KEEPING THE CASH REGISTERS RINGING: THE CHALLENGES FACING RETAIL REAL ESTATE. By: Gail M. Stern A LOOK BACK AT 2009

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1 KEEPING THE CASH REGISTERS RINGING: THE CHALLENGES FACING RETAIL REAL ESTATE I. INTRODUCTION AND UPDATE By: Gail M. Stern A LOOK BACK AT 2009 Prior to 2009, we thought the first 8 years of the new century were challenging in the retail real estate world. Traditional malls were dying, there was massive consolidation among traditional department stores, lifestyle and power centers were dotting the landscape, Katrina hit, and specialty retailers were struggling. Further, there was almost no new mall development. Some would say that by 2000, the United States was simply over-malled. Other factors contributing to lack of development included growth of REITs, lack of new specialty tenants and anchors, development of power and lifestyle centers, and online shopping. Then came 2009, where we saw the worst economic times in our generation, massive unemployment, deep decline in consumer confidence, an increase in bankruptcies and an almost complete lack of real estate financing. General Growth Properties ( GGP ), one of the largest shopping center developers, filed for Chapter 11 in April 2009, primarily to deal with over $20 billion in maturing debt. Less than a year later, and after potentially turning the SPE bankruptcy remote structure upside down, GGP received approval of a reorganization plan. The plan extended the maturity date for all loans, and allowed GGP to use its centralized cash management system. In exchange, GGP agreed to various loan modifications to address SPE issues and any future bankruptcy filings. Deadmalls.com just celebrated its 10 year anniversary. Its home page starts with Welcome to Retail History and gives a great sense of the changes in retailing in the past decade. The only slightly bright spot coming out of 2009 was the holiday season. U.S. retailers performed better than expected, and certainly better than the disastrous 2008 holiday season. Sales, however, were far below 2007 results. WHAT S IN STORE FOR 2010 Although there has certainly been some improvement in the economy, no one is expecting retail to rebound quickly. The problems that existed in the first decade of the 21 st century still exist. In addition, one can expect additional loan and lease defaults, new bankruptcies, continued consumer insecurity and a lack of new tenants. Shopping Centers Today described the new face of retail as loads of high-profile bankruptcies and tons of lost jobs, 1

2 sales sinking, values shrinking, occupancy dropping, vacancy topping and still no bottom in site. The good news for retailers rents are likely to continue to slide. Lack of capital will also detrimentally affect retail going into this decade. Not only will capital for new centers be virtually non-existent, even capital for renovation of successful centers will be limited. Maturing loans on existing centers will need to be extended by lenders, or more developers will file for bankruptcy or hand over the keys to the lenders. Lack of capital will also negatively impact the roll-out of new tenant concepts. Rent renegotiations have become rather commonplace, particularly with struggling tenants. If a developer has a choice of an empty space, or a reduced rent on an occupied space, the latter will be the choice. It is critical to developers that their malls remain tenanted, even if income is reduced. Across the country, the trend to update old and tired retail shopping centers and malls continues through creative revitalization and redevelopment. Redevelopment may involve demalling all or part of an existing mall as well as relocating existing anchors and in-line tenants. The process is costly and time consuming; the results, however, can yield tremendous benefits for developers, tenants and ultimately consumers. Numerous legal and business obstacles arise during the redevelopment process. Legal issues involving rezoning, re-platting and resubdividing are commonplace, as well as practical and community issues related to utilities, signage and overall concerns from neighbors and the local community. In connection with redevelopment and expansion, at least one developer has used condemnation as a strategy to acquire premises and lease rights. Existing owners of retail shopping centers and malls continue with revitalization and redevelopment in order to attract a stronger customer base as well as ensure that the property remains financially strong. As part of de-malling, the traditional regional mall consisting of three to five department store anchors, numerous in-line small shop tenants and a food court, is changing. Part of the impetus for redevelopment is based upon long-term sustainability and the need to give consumers what they want. Redevelopment projects involve various uses such as: movie theaters; big box retailers as anchors; lifestyle open air mall and strip centers; and mixed-use centers, including offices and residential uses. Redevelopment projects that involve de-malling require landlords to focus on four major areas of concern: (1) local community and governmental issues; (2) anchors; (3) inline tenant concerns; and (4) financing and lender issues. Within each of these categories, attention must be given to the appropriate parties and issues in order to ensure a successful redevelopment. Poor planning and lack of communication can create costly delays. Existing anchors present unique issues to a landlord when contemplating a redevelopment project. Recorded reciprocal easement agreements already in place and perhaps outdated contain specific rights, including no-build areas, that need to be negotiated and addressed. Land owned by some anchor tenants may need to be re-conveyed in order for the landlord s redevelopment project to move forward. Infrastructure issues related to parking, signage and traffic flow will all need to be addressed with anchor tenants. In most situations, 2

3 existing agreements require anchor consent to alterations or changes to the permitted build areas, common areas, roads, and other elements. Anchor tenants traditionally carry much more leverage than in-line tenants, and a landlord must gain the cooperation of the anchors to successfully redevelop. Anchors often use these situations to obtain benefits and further leverage with the developer. As developers and tenants together look for new ways to expand retail and bring consumers back into the stores, all will be thinking outside of the box. An increased focus on infill urban development, as well as international expansion, may produce results. Developers continue to seek international brands for expansion in the U.S. All must recognize that there are shopping alternatives and habits that will affect permanently the success of retail real estate. For example, the way companies sell, through the internet and other direct-to-consumer methods, has affected the success of shopping centers, but not to the extent once anticipated. However, as more retailers place direct links in their stores, revenues to landlords may be affected, particularly with regard to percentage rent. Consumers need to consume has also impacted center operations notably with regard to operating hours. Black Friday, used to start at 9 a.m. on the Friday after Thanksgiving. Some retailers have pushed that back to 6 a.m., while others now start on Thursday night. Some developers have attempted to force their specialty tenants to maintain the same vastly extended hours (6 a.m. midnight) as the anchors, with questionable success and results. Over the last several years, the growth in sales of gift cards both by retailers and the malls has pushed the Christmas shopping season well into January, skewing fourth quarter results and reducing retailers profits as gift card recipients wait until January to take advantage of post-holiday pricing. II. GETTING A RETAIL DEAL DONE All of these changes have had a substantive, if not at times, dramatic, impact on the landlord-tenant relationship and the lease. The impacts have not been all one-sided. Rent The key struggle in a deal today is the rent. Before now, there was almost an assumption that rents would increase when a new lease was negotiated. Developers are pushing to keep rents up, which affects the value of the center and ability to borrow, while tenants maintain that rents should decrease. Likely, rents in top tier centers will be flat or increase, while rents in less desirable centers will decrease. Interestingly, tenants with greater financial issues have been and may going forward be able to achieve lower rents. CAM and Other Expense Pass-throughs To ensure predictability of income, developers are converting expense pass-through charges to fixed fees. In some cases, just CAM charges are fixed, but often the fixed charge is more inclusive and covers other pass-through expenses such as insurance and marketing. 3

4 Although in-line tenants may be willing to convert to fixed charges, they must have a certain level of protection. In lieu of the extensive descriptions previously used to outline the charges included in CAM or other pass-through charges, tenants can protect themselves by spelling out the landlord obligations related to the common areas and shopping center, maintenance of certain levels of insurance, and establishment of marketing funds. Fixed charges benefit both developers and in-line tenants. The most difficult part of the process is setting the initial number. Developers want to build in a cushion to protect themselves. In-line tenants want to keep the first year amount as low as possible to reflect actual charges. Landlords also benefit from fixed charges because it eliminates expensive and timeconsuming audits. However, there is some risk to landlords if there are unexpected expenses, such as increased security requirements or unforeseen weather events. Co-tenancy To protect against the fallout from a changing shopping center, developers are looking for more flexibility in co-tenancy provisions (i.e., required operations by other tenants). Developers are attempting to secure the right to replace traditional department stores with other types of uses. In some cases, developers may wish to redevelop the entire parcel previously occupied by a department store. Other times, developers are filling some or all of the box with junior anchor stores, movie theaters, restaurant uses or more in-line space. In-line tenants are pushing back and attempting to ensure some level of protection in the changing landscape. Although the transformation of a traditional shopping center into a mixed use development after the departure of a department store helps to maintain the developer s income stream, some traditional in-line tenants are insisting on remedies to protect themselves in the event the shopping center evolves in a manner which was not anticipated. Shopping center redevelopment does not always translate into a successful environment for a traditional in-line tenant dependent on the customer base brought in by the more traditional shopping center department stores. Co-tenancy rights are critical for tenants in new centers, but because there are so few planned now, there is less focus on this point at this time. Other issues arise in connection with co-tenancy remedies, including types of alternate rent, duration of alternate rent and termination rights. Attached are sample clauses that address many of the issues that arise in the co-tenancy context. Use Clauses, Operating Covenants, Exclusive Clauses and Radius Restrictions Use clauses, operating covenants, exclusive clauses and radius restrictions have become increasingly important in lease negotiations. Use clauses set forth the uses that a tenant may make of the leased premises. Use clauses may also specifically restrict the tenant s use of the premises by limiting either the lines of business in which the tenant may engage or the items 4

5 which the tenant may sell from the leased premises. Operating covenants require a tenant to keep the premises open for business and operating continuously throughout the term of the lease, usually during certain hours and days. In addition, operating covenants may require the tenant to operate at specified levels of activity. Exclusive clauses restrict the landlord s right to lease other premises in the shopping center by granting the tenant the exclusive right to engage in a certain line of business or the sale of specific products. Radius restrictions prohibit the tenant from engaging in a competing line of business within a specified geographical area. Obviously, use clauses, operating covenants, exclusive clauses, and radius restrictions serve many purposes for both landlords and tenants. They aid in achieving ideal tenant mixes and increased customer traffic. They may be necessary to attract new tenants, and they may prevent dark stores. All may affect assignment and subletting and all are particularly relevant in connection with percentage rent leases. Therefore, a brief review of percentage rent is required. A percentage lease is one which bases rent, in whole or in part, on sales, profits, income and receipts derived from the leased premises. Typically, the lease establishes a minimum rental which must be paid regardless of sales. The lease will also provide that a percentage of gross sales must be paid on any sales above a specified base or breakpoint. Some percentage leases do not provide for a minimum base rent, while others provide for a nominal base rent, but most include a substantial base rent which covers the landlord s fixed costs. For use clauses, operating covenants, exclusives and radius restrictions, it is important to view each lease separately; the type of center and other factors will determine how important these clauses are in any particular situation. Careful drafting of these clauses is also important. A change of a word may render these clauses unenforceable. One must also specifically address enforcement and remedies for breach, as it may be almost impossible to prove actual damages. Internet Sales In calculating gross sales for purposes of percentage rent, tenants and landlords typically agree to carve out certain non-core business retail transactions that are not based on the sale of a tenant s product directly to the in-store consumer. Notwithstanding the amount of internet based transactions today, typical gross sales exclusions may not adequately address a tenant s internet sales (and similarly, but not discussed here, telephone and/or any other method of electronic order placement and/or acceptance). As retailers expand their platforms to include internet based selling, tenants should consider carving out internet sales on at least two levels internet sales originated outside a tenant s premises and internet sales originated from within a tenant s premises. A sale over the internet may be placed from a tenant s web page, whereby the customer is free, from his or her own computer, to browse inventory and purchase selected products, which are usually shipped directly from a warehouse (versus a tenant s store) to the consumer s home. A tenant s lease should clearly exclude these types of internet sales from a tenant s gross sales 5