rent clauses will have the natural break point increase dramatically with the increase to fixed rent. Perhaps a more reasonable negotiating approach would be that, if the presumption is that sales revenues would increase as a result of the remodeling, the landlord would receive more percentage rent by not increasing the fixed rent and by maintaining the original natural break point.

3) Relocation rights. Frequently, lease forms include the landlord's right to relocate the tenant, due to a remodeling of the shopping center, expansion of an anchor tenant, or the construction of a new phase of the shopping center. The landlord's right to relocate the tenant could be considered onerous if the location of the leased premises is one of the most important factors in a tenant's decision to open a store for business in a shopping center. If the relocation provision cannot be negotiated out of the lease form, there are some possible compromises to which the landlord and tenant can agree; a few include 1) the right to identify a relocation area on the site plan so that the proposed new location is clearly identified at the outset; 2) the right to request that the tenant is offered two to three choices for relocation; 3) an agreement from the landlord that the tenant will have no down time with its business so that the relocated premises are available for occupancy prior to having to close for business in the original premises; and 4) having the landlord pay for the cost of moving and the build-out of the new tenant improvements.

4) Signage permits; new laws. The remodeling will likely require that the tenant's exterior signs be removed for some period of time. During such occasions, the tenant would want the landlord to install temporary banners that are approved or provided by the tenant. Further, the tenant would negotiate that the landlord should pay for the cost to remove, reinstall and if need be, repair, any damage to the existing exterior signs caused by the landlord's remodeling of the shopping center. An alternate solution would be either to have the landlord pay for the construction and installation of the new sign or have the tenant do the construction and installation and offset the cost against minimum rent and additional rent. One other difficult issue that the landlord and tenant may encounter is that sign ordinances may have become stricter than those ordinances in existence at the time that the tenant's initial sign was installed. As a result, the tenant will not get the same size, type or look for its signs after the remodeling is finished. A compromise would be to have the landlord, at its own cost, make an appeal to the governmental authority for a variance for all the existing shopping center tenants. This, however, could lead to other problems if the existing tenants are “grandfathered” from the new ordinances, and the new tenants have disproportionate signs that create a motley look to the shopping center. Such an outcome might be contrary to the idea of the remodeling if, for example, the purpose was to achieve a new uniform look for the shopping center.

5) Compliance with laws (ADA) in the common area and premises. Just as with signs, the remodeling of the shopping center may trigger compliance with laws and other related issues in the common areas and the tenant's premises. Common area improvements could include the addition of handicap ramps and access, increased lighting, remediation of pre-existing hazardous materials (because the materials are going to be disturbed), increased landscaping, implementing community-related facilities, such as bus stops and ride-share programs, and contributions for off-site road and utility improvements. The common area improvements have to be funded somehow; therefore, it is important to review, analyze and negotiate the common area expense pass-through sections of the lease to determine if the existing tenants are obligated to contribute their share of such costs and attempt to reach an equitable outcome. Similarly, upgrades to the premises may trigger utility changes and improvements to restrooms and storefront doors. Again, a few possible compromises are either to have the landlord pay for the construction of the required upgrades because they were triggered by the remodeling or have the tenant perform the upgrades and offset the cost against minimum rent and additional rent. The tenant's participation may turn on the issue of whether the upgrade is mandatory (for example, the upgrade is required by the municipality because of the remodeling) or voluntary (for example, the upgrade is not required at the time of the remodeling, but done as a value-enhancing improvement).

6) Commencement and duration of construction activities. The tenant will not want construction-related activities of the remodeling to adversely affect its business, and one potential problem would be that the remodeling would occur during its high seasonal sales cycle. Although the landlord may want to limit the impact on the tenant's business, the landlord will also want to start at an economically advantageous time, for example, when it can secure a good construction loan rate and commence construction before interest rates rise. The sooner the remodeling is completed, the faster new leasing activity can occur in the shopping center and increase the value of the landlord's investment. It is important to try to quantify the duration of the construction-related activities. As a compromise, the parties can agree that no construction-related activities can commence during some seasonal retail event, such as the “going back to school or Christmas season,” which, in any event, should be identified in the lease with specific calendar dates.

7) Impact to access, parking and visibility. Customer access, parking and visibility are all equally important to the tenant, especially if the tenant intends to remain open during the remodeling period. The landlord will want to make sure that the remodeling is performed in an integrated manner and will view the process as a whole. For example, the landlord will want the actual construction work to start at one end of the center and move along to the opposite end. While it is unlikely that the landlord will delay, or skip over remodeling one section of a storefront so a tenant can conduct a sidewalk sale, the landlord and tenant can agree not to close portions of the common area or not to have construction staging areas that would impact on the tenant's access, parking and visibility. This “No Staging Area” can be clearly identified on a site plan to incorporate those specific areas and concerns.

8) Written notice. It is equally important that both parties be able to plan for the remodeling. However, the landlord would probably want to include a short notice period to the tenant before commencement, to account for any logistical problems that may arise in getting the remodeling started, (eg, approval of plans and obtaining permits, executing construction contracts and ordering materials). Conversely, the tenant will probably want a long notice period from the landlord before commencement in order to revise its business plan relative to maintaining inventories, hiring employees or shortening shifts, changing or delaying any promotional activities that would be impacted by the construction.

9) Tax increases. After the remodeling, there is a significant likelihood that the value of the real estate will increase and result in higher property taxes. Thereafter, the tenants would pay their respective proportionate shares of the increased tax base, which, on its face, seems straightforward, fair and reasonable. However, another way to fund the improvements, especially the upgrades or changes to the infrastructure facilities serving the shopping center, would be for the landlord to create a special assessment district for the shopping center and have the cost passed through to the tenant base as a tax increase rather than either a common area expense or as part of the construction loan used for the remodeling. The parties should review, analyze and negotiate the definition of “real property taxes” to determine whether such provisions exist and discuss a fair allocation.

10) Funding the remodeling (new loans, direct common area cost pass throughs, or reserve accounts). The landlord may fund the remodeling by obtaining a construction loan that incorporates the shopping center's existing cash flow and equity. The landlord may thereby recoup the expense by negotiating new rental rates for new tenants and renegotiating longer lease terms with existing tenants. The landlord may also want to have the ability to set up line items in the common area expense portion of the lease either to collect reserve accounts for the remodeling and/or have a direct pass through of such costs as they are incurred by the landlord. In any event, the parties should review, analyze and negotiate the definition of “common area expenses” to determine whether such provisions exist and discuss a fair allocation. For example, the tenant may not be willing to agree to pay its proportionate share of reserves for future construction on a monthly basis as part of common area costs. One possible compromise would be for the tenant to agree to pay for reserves in arrears after notice from the landlord, if and only if, the landlord actually uses the reserve account for the remodeling.

Summary

It is obvious that all potential lease transactions should be thoroughly reviewed and analyzed on a case-by-case basis relative to each party's desires, needs and leverage. A lease that does not address the cost, expense, and administration of the landlord's and tenant's rights and obligations with regard to a remodeling of the shopping center could eventually become an economic liability. To avoid future potential conflicts, therefore, the landlord and tenant should attempt to define the likelihood of remodeling and each party's respective rights and obligations clearly during lease negotiations. Next month's Commercial Leasing Law & Strategy will include sample lease language illustrating the points discussed.