Enhancing Tenant Flexibility in In-Line Retail Leases

What will the retailer do with the store? What may the retailer not do? Who else may do the same thing in the same shopping center? Most retailers will want to retain as much flexibility in using leased space as possible. A retailer that agrees “to sell at retail only Pet Rocks and no other use whatsoever” will likely find that the store cannot sustain success for very long. On the other hand, very few landlords ' concerned as they reasonably are with tenant mix ' will adopt a laissez-faire attitude toward use, so a retailer is not likely to be successful in negotiating a use clause allowing “any activity permitted by applicable law.”

What, then, is the ideal approach? The key is to maintain as much flexibility for the retailer as possible so that over a 5- or 10-year or even longer lease term, the retailer is able to adapt to changes in the market and maintain economic viability. Of course, this approach can also be beneficial to the landlord, as the retailer's ability to adapt to market variables will tend to support higher sales and greater percentage rents.

Taking the Pet Rock example above, the retailer would be better off with a use clause that permits the sale of “novelty and gift items.” Similarly, a watchmaker may wish to seek authority to sell any type of “jewelry,” a clothing retailer should include authority to sell “shoes and accessories,” and a bookstore should be permitted to sell “periodicals, journals, stationery and greeting cards.” In each case, the retailer has an obvious core, but the additional language permits flexibility, opens a broader market and contributes to success over the long term.

Of course, the more generalized a retailer's use clause becomes, the less likely it will be that the retailer will be successful in negotiating an exclusive use right in the shopping center. Where a landlord is even open to negotiating an exclusive use (many are not), the key will be to negotiate a clause that protects a lucrative product, product line or sector that has long-term staying power, while leaving aside protections the landlord is not likely to grant or which are extraneous in the first place. After all, an exclusive to sell Pet Rocks has little value in the third, fourth or fifth year after introduction, but an exclusive to sell gold jewelry, for example, can be valuable over the long term.

Radius Restrictions

“We met in Starbucks. Not the same Starbucks, but we saw each other at different Starbucks ' across the street from each other.” “Best In Show,” Warner Brothers/Castle Rock Entertainment, 2000.

How close is too close?

A landlord negotiating with a prized retailer will frequently attempt to ensure that the retailer will not locate a competing store in proximity to the new store. There are two principal reasons. First, the landlord is concerned that a competing location will cannibalize sales and cut into percentage rent payments. Second, and more subtly, is a concern over traffic. Landlords prefer to keep control over their tenant mix in part to stimulate maximum traffic in the shopping center, with the intent of increasing sales centerwide.

There are two lessons for the retailer here. First, if the lease does not include a percentage rent element, then the landlord has very little leverage or reason for obtaining and enforcing a radius restriction. Simply put, even if another store affects sales, the landlord's bottom line is not directly affected, because the retailer always pays the same base rent.

Addressing the landlord's second concern is more complicated, but there are some touchstones worth considering. If the retailer's product line is high end and there is not a logical second location for a store, then it may make sense to concede a limited radius restriction. For example, a retailer of fine, exclusive jewelry may not have any prospect of opening a second store within a 3- or 5-mile radius, so it is not necessarily harmed in agreeing to a radius restriction. (There are, of course, some exceptions to this, and both current and projected demographics must ultimately drive the retailer's negotiations and decisions.) In some metropolitan areas especially, however, there may be two or more shopping centers where a retailer desires a presence ' to demonstrate market penetration and to serve a wider audience of customers more conveniently ' and where such situations exist, radius restrictions can be counterproductive. In any case where the retailer believes that two or more stores will generate appreciably greater sales and increased net profits, it should be loath to agree to a radius restriction, even if a particular store's sales may end up being lower. (Interestingly, this tends not always to be the case, eg, Starbucks, where existing stores in proximity to old stores frequently see increases in sales. Obviously, Starbucks is highly unlikely to agree to a radius restriction!)

When a retailer does agree to a radius restriction, it is usually wise to attach a time limit to it. Again, the idea is to maintain the retailer's viability and flexibility over the entire term of the lease. As the demographics of an area change, the retailer may regret being governed by a radius restriction it was initially willing to give. Therefore, seek to have the radius restriction extinguished ' or the actual radius reduced ' after a reasonable period of time.

Opening and Operating Covenants

The landlord will want assurances in the lease that the retailer will open the store on time and operate it throughout the term of the lease. Again, both percentage rent and customer traffic are concerns.

It is not unreasonable for the retailer to agree to open the store; after all, the retailer's intent is to make sales. However, there are a number of events that can affect the retailer's ability to open on time. Chief among these is construction delays. Therefore, the retailer should be cautious about agreeing to a specific opening date. Enough time will be necessary to design and fit out the space, stock it and train personnel. Even if the retailer is willing to agree to a date certain, it should mitigate the potential effect of this agreement by ensuring that any penalties for failure to open, often expressed as a number of dollars per day, do not begin to accrue until some time after that date ' ideally 30 days or more. The retailer's inability to open when anticipated will already affect its revenue, and the additional penalty is not necessary as an incentive. Since the landlord may also be suffering from lost percentage rent in this situation, though, it will not always be possible to eliminate the late opening fee entirely. Finally with respect to opening, if the retailer is opening a store in a new shopping center, it should never be required to open for business unless a majority of the shopping center, including the anchors, have opened or open simultaneously.

When initially negotiating the lease, retailers will have a keen awareness of the statistics affecting the shopping center, but those demographics may change over time. For example, the demographics of the neighborhood may change or the retailer mix of the shopping center may become less favorable. Recognizing this, retailers would be well served by negotiating an option to go dark or terminate the lease at some specified point or points during the lease term (such options to be exercised freely or to be tied to sales figures). If a particular retailer mix is important to the retailer, it might also be wise to negotiate a co-tenancy provision allowing the retailer to terminate the lease if another retailer or mix of retailers fails to continue operating in the shopping center.

Once open, the landlord seeks to ensure that the space will continue to generate sales and will not go dark ' both to maintain percentage rents and to project the image of a vibrant center. Therefore, many landlords' form leases will contain continuous use clauses. Under that clause, landlords seek to force the retailer to operate, even if the retailer determines it is better off closing the store and continuing to pay rent. Landlords seek to enforce this provision either by imposing a daily fee for failure to operate or by obtaining an injunction ordering the retailer to operate. Under most state laws, the daily fee will be enforceable. In many states, however, the courts will refuse to grant an injunction to force a struggling retailer to operate, so there is little justification for including the language in the lease. Where a retailer is willing to include the fee language, a reasonable fee (rather than a punitive penalty) should be negotiated. In such situations, it will also frequently be useful for the retailer to have flexible assignment and sublease provisions in the lease.

Assignment and Subleasing

A sophisticated retailer may find at some point during the term of the lease that it would be desirable to close a location rather than continue to operate it with a miniscule profit, or worse, at a loss. Where the retailer would be penalized for violating a covenant to operate continuously, however, the ability to assign or sublet the premises may provide an alternative. (Subleasing may also be desirable where the retailer intends to continue occupying a portion of the space, but the more typical situation is where a retailer wants out of the space entirely.)

A typical landlord's form lease will likely say that a retailer may not assign or sublease the premises without the landlord's consent. In some states, this language will imply that the landlord's consent may not be unreasonably withheld; but in other states, the language will give the landlord a unilateral right to withhold consent. Some form leases will go so far as to say the landlord may withhold consent in its sole discretion. In such circumstances, the retailer may find it is out of options. Ideally, the retailer would negotiate an absolute right to assign or sublease, but the landlord, rightly concerned with its retailer mix, likely will not assent to this provision. The compromise, then, is to insert language saying that the landlord's consent to assignment and subleasing “will not be unreasonably withheld, conditioned or delayed.” In such circumstances, the landlord will then have the burden of proving that its refusal to consent was reasonable. Retailers that are part of a larger retailing family may also find it useful to obtain ' and many landlords will be more willing to grant ' language in the lease permitting assignment and subleasing to the retailer's affiliates and/or successors.

Finally, some leases may set out objective criteria that must be satisfied before the lease may be transferred. These may include net worth measurements, product line requirements, experience durations and the like. A savvy retailer negotiating such terms should keep in mind that if it is in a position where it needs to offload the lease, it will not want to be guaranteeing the landlord a better position than it originally negotiated; so the net worth requirement, for example, should not exceed the net worth of the retailer at the time it originally negotiated the lease.

Conclusion

A lease has life over a term of years, and a successful retailer's business is not static. A single brief article obviously cannot cover all the items a retailer must consider when negotiating an in-line lease. However, with a keen eye toward the items covered above, the retailer's business personnel and counsel will be well on their way to crafting a reasonable lease that gives the retailer the flexibility it needs to be successful over the entire term of the lease.

While it would not be possible to identify a “typical” in-line retailer (their perspectives vary as much as their products and their business plans), there are issues that recur in negotiation of leases for them. As attorneys negotiating on behalf of in-line retailers, it is important to consider the potential implications of the lease over its entire term and to plan for changes in clients' business plans by making the leases more flexible. This article examines selected practical issues in flexibility and makes recommendations for negotiating stronger leases from the retailers' perspective.

First, a practice note. The deal makers ' landlords, prospective retailers and retail brokers ' often negotiate letters of intent or term sheets that lay out in eloquent detail the rental rate, rental term and other traditional “business terms” of a pending lease without addressing some of the issues discussed in this article. To the extent any of these issues are important to the retailer's business plan, it is usually wise to make note of them early in the lease negotiations rather than “leaving them to the lawyers” to work out later.

Use, Use Restrictions and Exclusive Uses

What will the retailer do with the store? What may the retailer not do? Who else may do the same thing in the same shopping center? Most retailers will want to retain as much flexibility in using leased space as possible. A retailer that agrees “to sell at retail only Pet Rocks and no other use whatsoever” will likely find that the store cannot sustain success for very long. On the other hand, very few landlords ' concerned as they reasonably are with tenant mix ' will adopt a laissez-faire attitude toward use, so a retailer is not likely to be successful in negotiating a use clause allowing “any activity permitted by applicable law.”

What, then, is the ideal approach? The key is to maintain as much flexibility for the retailer as possible so that over a 5- or 10-year or even longer lease term, the retailer is able to adapt to changes in the market and maintain economic viability. Of course, this approach can also be beneficial to the landlord, as the retailer's ability to adapt to market variables will tend to support higher sales and greater percentage rents.

Taking the Pet Rock example above, the retailer would be better off with a use clause that permits the sale of “novelty and gift items.” Similarly, a watchmaker may wish to seek authority to sell any type of “jewelry,” a clothing retailer should include authority to sell “shoes and accessories,” and a bookstore should be permitted to sell “periodicals, journals, stationery and greeting cards.” In each case, the retailer has an obvious core, but the additional language permits flexibility, opens a broader market and contributes to success over the long term.

Of course, the more generalized a retailer's use clause becomes, the less likely it will be that the retailer will be successful in negotiating an exclusive use right in the shopping center. Where a landlord is even open to negotiating an exclusive use (many are not), the key will be to negotiate a clause that protects a lucrative product, product line or sector that has long-term staying power, while leaving aside protections the landlord is not likely to grant or which are extraneous in the first place. After all, an exclusive to sell Pet Rocks has little value in the third, fourth or fifth year after introduction, but an exclusive to sell gold jewelry, for example, can be valuable over the long term.

Radius Restrictions

“We met in Starbucks. Not the same Starbucks, but we saw each other at different Starbucks ' across the street from each other.” “Best In Show,” Warner Brothers/Castle Rock Entertainment, 2000.

How close is too close?

A landlord negotiating with a prized retailer will frequently attempt to ensure that the retailer will not locate a competing store in proximity to the new store. There are two principal reasons. First, the landlord is concerned that a competing location will cannibalize sales and cut into percentage rent payments. Second, and more subtly, is a concern over traffic. Landlords prefer to keep control over their tenant mix in part to stimulate maximum traffic in the shopping center, with the intent of increasing sales centerwide.

There are two lessons for the retailer here. First, if the lease does not include a percentage rent element, then the landlord has very little leverage or reason for obtaining and enforcing a radius restriction. Simply put, even if another store affects sales, the landlord's bottom line is not directly affected, because the retailer always pays the same base rent.

Addressing the landlord's second concern is more complicated, but there are some touchstones worth considering. If the retailer's product line is high end and there is not a logical second location for a store, then it may make sense to concede a limited radius restriction. For example, a retailer of fine, exclusive jewelry may not have any prospect of opening a second store within a 3- or 5-mile radius, so it is not necessarily harmed in agreeing to a radius restriction. (There are, of course, some exceptions to this, and both current and projected demographics must ultimately drive the retailer's negotiations and decisions.) In some metropolitan areas especially, however, there may be two or more shopping centers where a retailer desires a presence ' to demonstrate market penetration and to serve a wider audience of customers more conveniently ' and where such situations exist, radius restrictions can be counterproductive. In any case where the retailer believes that two or more stores will generate appreciably greater sales and increased net profits, it should be loath to agree to a radius restriction, even if a particular store's sales may end up being lower. (Interestingly, this tends not always to be the case, eg, Starbucks, where existing stores in proximity to old stores frequently see increases in sales. Obviously, Starbucks is highly unlikely to agree to a radius restriction!)

When a retailer does agree to a radius restriction, it is usually wise to attach a time limit to it. Again, the idea is to maintain the retailer's viability and flexibility over the entire term of the lease. As the demographics of an area change, the retailer may regret being governed by a radius restriction it was initially willing to give. Therefore, seek to have the radius restriction extinguished ' or the actual radius reduced ' after a reasonable period of time.

Opening and Operating Covenants

The landlord will want assurances in the lease that the retailer will open the store on time and operate it throughout the term of the lease. Again, both percentage rent and customer traffic are concerns.

It is not unreasonable for the retailer to agree to open the store; after all, the retailer's intent is to make sales. However, there are a number of events that can affect the retailer's ability to open on time. Chief among these is construction delays. Therefore, the retailer should be cautious about agreeing to a specific opening date. Enough time will be necessary to design and fit out the space, stock it and train personnel. Even if the retailer is willing to agree to a date certain, it should mitigate the potential effect of this agreement by ensuring that any penalties for failure to open, often expressed as a number of dollars per day, do not begin to accrue until some time after that date ' ideally 30 days or more. The retailer's inability to open when anticipated will already affect its revenue, and the additional penalty is not necessary as an incentive. Since the landlord may also be suffering from lost percentage rent in this situation, though, it will not always be possible to eliminate the late opening fee entirely. Finally with respect to opening, if the retailer is opening a store in a new shopping center, it should never be required to open for business unless a majority of the shopping center, including the anchors, have opened or open simultaneously.

When initially negotiating the lease, retailers will have a keen awareness of the statistics affecting the shopping center, but those demographics may change over time. For example, the demographics of the neighborhood may change or the retailer mix of the shopping center may become less favorable. Recognizing this, retailers would be well served by negotiating an option to go dark or terminate the lease at some specified point or points during the lease term (such options to be exercised freely or to be tied to sales figures). If a particular retailer mix is important to the retailer, it might also be wise to negotiate a co-tenancy provision allowing the retailer to terminate the lease if another retailer or mix of retailers fails to continue operating in the shopping center.

Once open, the landlord seeks to ensure that the space will continue to generate sales and will not go dark ' both to maintain percentage rents and to project the image of a vibrant center. Therefore, many landlords' form leases will contain continuous use clauses. Under that clause, landlords seek to force the retailer to operate, even if the retailer determines it is better off closing the store and continuing to pay rent. Landlords seek to enforce this provision either by imposing a daily fee for failure to operate or by obtaining an injunction ordering the retailer to operate. Under most state laws, the daily fee will be enforceable. In many states, however, the courts will refuse to grant an injunction to force a struggling retailer to operate, so there is little justification for including the language in the lease. Where a retailer is willing to include the fee language, a reasonable fee (rather than a punitive penalty) should be negotiated. In such situations, it will also frequently be useful for the retailer to have flexible assignment and sublease provisions in the lease.

Assignment and Subleasing

A sophisticated retailer may find at some point during the term of the lease that it would be desirable to close a location rather than continue to operate it with a miniscule profit, or worse, at a loss. Where the retailer would be penalized for violating a covenant to operate continuously, however, the ability to assign or sublet the premises may provide an alternative. (Subleasing may also be desirable where the retailer intends to continue occupying a portion of the space, but the more typical situation is where a retailer wants out of the space entirely.)

A typical landlord's form lease will likely say that a retailer may not assign or sublease the premises without the landlord's consent. In some states, this language will imply that the landlord's consent may not be unreasonably withheld; but in other states, the language will give the landlord a unilateral right to withhold consent. Some form leases will go so far as to say the landlord may withhold consent in its sole discretion. In such circumstances, the retailer may find it is out of options. Ideally, the retailer would negotiate an absolute right to assign or sublease, but the landlord, rightly concerned with its retailer mix, likely will not assent to this provision. The compromise, then, is to insert language saying that the landlord's consent to assignment and subleasing “will not be unreasonably withheld, conditioned or delayed.” In such circumstances, the landlord will then have the burden of proving that its refusal to consent was reasonable. Retailers that are part of a larger retailing family may also find it useful to obtain ' and many landlords will be more willing to grant ' language in the lease permitting assignment and subleasing to the retailer's affiliates and/or successors.

Finally, some leases may set out objective criteria that must be satisfied before the lease may be transferred. These may include net worth measurements, product line requirements, experience durations and the like. A savvy retailer negotiating such terms should keep in mind that if it is in a position where it needs to offload the lease, it will not want to be guaranteeing the landlord a better position than it originally negotiated; so the net worth requirement, for example, should not exceed the net worth of the retailer at the time it originally negotiated the lease.

Conclusion

A lease has life over a term of years, and a successful retailer's business is not static. A single brief article obviously cannot cover all the items a retailer must consider when negotiating an in-line lease. However, with a keen eye toward the items covered above, the retailer's business personnel and counsel will be well on their way to crafting a reasonable lease that gives the retailer the flexibility it needs to be successful over the entire term of the lease.