The Commercial Classroom: Retail leases - Edward Smith Jr.

This column is offered to help educate agents new to commercial and investment brokerage and serve as a review of basics for existing practitioners.

Retail Leases
Both landlords and tenants are scrutinizing each other when it comes to their leases. Shopping center landlords today are looking at potential retail tenants on a case-by-case basis. Sure, they want to fill their space, but how strong is the tenant’s business. Will they be able to fulfill their lease obligations and bring more people to all the stores in their shopping center.

Tenants are uncertain about their business too, they want the safety of shorter-term leases, with exit clauses.

Chain store retailers usually gave landlords a feeling of confidence in their performance. But today not every business will be successful at every location. What if the tenant goes bankrupt? In a Chapter 11 filing a retailer can reorganize and reject their current lease giving them negotiating power over their landlord.

From the tenant’s perspective they want exit rights in their leases. If they are not making money at that location, they want to be able to terminate their lease. The landlord doesn’t want an underperforming retailer in that space either.

We still have an unsettled market, and safeguards have to be built into leases to address all situations. We must understand certain lease clauses and what they mean to each side.

Percentage Leases can be set up in three different ways.
Many retailers consider the calendar year as if they bought all their inventory at the beginning of the year but do not realize their profit until the end of the year. In reality they pay a defined rent each month, but when their cumulative sales reach a certain dollar amount (usually around mid-year), they pay a percentage of their sales each month in addition to the base rent. This continues to the end of the calendar year and then the cycle starts all over again.

The point in sales the retailer must reach before a percentage of sales must be paid to the landlord as additional rent is called the natural breakeven point. This is determined using the following formula: annual rent ÷ percentage of sales = natural breakeven point.

As an example, the rent is $5,000 a month; $60,000 a year (annual rent) and a 5% of sales is negotiated: $60,000 ÷ 5% = $1.2 million. When the store’s sales reach $1.2 million the tenant will continue to pay the base monthly rent plus 5% of that month’s sales as additional rent. Again this continues to the end of the year, then the cycle starts all over again.

With this structure landlords generally have sufficient base rent for their revenue expectations and the percentage of sales in the second half of the year is additional revenue to them.

When dealing with the larger shopping centers and malls the tenant’s rent may be based on a negotiated dollar per square foot plus a percentage of their sales throughout the entire year. As an example, the rent is based on $35 per s/f plus 3% of your sales payable monthly.

Another method with these properties is where the tenant only pays a percentage of their sales each month.

With these last two methods, especially the later, landlords need to protect themselves. They will carefully exam the tenants past sales history and current expectations in consideration of giving them a percentage lease; as the landlord’s income is based on that sales revenue.

In these cases, the landlord considers the worst-case scenario. What if something unforeseen happens and the tenant’s sale volume declines. They are then not collecting the revenue they need.

Often with a percentage lease the landlord will insist on a recapture provision in the lease, to protect themselves. Recapture provision gives landlords the right to take back all or a portion of their property, by terminating all or part of a lease.

It may be triggered if a tenant does not maintain a specific minimum amount of business; reducing the landlords anticipated revenue. A poorly performing retail shop can affect the entire shopping centers image and the businesses of all the other tenants, reducing the landlord’s income even further. Recapture allows a landlord to remove an underperforming retail store, opening the space for a more profitable business.

The recapture provision may also be triggered when a tenant wishes to sublease or assign some or all of their space. Market conditions may have changed, and the landlord could rent the space for more money by exercising their recapture rights and taking back control of the property. The recapture clause also protects the landlord in an instance where the tenant attempts to sublease the property for a profit.

In many cases percentage leases have provided landlords with significantly more revenue than they would have received from just collecting rent. However, banks do not like the uncertainty and financing or acquiring shopping centers with percentage leases may be difficult.

Tenants need protection too! What if the anchor store closes or if several stores in a shopping center close? This reduces the number of people coming to the center and consequently reduces the other stores’ sales.

In these cases, tenants need co-tenancy clauses in their leases. Co-tenancy clauses can take many forms, but they give relief to the remaining tenants. The rent may be automatically reduced to a predetermined level, rent may be changed to a percentage of sales. Tenant may terminate the lease if the anchor or other vacant stores are not rented within a certain period of time or if the replacement tenants’ business no longer “feeds” the tenants business.

Sometimes a landlord has a large amount of space available and rents a portion of it to a tenant. Then another tenant is interested in taking the entire space. As an example, a grocery store (30,000 s/f) is vacated. The market is difficult, and the space has been empty for too long. A tenant wants to rent 7,500 s/f and the landlord agrees to do so. They move in; but the landlord would prefer a single tenant for the entire space. The landlord has a clause added to the lease relocation rights. This grants the landlord the option to relocate the existing tenant to another space in the building.

As you can imagine relocation is highly disruptive to the tenants. In this case if relocation rights are required, the tenant needs to protect themselves by negotiating several things. Landlord to pay for all moving expenses and necessary tenant improvements. Rent to be abated during the relocation period. That the replacement premises should be equal to or superior to the original space. Also, to allow the tenant to terminate the lease in lieu of relocation.

When dealing with large spaces that are free standing buildings, landlords will rent to a single tenant and give them a triple net (NNN) lease. The tenant will pay rent but will also be responsible for paying all the expenses of the property including taxes, insurance, utilities, repairs and all maintenance. The NNN lease may also include tenants responsibility for structural items such as the roof, bearing walls and floors. A NNN lease with a structural exclusion would make the landlord responsible for the roof, bearing walls and foundation.

Another form of lease that does occur in some triple net properties is called a bond lease. In this case the tenant is responsible for all operating expenses, taxes, maintenance, repairs and replacement of the entire building if necessary.

Edward Smith, Jr., CREI, ITI, CIC, GREEN, MICP, CNE, e-Pro, AHWD and CIRECT program developer, is a licensed real estate broker in New York and Connecticut and is a real estate broker with Smith Commercial Real Estate, Sandy Hook, CT.