Lurking in the Lease: Unexamined Risks Could Worsen the “Retail Apocalypse”
Originally Appeared on ABL Advisor by Mike Harris and Max Garbus
Concern about the fate of American retail is growing—and with good reason. Laden with debt, challenged by Amazon and racing to adapt to the changing consumer, a number of U.S. chains face uncertain futures. During the first quarter alone, Moody’s tracked a record nine loan defaults among retailers. Meanwhile, Cushman & Wakefield sees potential for another 11,000 store closings (as well as bankruptcy filings by an additional 25 at-risk chains) by the end of this year.
An unnerving feature of this so-called “retail apocalypse” is the ongoing wave of store closures by anchor tenants like Sears, Macy’s, JCPenney, Toys “R” Us and Bon-Ton, to name a few. The closures themselves are garnering no shortage of headlines.
However, those with financial interests in retail tenants and/or centers also need to monitor the potential for additional fallout. In particular, the wave of anchor vacancies has broad potential to trigger other tenants’ co-tenancy clauses, allowing them the opportunity to pay lower rents or even flee properties without incurring penalties. In the most severe cases, these dynamics could contribute to a death spiral at certain shopping centers and malls, a phenomenon reminiscent of the Great Recession.
Post-Recession Trends in Co-Tenancy
In assessing the risks posed by co-tenancy clauses, it is important to understand some of the factors in play. Typically, these provisions will fall into one of two categories: opening co-tenancy, typically reserved for when new centers or redevelopments are in their opening phases, and ongoing co-tenancy, which is applied to retailer operations over time.
A decade ago, ongoing co-tenancy clauses were extremely common for anchor tenants. Indeed, it would be no exaggeration to say that they were present in almost every lease—a stark reality that many U.S. landlords were forced to come to grips with during the recession. In fact, perhaps because landlords had such bad experiences with co-tenancy issues during the downturn, there has been a noticeable drop in ongoing co-tenancy clauses granted to anchor tenants over the past few years, based on what we have observed in performing detailed transactional due diligence on hundreds of deals since 2010.
That said, today’s anchor tenants continue to pursue and receive opening co-tenancy provisions. Retail is changing remarkably quickly, with household names that have endured for generations disappearing in a flash. Given that major projects—whether a ground-up mixed-use center or an ambitious redevelopment—can sometimes be phased in over years, the existence of opening co-tenancy clauses among anchors certainly does represent a potential risk.
Changes are also afoot with respect to the specific language in the leases of inline tenants. In older leases, inline tenants often have the ability to terminate their leases relatively early in the default period after an anchor goes dark.
Today, it is more common for their leases to provide for dramatic reductions in rent, or, alternatively, to enable the tenant to switch to percentage rent. The latter is hardly a welcome change at properties with declining traffic and sales. To be sure, clauses providing rent reduction or percentage rent in the case of co-tenancy violations were commonplace even a decade ago.
The real shift in the retail marketplace is away from clauses that grant the ability to terminate leases outright. Unfortunately for retailers and landlords, however, co-tenancy clauses continue to pose quite a danger in the event of rising vacancies. Part of the reason for this is the right, still granted in many leases, for tenants to leave the property if overall occupancy drops below a predetermined level. Across the country, retail landlords are doing their best to find strong national and regional tenants with real staying power. However, the volatility we are seeing in retail today is occurring at a time of relative growth and prosperity. In a sharp downturn, the combination of declining occupancy and right-to-terminate clauses could be catastrophic for some shopping centers.
Co-Tenancy and Adaptive Real Estate Strategies
Proactive landlords today are continually brainstorming on possible strategic responses to anchor store closures. Some are subdividing big-box or other large spaces in a bid to lease them to smaller retail and non-retail uses. Others aim to bring in apartments, condos or offices. However, co-tenancy requirements in some tenants’ leases represent potential obstacles to these moves.
In the wake of an anchor closure, for example, the lease might stipulate that the replacement tenant must represent a “similar use” (a lost Bon-Ton, say, would need to be replaced with another department store occupying roughly the same square footage). This could pose a problem if the landlord’s plan is to carve up the former anchor space and create a multi-tenant food hall.
If the center is performing well, the landlord-tenant relationship will ideally enjoy some give and take, with inline tenants potentially willing to renegotiate their leases to give landlords more flexibility on co-tenancy. However, if the center is headed in the wrong direction, such clauses can simply give inline tenants an “out.” For properties occupying the gray area between success and failure, then, the onus is on the landlord to actively show a strong commitment toward moving ahead with creative and fast solutions. Hesitate, and some tenants may lose confidence and choose to retreat from the property.
At healthier malls and shopping centers, landlords might actually welcome the loss of an uncooperative tenant, because this could provide more flexibility to reposition the property. Leverage is always a case-by- case calculation. The remaining tenant mix, as well as the prevailing levels of occupancy, traffic and sales, will be critical factors in determining whether the landlord-tenant relationship is cooperative or adversarial.
What to Do—Risks and Rewards
Virtually every retail lease contains a section binding both landlord and tenant to do “what is best” for the property. (This was precisely the rationale for Simon Property Group’s suing Starbucks over its closure of the Teavana stores.)
Moving forward, landlords and tenants alike should look for opportunities to craft language around co-tenancy that is amenable to the interests of both, whether they are collaborating on a new lease or a renegotiated one. The key to remember here is that, all too often, leases are negotiated without adequately considering the potential negative effects of co-tenancy clauses during a downturn. Most pro forma analyses anticipate growth rather than adversity; the negotiations should take into account the potentially harsh realities of retail volatility.
Meanwhile, all parties would also do well to conduct detailed risk assessments that include any potential collateral damage that could be set in motion by co-tenancy clauses, both at the property level and portfolio-wide. Certain modeling tools, such as an abbreviated co-tenancy and lease kick-out performance matrix, can allow users to quickly make such risk assessments based on different “war-gaming” scenarios. These include as data points all of the co-tenancy related clauses in play, which enables the landlord to see what would happen if, for example, two anchors were lost and occupancy at a property dropped to 81 percent, or if a specific anchor went dark at a given property.
The combination of co-tenancy clauses and rampant store closures clearly represents a risk for retailers and retail properties, with the potential to undermine both values and performance. However, there can be rewards to taking a proactive approach to strategic adaptation. By securing the freedom to replace a moribund anchor with a more dynamic use, landlords stand to drive traffic, reposition their properties and boost sales. They do not always act like it, but retailers and landlords truly are partners: Over the long term, both will benefit by revisiting leases to reduce the ill effects that could accrue from legacy co-tenancy clauses better suited to a bygone era.