Real Estate Advisor Law Blog : Ohio Real Estate Lawyer & Attorney : Ulmer & Berne Law Firm : Columbus, Cleveland OH

Almost all new build shopping centers are mixed use - they include some combination of office and residential in addition to the retail space. Elizabeth Hamilton, in house Real Estate Counsel at Office Depot, recently reminded me of the special problem this presents in allocating CAM, taxes and insurance. Some portion of each must be allocated to the office and residential components, but should it be on a strict per square foot basis for all users?  Taxes and insurance should be allocated among all users equally on a per square foot basis.  This means the dominator of the fraction defining a tenant's pro rata share should include all retail, office and residential space. (Of course, creating separate parcels eliminates or reduces the problem.) 

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An interesting situation  has come up several times just recently (these issues come in droves – after never confronting the issue for a really long time, all of a sudden you get the same issue coming up again and again):

• Tenant relocates to new space in the same center; 
• Landlord and Tenant amend existing lease to provide new space, rent and term; 
• Tenant entered into memorandum of lease and SNDA when it executed original lease; 
• There is a new loan with new lender in place at the time of the relocation; and
• Tenant enters into an amendment to the memorandum of lease at time of relocation. 

Who holds the senior interest – the tenant or the new lender?

If it is the same center, with the legal description of the center attached to original memorandum of lease, and the new lender consents to lease amendment, I believe the tenant should have senior interest.

If the tenant executed an entirely new lease rather than an amendment to the existing lease, would the analysis differ? It should not, otherwise form would trump substance.

A lender who consents in any way to a lease or amendment should not be able to terminate that lease upon foreclosure (unless of course if the tenant is in default).  Great minds differ on issues such as this, but law and equities lien in our direction.  What do you think ?

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When a prospective tenant speaks to a landlord about leasing space, one of the major points of discussion is usually the amount of square footage to be leased. The tenant will naturally need to rent sufficient space for the operation of its business, and the parties will often base the rent and common expense charges upon the square footage. However, although the parties may both use the term “square footage,” they may not be talking about the same thing.  As a tenant, the natural inclination is to think of square footage as the amount of space you can actually use for your business. This is often called the “usable area.” In contrast, the landlord may view square footage as the amount of space for which he can charge his tenants rent. This is referred to as the “rentable area” or “net leasable area.” 

To avoid misunderstandings, the parties need to be certain that they are talking about the same thing when discussing square footage. The Building Owners and Managers Association (BOMA) International promulgates a standard methodology to calculate both usable and rentable square footage; however, landlords are not required to use the BOMA standard and may instead use their own square footage calculation methods. As such, the parties should be aware of the following general definitions when negotiating a lease:

“Rentable Area” or “Net Leasable Area” is the amount of space for which the tenant will be charged rent and a proportionate share of common expenses. 

“Usable Area” is the amount of space the tenant can actually use for its personnel, furniture or retail operations. The Usable Area will be less than the rentable area because it will not include areas such as utility closets, stairwells and other common areas.

When evaluating the Rentable Area and Usable Area available in different buildings, the following terms are frequently used:

“Loss Factor” means the percentage of Rentable Area that is not usable. A high loss factor may indicate an inefficient design or large common areas.

“Load” or “Add-on” is the percentage of common area added to the Usable Area to determine the Rentable Area.      

Keep in mind that the precise means of calculating the Rentable Area and Usable Area may vary based on the locality or the parties involved. Therefore, it is important to set forth the basis for the calculations in the lease agreement. Having an understanding of the general definitions of these commonly used terms before negotiating a lease will help ensure landlord and tenant are speaking the same language.  In some instances it makes sense to include the electrical closet in the calculation, in other situations it does not.  Additionally, the tenant may want to reserve the right to verify the landlord’s square footage calculations to ensure the tenant is getting all the space it requires. 

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Recently, David Birdsall, Chief Development Officer for Phillips Edison, spoke to a group of real estate industry executives about the state of the retail industry and its impact on retail real estate.  Dave believes we are at the dawn of a new/old retail era.  Dave showed how the internet is changing how consumers shop and will continue to evolve to present easier and perhaps more desirable shopping experiences for consumers. We have already seen retailers changing their strategy to have one or two stores in a market at the top locations with the internet covering the rest, instead of trying to "store" the entire market. Dave says successful retail will instead  be "experience" driven. Shoppers will come to a retailer or a shopping center for the experience.  Thus, restaurants may become the new anchor. Authentic, local, family owned retailers may have a new special appeal.  Retailers will not be looking at mass openings but will concentrate on improving existing operations. New developments will be scarce. Existing "distressed" centers may need to be redeveloped for other uses. And successful retailers and landlords will be those who are really good operators - not just good financiers. 

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Vacancy rates are up; occupancy rates are down.  This spells opportunity for tenants and challenges for landlords.   The instinct which once prevailed in the real estate industry was to "go for the jugular" and cut the best deal you possibly can.  But real estate professionals know that today's "tenant market" will become tomorrow's "landlord market."  So, savvy real estate professionals are approaching the present  "soft" market with a creative approach which has the intention to make everyone a winner.  

Consider surplus space give backs; move-up to better space for the tenant with better terms for the landlord; percentage rent structured office leases for certain types of revenue generating space users (such as micro-office suites).  The options and opportunities are endless.   So, before you slit the throat of your adversary remember, what goes around comes around !

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So by now you’ve been to at least three conferences which tell you the economy has hit the bottom, it’s a U curve, 2010 will still be slow with savings and not consumption being the key characteristic, 2011 is a comeback year, but real estate will never get back to the boom boom days of only a few years ago. So what does it all really mean to the real estate professional?

1. Increased Competition. Whether it be for legal services, brokerage services, or commercial space, there is less demand and thus greater competition. But price is only one component of the decision factor. Service and quality still will be key decision factors. For example, while new centers have issues, retailers will still be looking to get into the established market leading centers and will pay the higher rent to get there. And having or obtaining a good relationship with a customer by providing over the top service is a great hedge against competition.

2. Marketing is Still Important. We all need to pay attention to expenses, but marketing is not one of the expenses to be cut. In the face of increased competition, it is more important than ever to get the quality message across. However, the marketing budget should be examined to make sure that the budget is allocated wisely. Place an emphasis on direct, active marketing most likely to get face to face with prospective customers.

3. Be Careful Extending Credit. There will still be higher than normal business failures, even by well established companies.

4. Do Not Sign Long Term Deals at Today’s Rates. Consider short term deals even where you normally want long term ones. Although no one can say with certainty, there is a good chance that rates will increase in 2012, so signing a long term deal now could tie you up at lower than market rates. Also, a credit tenant may have really good leverage now. Resist the temptation to sign a deal at any price. The balance of power may shift in a couple of years and that credit tenant may not have such great credit in a few years. As a tenant, consider the goodwill you will get, which can translate into tangible benefits, by merely being reasonable and not taking undue advantage of the economic climate.

5. Consider Other Sources of Income. Can the attorney branch out to other areas? Can the landlord come up with alternative uses for its vacant properties or monetize unused space ? Can the broker branch out to other consulting services?

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The following clause was in a first draft of a lease I recently reviewed for a client in the boilerplate provisions at the end under the heading “Mediation.” It is reproduced here verbatim (not kidding):

 “If a dispute arises out of or relates to this Lease, or the breach thereof, and if the dispute cannot be settled through negotiation, and if the parties so mutually agree, the parties shall first to try in good faith to settle the dispute by mediation administered by the American Arbitration Association under its Commercial Mediation Procedures before resorting to arbitration, litigation, or some other dispute resolution procedure. In the event the parties are unable to settle the dispute through mediation and, if the parties mutually agree, any unresolved disputes regarding this Lease shall be settled by an old-fashioned fistfight or best single card draw five-card poker hand. In the event the parties choose to settle the dispute by pugilism, each party waives any claims for personal injury damages or criminal prosecution against the other party. 

This may be my new favorite alternative dispute resolution clause. I am polling my colleagues to see if we have any golden glove boxing champs here. If so, I may have to insert this clause into my form. I can not decide whether the clause was a light hearted attempt to poke fun at how wordy leases have become and to see if the other party is actually reading it all, or whether it’s a reaction to the economy and an attempt to avoid legal fees, or whether the party drafting the lease (they are from Texas) just thinks they are tougher than us.

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In October, 2009 Morgan Stanley published its Mall and Lifestyle Center Handbook.  (Special thanks to Stephen Baumgarten, Senior Vice President Wealth Advisor Morgan Stanley Smith Barney Beachwood, Ohio for sharing the handbook with us).  The handbook is a must read for all retail developers, lenders, investors and retailers to understand the market forces impacting shopping center development and investment.

 

The handbook goes into great depth and analysis of the current state of the retail center real estate industry.  As of the date of publication of the handbook there were 1,095 regional malls in the United States and 268 lifestyle centers.  In 2007/2008 mall supply shrank 1.6% while lifestyle centers grew by 56% to 122 million square feet of space. 

 

The handbook analyzes "mall quality" identifying the characteristics which include some of the following: (i) trade area size and growth; (ii) tenant line-up; (iii) presence of "fresh" retail concepts; and (iv) anchor identity.

 

The authors of the handbook found that: (i) lifestyle centers presently have a competitive advantage over regional malls as a result of the variety of their tenant mix and less dependence on anchor tenants and apparel retailers; and (ii) public companies own 84% of the top 100 regional malls, while only 4 of the top 20 leading lifestyle centers are owned by public companies.

 

The authors predict that there will be consolidation in the shopping center industry as well as capitalized public companies and private investors look to expand over the next five years. 

 

Finally, the handbook contains an appendix of charts and analysis for market strength and market density for 40 of the largest United States metropolitan markets.

 

So, what can we take away from this study?  OPPORTUNITY does exist for current center owners to dispose of debt laiden centers; OPPORTUNTY does exist for REIT's and investors to acquire properties at reasonable cap rates; OPPORTUNITY does exist for lender's to finance well capitalized projects; and OPPORTUNITY does exist for retailers to enter centers which may not have previously been available.

 

Here is wishing for a strong Black Friday and a healthy holiday shopping season !

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When it comes to taking care of our own health, all too often we rely upon reactive maintenance. For example, you ignore your doctor’s warnings and continue to eat fast food and fail to exercise on a semi-regular basis. You had the chance to help control the situation with some basic preventive maintenance, but you were too busy working and focused on more immediate issues. Now, crisis strikes suddenly in the form of a heart attack. Assuming you survive, you are now left with complicated reactive maintenance, hoping to repair the damage that has already been done. But could this have been avoided with simple preventive maintenance?

Often, the answer is yes. The same holds true for the environmental health of a commercial landlord’s property investments. If you choose to look the other way while your tenants operate your property, environmental issues could be like ticking time bombs waiting to explode into a full scale emergency. The problem is simple. It is the tenant, not the landlord, that has physical control of your property. Yes, your lease agreement requires the tenant to comply with environmental laws, but what if they don’t and their failure is not immediately obvious? It could be years and years before the contamination is discovered by a Phase I analysis conducted by a potential buyer of your property. By that time, the old tenant may be out of business or impossible to locate, not to mention you just lost your sale and may be stuck with the costly clean-up expenses.

So what can be reasonably done to help prevent this from happening? One potential solution is what has come to be known as a Tenant Environmental Evaluation, or “TEE”. A TEE is a simple process handled by your environmental consultant that evaluates a new tenant’s expected use, periodically monitors that use throughout the lease term, and supervises the tenant’s exit from the property upon lease expiration to ensure all equipment and chemicals are properly removed. It is not nearly as involved, exhaustive, or costly as a Phase I since you are monitoring real time activities, not investigating past covered-up abuses. When it comes to your real property investments, the best advice and practice is to be proactive, not reactive. After all, a simple change to your diet beats a quadruple bypass any day!

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When representing a tenant, I always want an SNDA so that if the landlord defaults on its mortgage my client is assured that it can remain in the space as long as there are no tenant defaults. 

When representing a landlord, it is becoming increasingly more difficult to get lenders to make any change to their form subordination non-disturbance agreements ("SNDA").  Lenders are insisting that  tenants give up termination rights, offset rights, right to casualty proceeds and other valuable rights contained in the lease that the landlord was willing to give and which may even be customary provisions in a retail lease in today’s market.

Recently, I encountered the situation  where the lease contained a standard termination clause if a co-tenancy failure could not be cured within a set period of time. The landlord's lender would not agree that the tenant still had that right after a foreclosure.

So, is a tenant better off without an SNDA? If you weigh the probabilities, a tenant may be better of without one. If a lender forecloses, chances are the center is not performing well. If the lender forecloses and terminates the lease because there is no SNDA, how hurt is the tenant? Maybe the tenant would prefer termination. In the co-tenancy situation, the tenant gets the very remedy it was trying to preserve.  Without an SNDA the lender either has to terminate the Lease or accept every provision in it.  In this situation, the Tenant may be better off without the SNDA.

Granted if the tenant is performing well and does not wish to leave, there is some risk. But even in this situation, the only time a lender will terminate the lease is if the landlord wishes to redevelop the center.  A redevelopment, which will cost substantial sums, is highly unlikely in a healthy center. It is more likely that the lender will be doing everything it can to keep a well performing tenant.  Just something to consider – a tenant may very well be better off without an SNDA.

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A tenant always prefers an SNDA so that if the landlord's lender forecloses, the lender will have to respect the tenant's lease. But if the landlord files bankruptcy, or if the lender causes the landlord to file bankruptcy, the landlord can reject the tenant's lease anyway thereby subjecting the tenant to the very risk it was seeking to avoid.

In a currently ongoing bankruptcy case, the bankruptcy trustee went so far as to demand  the tenant to move out immediately because the trustee was shutting off utilities to save money for the estate.  In most cases, the lender does not want to avoid the lease because it wants the rental income. For the same reason, the trustee usually does not want to reject the lease. 

The real risk is where the property is to be redeveloped for a completely different use or is being held by a non-operator who wants no responsibility for operations whatsoever. In both cases, an SNDA may not suffice given the remedies available in bankruptcy.  

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It is certainly no surprise that the commercial real estate leasing market has turned into a "tenant favorable" market.  How long this will last is anyone's guess.  Give the current leasing market conditions and overall economic conditions tenants should take precautions to prevent becoming victims of their landlord's potential financial defaults and inability to obtain credit.  

1. Build-Out Allowances:  Tenant's should request that build-out allowances are placed in an "escrow" or are secured by a "letter of credit" to make certain that funds exist when the tenant's or the landlord's contractors have completed their work and are requesting to draw upon the same.  Alternatively, any unfunded build-out allowances could be reimbursed to a tenant through a right of "set-off" against future rents;
2. Building Services:  Tenant's should request "self-help" rights in the event the landlord can no longer provide building services as contracted for in the lease agreement.  Services such as maintenance, repairs, janitorial, HVAC and utility services that are interupted can have a negative affect on tenants ability to operate their businesses.  Set-off rights against future rents can enable a tenant to keep services on going;
3. Non-Disturbance:  Lenders want to keep the property occupied and tenants want to remain in their space undisturbed when the landlord is dealing with their lender issues.  Tenants should request that the landlord's lender enter into a "non-disturbance agreement" to permit the tenant to continue to occupy the premises even if the lender steps into the shoes of the landlord.  Tenants should expect that the lender will request that the tenant "subordinate" to the lender's interests in the premises;
4. Subleasing:  Subtenants should request the right to deal directly with the landlord in the event the tenant (sublandlord) defaults on the underlying lease.  

Stability of the project is at the core of ensuring that the interests of the landlord, tenant and lender are balanced.  Today issues we once considered remote can arise and should be contemplated and discussed before the shoe is on the other foot ! 

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 It seems like every day another retailer files bankruptcy.  Many more have frozen new deals, cancelled scheduled openings and even closed open stores. A shopping center landlord must monitor tenant monthly gross sales reports and tenant public filings to anticipate which of its tenants are or could become problem tenants. The landlord should also act quickly to declare a default of a tenant which is not paying rent and other charges timely.  One strategy for a tenant is to withhold rent to build a war chest before it files bankruptcy. A landlord that terminates a lease prior to the tenant filing for bankruptcy protection has significantly improved its leverage.  A well drafted lease, including tight permitted use clauses, can also increase the landlord's bargaining power.

A relatively new development is "designation rights." A tenant with multiple locations files for bankruptcy. The tenant then has the right to accept or reject its leases. The tenant sells this right to a "designation rights acquirer."  The acquirer seeks a return on its investment by finding new tenants to purchase the leases. In a successful center, the landlord may become vulnerable to having the lease assigned to a party the landlord would prefer not to have in its center, or at rates less than the landlord could otherwise obtain. So another potential income stream to the designation rights acquirer is payment from the landlord  in exchange for the designation rights acquirer rejecting the lease because the landlord does not want to take the chance of having a bad assignment. As more and more retailers are stopping expansion plans, it is possible that designation rights will become less valuable because the designation rights acquirer will both have a smaller universe of potential assignees and because the landlord may be more willing to accept a larger universe of assignees.

The new Bankruptcy Code amendments to Section 365(d)(4) which effectively shortened the period for a tenant to accept or reject a lease was supposed to give the landlord more leverage (120 days/extenable to 210 days).  However, sticking to the rejection period and taking all of the other steps will do no good if there is no demand for the space. The economic reality may still cause the landlord to extend the rejection period and work with the designation rights acquirer. So the real question is whether there is simply too much retail space built and how do we absorb the existing space? One answer seems to be mixed use - adding office and residential into the retail center. In any event, it is clear we will see a shake up in the retail industry in 2009.

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Recently at the January monthly Real Estate Roundtable breakfast sponsored by the University of Cincinnati, I was introduced to a fascinating new concept – the Roof Lease. Featured speaker Mike Phillips, President of Cincinnati based national real estate developer Phillips Edison Company, mentioned that Roof Leases are starting to spring up across the country. The basic concept is that in exchange for 15 – 20 years of guaranteed income (or in other words, payment for electricity generated from solar panels installed on the roof) a solar energy provider installs and maintains solar panels (generally with the help of grant money) on the roof of your shopping center. Once installed, the solar panels are capable of generating sufficient electricity to power the entire shopping center and provide a number of direct benefits for the landlord. These benefits include the ability to market as a green center featuring controlled electricity costs for tenants, reduced common area electric costs for itself, and the potential of becoming eligible for certain energy related tax credits. As an added benefit, solar panels can be easily hidden from sight; so there are no aesthetic concerns nor is their addition to an existing center likely to run afoul of antiquated zoning code height restrictions.

As a side note, if anyone knows about emerging trends in the shopping center world, it should be Mike Phillips. His company owns more than 240 properties across the county and his popularity was evidenced by the largest turnout by far of any UC Real Estate Roundtable breakfast in recent memory. 

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