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WEAPON OF MASS DESTRUCTION: The Co-Tenancy

In a perfect world our retail leases would not include co-tenancy provisions and in many A-centers deals are being done without these clauses. However, we don’t live in a perfect world and more often than not retailers are demanding their deals include a co-tenancy. Poorly structured co-tenancy provisions could not only lead to a landlord having a problem tenant, but a bad co-tenancy provision has the ability to destroy the value of a center–a true weapon of mass destruction.

During The Great Recession, co-tenancy provisions crippled the lifestyle center sector and to a certain extent the sector has not recovered because of the legacy left by poorly structured co-tenancy provisions.

In today’s world I would argue that co-tenancy is less correlated to a center’s success than in years past. There was a time where many lifestyle centers had very similar tenant lineups. Malls were the same way and included the same cast of characters in most malls. In turn, it became common for retailers to seek co-tenancy provisions that included the same list of core retailers. If properly structured, landlords could satisfy the co-tenancy.

The world has changed and given the lack of national apparel retailers, landlords today may not be able to satisfy co-tenancies. Why? The nature and composition of retail centers have changed. We are seeing more mixed use and non-retail uses, which in theory is driving traffic and creating success. In many cases a landlord today may do more to improve their center by adding a non-traditional use or a growing retailer than by adding a specific retailer to satisfy a co-tenancy.

I would argue that co-tenancy is less correlated to a retailer’s success today than in years past with sales being more dependent on the success of the overall project or center than just one neighboring retailer. The retail world today is less cookie cutter with more dynamic and unique mixed-use projects. In a cookie cutter world, co-tenancy is relevant; in today’s non-perfect world, co-tenancy is not necessarily the primary factor in determining a retailer’s success.

I have seen many co-tenancy provisions and have participated in several lease negotiations in which Retailer A refused to sign a lease until big-box Retailers X, Y and Z had done so also. And while I understand the tenant perspective, the retailer has put the landlord in a chicken versus egg positionthe landlord needs the lease signed with Retailer A to get the others; yet the retailer will not sign the lease unless the others do too. It seems like a bit of a belt and suspenders scenario to me and the retailer should consider focusing on another type of co-tenancy.

Alas, co-tenancies are not going away anytime soon, but if properly structured, a co-tenancy can be palatable, even from a landlord’s perspective. Traditionally, retailers are a creative bunch and congruent, as well, and they have brought their creativity to structuring co-tenancy provisions. There are a number of co-tenancy provisions put forth by retailers, but for purposes of this article, let’s focus on the two most common co-tenancy provisions: Opening Co-Tenancy and Operating Co-Tenancy.

OPENING CO-TENANCY

Typically, the way a retailer will want to structure an Opening Co-Tenancy is to state that the retailer will not be obligated to open for business unless the Landlord secures a specific tenant and/or anchor or meets a certain occupancy level. The danger and potential problem with this type of Opening Co-Tenancy provision is that it is the polar opposite of the primary goal of the landlord, which is to have a center with open stores. I have seen situations where a leasing team did a great job of securing tenants only to have the coveted tenants never open due to an Opening Co- Tenancy clause. One Opening Co-Tenancy situation I recall was a provision written into a lease mandating that the landlord achieve a certain occupancy level and three named tenants. The landlord achieved the occupancy level but 2 of the 3 tenants filed bankruptcy and liquidated. The retailer never opened for business and everybody lost.

Overall, I like to avoid the Opening Co-Tenancy altogether, but it is very tough to achieve in today’s environment. Instead, I engender confidence in the retailer by selling the assured success of a project. But, when this fails, as it often does, I try to structure my Opening Co-Tenancy based on an occupancy level and not named tenants.

Here is what you should include in your Opening Co-Tenancy provision:

Make the Opening Co-Tenancy based on an achievable overall occupancy level in your project.

If you have a mixed-use project, I suggest including the occupancy of offices and/or apartments, if the calculation works to your advantage.

Propose an occupancy level of 60%.

My argument is that at 60% the project is viable, and keep in mind that this threshold should be lower as this is an Opening Co-Tenancy; retailers will propose 80-85% and the conservative ones may even hit you with 90%. Anything north of 80% is too high. If you negotiate a 70% occupancy level for a co-tenancy provision, you have done well.

Stick with occupancy level, if possible, and stay away from named co-tenancy. If you find yourself forced to take the route of named tenants, do two things:

First, make sure you do not agree to an all or nothing provision in order to give yourself some room and the ability to satisfy the co-tenancy. Go with a percentage of a list of tenants, such as 6 out of 12, meaning the landlord must get 6 specifically named tenants to satisfy the co-tenancy. Of course the retailer is going to want a higher number than 6, but the key in negotiating this clause is to start with a big denominator.

Second, you must have the ability to replace retailers on the list with “mutually agreed upon retailers.” Using the example above, you do not want to be in a position where you start with 12 key tenants and then your list gets whittled down as some of your key 12 prospects find other sites, pass on your project, or file bankruptcy. Years ago I agreed to an Opening Co- Tenancy where I had to achieve 8 out of 12 retailers with no replacement language. One of the named retailers decided to go with another center, two retailers passed on the project and a fourth retailer filed for bankruptcy. Now what? I had no choice but to shoot for 8 out of 8, and long story short, we only leased to 7 of the retailers. The story has a happy ending, as the retailer opted to open, but we were lucky . . . . The co-tenancy demanding tenant could have walked, leaving us with nothing but time and money unwisely spent.

Give yourself some flexibility on anchors

In today’s world with weak anchors, anchorless centers, and hybrid centers, I like to stay away from an anchor-based Opening Co-Tenancy. However, if you have to go down this road (and you likely will at some point), the same rules as above apply.

Make sure you use a 2 out of 4 ratio or something similar. More importantly, expand your definition of an anchor. For example, if you agree to a named tenant co-tenancy for department stores and you have a structure that calls for you to achieve 2 out of 4, you may have boxed yourself into a corner. In reality, there may not be 4 viable department stores for your project. Alter your anchor definition to be based on square footage and not type. I like to go with 20,000 sf or above for an anchor definition, but if you can’t land at this level, try not to go higher than 50,000 sf.

It is important from the onset to frame the discussion on the anchor correctly. Years ago, anchors determined a center’s success or failure. Today I would argue center success is more highly correlated to the amount of square footage (i.e. critical mass) and the shopping experience. If you can diminish the power of the anchor in the retailer’s mind you have a better chance of negotiating a better Opening Co-Tenancy provision.

A properly structured Opening Co-Tenancy provision should meet the number one goal of the Landlord and that is to get the retailer to open for business. If the landlord does not satisfy the co-tenancy, the tenant should still have to open for business with the remedy for violating the co-tenancy being the tenant gets a lower rent (an alternate rent) than its contract rent.

Retailers will often ask for an alternate rent of 5% of sales, gross. A retailer can afford more, even in a project that may be poorly occupied, and a landlord should likely insist on a higher percentage and is why I typically push for 8%. However, keep in mind the end goal getting the retailer to open for business. I would gladly accept a 5% of sales deal in lieu of an empty storefront.

Lastly, you must have a fish-or-cut-bait provision in the event you do not satisfy the Opening Co- Tenancy. The tenant should only be able to stay on alternate rent for a period of time and then either the lease becomes null and void or the tenant returns to paying its contract rent. A commonly negotiated period of time to cure for an inline tenant is 12 months. The last thing you want is a tenant that is in your center paying alternate rent for the balance of a lease.

OPERATING CO-TENANCY

A very similar approach to structuring a good Opening Co-Tenancy provision may be used when structuring an Operating Co-Tenancy clause. However, you need even more flexibility in Operating Co-Tenancy since you are negotiating for the long-term. Often I see poorly worded Operating Co- Tenancy provisions that are too short-term. Yes, it is difficult to predict the future, but you need to consider the entire lease term when negotiating an Operating Co-Tenancy provision and try to anticipate not only the performance of your center but also try to gauge where the retail market will be in the future.

In an Operating Co-Tenancy try to:

Propose a lower occupancy level.

For an Opening Co-Tenancy, a retailer may need a higher occupancy number, but for an Operating Co-Tenancy, the retailer should be able to agree to a slightly lower number. If I can I structure the Opening Co-Tenancy occupancy level at 70% and the Operating Co-Tenancy occupancy level at 60%, the argument being that once the retailer is operating the occupancy level is less of a factor in their success as they have established their business.

Give yourself flexibility.

You need more flexibility than with the Opening Co-Tenancy, so try to go for lower occupancy levels and expand your definition for an Operating Co-Tenancy.

Negotiate a sales test.

The retailer’s number one goal is to maximize revenue, so the focus in negotiating an Operating Co-Tenancy provision should be on the retailer’s sales. I like to include a sales test provision within a lease that needs to be reached before the co-tenancy would kick-in. For example:

If the occupancy of a property remains at less than 60% for a six month period and tenant’s sales decrease by 10% during that period, tenant then has the right to go to an alternate rent.

To me the underlying reason of why a retailer pushes for a co-tenancy is to protect their downside risk. In turn, adding a sales test should be acceptable to a retailer. The logic being if a retailer’s sales stay the same or even increase, why should a Landlord be penalized? Despite the logic you will get pushback from retailers, but a sales test is the most important condition to add to an Operating Co-tenancy.

With an Operating Co-tenancy, be sure to negotiate a fair alternate rent. My perspective is an alternate rent of 5% is not high enough and too punitive for an Operating Co-Tenancy. The retailer’s business is established and they can afford more.

Regarding the time to cure, while 12 months may be ample you may need more time to satisfy the Operating Co-Tenancy and I have seen up to 24 months, especially for anchors.

Just as in Opening Co-Tenancy provision, the fish-or-cut-bait concept also applies to the Operating Co-Tenancy, along with the understanding that a landlord cannot have a tenant paying alternate rent for too long a period. You will find that retailers don’t easily close stores, as they may be in a position of having to take a sizable write-off from an accounting perspective. You may find the retailer returns to its contract rent if you have come to the end of your cure period and you have not satisfied the co-tenancy.

In conclusion, co-tenancy provisions are commonplace in retail leases. While they inure to the benefit of the tenant, a properly structured co-tenancy can be palatable for a landlord. A poorly structured or too narrow of a co-tenancy, however, has the ability to crush a center – a true weapon of mass destruction. Tread carefully when negotiating them.

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