Special Issues in Retail Leasing

While industrial and office leases each have one common use specified in the use provision, this topic is frequently the subject of much variety and negotiation in retail leases. Landlords attempt to limit the use to the sale of a particular product or service, and will not allow any other use in the premises. Landlords strategically plan for a particular tenant mix, or only allow a particular quality or category of tenants (such as a fashion mall). In doing so, landlords attempt to place tenants in certain locations to complement other nearby tenants. An unapproved change in use could ruin a landlord's plans for the tenant mix. On the other hand, the tenant wants the broadest possible use, to allow for evolving product lines or changes in product placement as consumer tastes change. While the landlord may be willing to allow some flexibility, often, a particular use (or even brand) justified the exact location of the tenant, and the landlord will be very sensitive about allowing the use to stray too much from the original use. Also, the landlord has to be careful not to allow too broad an expansion, or the tenant may be wrongfully permitted to sell products or services which violate another tenant's restrictions.

Implied Restrictions

This last part leads into the next use issue. Landlords should avoid permitting any implied or express exclusives. Doing so restricts future leases, which may be less important the smaller the size of the center. Where a landlord is required to provide an exclusive right, care should be taken to avoid restrictions on broad categories of items that may be sold by other retailers that clearly do not compete with the tenant in question. The exclusive should only be enforceable in situations where the tenant is not in default and is using the premises for the specific exclusive use. Carve-outs should be allowed for existing tenants, de minimus uses and anchor tenants. A tenant will rightfully insist that the exclusive use is not lost when the tenant is closed for remodeling or renovations or unless the tenant is in default beyond applicable cure periods. While a carve-out for existing tenants is reasonable, if the landlord is allowed to disapprove of a use change that would cause an exclusive violation, the landlord should agree that it will be required to disapprove.

Rogue Tenants

While many remedies may exist for a breach of an exclusive provision, a landlord should not suffer if there is a “rogue” tenant, or other occupant, that breaches its lease or occupancy agreement and begins competing with another tenant that has an exclusive. In that situation, as long as the landlord agrees to use commercially reasonable efforts to enjoin the wrongful use, no remedies should apply. The tenant may argue that after some period of time, it should be able to exercise its remedies regardless of the efforts of the landlord. Often, the remedy is a reduction of a portion of the base rent during the period of the violation, or conversion of the base rent to percentage only. While open to negotiation, the landlord may insist that the tenant provide evidence that it has suffered a loss of sales from the competition.

Whether the exclusive violation was intentional or the act of a “rogue” tenant, the tenant should not be allowed to terminate the lease absent some period of time that the violation continues. Often set at a year, this period can be extended in the “rogue” tenant situation. Regardless, if the tenant does not elect to terminate the lease, within some short period following the end of the one-year period (assuming this is the time frame for the reduced rental remedy), the tenant should be required to resume paying full rent.

Operating Covenants

Unlike office or industrial leasing, where as long as rent is paid, the landlord is satisfied, it is important for the success of the shopping center that all of the stores remain open. Landlords therefore insist that the lease require the store to be open by a date certain and that rent commencement is fixed as of that date. Steep penalties often will be added if this covenant is breached. Once open, the tenant should be required to continuously operate, fully stocked, staffed and fixtured. Minimum hours of operation are usually designated. Tenants may insist upon “opening windows” where they only need to open at certain key seasonal events. Should the landlord not deliver the premises timely to enable the tenant to make such date, the tenant may opt to delay acceptance of the space until the next season.

While landlords may accept such “windows,” it should be clear that if the tenant's delay causes the window to be missed, the tenant should not be allowed to take advantage of the delayed delivery. Similarly, if the tenant has sufficient leverage to negotiate against a continuous operation clause, the landlord should at least get a covenant to operate for a period of time (or even a covenant just to open fully stocked, staffed and fixtured), and the landlord should also have the right to terminate the lease at any time the tenant remains dark (other than for remodeling or renovation). In such a case, the tenant should reimburse the landlord for any unamortized construction allowance and/or brokerage commission.

Percentage Rent

Unique to retail leasing is the concept of percentage rent. Typically, this is defined as rent payable on a specified percentage of sales over a “natural break,” which is calculated by dividing the annual base rent by the specified percentage. The landlord should make sure the lease provides that if the tenant is not fully operating for any reason during the entire test period, the “breakpoint” is lowered to address the reduced operation.

Issues often arise on whether percentage rent is payable annually, after the lease year in question is over, or monthly, based upon an estimate of prior year's sales (with a reconciliation at the end of the year), or monthly once the breakpoint has been reached. Obviously, the tenant will argue for the annual amount, with the landlord attempting to procure one of the other alternatives.

The landlord should try to insist upon a narrow radius restriction. Otherwise, there is nothing preventing the tenant from opening a store across the street and essentially ending any possibility of the landlord getting percentage rent. What is an appropriate radius restriction depends on the type of store and the area (rural vs. inner city). Typically, three to five miles is appropriate in a dense community, with 10 miles being reasonable in a suburban or rural location. In addition to having a radius violation trigger a default, the landlord should require that any sales within the radius restriction (including sales by parties related to tenant) be included in the sales calculated from the premises. It is appropriate for the tenant to carve-out existing stores or those acquired in a multiple location acquisition of another national or regional chain's stores.

Much debate may occur relating to the definition of “gross sales.” The landlord should insist that sales of services as well as sales of merchandise be included. Care must be taken to include electronic sales generated from the premises as well as sales delivered from the premises. Sales of sublessees and licensees should also be included. The tenant will seek a variety of exclusions, including discounted sales to employees (usually limited to 1% or 2% of total gross sales), transfers of merchandise between stores, returns, credit card charges and sales not in the ordinary course of business.

In an effort to procure or retain retail tenants in a shopping center, many landlords will agree to convert fixed or base rent to rent based entirely on percentage, or gross sales from the tenant's operations in the premises. This has raised an interesting problem concerning the availability of sales records and the timing of the payment of rent based upon such sales. In many cases, sales records are not available for 30 days after the month in which such sales take place. Thus, the possibility exists that a landlord may have to wait three months between rent payments during the conversion process from fixed base rent to rent, which is based only upon gross sales. For example, following such a modification or extension of the lease effective May 1, the landlord would be required to wait until July 1 for its next payment. If the landlord were receiving fixed base rent on the first day of every month, the landlord would have received a rent payment on April 1 and then, because May gross sales (the first month under the new rent structure) will not be known until June 30, the landlord would not receive any payment until at least July 1. Payments will thereafter lag two months through the balance of the percentage rent period. This could prove problematic if the tenant is a large portion of the landlord's rental stream and the landlord is relying on rent payments to make its mortgage payments every month.

Using the example above, several alternatives are available to remedy this situation:

1. The tenant can be required to make a rent payment on May 1, and each subsequent month, based upon gross sales for the period two months earlier (for example, March sales information would be available on April 30 and used to determine May rent) and a rent payment could be made on May 1 without any interruption of cash flow to the landlord. As an alternative, gross sales can be based upon the prior year's sales during the same month (assuming this is not a new lease). The parties can then agree to a reconciliation of the relevant rental period on either a monthly basis (when actual sales are available) or annually.

2. The tenant can be required to pay a minimum base rent every month, beginning on May 1, which minimum is based upon an estimate of gross sales for the month in question. The tenant may want to suggest a lower base to hedge against possible sales concerns, but even in this scenario, the landlord continues to get a steady flow of income. Again, the parties can reconcile monthly or annually after actual gross sales are determined.

3. The tenant can be asked to “prepay” the last two months of the term upon executing the lease or amendment, or the last two months of the period when only percentage rent is payable (if fixed rent kicks in again at a later time), based again upon an estimate of gross sales for those two months. The landlord would therefore have current funds available for use when deposited,
instead of being two months in arr-ears throughout the term. There
would be a reconciliation after the end of the percentage rent only term, comparing actual rent calculated upon gross sales during the final two months of percentage rent to the prepayment amount previously paid.

Co-Tenancy

Perhaps the most hotly negotiated provision in retail leasing today involves the co-tenancy clause. While many tenants in larger centers want to know that one or more national tenants will be operating in the center, and that a minimum percentage of tenants will be open alongside the tenant in question, landlords are often unable to satisfy these provisions ' through no fault of their own. Tenant vacancies, bankruptcies and assignments have been occurring at alarming rates over the past four years, and a landlord can find itself in a snowball situation, where one vacancy can trigger a mass of future terminations. That is why many landlords are committing only to an “opening” co-tenancy, instead of an “ongoing” co-tenancy. The landlord must also take care to provide for substitution and replacement in those situations where ongoing co tenancy is required. Two tenants, occupying at least 80% of the space of a larger anchor, should be an acceptable replacement for a larger anchor where the two tenants are also national or regional. A tenant may require that each replacement be at least 30% of the square footage of the original tenant. A tenant should not be given remedies where the violation is temporary ' due to remodeling or restoration of the requisite co-tenant.

If there is a co-tenancy violation resulting in remedies in favor of the tenant, a situation similar to an exclusive violation should exist. The tenant should only be allowed a rent reduction for a period of time (12 months, for example), following which the tenant should be required to terminate the lease (during a short window period) or return to paying full rent. The tenant should not be given any remedies, however, if, in fact, the tenant has no covenant to operate. The tenant can only exercise its remedy for a co-tenancy violation if it is required to remain fully open for business.

Conclusion

Although several other issues exist that are particular only to retail leasing, the above discussion should alert both landlords and tenants to some of the more controversial provisions unique to shopping center leases. Armed with knowledge of these issues and the concerns of each side to the transaction, both landlords and tenants should be able to reach a middle ground satisfactory to them both.

Ira Fierstein, a member of this newsletter's Board of Editors, is Co-Chair of the Leasing Practice Group and a partner in the Chicago office of Seyfarth Shaw LLP. He has over 30 years of experience counseling national developers, shopping center owners and other clients regarding significant investments in retail, office and industrial properties.

While minor differences among lease forms may exist, depending on jurisdictional issues relating to remedies, enforceability, and transferability, there are entire topics that are heavily negotiated in retail leases that do not even come up in commercial leases for office or industrial properties.This article discusses three of these unique issues, and explores the positions asserted by both landlords and tenants in dealing with these provisions.

Use and Operation

Restrictions

While industrial and office leases each have one common use specified in the use provision, this topic is frequently the subject of much variety and negotiation in retail leases. Landlords attempt to limit the use to the sale of a particular product or service, and will not allow any other use in the premises. Landlords strategically plan for a particular tenant mix, or only allow a particular quality or category of tenants (such as a fashion mall). In doing so, landlords attempt to place tenants in certain locations to complement other nearby tenants. An unapproved change in use could ruin a landlord's plans for the tenant mix. On the other hand, the tenant wants the broadest possible use, to allow for evolving product lines or changes in product placement as consumer tastes change. While the landlord may be willing to allow some flexibility, often, a particular use (or even brand) justified the exact location of the tenant, and the landlord will be very sensitive about allowing the use to stray too much from the original use. Also, the landlord has to be careful not to allow too broad an expansion, or the tenant may be wrongfully permitted to sell products or services which violate another tenant's restrictions.

Implied Restrictions

This last part leads into the next use issue. Landlords should avoid permitting any implied or express exclusives. Doing so restricts future leases, which may be less important the smaller the size of the center. Where a landlord is required to provide an exclusive right, care should be taken to avoid restrictions on broad categories of items that may be sold by other retailers that clearly do not compete with the tenant in question. The exclusive should only be enforceable in situations where the tenant is not in default and is using the premises for the specific exclusive use. Carve-outs should be allowed for existing tenants, de minimus uses and anchor tenants. A tenant will rightfully insist that the exclusive use is not lost when the tenant is closed for remodeling or renovations or unless the tenant is in default beyond applicable cure periods. While a carve-out for existing tenants is reasonable, if the landlord is allowed to disapprove of a use change that would cause an exclusive violation, the landlord should agree that it will be required to disapprove.

Rogue Tenants

While many remedies may exist for a breach of an exclusive provision, a landlord should not suffer if there is a “rogue” tenant, or other occupant, that breaches its lease or occupancy agreement and begins competing with another tenant that has an exclusive. In that situation, as long as the landlord agrees to use commercially reasonable efforts to enjoin the wrongful use, no remedies should apply. The tenant may argue that after some period of time, it should be able to exercise its remedies regardless of the efforts of the landlord. Often, the remedy is a reduction of a portion of the base rent during the period of the violation, or conversion of the base rent to percentage only. While open to negotiation, the landlord may insist that the tenant provide evidence that it has suffered a loss of sales from the competition.

Whether the exclusive violation was intentional or the act of a “rogue” tenant, the tenant should not be allowed to terminate the lease absent some period of time that the violation continues. Often set at a year, this period can be extended in the “rogue” tenant situation. Regardless, if the tenant does not elect to terminate the lease, within some short period following the end of the one-year period (assuming this is the time frame for the reduced rental remedy), the tenant should be required to resume paying full rent.

Operating Covenants

Unlike office or industrial leasing, where as long as rent is paid, the landlord is satisfied, it is important for the success of the shopping center that all of the stores remain open. Landlords therefore insist that the lease require the store to be open by a date certain and that rent commencement is fixed as of that date. Steep penalties often will be added if this covenant is breached. Once open, the tenant should be required to continuously operate, fully stocked, staffed and fixtured. Minimum hours of operation are usually designated. Tenants may insist upon “opening windows” where they only need to open at certain key seasonal events. Should the landlord not deliver the premises timely to enable the tenant to make such date, the tenant may opt to delay acceptance of the space until the next season.

While landlords may accept such “windows,” it should be clear that if the tenant's delay causes the window to be missed, the tenant should not be allowed to take advantage of the delayed delivery. Similarly, if the tenant has sufficient leverage to negotiate against a continuous operation clause, the landlord should at least get a covenant to operate for a period of time (or even a covenant just to open fully stocked, staffed and fixtured), and the landlord should also have the right to terminate the lease at any time the tenant remains dark (other than for remodeling or renovation). In such a case, the tenant should reimburse the landlord for any unamortized construction allowance and/or brokerage commission.

Percentage Rent

Unique to retail leasing is the concept of percentage rent. Typically, this is defined as rent payable on a specified percentage of sales over a “natural break,” which is calculated by dividing the annual base rent by the specified percentage. The landlord should make sure the lease provides that if the tenant is not fully operating for any reason during the entire test period, the “breakpoint” is lowered to address the reduced operation.

Issues often arise on whether percentage rent is payable annually, after the lease year in question is over, or monthly, based upon an estimate of prior year's sales (with a reconciliation at the end of the year), or monthly once the breakpoint has been reached. Obviously, the tenant will argue for the annual amount, with the landlord attempting to procure one of the other alternatives.

The landlord should try to insist upon a narrow radius restriction. Otherwise, there is nothing preventing the tenant from opening a store across the street and essentially ending any possibility of the landlord getting percentage rent. What is an appropriate radius restriction depends on the type of store and the area (rural vs. inner city). Typically, three to five miles is appropriate in a dense community, with 10 miles being reasonable in a suburban or rural location. In addition to having a radius violation trigger a default, the landlord should require that any sales within the radius restriction (including sales by parties related to tenant) be included in the sales calculated from the premises. It is appropriate for the tenant to carve-out existing stores or those acquired in a multiple location acquisition of another national or regional chain's stores.

Much debate may occur relating to the definition of “gross sales.” The landlord should insist that sales of services as well as sales of merchandise be included. Care must be taken to include electronic sales generated from the premises as well as sales delivered from the premises. Sales of sublessees and licensees should also be included. The tenant will seek a variety of exclusions, including discounted sales to employees (usually limited to 1% or 2% of total gross sales), transfers of merchandise between stores, returns, credit card charges and sales not in the ordinary course of business.

In an effort to procure or retain retail tenants in a shopping center, many landlords will agree to convert fixed or base rent to rent based entirely on percentage, or gross sales from the tenant's operations in the premises. This has raised an interesting problem concerning the availability of sales records and the timing of the payment of rent based upon such sales. In many cases, sales records are not available for 30 days after the month in which such sales take place. Thus, the possibility exists that a landlord may have to wait three months between rent payments during the conversion process from fixed base rent to rent, which is based only upon gross sales. For example, following such a modification or extension of the lease effective May 1, the landlord would be required to wait until July 1 for its next payment. If the landlord were receiving fixed base rent on the first day of every month, the landlord would have received a rent payment on April 1 and then, because May gross sales (the first month under the new rent structure) will not be known until June 30, the landlord would not receive any payment until at least July 1. Payments will thereafter lag two months through the balance of the percentage rent period. This could prove problematic if the tenant is a large portion of the landlord's rental stream and the landlord is relying on rent payments to make its mortgage payments every month.

Using the example above, several alternatives are available to remedy this situation:

1. The tenant can be required to make a rent payment on May 1, and each subsequent month, based upon gross sales for the period two months earlier (for example, March sales information would be available on April 30 and used to determine May rent) and a rent payment could be made on May 1 without any interruption of cash flow to the landlord. As an alternative, gross sales can be based upon the prior year's sales during the same month (assuming this is not a new lease). The parties can then agree to a reconciliation of the relevant rental period on either a monthly basis (when actual sales are available) or annually.

2. The tenant can be required to pay a minimum base rent every month, beginning on May 1, which minimum is based upon an estimate of gross sales for the month in question. The tenant may want to suggest a lower base to hedge against possible sales concerns, but even in this scenario, the landlord continues to get a steady flow of income. Again, the parties can reconcile monthly or annually after actual gross sales are determined.

3. The tenant can be asked to “prepay” the last two months of the term upon executing the lease or amendment, or the last two months of the period when only percentage rent is payable (if fixed rent kicks in again at a later time), based again upon an estimate of gross sales for those two months. The landlord would therefore have current funds available for use when deposited,
instead of being two months in arr-ears throughout the term. There
would be a reconciliation after the end of the percentage rent only term, comparing actual rent calculated upon gross sales during the final two months of percentage rent to the prepayment amount previously paid.

Co-Tenancy

Perhaps the most hotly negotiated provision in retail leasing today involves the co-tenancy clause. While many tenants in larger centers want to know that one or more national tenants will be operating in the center, and that a minimum percentage of tenants will be open alongside the tenant in question, landlords are often unable to satisfy these provisions ' through no fault of their own. Tenant vacancies, bankruptcies and assignments have been occurring at alarming rates over the past four years, and a landlord can find itself in a snowball situation, where one vacancy can trigger a mass of future terminations. That is why many landlords are committing only to an “opening” co-tenancy, instead of an “ongoing” co-tenancy. The landlord must also take care to provide for substitution and replacement in those situations where ongoing co tenancy is required. Two tenants, occupying at least 80% of the space of a larger anchor, should be an acceptable replacement for a larger anchor where the two tenants are also national or regional. A tenant may require that each replacement be at least 30% of the square footage of the original tenant. A tenant should not be given remedies where the violation is temporary ' due to remodeling or restoration of the requisite co-tenant.

If there is a co-tenancy violation resulting in remedies in favor of the tenant, a situation similar to an exclusive violation should exist. The tenant should only be allowed a rent reduction for a period of time (12 months, for example), following which the tenant should be required to terminate the lease (during a short window period) or return to paying full rent. The tenant should not be given any remedies, however, if, in fact, the tenant has no covenant to operate. The tenant can only exercise its remedy for a co-tenancy violation if it is required to remain fully open for business.

Conclusion

Although several other issues exist that are particular only to retail leasing, the above discussion should alert both landlords and tenants to some of the more controversial provisions unique to shopping center leases. Armed with knowledge of these issues and the concerns of each side to the transaction, both landlords and tenants should be able to reach a middle ground satisfactory to them both.

Ira Fierstein, a member of this newsletter's Board of Editors, is Co-Chair of the Leasing Practice Group and a partner in the Chicago office of Seyfarth Shaw LLP. He has over 30 years of experience counseling national developers, shopping center owners and other clients regarding significant investments in retail, office and industrial properties.