Stay in Touch with REA-lity

This article uses the term “REA” to include the following types of agreements:

• Reciprocal Easement Agreements (“REAs”), in which multiple parcel owners grant reciprocal easements and agree as to the operation of a project and other matters;
• Construction, Operation and Reciprocal Easement Agreements (“COREAs”), which are REAs that include construction provisions; and
• Declarations of Covenants, Conditions and Restrictions (“CC&Rs”) and other similar sounding Declarations in which one party “declares” the easements, operations and other matters before conveying any parcels to other parties.

When a developer conveys parcels to affiliates (which it may do, for example, for estate-planning reasons), it may be tempting to avoid creating an REA, but an affiliate may decide to convey its parcel to a third party or there may be a disagreement among the affiliated owners of the parcels (especially among second and third generation heirs), at which point it may be too late to achieve a meeting of the minds as to the operation and uses of a project.

When leasing space in a project not yet affected by an REA, the developer should consider: 1) the effect of the lease on the possible drafting and implementation of an REA; and 2) the effect of a future REA on the lease. As part of its calculus in the leasing process, the developer should permit as much flexibility as possible for future uses and operations. There are a number of potential pitfalls for the unwary, but there are also possible mitigation techniques.

Exclusives

In granting an exclusive use right to a tenant, how should the developer (in its capacity as landlord under its leases) deal with a possible breach of the exclusive on the conveyed parcel following a conveyance? (See article infra by Harvey Haber, page 3.) Many leases include a provision releasing the landlord from future liability upon a sale of the project, but fail to deal with a sale of one or more parcels. Unless such a parcel sale is highly unlikely, the lease should provide that the parcel buyer assumes (and the selling landlord is released from) liability for any such breach. (Consider whether such release and assumption should be absolute or prospective only.) The tenant will want such assumption to be set forth in a recorded document, so that third parties have notice. The REA can perform that function.

If the selling owner is released from liability and if the violation of the exclusive occurs on the other parcel, should the developer also be freed from the impact of a reduced rent or percentage-rent-only provision in its lease? Should the answer depend on whether the landlord included an appropriate restriction in the lease of the tenant violating the exclusive but the tenant (sometimes called a “rogue” tenant) ignored the restriction in its lease? Is the answer different if the developer conveyed the parcel to its affiliate? A provision that limits enforcement to property owned by the developer at the time of the violation would of course be best for the developer, but that is a difficult “ask” for many tenants with bargaining power.

Operating Expense Pass-Throughs

Developers usually allocate the operating expenses of a project in their leases, and tenants pay their proportionate shares of such expenses. What happens if there is a gap when a future REA allocates operating expense pass-throughs differently to the parcel on which a tenant is located? Indeed, there are potentially two relevant gaps: 1) the gap between the actual costs that a developer incurs and pass-through to tenants that have negotiated CAM protections in their leases; and 2) the gap between operating expenses allocated by the developer (or its designated operator) under the REA to a parcel and operating expenses a landlord of that parcel collects from its tenant(s) under their leases. The latter gap would likely be based on a different formula for pass-through calculation (e.g., a real estate tax allocation that is based on separately assessed parcels in the REA and based on a pro rata square-footage calculation in a lease). Either gap may impact the pricing on a sale, but the latter is more unusual and perhaps more likely to create post-closing disputes if not highlighted during the due diligence process.'

As a related matter, consider providing flexibility in the lease as to which party performs common area maintenance functions. Especially if one or more parcels is later conveyed, the operator may not be the original developer/landlord. Additionally, consider including any operator's management fee as a pass through; however, a tenant may object to both an administrative fee payable to the developer and a separate management fee paid to a separate operator (especially if an affiliate of the developer).

Co-Tenancy and Termination

If a tenant's lease permits it to terminate or pay reduced rent based on a percentage-based co-tenancy calculation (an occupancy threshold based on the percentage of tenants or floor area), what happens if tenants located on a parcel conveyed to another owner pursuant to leases executed by the other owner cease operating? Does the co-tenancy calculation change so that only tenants on the property owned by the developer from time to time are taken into consideration? If not, the developer may encounter difficulties because it will not be able to replace the tenants who are no longer operating, with replacement tenants on the other parcel and, under these facts, could have done nothing to reduce the possibility of cessation in operation (for example, by including an operating covenant in the lease) since it was not a party to the applicable leases. However, the effect on such tenant's sales is probably not related to the parcel lines or the identity of the landlord. One compromise might be to change the calculation as noted for the percentage-based co-tenancy calculation, but not for specifically required occupants like department stores.

Use and Design Restrictions

An REA is likely to contain use, design, access, parking and related restrictions, and a developer could draft its leases such that the REA would trump the leases as to any such restrictions, in order to avoid conflicts and confusion (especially if it controls the content of the REA). However, as difficult as this issue is for a tenant regarding restrictions in an existing REA (given the effort required to analyze the REA), it is even more difficult for a tenant in the context of an unknown future REA.

Control or Approval Rights

Although many tenants request a right to control or approve matters like the design and configuration of a development (including site plan matters like permissible building areas), signage and parking in its lease, a developer will not only want the right to control the initial development of its project, but may need to grant such right to other parties later, in the context of a sale of one or more parcels and an attendant REA. The developer and any other owners might need to make changes to a project for many reasons, including changes in use or requirements of entitlements for future phases. Should a tenant be granted any such controls (and there may be little choice with respect to larger tenants), issues similar to those noted above as to exclusives may arise, including whether the developer will be liable for a violation by another parcel owner and whether the tenant has enforcement rights under the REA.

Parking

If a tenant's lease requires a certain parking ratio, specify in the lease whether such ratio can be fulfilled only on the property owned by the developer from time to time, or also on other parcels that are part of the same project. Any future REA should take into account the parking ratio requirements in existing leases.

REA Approval Issues

Be wary of permitting the tenant to have approval rights over any future REA and any amendments thereto. In each case, to the extent a developer must agree to some approval rights, it is preferable to limit such approvals only to those provisions that materially and adversely affect the tenant or its operations. Also beware of any tenant requests for rights to approve the removal of property from the project or the addition of new property to the project, as these changes are likely to affect calculations involving floor area (e.g. common area maintenance).

Additional Suggestions

Developer Release

Consider drafting an express provision in each lease permitting the conveyance of all or part of the development and the release of the developer from all obligations under the lease as to a parcel that is conveyed, so long as an assignment & assumption is entered into (or created by an REA). To the extent that an REA is in place when any parcel is conveyed, the parties should consider preparing an amendment adding or replacing the developer with such buyer as the party with respect to the parcel that is conveyed.

Enforcement Issues

Consider whether a tenant should be given direct enforcement rights under the REA. Such rights give the tenant the control desired without involving the developer; however, this should be weighed against the developer's loss of control in dealing with other parties with whom it may have ongoing relationships. Therefore, these types of rights are rarely granted to any tenant other than an anchor or other significant national tenant. Alternatively, the developer could agree to use commercially reasonable efforts to enforce the REA; however, this may give rise to questions of how much enforcement is necessary. Must the developer litigate and/or appeal if the tenant so demands regardless of whether the developer believes such actions are practical?

Making Commitments

Beware of making commitments on matters in which the developer may lack control under an REA, e.g., access to books and records, audit rights, and the right to approve amendments to an REA if the developer is not an “approving party.”

Katherine Casale MacNally is an associate in the Chicago office of Pircher, Nichols & Meeks, a national real estate law firm. Sheldon A. Halpern is a partner in the firm's Los Angeles office.

In a perfect world, every developer of a project would know exactly how it would be used, both initially and in the future, and know all parties that would be involved with the project, including future developers of adjacent parcels and all tenants. In reality, parties and uses change over time, and multi-phase and mixed-use projects are becoming increasingly more common. It is not always easy to anticipate the necessity of an REA at the beginning of a development project, but a developer should at least leave open all options when drafting leases. This article examines the issues that arise when there is no REA at the time a project is being leased, but there is a realistic possibility that an REA will be required as and when portions of the property are conveyed as separate parcels.

What Is an REA?

An REA permits a multiple-parcel property to be tied together as a cohesive project when some of the parcels are conveyed to third parties. Conveyances may be made for a variety of reasons, including recovering development costs (and, hopefully, additional returns), and in a number of contexts, including: 1) a multi-phase development; 2) financing of less than the entire project; 3) adding other uses (including different ownership for each use because of specialization of developers); and 4) marketing to an occupant that wants to own its own parcel. An REA can, for example, grant easements, permit or require the construction of improvements, standardize or restrict operations and uses, provide for site plan and design controls, and set forth cost-sharing protocols.

This article uses the term “REA” to include the following types of agreements:

• Reciprocal Easement Agreements (“REAs”), in which multiple parcel owners grant reciprocal easements and agree as to the operation of a project and other matters;
• Construction, Operation and Reciprocal Easement Agreements (“COREAs”), which are REAs that include construction provisions; and
• Declarations of Covenants, Conditions and Restrictions (“CC&Rs”) and other similar sounding Declarations in which one party “declares” the easements, operations and other matters before conveying any parcels to other parties.

When a developer conveys parcels to affiliates (which it may do, for example, for estate-planning reasons), it may be tempting to avoid creating an REA, but an affiliate may decide to convey its parcel to a third party or there may be a disagreement among the affiliated owners of the parcels (especially among second and third generation heirs), at which point it may be too late to achieve a meeting of the minds as to the operation and uses of a project.

When leasing space in a project not yet affected by an REA, the developer should consider: 1) the effect of the lease on the possible drafting and implementation of an REA; and 2) the effect of a future REA on the lease. As part of its calculus in the leasing process, the developer should permit as much flexibility as possible for future uses and operations. There are a number of potential pitfalls for the unwary, but there are also possible mitigation techniques.

Exclusives

In granting an exclusive use right to a tenant, how should the developer (in its capacity as landlord under its leases) deal with a possible breach of the exclusive on the conveyed parcel following a conveyance? (See article infra by Harvey Haber, page 3.) Many leases include a provision releasing the landlord from future liability upon a sale of the project, but fail to deal with a sale of one or more parcels. Unless such a parcel sale is highly unlikely, the lease should provide that the parcel buyer assumes (and the selling landlord is released from) liability for any such breach. (Consider whether such release and assumption should be absolute or prospective only.) The tenant will want such assumption to be set forth in a recorded document, so that third parties have notice. The REA can perform that function.

If the selling owner is released from liability and if the violation of the exclusive occurs on the other parcel, should the developer also be freed from the impact of a reduced rent or percentage-rent-only provision in its lease? Should the answer depend on whether the landlord included an appropriate restriction in the lease of the tenant violating the exclusive but the tenant (sometimes called a “rogue” tenant) ignored the restriction in its lease? Is the answer different if the developer conveyed the parcel to its affiliate? A provision that limits enforcement to property owned by the developer at the time of the violation would of course be best for the developer, but that is a difficult “ask” for many tenants with bargaining power.

Operating Expense Pass-Throughs

Developers usually allocate the operating expenses of a project in their leases, and tenants pay their proportionate shares of such expenses. What happens if there is a gap when a future REA allocates operating expense pass-throughs differently to the parcel on which a tenant is located? Indeed, there are potentially two relevant gaps: 1) the gap between the actual costs that a developer incurs and pass-through to tenants that have negotiated CAM protections in their leases; and 2) the gap between operating expenses allocated by the developer (or its designated operator) under the REA to a parcel and operating expenses a landlord of that parcel collects from its tenant(s) under their leases. The latter gap would likely be based on a different formula for pass-through calculation (e.g., a real estate tax allocation that is based on separately assessed parcels in the REA and based on a pro rata square-footage calculation in a lease). Either gap may impact the pricing on a sale, but the latter is more unusual and perhaps more likely to create post-closing disputes if not highlighted during the due diligence process.'

As a related matter, consider providing flexibility in the lease as to which party performs common area maintenance functions. Especially if one or more parcels is later conveyed, the operator may not be the original developer/landlord. Additionally, consider including any operator's management fee as a pass through; however, a tenant may object to both an administrative fee payable to the developer and a separate management fee paid to a separate operator (especially if an affiliate of the developer).

Co-Tenancy and Termination

If a tenant's lease permits it to terminate or pay reduced rent based on a percentage-based co-tenancy calculation (an occupancy threshold based on the percentage of tenants or floor area), what happens if tenants located on a parcel conveyed to another owner pursuant to leases executed by the other owner cease operating? Does the co-tenancy calculation change so that only tenants on the property owned by the developer from time to time are taken into consideration? If not, the developer may encounter difficulties because it will not be able to replace the tenants who are no longer operating, with replacement tenants on the other parcel and, under these facts, could have done nothing to reduce the possibility of cessation in operation (for example, by including an operating covenant in the lease) since it was not a party to the applicable leases. However, the effect on such tenant's sales is probably not related to the parcel lines or the identity of the landlord. One compromise might be to change the calculation as noted for the percentage-based co-tenancy calculation, but not for specifically required occupants like department stores.

Use and Design Restrictions

An REA is likely to contain use, design, access, parking and related restrictions, and a developer could draft its leases such that the REA would trump the leases as to any such restrictions, in order to avoid conflicts and confusion (especially if it controls the content of the REA). However, as difficult as this issue is for a tenant regarding restrictions in an existing REA (given the effort required to analyze the REA), it is even more difficult for a tenant in the context of an unknown future REA.

Control or Approval Rights

Although many tenants request a right to control or approve matters like the design and configuration of a development (including site plan matters like permissible building areas), signage and parking in its lease, a developer will not only want the right to control the initial development of its project, but may need to grant such right to other parties later, in the context of a sale of one or more parcels and an attendant REA. The developer and any other owners might need to make changes to a project for many reasons, including changes in use or requirements of entitlements for future phases. Should a tenant be granted any such controls (and there may be little choice with respect to larger tenants), issues similar to those noted above as to exclusives may arise, including whether the developer will be liable for a violation by another parcel owner and whether the tenant has enforcement rights under the REA.

Parking

If a tenant's lease requires a certain parking ratio, specify in the lease whether such ratio can be fulfilled only on the property owned by the developer from time to time, or also on other parcels that are part of the same project. Any future REA should take into account the parking ratio requirements in existing leases.

REA Approval Issues

Be wary of permitting the tenant to have approval rights over any future REA and any amendments thereto. In each case, to the extent a developer must agree to some approval rights, it is preferable to limit such approvals only to those provisions that materially and adversely affect the tenant or its operations. Also beware of any tenant requests for rights to approve the removal of property from the project or the addition of new property to the project, as these changes are likely to affect calculations involving floor area (e.g. common area maintenance).

Additional Suggestions

Developer Release

Consider drafting an express provision in each lease permitting the conveyance of all or part of the development and the release of the developer from all obligations under the lease as to a parcel that is conveyed, so long as an assignment & assumption is entered into (or created by an REA). To the extent that an REA is in place when any parcel is conveyed, the parties should consider preparing an amendment adding or replacing the developer with such buyer as the party with respect to the parcel that is conveyed.

Enforcement Issues

Consider whether a tenant should be given direct enforcement rights under the REA. Such rights give the tenant the control desired without involving the developer; however, this should be weighed against the developer's loss of control in dealing with other parties with whom it may have ongoing relationships. Therefore, these types of rights are rarely granted to any tenant other than an anchor or other significant national tenant. Alternatively, the developer could agree to use commercially reasonable efforts to enforce the REA; however, this may give rise to questions of how much enforcement is necessary. Must the developer litigate and/or appeal if the tenant so demands regardless of whether the developer believes such actions are practical?

Making Commitments

Beware of making commitments on matters in which the developer may lack control under an REA, e.g., access to books and records, audit rights, and the right to approve amendments to an REA if the developer is not an “approving party.”

Katherine Casale MacNally is an associate in the Chicago office of Pircher, Nichols & Meeks, a national real estate law firm. Sheldon A. Halpern is a partner in the firm's Los Angeles office.