Revisiting Credit Support in Early Sale Transactions

In contrast, in an earn-out transaction, only the portion of the purchase price attributable to the income-producing space is paid at closing, with the purchaser making future purchase price installment payments as tenants of previously vacant space commence rent payments. Accordingly, the seller would have a strong preference for the front-loaded purchase price feature offered by the income-support transaction. In addition, because the income-support transaction does not involve a master lease, which is required to be repeatedly amended (with appropriate lender and other consents obtained) as vacant space is leased, the income-support feature has the opportunity to present fewer administrative burdens than a master lease transaction.

Mechanics

Once the parties agree to structure the sale transaction with an income-support feature, a number of mechanics will need to be established. First, the parties should agree upon the amount of space that is required to be income producing. The seller's objective in this regard is to establish an additional number of square feet, which must initially become income producing after closing in order to release the seller from its income-support obligations. In other words, if the parties negotiate a purchase price assuming that 400,000 square feet of a 500,000 square foot shopping center will be income producing at closing and only 325,000 square feet is actually income producing at closing, then the seller should initially be required to make income-support payments on 75,000 square feet of vacant space (i.e., the difference between the 325,000 square feet of income-producing space at closing, and the 400,000 square feet assumed to be income producing at closing).

Alternatively, the purchaser should be expected to require that a total number of square feet be income producing (i.e., 400,000) in order to release the seller from its income-support obligations. The resolution of this subtle distinction determines the party that will bear the risk of post-closing tenant defaults. If the seller is required to attain a total number of income-producing square feet (i.e., 400,000) within the project, rather than to cause an additional number of square feet (i.e., 75,000) initially to become income producing after closing, then the seller would be responsible for back-filling any space vacated by tenants that default after closing. Inasmuch as the purchaser has underwritten its purchase offer for the shopping center on the basis of, among other things, its credit analysis of the project's tenants, the burden of post-closing tenant default should be placed on the purchaser. Such a result is consistent with the risk burden placed on the purchaser of a fully leased shopping center and should be no different in the early sale transaction. Accordingly, the seller should be careful to establish its post-closing income-support obligations on causing an additional number of square feet of space to become income producing initially rather than causing a total number of square feet of space to be income producing.

Second, the parties will need to establish the appropriate level of income support. The support amount would typically include payments of base rent, common area charges, insurance, and taxes. Payments for common area charges, insurance, and taxes should be based on budgeted amounts for the current calendar year and expressed in dollars per square foot per day. In addition, the parties may agree to negotiate a true-up based on actual expenses incurred. Base rent support payments can be tied either to average pro-forma rents on the vacant space or on the average base rent payable by the existing project tenants, with the latter more likely to be favorable to the seller. Once the support payment for base rent is determined, it, too, should be expressed in dollars per square foot per day. As a result, the parties will have established a full support amount that can be calculated daily on the basis of the number of the required square feet that are not then income producing.

Third, the parties will need to establish the timing of the support payments. The seller would naturally prefer the support payments to be paid in arrears within a short period of time after the end of each calendar month based on the actual portion of the incremental space not income producing for the prior month. Often, however, the purchaser will require such payments to be made monthly, in advance, in an estimated amount, as though the space were leased to rent-paying tenants. In this scenario, the parties should provide for a quick reconciliation of the estimated income-support payment following the end of each calendar month during the support period.

Fourth, the seller should negotiate the length of the period during which the seller must make income-support payments. This period would commence on the date of closing and would continue until the earlier to occur of the date the required vacant space becomes income producing and an outside date certain, without regard to whether the required level of income-producing space has been achieved. After closing, the seller loses control of the operation, management, and marketing of the shopping center to the purchaser. While the seller should be required to use its good faith efforts to lease vacant space in the project, it is not enough to market space in the project aggressively if the project itself is being mismanaged. Accordingly, it is important for the seller to negotiate an outside date, perhaps 12-to 18-months after closing, on which the seller's obligation to provide income support should end.

Post Closing Rights, Responsibilities, and Reservations

After the mechanics have been finalized, the parties will need to focus on their respective post-closing leasing rights, responsibilities, and reservations. In order to secure tenants for the vacant space in the project, the seller should have the right to act as the purchaser's exclusive leasing agent for the project, fielding all inquiries and screening all prospective tenants. Once the seller identifies a suitable prospective tenant, the seller will need to be able to move quickly to negotiate and finalize a lease transaction with such prospect. Accordingly, the purchase agreement should identify a number of leasing parameters, which, if satisfied, would permit the seller to fully negotiate a lease with the prospective tenant, without requiring the consent of the purchaser. Customary parameters would include rental rates in excess of an agreed amount, improvement allowances below an agreed amount, minimum term length, and the lease form.

If a prospective tenant satisfies each of the established criteria and utilizes the project lease form (with changes similar to those negotiated by other tenants at the project), then the purchaser would have no approval rights with respect to the lease and should be required to sign it within a short period of time, perhaps three-to five-business days after the seller presents the lease to the purchaser for execution. Moreover, to the extent the seller is negotiating leases with tenants at the time the purchase and sale agreement is signed, the parties should identify such prospective tenants, and the purchaser should pre-approve the leases with such tenants upon the terms contained in the most current lease draft. Such pre-approval will streamline the leasing process and enable the seller to convert prospective tenants into signed tenants more quickly, thereby accelerating the end of the seller's income-support obligations with respect to the vacant space.

Additionally, the purchase agreement should clearly identify the party responsible for costs associated with such post-closing leasing. Presumably, the seller would bear the cost of all brokerage commissions, legal fees, improvement allowances, and related leasing expenditures. However, the purchaser may require that certain estimated payments for brokerage commissions and improvement allowances be credited to the purchaser at closing, inasmuch as these items, if unpaid by the seller, could result in the filing of a lien against the property. In such event, the parties must be clear that if the purchaser fails to pay any credited construction allowance that is due and owing to a tenant as a condition of rent commencement, then the seller should be released from its obligations to make income support payments with respect to the space leased by such tenants, notwithstanding the purchaser's failure to pay the construction allowance, provided all other conditions to rent commencement have been satisfied. Also, if the lease that demises the balance of the then-unleased portion of the vacant space also demises additional square footage in the shopping center, then the costs incurred by the seller in connection with such lease transaction should be prorated between the purchaser and the seller, with the numerator being the then-unleased portion of the vacant space and the denominator being the total floor area demised by such lease.

Finally, the seller should reserve to itself certain access and enforcement rights in the purchase agreement and in the assignment of leases signed at closing. Because the seller will be the party responsible for the cost of leasing expenses, to the extent any lease, which is not income producing as of the closing date, requires the landlord to construct any leasehold improvements for the tenant, the seller would likely be the appropriate party to perform such construction. Accordingly, the purchase agreement should grant post-closing access rights to the seller to permit the seller to construct and install such improvements.

Furthermore, if a tenant under a lease that is not income producing at closing fails to timely commence the payment of rental under its lease, then the seller's income support obligations would continue until such time as the tenant commences payment of rental. Inasmuch as the purchaser is collecting income for the space from the seller, the purchaser does not have a meaningful incentive to pursue any remedy for breach against such nonpaying tenant. Therefore, the purchase agreement should reserve to the seller the right to enforce the terms of leases that are executed by the purchaser after the closing. Such a reservation will provide the seller the requisite authority to pursue specific performance or other remedies against a defaulting tenant in an effort to relieve the seller of its income-support obligations. A similar reservation should be included in the assignment of leases executed at closing with respect to those leases that have been signed but have not become income producing as of the closing date. The seller, however, should expect the sophisticated purchaser to exclude specifically, in each case, termination or eviction proceedings from the seller's enforcement rights.

Summary

By carefully establishing income-support mechanics and allocating the requisite post-closing leasing rights and responsibilities, the seller can simultaneously maximize its sale price in an early sale transaction and control its post-closing liabilities.

The final installment of this series will address 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 Two of a Three-Part Series

Part One of this three-part article discussed credit support transactions in general. This installment concentrates on income support.

In an early sale transaction, the purchaser and seller anticipate that a significant portion of the floor area of the project will not be income producing at the time of closing. As part of the transaction structure, the parties would negotiate a purchase price that assumes a certain portion of the project is occupied by rent-paying tenants at closing. To the extent that the income-producing space at closing is less than the assumed amount of income-producing space, the seller would make monthly rental payments to the purchaser, thereby enabling the purchaser to fully realize the income from the project, which is assumed to be in place at closing. By structuring the sale transaction in this manner, the seller is able to realize the full purchase price for the project at closing.

In contrast, in an earn-out transaction, only the portion of the purchase price attributable to the income-producing space is paid at closing, with the purchaser making future purchase price installment payments as tenants of previously vacant space commence rent payments. Accordingly, the seller would have a strong preference for the front-loaded purchase price feature offered by the income-support transaction. In addition, because the income-support transaction does not involve a master lease, which is required to be repeatedly amended (with appropriate lender and other consents obtained) as vacant space is leased, the income-support feature has the opportunity to present fewer administrative burdens than a master lease transaction.

Mechanics

Once the parties agree to structure the sale transaction with an income-support feature, a number of mechanics will need to be established. First, the parties should agree upon the amount of space that is required to be income producing. The seller's objective in this regard is to establish an additional number of square feet, which must initially become income producing after closing in order to release the seller from its income-support obligations. In other words, if the parties negotiate a purchase price assuming that 400,000 square feet of a 500,000 square foot shopping center will be income producing at closing and only 325,000 square feet is actually income producing at closing, then the seller should initially be required to make income-support payments on 75,000 square feet of vacant space (i.e., the difference between the 325,000 square feet of income-producing space at closing, and the 400,000 square feet assumed to be income producing at closing).

Alternatively, the purchaser should be expected to require that a total number of square feet be income producing (i.e., 400,000) in order to release the seller from its income-support obligations. The resolution of this subtle distinction determines the party that will bear the risk of post-closing tenant defaults. If the seller is required to attain a total number of income-producing square feet (i.e., 400,000) within the project, rather than to cause an additional number of square feet (i.e., 75,000) initially to become income producing after closing, then the seller would be responsible for back-filling any space vacated by tenants that default after closing. Inasmuch as the purchaser has underwritten its purchase offer for the shopping center on the basis of, among other things, its credit analysis of the project's tenants, the burden of post-closing tenant default should be placed on the purchaser. Such a result is consistent with the risk burden placed on the purchaser of a fully leased shopping center and should be no different in the early sale transaction. Accordingly, the seller should be careful to establish its post-closing income-support obligations on causing an additional number of square feet of space to become income producing initially rather than causing a total number of square feet of space to be income producing.

Second, the parties will need to establish the appropriate level of income support. The support amount would typically include payments of base rent, common area charges, insurance, and taxes. Payments for common area charges, insurance, and taxes should be based on budgeted amounts for the current calendar year and expressed in dollars per square foot per day. In addition, the parties may agree to negotiate a true-up based on actual expenses incurred. Base rent support payments can be tied either to average pro-forma rents on the vacant space or on the average base rent payable by the existing project tenants, with the latter more likely to be favorable to the seller. Once the support payment for base rent is determined, it, too, should be expressed in dollars per square foot per day. As a result, the parties will have established a full support amount that can be calculated daily on the basis of the number of the required square feet that are not then income producing.

Third, the parties will need to establish the timing of the support payments. The seller would naturally prefer the support payments to be paid in arrears within a short period of time after the end of each calendar month based on the actual portion of the incremental space not income producing for the prior month. Often, however, the purchaser will require such payments to be made monthly, in advance, in an estimated amount, as though the space were leased to rent-paying tenants. In this scenario, the parties should provide for a quick reconciliation of the estimated income-support payment following the end of each calendar month during the support period.

Fourth, the seller should negotiate the length of the period during which the seller must make income-support payments. This period would commence on the date of closing and would continue until the earlier to occur of the date the required vacant space becomes income producing and an outside date certain, without regard to whether the required level of income-producing space has been achieved. After closing, the seller loses control of the operation, management, and marketing of the shopping center to the purchaser. While the seller should be required to use its good faith efforts to lease vacant space in the project, it is not enough to market space in the project aggressively if the project itself is being mismanaged. Accordingly, it is important for the seller to negotiate an outside date, perhaps 12-to 18-months after closing, on which the seller's obligation to provide income support should end.

Post Closing Rights, Responsibilities, and Reservations

After the mechanics have been finalized, the parties will need to focus on their respective post-closing leasing rights, responsibilities, and reservations. In order to secure tenants for the vacant space in the project, the seller should have the right to act as the purchaser's exclusive leasing agent for the project, fielding all inquiries and screening all prospective tenants. Once the seller identifies a suitable prospective tenant, the seller will need to be able to move quickly to negotiate and finalize a lease transaction with such prospect. Accordingly, the purchase agreement should identify a number of leasing parameters, which, if satisfied, would permit the seller to fully negotiate a lease with the prospective tenant, without requiring the consent of the purchaser. Customary parameters would include rental rates in excess of an agreed amount, improvement allowances below an agreed amount, minimum term length, and the lease form.

If a prospective tenant satisfies each of the established criteria and utilizes the project lease form (with changes similar to those negotiated by other tenants at the project), then the purchaser would have no approval rights with respect to the lease and should be required to sign it within a short period of time, perhaps three-to five-business days after the seller presents the lease to the purchaser for execution. Moreover, to the extent the seller is negotiating leases with tenants at the time the purchase and sale agreement is signed, the parties should identify such prospective tenants, and the purchaser should pre-approve the leases with such tenants upon the terms contained in the most current lease draft. Such pre-approval will streamline the leasing process and enable the seller to convert prospective tenants into signed tenants more quickly, thereby accelerating the end of the seller's income-support obligations with respect to the vacant space.

Additionally, the purchase agreement should clearly identify the party responsible for costs associated with such post-closing leasing. Presumably, the seller would bear the cost of all brokerage commissions, legal fees, improvement allowances, and related leasing expenditures. However, the purchaser may require that certain estimated payments for brokerage commissions and improvement allowances be credited to the purchaser at closing, inasmuch as these items, if unpaid by the seller, could result in the filing of a lien against the property. In such event, the parties must be clear that if the purchaser fails to pay any credited construction allowance that is due and owing to a tenant as a condition of rent commencement, then the seller should be released from its obligations to make income support payments with respect to the space leased by such tenants, notwithstanding the purchaser's failure to pay the construction allowance, provided all other conditions to rent commencement have been satisfied. Also, if the lease that demises the balance of the then-unleased portion of the vacant space also demises additional square footage in the shopping center, then the costs incurred by the seller in connection with such lease transaction should be prorated between the purchaser and the seller, with the numerator being the then-unleased portion of the vacant space and the denominator being the total floor area demised by such lease.

Finally, the seller should reserve to itself certain access and enforcement rights in the purchase agreement and in the assignment of leases signed at closing. Because the seller will be the party responsible for the cost of leasing expenses, to the extent any lease, which is not income producing as of the closing date, requires the landlord to construct any leasehold improvements for the tenant, the seller would likely be the appropriate party to perform such construction. Accordingly, the purchase agreement should grant post-closing access rights to the seller to permit the seller to construct and install such improvements.

Furthermore, if a tenant under a lease that is not income producing at closing fails to timely commence the payment of rental under its lease, then the seller's income support obligations would continue until such time as the tenant commences payment of rental. Inasmuch as the purchaser is collecting income for the space from the seller, the purchaser does not have a meaningful incentive to pursue any remedy for breach against such nonpaying tenant. Therefore, the purchase agreement should reserve to the seller the right to enforce the terms of leases that are executed by the purchaser after the closing. Such a reservation will provide the seller the requisite authority to pursue specific performance or other remedies against a defaulting tenant in an effort to relieve the seller of its income-support obligations. A similar reservation should be included in the assignment of leases executed at closing with respect to those leases that have been signed but have not become income producing as of the closing date. The seller, however, should expect the sophisticated purchaser to exclude specifically, in each case, termination or eviction proceedings from the seller's enforcement rights.

Summary

By carefully establishing income-support mechanics and allocating the requisite post-closing leasing rights and responsibilities, the seller can simultaneously maximize its sale price in an early sale transaction and control its post-closing liabilities.

The final installment of this series will address 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.