Need Allowance for Allowance

Landlords and their lenders need to rethink their position on payment of construction allowances. The rental structure of a lease is based in part on the amount of the allowance. If a tenant receives no allowance, the lease would undoubtedly provide for a lower rent payment. A portion of the rent is repayment of the allowance with interest. Yet, I see landlords and lenders insist upon provisions that ignore the reality of the allowance structure.

 

1.      Landlords often insist that the allowance only be used for certain items and that the tenant provide evidence that it is spending the allowance only on these items. And that the tenant will not receive the allowance to the extent it does not so spend the funds. However the landlord is unwilling to reduce the rent if tenant does not get the full allowance. The landlord thus gets a windfall: tenant pays the full rent including that portion allocable to the allowance, but does not get the full allowance. The essence of the lease is defeated. It would seem, that either the landlord should agree to pay the allowance, regardless of costs, or should agree to a rent reduction to the extent the full allowance is not paid. Landlords sometimes say this is a requirement of their lender. If that is really the case, the lender needs to rethink their position based on the reality of the structure of the lease.

 

2.      Lenders are increasingly refusing to allow a tenant to offset rent for any part of the allowance not paid (as it relates to a post foreclosure offset). Once again, this leads to the tenant paying full rent (for which the lender or its assignee gets the full benefit) without receiving the full allowance. If the lender approves the lease, and in fact the execution of the lease benefits the lender as it increases the value of its security, the lender should allow the offset separate and apart from the fact that it gets the benefit of the full rent.

 

3.      Landlords sometimes insist that upon default, in addition to the other damages, landlord wants repayment of the unamortized allowance. However, the tenant is obligated to pay the rent – unpaid rent is clearly an element of damages. If the rent includes repayment of the allowance, having the unamortized allowance included as a separate element of damages is a double recovery for landlord.

 

Resolving this issue not only solves difficult lease issues, but would alleviate a key issue in the SNDA.

Five Points to Consider When Leasing Construction Equipment

 

 

As the construction industry starts to rebound from a down market, rentals of project equipment are on the rise. Whether you are an owner, principal contractor, or specialty trade subcontractor, you may very well be renting equipment for use on an upcoming project. Here are five important points to bear in mind:

 

1.    Do not accept the equipment without thoroughly inspecting it first. Failure to do a full, visual and utility inspection on a rental product could mean that you may be held responsible for existing damages or defects in the equipment. If damage is not documented prior to acceptance of equipment, it will be your word against the lessor’s—and the lessor is likely to have favorable contract language on its side. The best way to avoid this fight is to conduct a thorough inspection while recording (perhaps by taking digital photos) every aesthetic or operational issue with the equipment. Conduct the inspection in the presence of the lessor, provide the lessor with documentation or notes of all existing damage, and retain a copy of the documentation. Also be sure to reject the equipment if it does not appear to be fully functional.

2.    Be sure to obtain insurance coverage for the rental, or confirm in writing that coverage is otherwise in place. Under the lease agreement, the renter is typically charged with the duty to obtain insurance coverage for the equipment, both in the name of the renter and the lessor. Failure to have required coverage in place pursuant to the terms of a lease agreement will mean that you are responsible for casualty or loss to the equipment.

3.    Make sure your operating team is well-trained on the equipment’s maintenance. Required maintenance will often be spelled out succinctly in the rental agreement. If so, be sure to train your team to abide by it. If not, ask the lessor for its suggested maintenance in writing. If you fail to conduct required maintenance, the equipment may be damaged and you will be stuck with a hefty repair bill, or worse, you may be forced to purchase it —whether you want it or not.

4.    Meet the scheduled equipment return deadlines. Per most rental agreements, you will be charged an entire extra day (or week or month, depending on the duration of the rental) if you fail to return the equipment by the allotted time set forth in the contract. For large pieces of machinery, this could mean a significant price.

5.    If the equipment runs on gas or diesel, return it with a full tank. Much like national car rental companies, an equipment lessor can charge you significantly enhanced amounts for fuel if you neglect to “gas up” before
you return a piece of construction equipment. These amounts can add up and hurt your bottom line if your project teams are consistently leaving the gas bill to the mercy of your lessors.

With these points in mind, rent wisely and build safely, timely, and well.

Opportunities in the Housing Market

2012 is likely to be similar to 2010 and 2011 in many segments of the real estate industry.  However, the residential rental market is frequently mentioned as a bright spot. There is more demand than supply to meet the needs of the market place.  Apartment communities and apartment buildings will surely meet most of the need with an already existing ready to go inventory.

The over building and easy credit  of the pre-recession period put many homeowners into properties which are presently under water.  The lenders are faced with the decision to either:

1.  Foreclose and sell;

2.  Amend and extend the loan; or

3.  Allow the homeowners to short sell.

 

None of which are good options for anyone.  Employment opportunities make increasing family incomes difficult to achieve; so even employed homeowners which are not in default can not keep up as their homes lost market value as a result of foreclosures and over supply.  The best thing for the home owner is to remain in their home, keep it up and seek to stabilize the neighborhood. 

 

We can wait for the government to legislate a solution, or we can consider what is best for our lending institutions, communities and neighbors.  Richard Florida in his book The Great Reset identifies the problem, cause and some solutions such as:

 

1.  Reduce interest rates to reset the home financing to a level in which the homeowner can afford to remain in the home.  Surely, this would cost less than foreclosing and selling a home at a loss.

 

2.  Agree with the homeowner to take a deed in lieu of foreclosure, transfer ownership of the home to either the lender or a rental company; rent the home to the former homeowner at a market rental rate; and give the homeowner or renter the option to buy the home back (with appropriate credits for previously paid equity etc.).

 

Keep the home occupied by the people who will take care of it the best and give them an opportunity to once again become a home owner.  Everyone wins when the property values in a neighborhood stabilize. 

 

Lenders and developers can create opportunity where everyone benefits and the capital cost is low.

Change the Locks !!!!

The Illinois General Assembly has recently amended the Landlord and Tenant Act   to add a new requirement for landlords:  when a unit changes over to a new tenant the locks must be changed or rekeyed.  This applies to dwelling units only.  The Act is not applicable for dwelling units in a building of 4 units or less when the owner occupies one of the units.  Failure to comply will make the landlord strictly liable for all resulting damages from theft suffered by the tenant.  See the Act for specifics.  

The Best Real Estate Advice a Small Business Will Ever Receive

I may be over-selling this post a bit, but not by much. There’s no doubt for most small businesses and start-ups that the first, and perhaps only, real estate transaction the firm will enter into is a commercial lease. Whether it is for a retail store, manufacturing or studio space, or a restaurant, there are a few things the small business owner should keep in mind while reviewing that first lease.

 

There is no such thing as a form lease. In all likelihood the Landlord will present you with a lease, pre-printed with your business name and other details inserted, and say it’s his typical form lease. Do not hear the word “form” and assume you can’t negotiate. No doubt the landlord presents the same lease to all prospective tenants – but you know your business, the landlord doesn’t. Read every provision as if it’s open for discussion, and keep in mind the particular needs of your business that are likely not reflected in the form. 

 

“Base Rent” isn’t the only rent. The term that will rightfully be most heavily negotiated in your lease is the base rent – i.e. the fixed amount you pay each month. Even if you get a great deal on base rent, the lease in totality may not be a good business value based on other charges. First, most commercial leases will be “triple net,” a fancy way of saying that the tenant is also responsible for taxes, insurance and operating charges. The most flexible of these are the operating charges. Make sure you’re not being charged for expenses that don’t benefit your space, and that you pay a proportionate amount to other tenants if the space is in a multi-tenant center. Also keep an eye out for “percentage rent.”  In leases with percentage rent provisions, the tenant will pay a percentage of its revenue over a certain dollar amount to the landlord. This isn’t necessarily bad for the tenant, as it provides a mutual incentive for landlord and tenant to want the business to succeed, and it may be coupled with a lower base rent. Percentage rent provisions must be reviewed with care though.

 

Notice the notices. Once you sign your lease and move in, keep the lease in a place where it’s easy to reference. Consider drafting a quick lease summary, possibly with the assistance of your attorney, which reminds you of critical dates and costs under the lease. Many sections of the lease will have requirements for the tenant to give notice to the landlord. For example, if you have the option of renewing your lease a notice will undoubtedly be required, sometimes as much as a year in advance of lease expiration. The tenant must follow the notice requirements precisely to avoid forfeiting its right to any option periods. 

 

Of course these brief provisions are not the only things to keep in mind when reviewing your small business’s first lease. It’s always advisable to make the small investment to have your attorney review the lease before signing. But by keeping the above advice in mind you can avoid some of the most common leasing mistakes made by small businesses. 

Green Leasing Unveiled - Part II

In Part I of our series on the particulars of Green Leasing, we discussed Lease Term and Operating Expenses. Now we turn to a robust area for implementing sustainable processes between Landlords and Tenants:

Interior Alterations and Repairs

 

A typical commercial lease will have two separate sections, one on maintenance and repairs, and one on tenant improvements. The green leasing concern is the same in each – what requirements or incentives can be inserted in the Lease to assure that any changes to the premises live up to the parties’ expectations surrounding sustainability and energy efficiency?

 

First, the lease must deal with the minor, day-to-day changes that after move-in are typically the responsibility of the tenant. The perfect example here is lighting. As the landlord, does your third party rating agency require that you maintain certain forms of lighting? If you’re LEED-certified, it likely does. LEED for Commercial Interiors awards points for the percent reduction in lighting power below certain standards. If the tenant were to insert lighting that was not motion sensitive, for example, your lighting power reduction would be reduced and your LEED level of certification jeopardized. A simple insertion in the appropriate lease section requiring tenant to comply with landlord’s sustainability practices and any third-party rating system can give landlord some control of tenant’s actions in this area.

 

Second are those more major renovations undertaken by a tenant. Here, the lease needs to assure landlord and tenant cooperate and communicate to either (a) maintain any sustainable systems or third party ratings already employed for the project; or (b) for an initial build-out, agree on a level of sustainability or certification that is reasonable and desirable for each party. One major concern at this level is the contractors employed by tenant – a green lease should spell out that any professional engaged for tenant’s work must be LEED qualified (or a similar certification assuring the contractor is familiar with sustainable design). The lease may go so far as to specify the specific level of LEED certification to be sought for the interior design, although such a section would need sufficient caveats and waivers to assure neither party was accepting undue risk if the desired certification was not achieved.

Co-Working Office Space

As more workers and entrepreneurs are requiring space to hold meetings and appointments outside the company office, there is a growing need for locations away from homes in which to "plug in", make phone calls without the background music and noise of a Starbucks or other such cafe. The industry which addresses this need is referred to as the "co-working office space industry."

 

Two companies on the west coast are now meeting this need: NextSpace and Blankspaces. Both offer a table, chair, phone and Internet, coffee, conference rooms, private offices all for a daily, weekly or monthly fee. 

 

The benefits of "co-working office space" is that the working space is quieter, easy to plug in computers and cell phones, meet and collaborate with colleagues and clients. This is another way to take our over abundance of retail and suburban office space and adaptively reuse it. 

 

So, whether you are managing a work force and need space for them to operate from outside the company's offices or you are a property owner looking to turn empty space into income producing space, this is an idea worth considering!

Green Leasing Unveiled - Part 1

As the movement to increase energy efficiency and create sustainable operations has swept across the real estate industry, more and more commercial tenants and property owners are expressing interest in “green leasing.”

What, exactly, is a “green lease?” 

 

To be sure there is no form green lease; rather the term describes the evolution from a traditional, split incentive triple-net commercial lease to a lease that aligns incentives so that landlord and tenant are collectively pursuing goals of energy efficiency and sustainable practices. Typically, a green lease will include measuring criteria or rules that implement all or portions of ratings systems such as Energy Star® and the U.S. Green Building Council’s LEED™ program. 

 

This post is the first in a series examining in detail some of the changes one may see when using a green lease. Today’s topics: Lease term and operating expenses.

 


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Is There a Walmart in Your Future ?

 Walmart has opened its supercenters in many if not most urban and rural communities.  Where do they go next ?  With the over abundance of strip store space just about everywhere Walmart has many options.  Walmart is embracing the concept of 'in-flll" with three concept store formats with which they are experimenting:

 

  1. Walmart Express:  15,000 square foot small store concept with a variety of product assortment;
  2. Walmart Market:     25,000-70,000 square foot grocery and home goods focused stores;
  3. Walmart on Campus:  3,300 square foot stores with product assortments geared to the needs of students (cross between a Walgreen's and a Staple's).

Expect to see Walmart and its competitors rolling out stores as they fine tune these concepts.  Will communities embrace these stores or tighten zoning and use rules and regulations ?  As we have written in prior posts, retail is going to re-tool and re-define itself;  developers and lenders take note.  

 

Taking Advantage Can Be Disadvantage

A recent off hand statement by a Landlord's attorney got me thinking. I was representing a national retailer in a lease negotiation. We got to an issue that sophisticated landlords typically ask for and most retailers typically concede.  Our client, however, does not typically concede the issue.  The issue has unique meaning for our client because of their specific line of business.  When I told Landlord’s attorney that we do not ever agree to it, his response was “Boy, I wish I was a tenant attorney these days.”

I then tried to explain to him that this was not a case of the Tenant trying to take advantage of a down market, or exploiting some perception of leverage. Rather, this retailer was different from other retailers when considering their product mix and customer base.  And so it was a special business issue, not trying to take advantage; and I meant it !

 

Taking advantage of a superior bargaining position is not always the best thing for anyone. If you take undue advantage, you can be sure the other side will remember it. Then, in the next deal where you may not have the advantage, issues that should be conceded in your favor may not get conceded. Or during the relationship you might find you need a favor or just cooperation.  If you have soured the relationship because of taking undue advantage, the other side may not be so quick to help out. 

 

So the point is to negotiate for what you really need.  Do not demand more than you need or refuse to give what you can.  Protect your client’s real concern.  Anything more may harm the client more than it helps.

Are We There Yet?

            The ubiquitous refrain at any gathering of commercial real estate professionals in the past 24 months can be summed up in a few short questions: Are you busy? Who is lending? No, seriously, who is lending? And -- of course -- when will this end?

            As 2011 kicks into gear the refrain is the same but our answers (hopefully) are beginning to take a turn for the better. The refreshed outlook is largely supported by a recent Morgan Stanley report titled “CRE Recovery in Place: Investment Cross-Currents.” Though heavy with charts and graphs, some of the positive takeaways include:

 

            1.         2010 formed a solid bottom and 2011 should see gradually increasing commercial asset prices and risk appetite. The caveat? Recovery is still market-by-market and much slower in those areas where housing is a primary economic driver.

 

            2.         A base (i.e. middle of the road) projection of a 12.5% increase in value for commercial real estate assets. This would leave prices about midway between the 06-07 peak and the 2009 valley.  As many owners begin to get above water on their loans, lending can be expected to pick up.

 

            3.         Bank losses on commercial real estate will remain high, but will begin to decline in late 2011 or early 2012. While the ratio of non-performing loans continues to be above average, forward-looking projections of delinquencies have decreased. As this improvement moves forward, expect CRE-heavy banks to out-perform others. Perhaps this could drive banks back to the market?

 

            4.         Strip-center based REITs will see a pick-up as major anchor tenants, including Wal-Mart, Best Buy, Dollar General and Jo-Ann Stores, have announced expansion plans for 2011.

 

This is music to the ears not only of real estate professionals like us, but also to the commercial property owners that had to sit on assets to avoid taking large losses through this past cycle. Maybe at our gatherings in 2012 we’ll be asking when we’ll get our next vacation instead of our next deal.

Another Reason To Consider a Flat Tax

Landlord's have gone to fixed CAM to reduce administrative expenses and disputes with their tenants. The government could accomplish the same by going to a flat tax - no need for complicated tax regulations that create unintended consequences; no need for intrusive audits where the government is at odds with its constituents; in fact maybe no need for the IRS. Take for example the so called "self-rental rule." The Code ( Reg. 1. 469-2(f)(6) if your are keeping score at home) provides (unfairly) that if a taxpayer owns property that it rents to a company in which it has an ownership interest, then any rental loss is passive, but any rental income is active. Really?  This means the loss in the first year cannot offset against  income in the second year.  In fact the loss can never be used at all unless the taxpayer has some passive income from an unrelated deal not involving the rental of property to any entity in which he or she has an interest. Classic case of tails, the taxpayer loses and heads, the IRS wins. 

ELIMINATING OFF-BALANCE-SHEET ACCOUNTING OF LEASES

 

Remember Enron and off-balance-sheet accounting scandals? The efforts to clean up these accounting practices are still in the works and are about to hit the world of commercial real estate—arguably at the worst possible time. The Financial Accounting Standards Board (FASB) (which is endowed with the power to decide U.S. generally accepted accounting principles) and its international counterpart, the International Accounting Standards Board (IASB) are hoping to enact a new lease accounting standard by 2013. The Securities and Exchange Commission in a 2005 report to Congress estimated that the current lease accounting standards which went into effect in 1976 allow tenants to keep about $1.25 trillion in future liabilities off-balance-sheet.   

Currently, a lease may be shown on a tenant’s balance sheet as either a capital lease which is treated on the balance sheet much like a finance transaction or as an operating lease which is mostly off-balance sheet. The FASB and IASB believe that investors are not getting a full picture of a tenant’s obligations when the lease is treated as an operating lease because the lease payments are recognized as an expense when they are incurred or paid rather than all of the rental payments for the term appearing as a liability on the balance sheet. 

 

 

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Some Good News About Empty Big Boxes

The current economic downturn and the corresponding contraction of the retail sector have resulted in a glut of vacant “big-box” retail stores in shopping centers across the country. Vacant big-box spaces pose special challenges for landlords and communities. While the number of vacant big-box spaces is daunting, there are glimmers of hope as landlords and communities have become increasingly creative in their re-adaptive uses of these dark spaces. For creative landlords who are willing to invest in redesigning and redeveloping vacant big-box spaces, big boxes can provide opportunities for both landlords and communities.

Across the U.S., vacant big-box spaces have been successfully retrofitted for use by nonretail users such as churches, schools, colleges, medical and dental facilities, libraries, office and municipal tenants, health clubs, and other tenants who require large parking areas. Because traditional retail tenants are not available to fill vacant big-box spaces, Landlords should strongly consider non-traditional tenants for re-adaptive uses of vacant big-box spaces because they fill up highly visible vacant spaces (and community eye sores); they tend to be long-term, stable, credit tenants who may invest up-front in infrastructure improvements; and they are often well received by the community because of the benefits they provide.

 

 

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Audit Those Leases

The typical co-tenancy clause provides that if occupancy at a shopping center falls below a certain level and/or certain other key tenants close, the tenant gets rent relief and at some point the right to terminate its lease. In the current retail environment, all sophisticated tenants demand some sort of co-tenancy protection.  Landlords have generally accepted the fact that they must agree to some sort of co-tenancy if they are to get the tenants they desire.

However, mortgage lenders need to carefully consider the co-tenancy provisions also because they affect the value of their collateral, and of course if they are foreclosing it is likely that there is a co-tenancy failure. Obviously, a lender prefers no co-tenancy clauses in the leases. However, the challenge is that without them, there is no project in the first instance. But, the lender should carefully review all co-tenancy clauses so at least it knows the risk involved before taking any action.

 

Government as Tenant

I was recently in the offices of the FBI Cincinnati Division attending the FBI Citizens' Academy program, and it made me think about a leasing opportunity (in addition to thinking about what an awesome job our FBI really does and how dedicated and effective are our FBI professionals).  The recent economy has resulted in higher vacancies for our commercial properties and less demand for the resulting vacant space.  In a general sense, our government has stepped in as consumer to invigorate the economy.  Maybe our government also represents an opportunity for the commercial real estate market. The government has to occupy space, whether by lease or purchase.  I have represented a landlord who leased space to a governmental office (a state judge), and there are several issues that arise which are not present on a typical retail or office lease.  For example, the background of the Landlord becomes an issue, there are restrictions on the parties the Landlord hires at the site and the terms of such engagements, security is extra important and the tenant may require the right to terminate if its budget is changed.  In addition, certain government offices may not be desirable in a a multi-tenant property.  So while the government may be an opportunity,  be mindful of their needs and the costs to comply with the same.

Mixed Use Centers - How Do You Allocate CAM?

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.) 

CAM may be more complicated. The operating expenses attributable solely to the office component (such as the maintenance of an elevator or lobby area) should be allocated only to the office tenants, meaning that those costs should be deducted from the CAM allocated to the retail tenants. But then should the balance be spread over all tenants, retail and office? Retail tenants use more CAM than office tenants so that may not really be fair. Some landlords analyze it item by item to allocate between office and retail tenants. Some simply figure out what the market rate for office is and deduct that off the top. Others deduct based on a per square foot or percentage reduction and a general application of how they think CAM should be allocated. In any of these methods, the denominator of the fraction is just the retail area (because the aggregate CAM is reduced before the fraction is applied.)
 
The key here is to recognize the issue and have the Landlord explain how it allocates each item and then to make sure the Lease reflects this methodology. There is definite room for disagreement as to how to allocate, but the actual cost difference is probably not material. However, is this not another reason why fixed CAM is better?

MORE SNDA THOUGHTS....

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 ?

Know Your Terminology Before Negotiating a Lease

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. 

Reinventing Retail?

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. 

 

Creative Leasing

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 !

It's The Economy Again Stupid.

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.
  1. 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.
  1. Be Careful Extending Credit. There will still be higher than normal business failures, even by well established companies.
  1. 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.
  1. 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?

Is it a Sign of the Times?

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.

Retail Developer, Investor, Lender and Retailer Must Read

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 !

Environmental Check-Up

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!

Another Thought On SNDAs.

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.

Landlord bankruptcy - is SNDA really that valuable?

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.  

The Shoe is on the Other Foot

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 ! 

 

 

Policing Leasing

 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.

Who Knew Being Green Could Be So Easy !

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.