Revisiting Credit Support in Early Sale Transactions

Second, once the applicable tenants are identified, the opening co-tenancy support amount should be established. The opening co-tenancy support amount will be the difference between the alternative rental amount actually paid by the tenants entitled to opening co-tenancy relief and the full amount of rental such tenants would pay in the absence of the applicable opening co-tenancy provision.

However, because reduced rental payments in connection with failed opening co-tenancy conditions are often structured as a percentage of the benefited tenant's gross sales, the exact amount of the opening co-tenancy support payments will not be known at the time of closing. Moreover, the uncertain nature of the amount of the opening co-tenancy support payment will also impact the timing of the seller's opening co-tenancy support payments to the purchaser. If a tenant's reduced rental payment is tied to a percentage of gross sales, then such tenant's rent payment for any particular month, say January, will not be ascertained until after the tenant has reported its January sales. If the tenant is afforded 20 or 30 days after the end of each month to report sales, then the seller will likely not know the amount of its opening co-tenancy support payment for January with respect to such tenant until the end of February.

Accordingly, in order to ascertain the exact amount of its opening co-tenancy support obligations, the opening co-tenancy support amount should be payable only after the applicable tenants are required to make their respective payments of reduced rental. As a result, the seller's opening co-tenancy support amount for any particular month will likely be paid in more than one installment. Similar to the income support scenario, a purchaser is not likely to be satisfied with the deferred payment of rental by two months or more. Accordingly, the parties can agree to make opening co-tenancy support payments in advance on the first day of each month in an estimated amount. If the tenant has meaningful historical sales figures for its store in the shopping center or if reliable comparable-store sales are available, then the parties can make an educated guess as to the likely amount of such tenant's reduced rental. In such scenario, the seller can make an estimated payment to the purchaser, and the parties can reconcile the estimated payment with the actual liability at such time as the actual liability is established.

Additionally, the parties should establish the duration of the opening co-tenancy support period. The opening co-tenancy support period should commence at closing and continue until the earlier to occur of the date the co-tenancy requirements for each of the specified tenants entitled to co-tenancy relief at closing have been satisfied and an outside date certain. When determining whether a tenant's opening co-tenancy requirements have been satisfied, the seller should argue that all tenants open as of the closing date should be deemed to be open at all times during the duration of the opening co-tenancy support period. If a tenant's lease requires that 75% of the floor area of the shopping center be open for business to satisfy its opening co-tenancy conditions and only 70% of the floor area of the shopping center is open at closing, then the seller should only be required to open an additional 5% of the floor area of the shopping center in order to be released from making any further opening co-tenancy support payments with respect to such tenant. If tenants leasing 3% of the floor area of the shopping center were to close for business after closing and prior to the date the additional 5% of floor area opens for business, then the shopping center would only be 72% open at the time the seller has opened such additional 5% of floor area. For the underwriting reasons discussed above, because the 3% closure occurs post-closing, the risk of such post-closing tenant default should rest with the purchaser, and such vacated space should be considered open for purposes of determining whether the seller has satisfied its opening co-tenancy requirements.

In determining an appropriate sunset period for the opening co-tenancy support payments, similar to the income support context, the purchaser has the operational, management, and marketing control of the shopping center. If the shopping center is mismanaged after closing, the seller's ability to lease vacant space in the project post-closing is adversely affected. Moreover, if the opening co-tenancy provisions in the project leases were structured with sunset provisions on the applicable tenants' economic relief, such tenants would be required, after a specified period of time, either to terminate their leases or commence paying full rental. At a minimum, the seller should argue for a sunset on its opening co-tenancy support obligations that corresponds with the sunset in the opening co-tenancy provisions of the applicable leases.

Additional Considerations

Once the mechanics of the opening co-tenancy support have been negotiated, the seller should reserve for itself two of the landlord's rights under the leases. First, the seller should retain the right to audit and inspect the monthly gross sales statements of each tenant whose economic opening co-tenancy relief is tied to a percentage of gross sales to ensure that such tenant pays the correct amount of opening co-tenancy alternative rent. If a tenant understates its monthly gross sales, such tenant's opening co-tenancy alternative rent is reduced, thereby resulting in an overpayment by the seller of the opening co-tenancy support amount. Because the purchaser is receiving the same amount of money each month with respect to such tenant's lease (with the source of the funds allocated between the tenants and the seller), the purchaser has no incentive to spend the time or money to audit the tenant's gross sales statements. Accordingly, the seller should reserve such audit rights, through an express reservation in the assignment of leases, to conduct gross sales audits to the extent permitted in the applicable leases.

Also, the seller should reserve the right to enforce the opening and operating covenants of all tenants at the shopping center and reserve the right to pursue such tenants for opening and operating defaults. If a tenant fails to open on time and operate under its lease, such failure may adversely impact the seller's ability to satisfy the opening co-tenancy requirements contained in other tenants' leases, thereby extending the seller's opening co-tenancy support obligations. In such event, the purchaser again is indifferent, inasmuch as the economic burden of such failure to open (i.e., the continued payment of opening co-tenancy alternative rent by other tenants) is borne by the seller. As a result, the seller should reserve the right to enforce the opening and operating covenants of all tenants, thereby providing the seller the requisite authority to pursue specific performance or other remedies against a tenant that fails to open in accordance with the terms of its lease. Again, such a reservation will likely exclude termination or eviction proceedings.

Finally, the parties may be required to address what happens if a tenant whose opening co-tenancy conditions had not been satisfied at closing terminates its lease pursuant to its opening co-tenancy clause. If the seller has successfully negotiated a sunset provision on its opening co-tenancy support obligations, the seller should propose that it continue making its opening co-tenancy support payments until such space is back-filled and again becomes income producing or until its opening co-tenancy support obligations otherwise cease pursuant to the negotiated sunset. Alternatively, the parties could negotiate something akin to a termination fee, whereby the seller makes a lump sum payment to the purchaser. Such a lump sum could be established as the rental payments such tenant would be required to make over a certain period of time.

Conclusion

In an investment environment that encourages the early sale of shopping center properties, carefully structuring post-closing income support and opening co-tenancy support obligations can allow the seller to provide credit support prudently to the purchaser. Such credit support should be designed to reduce or eliminate the income drag attributable to vacant space and opening co-tenancy-based rental reductions, thereby maximizing the sale price of the project to the seller.

In early sale transactions, particularly those involving lifestyle shopping centers, the seller may be faced with the prospect of closing the transaction prior to the date on which each of the tenants' opening co-tenancy conditions have been satisfied. To the extent that a tenant's opening co-tenancy conditions have not been satisfied, such tenant, if open, is likely paying a reduced rental, whether tied to a percentage of minimum rent or a percentage of gross sales. Sometimes the reduced rental applies only to minimum rent; other times it includes common area charges, insurance, and taxes. As a result, the project is not generating its maximum level of income, thereby resulting in a lower income stream for the purchaser at closing. To avoid a reduction in the purchase price as a result of such opening co-tenancy rental relief, the seller can make post-closing payments to close this income gap.

Mechanics

Similar to the income support mechanics, the parties will need to establish a number of procedures to address the seller's opening co-tenancy support obligations. First, the parties should identify those tenants which, as of the closing date, are not required to open or are entitled to pay a reduced rental as a result of the failure of an opening co-tenancy condition. The seller's objective in this regard is to designate the specific tenants with respect to which the seller will be required to make opening co-tenancy support payments. By establishing the seller's opening co-tenancy support obligations with a defined universe of tenants, the seller can more easily quantify the cost and extent of its post-closing opening co-tenancy support obligations. Moreover, it eliminates the possibility that the seller becomes responsible for opening co-tenancy support payments for additional tenants for unforeseen reasons. For example, at closing one or more leases may be signed but not income producing. The opening co-tenancy requirements may be satisfied with respect to such leases at the time of closing, but prior to such time as the tenant under such lease opens for business, one or more tenants cease operating at the project. As a result of such closure, the tenant under such lease may then be allowed to pay a reduced opening co-tenancy rental. Inasmuch as the seller would not bear the risk of post-closing tenant closures if the project were sold when fully income producing, the seller should not bear such risk in the early sale transaction.

Second, once the applicable tenants are identified, the opening co-tenancy support amount should be established. The opening co-tenancy support amount will be the difference between the alternative rental amount actually paid by the tenants entitled to opening co-tenancy relief and the full amount of rental such tenants would pay in the absence of the applicable opening co-tenancy provision.

However, because reduced rental payments in connection with failed opening co-tenancy conditions are often structured as a percentage of the benefited tenant's gross sales, the exact amount of the opening co-tenancy support payments will not be known at the time of closing. Moreover, the uncertain nature of the amount of the opening co-tenancy support payment will also impact the timing of the seller's opening co-tenancy support payments to the purchaser. If a tenant's reduced rental payment is tied to a percentage of gross sales, then such tenant's rent payment for any particular month, say January, will not be ascertained until after the tenant has reported its January sales. If the tenant is afforded 20 or 30 days after the end of each month to report sales, then the seller will likely not know the amount of its opening co-tenancy support payment for January with respect to such tenant until the end of February.

Accordingly, in order to ascertain the exact amount of its opening co-tenancy support obligations, the opening co-tenancy support amount should be payable only after the applicable tenants are required to make their respective payments of reduced rental. As a result, the seller's opening co-tenancy support amount for any particular month will likely be paid in more than one installment. Similar to the income support scenario, a purchaser is not likely to be satisfied with the deferred payment of rental by two months or more. Accordingly, the parties can agree to make opening co-tenancy support payments in advance on the first day of each month in an estimated amount. If the tenant has meaningful historical sales figures for its store in the shopping center or if reliable comparable-store sales are available, then the parties can make an educated guess as to the likely amount of such tenant's reduced rental. In such scenario, the seller can make an estimated payment to the purchaser, and the parties can reconcile the estimated payment with the actual liability at such time as the actual liability is established.

Additionally, the parties should establish the duration of the opening co-tenancy support period. The opening co-tenancy support period should commence at closing and continue until the earlier to occur of the date the co-tenancy requirements for each of the specified tenants entitled to co-tenancy relief at closing have been satisfied and an outside date certain. When determining whether a tenant's opening co-tenancy requirements have been satisfied, the seller should argue that all tenants open as of the closing date should be deemed to be open at all times during the duration of the opening co-tenancy support period. If a tenant's lease requires that 75% of the floor area of the shopping center be open for business to satisfy its opening co-tenancy conditions and only 70% of the floor area of the shopping center is open at closing, then the seller should only be required to open an additional 5% of the floor area of the shopping center in order to be released from making any further opening co-tenancy support payments with respect to such tenant. If tenants leasing 3% of the floor area of the shopping center were to close for business after closing and prior to the date the additional 5% of floor area opens for business, then the shopping center would only be 72% open at the time the seller has opened such additional 5% of floor area. For the underwriting reasons discussed above, because the 3% closure occurs post-closing, the risk of such post-closing tenant default should rest with the purchaser, and such vacated space should be considered open for purposes of determining whether the seller has satisfied its opening co-tenancy requirements.

In determining an appropriate sunset period for the opening co-tenancy support payments, similar to the income support context, the purchaser has the operational, management, and marketing control of the shopping center. If the shopping center is mismanaged after closing, the seller's ability to lease vacant space in the project post-closing is adversely affected. Moreover, if the opening co-tenancy provisions in the project leases were structured with sunset provisions on the applicable tenants' economic relief, such tenants would be required, after a specified period of time, either to terminate their leases or commence paying full rental. At a minimum, the seller should argue for a sunset on its opening co-tenancy support obligations that corresponds with the sunset in the opening co-tenancy provisions of the applicable leases.

Additional Considerations

Once the mechanics of the opening co-tenancy support have been negotiated, the seller should reserve for itself two of the landlord's rights under the leases. First, the seller should retain the right to audit and inspect the monthly gross sales statements of each tenant whose economic opening co-tenancy relief is tied to a percentage of gross sales to ensure that such tenant pays the correct amount of opening co-tenancy alternative rent. If a tenant understates its monthly gross sales, such tenant's opening co-tenancy alternative rent is reduced, thereby resulting in an overpayment by the seller of the opening co-tenancy support amount. Because the purchaser is receiving the same amount of money each month with respect to such tenant's lease (with the source of the funds allocated between the tenants and the seller), the purchaser has no incentive to spend the time or money to audit the tenant's gross sales statements. Accordingly, the seller should reserve such audit rights, through an express reservation in the assignment of leases, to conduct gross sales audits to the extent permitted in the applicable leases.

Also, the seller should reserve the right to enforce the opening and operating covenants of all tenants at the shopping center and reserve the right to pursue such tenants for opening and operating defaults. If a tenant fails to open on time and operate under its lease, such failure may adversely impact the seller's ability to satisfy the opening co-tenancy requirements contained in other tenants' leases, thereby extending the seller's opening co-tenancy support obligations. In such event, the purchaser again is indifferent, inasmuch as the economic burden of such failure to open (i.e., the continued payment of opening co-tenancy alternative rent by other tenants) is borne by the seller. As a result, the seller should reserve the right to enforce the opening and operating covenants of all tenants, thereby providing the seller the requisite authority to pursue specific performance or other remedies against a tenant that fails to open in accordance with the terms of its lease. Again, such a reservation will likely exclude termination or eviction proceedings.

Finally, the parties may be required to address what happens if a tenant whose opening co-tenancy conditions had not been satisfied at closing terminates its lease pursuant to its opening co-tenancy clause. If the seller has successfully negotiated a sunset provision on its opening co-tenancy support obligations, the seller should propose that it continue making its opening co-tenancy support payments until such space is back-filled and again becomes income producing or until its opening co-tenancy support obligations otherwise cease pursuant to the negotiated sunset. Alternatively, the parties could negotiate something akin to a termination fee, whereby the seller makes a lump sum payment to the purchaser. Such a lump sum could be established as the rental payments such tenant would be required to make over a certain period of time.

Conclusion

In an investment environment that encourages the early sale of shopping center properties, carefully structuring post-closing income support and opening co-tenancy support obligations can allow the seller to provide credit support prudently to the purchaser. Such credit support should be designed to reduce or eliminate the income drag attributable to vacant space and opening co-tenancy-based rental reductions, thereby maximizing the sale price of the project to the seller.