Leveraging Your Lease in These Turbulent Times

Given the current economic uncertainty, now is the time for retail landlords and tenants to put themselves in the strongest possible legal and economic position. A critical audit of lease rights and obligations can help do this. Using the steps below, a landlord or tenant can proactively evaluate where it currently stands, identify positions of strength and weakness, and execute on the strongest possible strategy to achieve this goal.

Step 1: Identify Your Weaknesses

Whether you are a tenant or a landlord, you will be on your best legal footing when you are in full compliance with your lease obligations ' in other words, you are not in default or on a course to create a default. Before you can effectively use the leverage that the current economic climate may provide, you must know your weaknesses and whether you are in default. Typically, the landlord will have the advantage of having fewer obligations under the lease, but an audit of those obligations can show both the way to improve a tenant's operation and the basis to request concessions. Often, maintenance and repair obligations of the landlord under a lease require that the tenant give notice and provide the landlord with a stated amount of time to fulfill its lease obligations (and, frequently, a tenant's only remedy is to perform a repair that the landlord was supposed to do and seek reimbursement for costs it incurs). Tenants, on the other hand, have a variety of provisions where they may be in default under a lease, even though the landlord has not notified the tenant of a default. A tenant will be significantly weakened when making a request for rent abatement or for a reduction in the size of the premises if the tenant is not in full compliance with its lease obligations. Conversely, a landlord should ensure that it is meeting all of its lease obligations, and it should investigate where a particular tenant may not be ' this may be the opening that the landlord needs to secure a modification of an exclusive use provision, to address leakages in operating cost reimbursements, to secure the release of a landlord's co-tenancy covenant, or to obtain consent to use the common area to generate revenue. Discovering a tenant default may also give a landlord the leverage it needs to fend off demands from a tenant that may adversely impact not only the landlord's current bottom line, but the long-term value of the property, as well.

Revisit Your Use Clause

The first item to audit to determine whether you are in default may be your use clause. If you are a tenant, your business may have changed during the term of your lease, and the goods, products, and services you are selling may be different from what you anticipated you would be selling when you negotiated the lease. This can create a problem, as landlords generally try to define a tenant's use narrowly.

Assume, for example, that a lease contained the following use clause:

Tenant may operate in the Premises solely for the purpose of offering athletic sporting goods and for no other use whatsoever.

If a sporting goods store has started offering products and services that are not technically considered sporting goods, the sale of those products and services may violate its use clause. Moreover, if a tenant is providing sports medicine services and products, the tenant may violate another tenant's exclusive for homeopathic remedies and treatments. Use clause violations may be particularly serious to a landlord because the exclusive uses granted to other tenants may allow those tenants to reduce rent or terminate their leases upon such a violation. The landlord may be forced to take action against the offending tenant to preserve the landlord's lease with the tenant whose exclusive is being violated. In this climate, both your landlord and other tenants with exclusives are likely to notice your additional products and services, and a tenant with a violated exclusive may seek to stop this use as a way to improve its performance in this challenging economic climate for retailers.

If a tenant finds itself in this situation, it is best to get the answers to a few questions. First, the tenant should determine whether a material amount of revenue is being generated from the prohibited goods or services and how much square footage is being utilized within the premises for the sale of these goods. Second, the exclusive uses set forth in the lease (frequently these are buried in an exhibit to the lease) should be reviewed to see whether the tenant is merely violating its own use clause or if it is also selling products or services that another tenant in the shopping center has the exclusive right to sell. Third, a survey should be made of the products and services offered by tenants that entered into leases after the date of the tenant's lease. If a tenant is selling some of the same products and services as a specialty retailer that came to the shopping center after the date of the tenant's lease, it is likely the landlord granted that specialty retailer an exclusive use and that the tenant's use clause is not broad enough to permit the tenant to continue the exclusive use.

If it turns out that no other tenant in the shopping center was granted an exclusive for the products or services in question ' and depending on the amount of revenue that a tenant is generating from these goods and services and the amount of space the tenant is using for them ' a better strategy to address the lease default (rather than simply ceasing to offer the products or services) may be to go to the landlord and ask that the permitted use clause be amended to allow the tenant to sell these products and services. While the landlord may be thrilled that the tenant is not asking for something that will diminish the landlord's income from the shopping center (i.e., rent abatement, a request to “right-size” its premises, etc.), a tenant should be prepared for the landlord to want something in return for this concession. If, however, the tenant is violating an exclusive granted to another tenant in the shopping center, a request to the landlord to amend the lease will likely not be in the tenant's best interests. In such a case, the landlord will no longer be able to plead ignorance to the tenant that has been granted this exclusive, and the landlord may be forced to take action to put the violating tenant in default. If continuing to offer these products or services is not vital, simply ceasing to sell these items will return the tenant to compliance under the lease. However, if the tenant's business is not viable without the revenue generated from these items, the tenant may have no choice but to approach the landlord to negotiate some relief. Now is the time to deal with this issue, as a landlord will likely want to make every effort to find a solution that is satisfactory to both the requesting tenant and the other affected tenant(s). In this market, landlords have strong incentives to preserve every lease with a rent-paying tenant, and they do not want to evict a tenant only to have to find a new tenant in a reduced market.

Co-tenancy Covenants

Some landlords, whether due to pressure to lease a center or a belief that creditworthy tenants at the time the lease was made would never fall into financial distress, have allowed tenants to negotiate operating co-tenancy covenants in their leases such as the following:

If at any time during the term of this Lease, Big Box Electronic Store and Brand A Grocery Store (the “Anchor Tenants”) cease operations at the Shopping Center, the Minimum Rent payable hereunder shall be reduced by fifty percent (50%). In the event that either of the Anchor Tenants shall cease operations for a period of six months in any twelve-month period, Tenant shall have the right to terminate the Lease.

Now that a number of large big box retailers in numerous locations have rejected leases in bankruptcy or have gone dark, it is time for both landlords and tenants to review the co-tenancy requirements in their leases closely. The sample co-tenancy requirement above is especially harsh on the landlord because the landlord has no way to cure the failure of the co-tenancy requirement by bringing a replacement tenant into the shopping center. A requesting tenant with this lease provision may have significant leverage to improve its economic condition.

Radius Clauses

If a tenant has opened new locations since the date of the lease, the parties should investigate whether the radius clause in the lease has been breached.

Insurance Requirements

Tenants should make sure that they continue to maintain all required insurance coverage under the lease and that they submit updated certificates to the parties required under the lease.

Signage

If a tenant has replaced its signage since the inception of the lease, the tenant should review whether the signage complies with the lease requirements and if any needed landlord consents were obtained.

Rules and Regulations

Landlords and tenants should review the rules and regulations required by the lease (including any updates) to determine whether the parties comply.

Step 2: Identify the Rights That You Have and the Rights That You Want

Once a landlord or tenant knows whether it is in full compliance or has identified where there may be an issue, it should review the lease again with an eye toward rights negotiated initially that are no longer as important. This knowledge will help the parties trade the deletion of one provision for relief from another or the addition of a new right. By giving up a termination right that is not as critical to its business, a tenant may allow the lease to be underwritten better and give the landlord an economic incentive to grant the tenant's requested concession. If a tenant believes that its business would remain strong, even if a key anchor went dark, then it may serve the tenant well to offer to delete this provision as consideration for a rent abatement or a reduction in the size of the premises. A tenant may view the prospect of reduced rent now as superior to the protection afforded by its current broad exclusive use provision. A key anchor in a shopping center that has the right to go dark and not continuously operate in the premises may have substantial leverage because the landlord may grant a concession to the anchor tenant, not only to avoid a large space being dark, but also to prevent the potential domino effect of the anchor being dark on other leases in the shopping center.

A landlord may offer a tenant an exclusive use provision or may modify the radius clause in a lease to secure a modification of the operating co-tenancy covenant. Due to unanticipated higher operating costs and taxes, and often low caps on the increase in operating expenses, some leases do not allow full reimbursement of the landlord's operating costs. This operating cost leakage can significantly impact the value of the property. A savvy landlord may want to take the position that it will forbear from exercising its rights for a tenant default (such as the revocation of an exclusive use provision) in exchange for the tenant's agreement to amend the lease to reset the base expense and allow the landlord to be reimbursed more fully for the tenant's actual pro rata share of expenses.

Step 3: Make the Deal

Once a lease has been audited and the best negotiating position determined, a deal can be made. In the current economic environment, many tenants would benefit by requesting concessions, and these requests may not be unanticipated. Landlords benefit when they can retain existing tenants and make them stronger. Landlords may be able to trade concessions for consents to different uses of a property that will increase revenue. Any negotiation with a tenant that results in more clearly defined lease rights and reduces ambiguity will aid underwriting and will be an advantage to the landlord when the property is sold or refinanced.

Conclusion

In the current tough times, it may seem difficult to justify incurring costs to audit leases critically and negotiate changes. The opposite may be true. Tenants may gain by using the bargaining power given them by the current economic situation. Making a request of a landlord without a full understanding of a tenant's lease obligations, however, can prevent a tenant from achieving the economic relief it needs and could have obtained. Similarly, landlords can use these requests as an opportunity. In order to be prepared to maximize the benefit (and reduce the loss), a landlord must evaluate its position under each lease critically before a concession is requested. A full understanding of a landlord's needs will allow the landlord to address the tenant's currents needs and improve the landlord's long-term position.

Jane Snoddy Smith, a member of this newsletter's Board of Editors, is a partner in Fulbright & Jaworski's Austin, TX, office. She focuses on transactional law with a concentration in commercial real estate. Bryan Patrick, an Associate in the same office, focuses on corporate and real estate law.

Given the current economic uncertainty, now is the time for retail landlords and tenants to put themselves in the strongest possible legal and economic position. A critical audit of lease rights and obligations can help do this. Using the steps below, a landlord or tenant can proactively evaluate where it currently stands, identify positions of strength and weakness, and execute on the strongest possible strategy to achieve this goal.

Step 1: Identify Your Weaknesses

Whether you are a tenant or a landlord, you will be on your best legal footing when you are in full compliance with your lease obligations ' in other words, you are not in default or on a course to create a default. Before you can effectively use the leverage that the current economic climate may provide, you must know your weaknesses and whether you are in default. Typically, the landlord will have the advantage of having fewer obligations under the lease, but an audit of those obligations can show both the way to improve a tenant's operation and the basis to request concessions. Often, maintenance and repair obligations of the landlord under a lease require that the tenant give notice and provide the landlord with a stated amount of time to fulfill its lease obligations (and, frequently, a tenant's only remedy is to perform a repair that the landlord was supposed to do and seek reimbursement for costs it incurs). Tenants, on the other hand, have a variety of provisions where they may be in default under a lease, even though the landlord has not notified the tenant of a default. A tenant will be significantly weakened when making a request for rent abatement or for a reduction in the size of the premises if the tenant is not in full compliance with its lease obligations. Conversely, a landlord should ensure that it is meeting all of its lease obligations, and it should investigate where a particular tenant may not be ' this may be the opening that the landlord needs to secure a modification of an exclusive use provision, to address leakages in operating cost reimbursements, to secure the release of a landlord's co-tenancy covenant, or to obtain consent to use the common area to generate revenue. Discovering a tenant default may also give a landlord the leverage it needs to fend off demands from a tenant that may adversely impact not only the landlord's current bottom line, but the long-term value of the property, as well.

Revisit Your Use Clause

The first item to audit to determine whether you are in default may be your use clause. If you are a tenant, your business may have changed during the term of your lease, and the goods, products, and services you are selling may be different from what you anticipated you would be selling when you negotiated the lease. This can create a problem, as landlords generally try to define a tenant's use narrowly.

Assume, for example, that a lease contained the following use clause:

Tenant may operate in the Premises solely for the purpose of offering athletic sporting goods and for no other use whatsoever.

If a sporting goods store has started offering products and services that are not technically considered sporting goods, the sale of those products and services may violate its use clause. Moreover, if a tenant is providing sports medicine services and products, the tenant may violate another tenant's exclusive for homeopathic remedies and treatments. Use clause violations may be particularly serious to a landlord because the exclusive uses granted to other tenants may allow those tenants to reduce rent or terminate their leases upon such a violation. The landlord may be forced to take action against the offending tenant to preserve the landlord's lease with the tenant whose exclusive is being violated. In this climate, both your landlord and other tenants with exclusives are likely to notice your additional products and services, and a tenant with a violated exclusive may seek to stop this use as a way to improve its performance in this challenging economic climate for retailers.

If a tenant finds itself in this situation, it is best to get the answers to a few questions. First, the tenant should determine whether a material amount of revenue is being generated from the prohibited goods or services and how much square footage is being utilized within the premises for the sale of these goods. Second, the exclusive uses set forth in the lease (frequently these are buried in an exhibit to the lease) should be reviewed to see whether the tenant is merely violating its own use clause or if it is also selling products or services that another tenant in the shopping center has the exclusive right to sell. Third, a survey should be made of the products and services offered by tenants that entered into leases after the date of the tenant's lease. If a tenant is selling some of the same products and services as a specialty retailer that came to the shopping center after the date of the tenant's lease, it is likely the landlord granted that specialty retailer an exclusive use and that the tenant's use clause is not broad enough to permit the tenant to continue the exclusive use.

If it turns out that no other tenant in the shopping center was granted an exclusive for the products or services in question ' and depending on the amount of revenue that a tenant is generating from these goods and services and the amount of space the tenant is using for them ' a better strategy to address the lease default (rather than simply ceasing to offer the products or services) may be to go to the landlord and ask that the permitted use clause be amended to allow the tenant to sell these products and services. While the landlord may be thrilled that the tenant is not asking for something that will diminish the landlord's income from the shopping center (i.e., rent abatement, a request to “right-size” its premises, etc.), a tenant should be prepared for the landlord to want something in return for this concession. If, however, the tenant is violating an exclusive granted to another tenant in the shopping center, a request to the landlord to amend the lease will likely not be in the tenant's best interests. In such a case, the landlord will no longer be able to plead ignorance to the tenant that has been granted this exclusive, and the landlord may be forced to take action to put the violating tenant in default. If continuing to offer these products or services is not vital, simply ceasing to sell these items will return the tenant to compliance under the lease. However, if the tenant's business is not viable without the revenue generated from these items, the tenant may have no choice but to approach the landlord to negotiate some relief. Now is the time to deal with this issue, as a landlord will likely want to make every effort to find a solution that is satisfactory to both the requesting tenant and the other affected tenant(s). In this market, landlords have strong incentives to preserve every lease with a rent-paying tenant, and they do not want to evict a tenant only to have to find a new tenant in a reduced market.

Co-tenancy Covenants

Some landlords, whether due to pressure to lease a center or a belief that creditworthy tenants at the time the lease was made would never fall into financial distress, have allowed tenants to negotiate operating co-tenancy covenants in their leases such as the following:

If at any time during the term of this Lease, Big Box Electronic Store and Brand A Grocery Store (the “Anchor Tenants”) cease operations at the Shopping Center, the Minimum Rent payable hereunder shall be reduced by fifty percent (50%). In the event that either of the Anchor Tenants shall cease operations for a period of six months in any twelve-month period, Tenant shall have the right to terminate the Lease.

Now that a number of large big box retailers in numerous locations have rejected leases in bankruptcy or have gone dark, it is time for both landlords and tenants to review the co-tenancy requirements in their leases closely. The sample co-tenancy requirement above is especially harsh on the landlord because the landlord has no way to cure the failure of the co-tenancy requirement by bringing a replacement tenant into the shopping center. A requesting tenant with this lease provision may have significant leverage to improve its economic condition.

Radius Clauses

If a tenant has opened new locations since the date of the lease, the parties should investigate whether the radius clause in the lease has been breached.

Insurance Requirements

Tenants should make sure that they continue to maintain all required insurance coverage under the lease and that they submit updated certificates to the parties required under the lease.

Signage

If a tenant has replaced its signage since the inception of the lease, the tenant should review whether the signage complies with the lease requirements and if any needed landlord consents were obtained.

Rules and Regulations

Landlords and tenants should review the rules and regulations required by the lease (including any updates) to determine whether the parties comply.

Step 2: Identify the Rights That You Have and the Rights That You Want

Once a landlord or tenant knows whether it is in full compliance or has identified where there may be an issue, it should review the lease again with an eye toward rights negotiated initially that are no longer as important. This knowledge will help the parties trade the deletion of one provision for relief from another or the addition of a new right. By giving up a termination right that is not as critical to its business, a tenant may allow the lease to be underwritten better and give the landlord an economic incentive to grant the tenant's requested concession. If a tenant believes that its business would remain strong, even if a key anchor went dark, then it may serve the tenant well to offer to delete this provision as consideration for a rent abatement or a reduction in the size of the premises. A tenant may view the prospect of reduced rent now as superior to the protection afforded by its current broad exclusive use provision. A key anchor in a shopping center that has the right to go dark and not continuously operate in the premises may have substantial leverage because the landlord may grant a concession to the anchor tenant, not only to avoid a large space being dark, but also to prevent the potential domino effect of the anchor being dark on other leases in the shopping center.

A landlord may offer a tenant an exclusive use provision or may modify the radius clause in a lease to secure a modification of the operating co-tenancy covenant. Due to unanticipated higher operating costs and taxes, and often low caps on the increase in operating expenses, some leases do not allow full reimbursement of the landlord's operating costs. This operating cost leakage can significantly impact the value of the property. A savvy landlord may want to take the position that it will forbear from exercising its rights for a tenant default (such as the revocation of an exclusive use provision) in exchange for the tenant's agreement to amend the lease to reset the base expense and allow the landlord to be reimbursed more fully for the tenant's actual pro rata share of expenses.

Step 3: Make the Deal

Once a lease has been audited and the best negotiating position determined, a deal can be made. In the current economic environment, many tenants would benefit by requesting concessions, and these requests may not be unanticipated. Landlords benefit when they can retain existing tenants and make them stronger. Landlords may be able to trade concessions for consents to different uses of a property that will increase revenue. Any negotiation with a tenant that results in more clearly defined lease rights and reduces ambiguity will aid underwriting and will be an advantage to the landlord when the property is sold or refinanced.

Conclusion

In the current tough times, it may seem difficult to justify incurring costs to audit leases critically and negotiate changes. The opposite may be true. Tenants may gain by using the bargaining power given them by the current economic situation. Making a request of a landlord without a full understanding of a tenant's lease obligations, however, can prevent a tenant from achieving the economic relief it needs and could have obtained. Similarly, landlords can use these requests as an opportunity. In order to be prepared to maximize the benefit (and reduce the loss), a landlord must evaluate its position under each lease critically before a concession is requested. A full understanding of a landlord's needs will allow the landlord to address the tenant's currents needs and improve the landlord's long-term position.

Jane Snoddy Smith, a member of this newsletter's Board of Editors, is a partner in Fulbright & Jaworski's Austin, TX, office. She focuses on transactional law with a concentration in commercial real estate. Bryan Patrick, an Associate in the same office, focuses on corporate and real estate law.