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

6 because there is no nexus between a tenant s premises-based product sales and the sale that originated on its web page, and the product is shipped from another location to the customer. Most landlords and tenants would not dispute this transaction as an exclusion from gross sales. However, in the event a tenant has installed a computer or other electronic terminal within its leased premises, landlords and tenants have differing opinions. Including sales from the in-store computer depends on, among other things, the product offered, physical location of the product and where the consumer receives the product. From a tenant s perspective, if a customer can place an order from an in-store computer for goods not offered for sale from the premises that are shipped from a remote location directly to the customer, the sale should be excluded. A tenant may argue the customer is no different than one that merely browses its inventory without consummating an in-store sale and further that the tenant incurs, at least on an enterprise wide level, different costs for storage and distribution when the product is not in the store. Landlords may disagree because the customer is physically standing in the space being rented. If, however, a customer can place an order from an in-store computer for goods located at the premises (either on the floor or in the storeroom) and immediately thereafter receive the goods within the premises, the sale should legitimately be part of gross sales. In this instance, the use of the terminal would be akin to a self-checkout at a grocery store and a tenant would be challenged to assert an exclusion from gross sales. Tenants and landlords should, however, be aware of potential use and exclusive issues if the in-store computer is not dedicated to goods permitted or prohibited, as the case may be, in accordance with use and exclusive clauses. To avoid potential conflict as a result of this issue, landlords and tenants should work closely to understand the product lines offered in the store and online. FUTURE OF SHOPPING CENTERS Retail real estate will continue to evolve as all parties work to keep shoppers in malls. Continued developer and department store consolidation is expected. A significant number of malls are likely to fail within the next five years. No tenant will want to be the last one to turn out the lights, so co-tenancy and kick-outs will continue to be heavily negotiated. REITs continual need to grow Funds From Operations will impact leverage, rent and operations generally. Developers need to keep shopping interesting and entertaining, as do retailers. Everyone will need to adjust to technology changes. All we can be certain of is that the future of malls may be unknown, but not uninteresting. 6

7 EXHIBIT A Alternate Replacement Provision for Additional Development Flexibility An Alternative Comparable Replacement Tenant for purposes of this Section shall mean a comparable retail fashion department store, which offers retail fashion merchandise of a nature, quality, mixture and quantity currently offered (or expected to be offered) by the Key Tenant it is replacing (or if not yet open, offered as of the initial opening of such Key Tenant). Notwithstanding the foregoing, Landlord shall have the right, with respect to only one (1) Key Tenant, to have an Alternative Comparable Replacement Tenant be deemed to mean one of the following: 1. An area comprised of big box retail tenants, with each big box tenant occupying at least square feet of contiguous space, and with each big box tenant having at least years retailing experience, and each of the caliber found in other comparable shopping centers; 2. One national or regional retailer (as those terms are commonly defined in the retail shopping industry) operating under one (1) trade name; 3. A movie theater with a minimum of screens; or 4. A lifestyle addition to the Shopping Center being occupied by a combination of small shop national or regional retail tenants, each with at least five (5) years retailing experience, and each of the caliber found in other comparable shopping centers, and including fountains, restaurants, and other public amenities in an integrated and cohesive cross-shopping experience. Notwithstanding the foregoing, to qualify as an Alternative Comparable Replacement: 1. The tenant(s) must have entrances accessible to customers in the enclosed Shopping Center mall area during normal mall hours; 2. The tenant(s) must be open and operating for business from at least percent ( %) of the gross leasable area previously occupied by the Key Tenant being replaced; and 3. Such tenant(s) shall not include any of the following: a. [prohibited named replacements will vary depending on the tenant s type of business]; b. A sporting goods store; c. An office supply store; d. An appliance store; e. An automobile services, sales, or rental facility; f. A pet store, pet supply store, or pet clinic; g. A home improvement store; or h. A store offering as its primary use, the sale of discount merchandise. 7

8 EXHIBIT B Sample Construction/Possession Co-tenancy Provision Notwithstanding anything contained in this Lease to the contrary, Tenant shall not be required to accept Landlord s delivery of possession of the Premises (nor shall Rent accrue) unless Landlord has provided Tenant with a written certificate from an authorized officer of Landlord (the Certificate of Occupants ), verifying that (a) at least percent ( %) of the leasable floor area of the Shopping Center is leased to occupants obligated to be open and operating for business to the public on or before the Grand Opening Date (as defined in Section ), and (b) the tenant doing business under the trade name, is obligated to be open and operating its premises for business to the public on or before the Grand Opening Date, and (c) the tenant doing business under the trade name, is obligated to be open and operating its premises for business to the public on or before the Grand Opening Date, and (d) at least seven (7) Preferred Occupants (as defined herein below) are obligated to be open and operating their respective premises for business to the public on or before the Grand Opening Date. A Preferred Occupant shall mean any Occupant operating under any of the following trade names:. In the event Landlord fails to provide Tenant with the Certificate of Occupants (as defined above) on or before ( Possession Co-Tenancy Sunset Date ), Tenant may terminate this Lease ( Possession Co-Tenancy Termination Right ), without penalty or repayment of any portion of the Construction Allowance (as defined in Section ), immediately upon written notice ( Possession Co-Tenancy Termination Notice ) to Landlord, which notice must be given, if at all, anytime during the period commencing on the day following the Possession Co-Tenancy Sunset Date and continuing until the one hundred twentieth (120 th ) day following the Possession Co-Tenancy Sunset Date (provided, however, that Tenant may not terminate the Lease if Landlord has met the conditions set forth above prior to the date Tenant elects to terminate the Lease). In the event Tenant elects to terminate this Lease as set forth hereinabove, Landlord shall, within thirty (30) days after the date on which Landlord has received the Possession Co-Tenancy Termination Notice, reimburse Tenant for its actual and reasonable out-of-pocket costs in connection with Tenant s legal fees associated with the review and negotiation of this Lease and Tenant s architectural design fees associated with Tenant s preparation of documents, as liquidated damages. Notwithstanding anything contained in this Section to the contrary, Tenant s Possession Co- Tenancy Termination Right shall be null and void and of no further force and effect in the event Tenant accepts Landlord s delivery of possession of the Premises prior to the Possession Co- Tenancy Sunset Date. 8

9 EXHIBIT C Sample Co-Tenancy Provision A. If at any time during the Term either or both of the following shall occur: (I) (II) (III) Any of the retail fashion department store tenants identified as <trade name>, <trade name>, and <trade name> (collectively, Key Tenants, or singularly, Key Tenant ), which are occupying square feet, square feet, and square feet of floor area respectively in the locations identified on the Site Plan attached as Exhibit A as being occupied, or to be occupied, by such Key Tenants (collectively, Key Tenants Premises, or singularly, Key Tenant Premises ), or Comparable Replacement Tenants of such Key Tenant or Key Tenants, as defined below, shall fail to be open for business to the public within at least ninety five percent (95%) of the floor area of the Key Tenants Premises; and/or At least [number] (##) of the following specialty retailer co-tenants; <trade name>, <trade name>, and <trade name> (each, Specialty Retail Tenant, or collectively, Specialty Retail Tenants ); which are occupying premises in the location identified on the Site Plan attached as Exhibit A (each Specialty Retail Tenant Premises, or collectively, Specialty Retail Tenants Premises ), or Comparable Specialty Retail Tenants, as defined below, fail to be open for business to the public in at least ninety-five (95%) of the floor area of the respective Special Retail Tenant Premises; and/or Less than (a) eighty percent (80%) of the gross leasable floor area of the [enclosed mall of the Shopping Center] [the retail improvements] shown on the Site Plan, which gross leasable floor area of the Shopping Center shall in no event be less than square feet of gross leasable floor area; and/or less than (b) eighty-five (85%) of the gross leasable floor area of Level of the Shopping Center shown on the Site Plan, which gross leasable floor area of Level shall in no event be less than square feet of gross leasable floor area, (which calculations of gross leasable floor area in clauses (a) and (b) shall exclude the floor area of the Key Tenants Premises to the extent that it is open for business), is occupied by Permanent Retail Tenants (as defined below) which are open for business to the public; (the requirements set forth in clauses (I), (II) and (III) of this paragraph (A) being hereinafter referred to as the Co-Tenancy Requirements or individually as a Co-Tenancy Requirement ), then in the event of a violation of any one or more of the Co-Tenancy Requirements: (i) If Tenant has not yet opened for business in the Demised Premises, Tenant shall not be required to open for business in the 9

10 Demised Premises, and the Commencement Date shall not occur until such time as the Co-Tenancy Requirements have been fully satisfied; and (ii) (iii) (iv) If Tenant has opened or elects to open for business in the Demised Premises, Tenant s obligation to pay Minimum Rent, Percentage Rent, Additional Rent and all other charges (collectively, Rent ) shall abate (effective retroactively to the first day of such violation), and Tenant shall pay a reduced monthly gross rent equal to the lesser of: (i) percent ( %) of Gross Sales, or (ii) percent ( %) of the monthly installment of Minimum Rent, such amount to be paid monthly in arrears on or before the thirtieth (30 th ) of each month; and If any such failure continues for more than ninety (90) days, Tenant shall have the right, at any time thereafter, to terminate this Lease by notice to Landlord ( Tenant s Termination Notice ), which right shall continue until Landlord remedies the failure of the applicable Co-Tenancy Requirement. In the event Tenant exercises its right to terminate under this paragraph, this Lease shall terminate effective upon the date specified in Tenant s Termination Notice (regardless of whether the failure is cured following the date Tenant gives such notice) with the same effect as if such date was the scheduled expiration date of this Lease; and If any violation of any Co-Tenancy Requirement or Co-Tenancy Requirements continue for more than ninety (90) days, Tenant shall have the right, at any time thereafter, to discontinue its operations in the Premises for such periods and from time to time, as Tenant, in its sole discretion, may determine, in which case Tenant s monthly gross rent, in lieu of Rent shall be equal to percent ( %) of the monthly installment of Minimum Rent. B. For purposes of this Lease, the phrase Comparable Replacement Tenant shall mean a Permanent Retail Tenant (as defined below) which is reasonably acceptable to Tenant and currently defined in the retail industry as a retail fashion department store, which has a regional or national reputation, which offers retail fashion merchandise of a nature, quality, mixture and quantity and with a retail service level currently offered by the Key Tenants as of the date hereof (or upon such Key Tenants initial opening for business fully stocked if not yet open as of the date of this Lease) and which shall in no event include without limitation any bookstores, furniture stores, toy stores, pet supply stores, sporting goods stores, hardware stores, home improvement stores, drug stores, grocery stores, supermarkets, theaters, cinemas, warehouse clubs, clearance, discount or wholesale price stores, or any so-called value retail stores (which would include, without limitation, Kohl s, Target, Wal- 10

11 Mart and K-Mart). To qualify as a Comparable Replacement Tenant under this paragraph, such tenant shall operate within at least ninety-five percent (95%) of the floor area of the Key Tenant Premises occupied by such Key Tenant being replaced. C. For the purposes of this Lease, the phrase Comparable Specialty Retail Tenant means a Permanent Retail Tenant reasonably acceptable to Tenant which has a regional or national reputation and which is currently defined as a specialty fashion retailer within the retail industry and which shall offer fashion merchandise with price points, product quality, mixture and quantity, and a retail service level currently offered by any one of the Specialty Retail Tenants. To qualify as a Comparable Specialty Retail Tenant under this paragraph, such tenant shall operate within at least ninety-five percent (95%) of the floor area of the Specialty Retail Tenant Premises occupied by such Specialty Retail Tenant being replaced. D. For the purposes of this Lease, the phrase Permanent Retail Tenants, or singularly Permanent Retail Tenant, shall mean Retail Tenant(s) (as hereinafter defined), other than Tenant and affiliates of Tenant, occupying space in the Shopping Center that has been professionally designed and fixtured, and operating in a first class manner under a lease with a fixed term of a continuous period of at least three (3) years in duration without any discretionary termination right (including without limitation any socalled kickout right), other than such termination rights arising solely from cotenancy, casualty, condemnation, and Landlord s default, which would allow such Retail Tenant or Landlord to terminate or cancel its lease within such three (3) year period. Permanent Retail Tenants shall not include any tenants or occupants of kiosks, pushcarts, or other selling areas in the Common Areas, seasonal or fad tenants, or occupants under any license or similar agreement. For the purposes of this Lease, the phrase Retail Tenants, or singularly Retail Tenant, shall mean tenant(s) operating for the primary purpose of the sale of merchandise at retail and which shall not include, by way of example, without limitation, any cinema, theater, restaurant, beauty salon, office, library or arcade. [ALT] Key Tenant Closing Due To Casualty, Etc. In the event that any Key Tenant, or Comparable Replacement Tenant, is closed for business as a result of casualty, condemnation, or events of force majeure, such event shall not constitute a violation of the applicable Co-Tenancy Requirement, provided that such Key Tenant or Comparable Replacement Tenant is at all times diligently pursuing reopening for business and provided further that in no event shall such Key Tenant or Comparable Replacement Tenant be closed for business for a period that exceeds one hundred eighty (180) days, in which event such closure shall be deemed a violation of the applicable Co-Tenancy Requirement retroactive to the date of such casualty, condemnation or force majeure event. [ALT] Landlord s Right To Demand Full Rent 11

12 In the event that Tenant shall have paid monthly gross rent in lieu of Rent as a result of a violation of the Co-Tenancy Requirement or Co-Tenancy Requirements for a period of one (1) year or more, Landlord may make written demand upon Tenant to resume paying full Rent, and if Tenant fails to terminate this Lease as provided in this Section within sixty (60) days after receipt of such written demand from Landlord, Tenant shall be deemed to have waived its right to terminate pursuant to this Section for such violation of the applicable Co-Tenancy Requirement(s), and Tenant shall thereafter resume paying full Rent under this Lease effective as of the sixty-first (61 st ) day following the date of Landlord s written demand. [ALT] Landlord s Right to Nullify Termination Notwithstanding the foregoing, with respect to the Co-Tenancy Requirement relating to Key Tenants, if within seven (7) days of Landlord s receipt of Tenant s Termination Notice, Landlord shall provide Tenant with written notice ( Landlord s Replacement Notice ) and evidence satisfactory to Tenant that Landlord has entered into binding written lease agreement(s), with a Comparable Replacement Tenant sufficient and likely to bring the Shopping Center into compliance with the applicable Co-Tenancy Requirement within three (3) months of the date of Tenant s Termination Notice, then Tenant s termination shall not be effective for a period of three (3) months from the date of Tenant s Termination Notice (the Replacement Period ), while Landlord diligently pursues the build-out of the space to be occupied by such Comparable Replacement Tenant. If prior to the expiration of the Replacement Period the identified Comparable Replacement Tenant has opened for business, and the Shopping Center is thereby in compliance with the Co-Tenancy Requirements, then Tenant s Termination Notice shall be vitiated and rendered null and void ab initio. However, if upon the expiration of the Replacement Period the identified Comparable Replacement Tenant has not opened for business, then Tenant s Termination Notice shall be fully effective as of the termination date specified therein, all as if the provisions providing for the Replacement Period had not been included in this Lease. 12

13 EXHIBIT D Sales D Sales Test Operating Co-Tenancy: If during the Term, (a)(i) less than 70% of the gross leasable area in the Shopping Center (including Tenant and any parent, subsidiary or affiliated companies of Tenant and excluding the gross leasable area of all anchors and outparcels) is occupied by tenants that are open and operating for business or (ii) less than * [TYPICALLY A NUMBER THAT IS ONE LESS THAN EXISTING NUMBER OF ANCHORS] anchors or their Suitable Replacement(s) (as defined below) are open and operating for business in the Shopping Center ((i) and (ii) collectively, the Occupancy Failure ) and such Occupancy Failure continues for 12 consecutive months, and (c) if Tenant's Net Sales for the 12 consecutive month period from the date such Occupancy Failure commences decrease by more than 10% as compared to Tenant's Net Sales from the immediately preceding 12 month period (the "Sales Measuring Period") ((a), (b) and (c) all collectively the "Operating Failure") then, provided Tenant is not in default under the Lease beyond any applicable cure periods and is open and operating in the Leased Premises in a manner that is at least equivalent to the operations in the Leased Premises prior to the Occupancy Failure, Tenant shall have the right beginning on the first day of the 13th month after the Occupancy Failure to pay to Landlord (notwithstanding anything to the contrary contained in ARTICLE ), in lieu of Minimum Annual Rental, Percentage Rental and all additional rental, an amount equal to 5% of Net Sales (as defined in ARTICLE ) not to exceed Minimum Annual Rental and Percentage Rental otherwise payable for each and every month (hereinafter Substitute Rent ), payable monthly, in arrears, within 20 days following the end of each calendar month. Tenant agrees to give Landlord written notice of Tenant s intention to exercise this remedy. In addition, if, within 18 months following the date on which an Operating Failure shall have occurred, such Operating Failure shall not have been cured, Tenant shall have the right, prior to the remedying by Landlord of the Operating Failure, to terminate this Lease by written notice sent to Landlord and, upon a date which shall be at least 60 days following the date of the notice, this Lease shall cease and terminate; provided, however, that if the Operating Failure shall be an Operating Failure described in clause (ii) of this Section and if, within the 18 month period during which such Operating Failure shall be continuing, Landlord shall send Tenant a notice (the Vitiating Notice ) that the Suitable Replacement, the information of which shall be specified in the Vitiating Notice, shall open for the conduct of business, then any notice sent by Tenant on account of the Operating Failure shall be void and of no force and effect, and this Lease shall continue upon all of its terms and conditions; provided further, however, that if the Suitable Replacement shall not open for the conduct of business within 6 months following the date of Landlord s Vitiating Notice, Tenant shall have the right, to cancel and terminate this Lease by written notice sent to Landlord and, on the date which shall be at least 60 days following the date of that notice, this Lease shall cease and terminate. In the event Tenant has not sent the notice of its intent to terminate within 60 days after the end of the 18 month period, then Tenant s right to pay Substitute Rent shall cease and Tenant shall resume paying all Minimum Annual Rental and Percentage Rental and all other rents under the Lease as if this Section was not in place. A Suitable Replacement shall be any of the following: (a) another anchor; or (b) a tenant or combination of tenants that occupy an aggregate area of at least 50% of the square footage of the former anchor. Notwithstanding the foregoing provisions, if Tenant opens for 13

14 business on the date required in Section, but subsequently fails to continuously operate in the Leased Premises, and the Operating Failure has not been fulfilled, then notwithstanding the foregoing provisions, the payment of Minimum Annual Rental, Percentage Rental and additional rental shall start on the date Tenant ceases to continuously operate its business in the Leased Premises and Tenant shall not have the right to terminate the Lease. If however, the foregoing conditions have not been met on the date Tenant resumes to continuously operate its business in the Leased Premises, the Minimum Annual Rental, Percentage Rental and additional rental shall be abated as indicated above until the conditions are met, and Tenant shall regain the right to terminate this Lease. 14

15 EXIT AND RESTRUCTURING STRATEGIES FOR RETAIL DEALS I. INTRODUCTION By: Ann Peldo Cargile Entering into a retail deal, regardless of whether it involves a lease, ground lease or pad sale, takes optimism. Each party enters into a new venture that it fully expects will be a mutual success. Unfortunately, the success of a retail enterprise relies in large part on the discretionary income of often fickle customers. The hottest concept one year may be old news the next season. Thus, the positive expectations that abound at the front end of a retail deal must be tempered with a certain degree of cynicism. Both sides need to craft exit tools, if the retail operation does not succeed. This article will address options for restructuring or, if need be, exiting a retail relationship. The discussion will focus primarily on leasing, but will also touch on arrangements where a retailer owns a pad that is part of a larger development. II. FRONT END PROTECTIONS The logical time to structure exit strategies occurs during initial negotiations. Generally, a landlord's lease form contains all the bells and whistles the landlord needs to enforce the lease, but the tenant must expressly insist on provisions protecting its down side. Correspondingly, many national retailers have form leases and reciprocal easements agreements ("REAs") that protect their interests, but do not offer the landlord or owner of the development viable options if the retailer experiences a downturn. The next section of this article discusses several common front end protections the parties may discuss. A. Co-tenancy A sophisticated tenant will look for assurances that the landlord will lease and operate the center as represented, both as a condition to the tenant opening for business and to the tenant paying fixed rent throughout the lease term. The tenant will want a requisite number of the proposed anchor tenants, which are the main draw to the center, to open. The tenant will also want the balance of the center to thrive, with a minimum percentage of the small tenants open to coax customers to stay and shop. If the center does not satisfy either of these tests, the tenant will initially want relief on its rent, and eventually the right to terminate the lease. Co-tenancy provisions pose a significant risk for the landlord. The landlord cannot guarantee that any given tenant will remain in business. Even if a lease requires the tenant to remain open and operate for business, as a practical matter, courts have routinely refused to grant landlords the remedy of specific performance for such an obligation, on the grounds that the court cannot reasonably monitor an ongoing business operation. Co-tenancy provisions can have a domino effect, where one store closing may trigger rent concessions or termination rights in a number of other leases. Thus, a wise landlord will negotiate for time to resolve a co-tenancy violation before tenant remedies come into play. The landlord will also want to tie the tenant's remedies to damages the tenant has actually suffered because of the co-tenancy violation. For instance, there may be a co-tenancy violation in the center that does not materially impair the tenant's sales. If the lease gives the tenant the unfettered right to pay reduced rent, the tenant may happily operate for years paying a fraction of its normal rent. This devalues the center and impairs the landlord's ability to refinance or sell it. Further, if the tenant has an ongoing termination right because of a 15

16 co-tenancy violation, no lender or purchaser will allow any credit for that lease in valuing the center. Therefore, all co-tenancy remedies need to expire at some point. Either the tenant must terminate the lease or go back to full rent. A common structure for a co-tenancy provision would therefore look something like the following: 1. Landlord has months after notice from the tenant to remedy the violation (the "Cure Period"). 2. If the violation is not remedied within the Cure Period, the tenant thereafter pays percentage rent in lieu of fixed rent [and expense pass-throughs]. 3. If the co-tenancy violation continues for months (the "Cure Deadline"), the tenant thereafter has the right to terminate the lease upon months' notice to the landlord. 4. If the tenant ceases doing business in the center at any time prior to the Cure Deadline, the tenant's remedies go away and full rent resumes. 5. If the co-tenancy violation continues for months (the "Tenant Remedy Deadline"), the tenant must either terminate the lease or waive its termination right and return to full rent. B. Gross Sales Thresholds Sometimes a tenant will have doubts as to whether a location will generate enough sales to justify long term operation. In that instance, the tenant may ask the landlord for a right to terminate the lease if its gross sales do not exceed a certain threshold. This presents several issues for the landlord. First, the landlord will need the tenant to commit to operate in the center long enough to attempt to grow a customer base. Second, underwriters will value the lease as if the termination right will be exercised. Last, the landlord may find itself out of pocket for leasing commissions, tenant improvement allowances and legal costs if the tenant terminates the lease. The landlord can protect against loss of expenses by providing that the termination option can only be exercised if the tenant reimburses the landlord for unamortized costs associated with the lease. A smart landlord will also ask for advance notice of termination, in order for it to have time to find another tenant. The landlord must also tie a termination option based on gross sales to a continuous operations clause. If the tenant goes dark, its sale will obviously drop, so the termination option needs to be contingent upon the tenant operating its business at full capacity. Thus, a termination right based on gross sales will often have the following features: 1. The tenant must operate for business at least years, fully staffed, stocked and fixtured (the "Test Period"). 2. The tenant must report its gross sales to the landlord promptly during the Test Period. 3. The tenant must give the landlord at least months' prior notice of its election to terminate the lease. 16

17 4. The tenant must elect to terminate the lease within days following the Test Period or the termination option is waived. 5. The tenant must pay the landlord's costs associated with the lease, amortized over the initial lease term [at the time the Tenant exercises the termination option]. C. Pre-negotiated Termination Options If a tenant has a high level of insecurity on the front end, it may ask for a simple termination option after an initial operating period, regardless of its gross sales. In such a case, aside from gross sales reporting, the landlord will have the same concerns as for a termination option based on gross sales, and the option will include items 3, 4 and 5 in Section B, above. D. Landlord Solvency Concerns Most discussions of exit strategies focus on problem tenants, but, especially in the current environment where lenders are taking back properties, a tenant which is making a significant investment in its space will want assurances that the lender will not terminate the lease if it forecloses on the center. Generally speaking a lender will consent to a non-disturbance agreement at the outset of a lease, if the tenant likewise agrees to recognize (and attorn to) the lender as its landlord following a foreclosure. However, the tenant will not want to pay a foreclosing lender rent if the tenant has not received allowances the landlord has promised. At minimum, a tenant should ask for an offset right in its lease, allowing it to recover unpaid allowances before it must pay rent. If the allowance is significant and the tenant cannot or does not want to recoup its costs from the rent over time, the tenant may want the lender to agree to fund any unpaid allowances if it forecloses. This may present a significant issue for the lender, because it is one thing for the lender to receive reduced cash flow from the property, and something else entirely for the lender to invest additional sums after foreclosure. The resolution in this instance will likely be for the lender to require the landlord/borrower to escrow sufficient money to fund the improvement allowance as a condition of the lender approving the lease. These issues should all be sorted out in a subordination, non-disturbance and attornment agreement between the lender and the tenant, which may have the following provisions: 1. Lender agrees not to disturb the tenant's possession of the premises as long as the tenant is not in default. 2. Tenant agrees to attorn to the lender after foreclosure. 3. Lender agrees the tenant will have offset rights for unpaid allowances. 4. After foreclosure the lender will fund any unpaid allowance [If and only if the landlord escrows the allowance with the lender pursuant to a separate agreement]. The tenant may want additional protections from the landlord that allowances will be paid in a timely fashion, even if the lender does not take over the property. Possible forms collateral include a parent guaranty, if the landlord is a single asset subsidiary, or a letter of credit. The tenant may also require that the landlord fund a build-out allowance aggressively, posting payment with the tenant before work is done so that the tenant need never come out of pocket for 17

18 construction costs. Of course, this last option has its down side from the landlord's perspective, because if the tenant does not manage construction well or does not apply the money as anticipated, the landlord could find itself out of pocket for an allowance to a tenant that never opens in the center. Placing the allowance in escrow with a third party, such as a title company, may provide a suitable compromise. III. OPTIONS AFTER THE RETAILER IS IN TROUBLE A. Overview Although a party may try to craft exit options on the front end of the deal, this may not be feasible for a number of reasons. First, an early termination right may prevent a landlord from using a lease to finance construction. A ten year lease with a termination right after three years constitutes a three year lease in the mind of a lender. Further, a retailer simply may not have enough bargaining power to obtain a termination right. Anchor tenant deals are often breakeven for landlords and developers, who make most of their money on the small shop spaces. The unfortunate truth is that the small operator, who can least afford a downturn, often gets few or no exit rights at the time it executes its lease or buys its parcel. Small operators gain their leverage when the other side perceives that the business has a strong likelihood of failing if the parties do not restructure the deal. When a tenant's business starts to struggle, the tenant must address whether its exit strategy consists of paying what is necessary to terminate the lease, or whether it can recast the economic terms of the lease so it can survive until the lease expires. Often a solvent national tenant that has successful stores elsewhere is worse off in negotiating an exit with the landlord than a "Mom and Pop" store than has no other assets. For a national chain, the landlord may insist on a check, while for a single store operator, the landlord may accept a more creative solution. Only then should the parties move forward. Every restructure should begin with an assessment of not only the economics of the deal, but also what may be missing. As a preliminary matter, any party that is considering granting a concession should require the other party to deliver an estoppel certifying that it has no claims, offset rights or defenses to performance. If a guaranty exists, the guarantor should also confirm that the guaranty remains in effect without defenses. If there are other gaps in documentation, such as missing exhibits or commencement agreements, these should be plugged as well. B. Sales, Subleasing and Assignment 1. The Retailer's Perspective Finding another party to take over the space, by sale, assignment or sublease, presents the most obvious means of reducing the retailer's exposure. The average landlord lease form will permit some type of subleasing with landlord consent, and the laws of many states require landlords to act reasonably in granting such consent. Most REAs do not prohibit the transfer of the retailer's fee interest. However, the retailer will need to examine the documents, not only for the provisions that expressly deal with sale, assignment and subleasing, but also for more subtle ways a landlord or center operator can obstruct a transfer of the space. For instance, a narrow permitted use clause can block a new operation. The original retailer's business may have failed because of an unsuitable location. In this instance, another, similar use will not make the 18