Revisiting Credit Support in Early Sale Transactions

In another transaction structure, the seller can retain leasing risk by master-leasing most, if not all, of the vacant square footage of the project from the purchaser at closing. As such vacant space is leased to third-party tenants, the master lease is amended to remove such leased space from the master-lease premises, and the seller's rent obligations with respect to such removed space terminate at such time as the incoming space tenant commences payment of its rent obligations.

A third technique contemplates the seller making certain monthly payments to the purchaser after closing with respect to all or a portion of the vacant space or other income-challenged space in the project. Transactions with a credit support feature offer a number of advantages to the seller. Moreover, they provide the flexibility to address more cleanly certain 'drags' on income that may be present in the early sale of a shopping center than with a typical newly developed office building or industrial project. This three-part article focuses on the credit support transaction, identifying the advantages to the seller, the pitfalls to the unwary, and the mechanics that should be carefully negotiated as part of the purchase and sale agreement.

Early Sale Transactions

Not infrequently, shopping centers that are the subject of early sale transactions will present two different, but related, challenges to the seller. First, by virtue of the timing of the sale, the project will be less than fully income producing, leaving a potentially significant gap between the project rentals at closing and the projected project rentals once the project is fully leased. This gap, if not otherwise bridged, can result in the seller's failing to realize a substantial portion of the project's value. Second, depending on the nature of the project, the seller may have been required to provide opening co-tenancy rights to numerous tenants as an inducement to their joining the project. Such opening co-tenancy arrange-ments are most common in the development of lifestyle shopping centers and frequently require either certain named tenants, or tenants in 70% or more of the floor area of the project, to be open and operating. If either or both of such requirements are not met, then the tenant benefited by the opening co-tenancy clause would be entitled to delay opening its store and commencing payment of its rental obligations. Or, if required to open notwithstanding such opening co-tenancy failure, the tenant would be entitled to pay a reduced rental. Either scenario would further erode project income at the time the project is sold. To offset or minimize these head winds to income, the seller can make post-closing payments to the purchaser, not only for vacant space but also for rent reductions resulting from opening co-tenancy relief.

The next two installments will address income support and co-tenancy support.

James H. Marshall is a member of Daspin Aument, LLP, in Chicago and concentrates his practice in the area of commercial real estate development His practice includes all facets of development work, including acquisition, sale, leasing, financing, and entitlement for projects throughout the Midwest and across the country.

Part One of a Three-Part Series

The current popularity of real estate as an investment class has fostered a favorable environment for the sale of shopping centers, among other properties. With demand seeming to outstrip supply and competition fierce among institutional purchasers, many shopping centers are now sold before the retail spaces therein are fully leased and income producing. Because institutional purchasers typically require a minimum level of return on their investment dollar, they typically will not accept full responsibility for the completion of project leasing. Accordingly, in such early sale transactions, sellers frequently retain some measure of post-closing leasing risk.

An early sale transaction can be structured in a number of ways to ascribe post-closing leasing risk to the seller. One such transaction structure is the earn-out sale, in which the seller is paid a capitalized amount for the leases that are income producing at the time of sale, with future portions of the purchase price to be paid over time, as leases become income producing. In earn-out sales, the seller retains the exclusive right to lease vacant portions of the project for an agreed period of time. Then, as tenants commence payment of rental for space that was not income producing at closing, the purchaser pays a capitalized amount based on the rent payable under such tenants' leases.

In another transaction structure, the seller can retain leasing risk by master-leasing most, if not all, of the vacant square footage of the project from the purchaser at closing. As such vacant space is leased to third-party tenants, the master lease is amended to remove such leased space from the master-lease premises, and the seller's rent obligations with respect to such removed space terminate at such time as the incoming space tenant commences payment of its rent obligations.

A third technique contemplates the seller making certain monthly payments to the purchaser after closing with respect to all or a portion of the vacant space or other income-challenged space in the project. Transactions with a credit support feature offer a number of advantages to the seller. Moreover, they provide the flexibility to address more cleanly certain 'drags' on income that may be present in the early sale of a shopping center than with a typical newly developed office building or industrial project. This three-part article focuses on the credit support transaction, identifying the advantages to the seller, the pitfalls to the unwary, and the mechanics that should be carefully negotiated as part of the purchase and sale agreement.

Early Sale Transactions

Not infrequently, shopping centers that are the subject of early sale transactions will present two different, but related, challenges to the seller. First, by virtue of the timing of the sale, the project will be less than fully income producing, leaving a potentially significant gap between the project rentals at closing and the projected project rentals once the project is fully leased. This gap, if not otherwise bridged, can result in the seller's failing to realize a substantial portion of the project's value. Second, depending on the nature of the project, the seller may have been required to provide opening co-tenancy rights to numerous tenants as an inducement to their joining the project. Such opening co-tenancy arrange-ments are most common in the development of lifestyle shopping centers and frequently require either certain named tenants, or tenants in 70% or more of the floor area of the project, to be open and operating. If either or both of such requirements are not met, then the tenant benefited by the opening co-tenancy clause would be entitled to delay opening its store and commencing payment of its rental obligations. Or, if required to open notwithstanding such opening co-tenancy failure, the tenant would be entitled to pay a reduced rental. Either scenario would further erode project income at the time the project is sold. To offset or minimize these head winds to income, the seller can make post-closing payments to the purchaser, not only for vacant space but also for rent reductions resulting from opening co-tenancy relief.

The next two installments will address income support and co-tenancy support.

James H. Marshall is a member of Daspin Aument, LLP, in Chicago and concentrates his practice in the area of commercial real estate development His practice includes all facets of development work, including acquisition, sale, leasing, financing, and entitlement for projects throughout the Midwest and across the country.