From Tension to Success: Broker-Owner Relationships in Retail Leasing

An Illustration

Consider, for example, “Jimmy,” a talented, knowledgeable optimist who truly understands the retail market, where he works finding new prospective tenants. Further, also consider “Larry,” an asset manager at CAm SHare Assets COWorkers, Inc. (“CASH COW”). CASH COW has worked with Jimmy on many deals. Larry knows Jimmy well. In the course of finalizing the deal terms in an LOI, and subsequently during the lease negotiation, their views periodically differ. But from those differing views — from that tension — Jimmy and Larry end up with a better deal, because tension is the antithesis of the blinders we all wear.

Jimmy and Larry know that where there is tension, there is a good chance that two parties have given disproportionate focus to different sides of the topic. There is genuine benefit in constructive dialogue with a trusted colleague who disagrees with your view. The dialogue will flesh out the concern, help avoid “one-issue focus,” and bring owners' attention to other considerations that also address mutual needs.

For example, Jimmy advises Larry about the latest prospective retail tenant, a small local coffee shop with a large following of devoted customers, whose lease in a nearby, lower quality property is ending soon, and who wishes to come to Larry's shopping center. Java Me Now has good credit, a solid track history over the last three years, a workaholic principal and a drive to succeed. During the LOI and the subsequent lease negotiation, three topics become points of tension: the breadth of the use, the duration of the term and the obligation to report sales. The following discussions and compromises prove that the tension cleared away the blinders and brought about good results.

The Breadth of the Use

Jimmy urges that the use should be far more open than a typical coffee shop. Jimmy feels vested in the tenant's desire for success, and wants to allow Java Me Now to expand into other food categories and grow its business. Jimmy notes that coffee shops rarely sell only coffee, and Java Me Now has to have latitude to grow. He reminds Larry about the expansion and revenue opportunities offered by national coffee shop chains.

Larry, however, had asked Jimmy only to bring him a coffee shop. Larry is worried about causing competitive friction among the existing tenants. Larry notes that the center already has a grocery store, three restaurants and a small bakery. Jimmy correctly notes that only the grocery store has an exclusive against competition, and its language allows one coffee shop. If Larry ignores the broker's guidance, Larry might lose the deal or, arguably worse, strong-arm the local tenant into accepting an overly restrictive use clause that may well damage its chances of success — which translates to inability to pay rent.

If Jimmy's expansive inclination to very much broaden the use were to govern, there could be problems with the grocery store's exclusive, and there could be resentment from the other unprotected tenants (those without exclusives who feel burdened by undue competition). That resentment might color their decision-making on whether to remain at the center in the long run. Worse, the desire to give Java Me Now all it wants on use might tempt the coffee shop to lose sight of its primary mission and purpose. It would not be the first time a tenant bit off more than it could chew, trying to be everything to everyone and losing its consumer appeal.

After discussion, the tension results in a middle approach that addresses the concerns and proves superior to either initial position: Java Me Now can expand into incidental food sales typical for a neighborhood coffee shop (a win for Java Me Now), but cannot violate the grocer's restrictions (that would be a given anyway). Gross sales from incidental prepared ready-to-eat food cannot exceed 20% of total revenues, a compromise that addresses the food sales desire of the tenant, but is sensitive to other tenants' concerns about undue competition. E pluribus unum: The competing views collide and result in the best reasonable approach.

Duration of Term

In today's retail market, Jimmy knows tenants have greatly varying wishes on term, and there is often a struggle over three, five or 10 years for an initial term. Jimmy believes in the prospect; Java Me Now has great potential and will serve the center's draw of customers well. Java Me Now will be the envy of nearby shopping centers and Jimmy wants to lock it up for as long as possible, which surely is in the best interests of ownership. Jimmy has caused Java Me Now to agree to an LOI that it will accept an initial 10-year term with a five-year renewal option at market rents. (Author's note: For the cynics who say, “Sure, but Jimmy just wants more commission,” know that ownership has an arrangement that mostly compensates the first five years of term only. Jimmy is acting out of genuinely good motives for ownership's best interests).

Jimmy is concerned that a short-term lease will result in a neighboring shopping center stealing away the successful coffee shop in three years.

Larry, on the other hand, is worried that Java Me Now is a local player with the greater risks of failure that come with its one-store position in the marketplace, including lack of “chain appeal.” Larry wants to give Java Me Now a chance, but not a 10-year chance. And Larry does not want to grant a renewal right. He wants to keep his options open.

After discussion, the compromise benefits all, while protecting all as well. Larry will agree to a 10-year initial term and one option to renew for five years, but with protection against lackluster performance by measuring sales. If gross sales during the third year do not reach a milestone amount, then Larry can terminate the lease, but only if Larry chooses to do so within 30 days after those first three years. If gross sales do not reach another milestone amount in the fifth year, either party can terminate the lease, again only if either party so elects within 30 days after the fifth year ends. The renewal term option cannot be exercised unless gross sales per annum averaged over the last five years of the initial term have reached still another annual milestone amount.

In this manner, Java Me Now is assured of the long-haul term it wishes, while having protection half-way through the term if its performance is failing, and ownership has financial milestone protections throughout. Again, the tension yields a better result than the two initial approaches alone.

Sales Reporting

The common perspective of tenants is that if there is no percentage rent to pay, there is absolutely no reason to report sales. The tenant may feel it is an “invasion” of its business information; it is just none of the landlord's business and it is an administrative irritation and burden — a waste of time. Java Me Now has a similar view. It is especially concerned that its competitors could learn the most profitable products from its sales data. Java Me Now considers this information private and is adamant it will not share the information … until it is no longer adamant when agreeing to sales milestones. Nonetheless, Java Me Now wants to report sales only for the period where a milestone requires analysis, and only wants to report a single, gross sales number. Jimmy supports the position of Java Me Now.

Jimmy tells Larry that the landlord will get the data it needs. Since there is percentage rent, there is no need to insist on more sales data. However, Larry has other reasons for wanting data. Larry wants to be able to act proactively, not reactively, to a failing tenancy. The frequent reporting of gross sales allows Larry to know — and to react in a timely manner — if a problem is developing. Larry could seek a replacement tenant, enter into a remarket agreement with Java Me Now, or even make business suggestions to help before the doors are permanently shut. Larry suggests a confidentiality clause that will protect the concern about privacy, but Larry wants the data reported every month. Larry also wants to have aggregate sales data for all his tenants so CASH COW can assist leasing efforts by touting an enviable average sales per square foot of all its tenants (assuming the numbers are enviable, of course).

Again, from the tension comes a compromise that reasonably addresses all the concerns. The tenant will report its sales on a quarter-annual basis, by email (to make it simple and without administrative burden), giving just the gross sales figure without breakdown by category (addressing the tenant's concern about disclosing its “gem” profitable items). The lease will have a good confidentiality clause, but the landlord is permitted to use the data as part of the centerwide aggregate statistic without attribution of any specific amounts drawn from the tenant's operation.

Conclusion

The lessons to all in lease negotiations, as in much of life, are many, and a few especially seem clear: Do not shy away from controversy and disagreement, but embrace it for its value; recognize we all wear blinders to some degree by virtue of our own experiences and biases; and welcome the opportunity to improve results for all through constructive dialogue and the resulting newly enlightened compromises.

***** David S. Drobner is a partner in the Real Estate Practice Group of Duane Morris LLP. He is based in the firm's Miami office.