Retail Leasing Pitfalls

Recent consumer spending increases are evidence the economy is starting to recover. Retail real estate tends to recover late in the economic cycle. Leasing issues will continue to be of concern in the retail marketplace – whether the location is in a distressed environment or where recovery is starting to take root.

Typically, tenants are negotiating from a position of strength during times of economic downturn. With the right location and the right market characteristics, landlords may not be required to accept poorer economic terms for empty space in order to attract appropriate tenants. In times of economic uncertainty, several potential pitfalls in retail leases can create problems if not properly negotiated.

Use Restrictions

Use restrictions and exclusivity clauses frequently have the potential of hampering a landlord’s efforts to obtain new tenants. For the landlord, it is always important to have such provisions drafted as concise, narrow and clear as possible. Oftentimes, comprehensive use restrictions are mandated by big box anchor tenants. As vacancy rates have recently climbed and proven credit worthy tenants become scarce, use restrictions or exclusive clauses have become more flexible. Landlords are eager to fill empty space and tenants who may be slow in paying their rent may be more forgiving if use restrictions are infringed upon or ignored. However, non-documented waivers or alterations can cause problems as the economy recovers. As improved business allows tenants to resume prompt payment of rent, such informal waivers can become problematic as tenants assert their rights. Any waivers of use restrictions should be in writing and supported by separate compensation (such as one-time partial rent abatement).

While use restrictions are often negotiated to be tenant specific, leases will frequently contain general provisions that outline prohibited uses landlords one time deemed undesirable. The changing economy has made uses that were once considered detrimental to a retail center’s operations much more appealing. This can be partially attributed to the recession. It can also be partially attributed to changing public perception of such businesses entering into the mainstream of retailers. Other non-traditional uses, like emergency care facilities, are attracted by favorable leases rates, but may be prohibited due to over broad use restrictions. Existing tenants may prefer to amend leases to accommodate changes in use restrictions to support decreased vacancies. Landlords can avoid these problems by providing enough flexibility in use restrictions to allow changes in reaction to economic conditions.

Tenant Improvements

Tenant improvement allowances can be a costly incentive that a landlord offers to a tenant. The risk of a landlord being foreclosed upon by its lender or simply going out of business adds caution to a tenant that may be relying upon that landlord for paying the incentives agreed to under the lease. One of the measures a tenant can require is for the tenant improvement allowance to be escrowed in order to ensure the costs are covered regardless of whether the landlord is still around after the tenant improvements are completed. Such escrowed funds can be drawn upon based upon a percentage of completion or a predetermined schedule. Letters of credit are another option tenants can rely upon for the payment of tenant improvement allowances.

Common Area Maintenance Expenses

Changes for common area maintenance (CAM) can be a significant financial component of a lease and can change dramatically over a lease term. Landlords tend to have the superior control and historical information. While savvy tenants go to great lengths to put caps on controllable costs and clarify what is and is not a permissible CAM expense, there are still some areas where a landlord is making a profit on delivery of services. Conversely, landlord’s can find themselves in a tenuous position as the landlord’s share of CAM expenses increase as vacancy increases. By promising to provide a certain level of service to existing tenants, landlords must underwrite the cost of those services to the vacant lease space, which could be mitigated with carefully prepared lease provisions.

Subordination/Non-Disturbance and Attornment Agreements

The Subordination, Non-Disturbance and Attornment Agreement (SNDA) offers a benefit to both the landlord and the tenant. There is more of a direct benefit to the landlord’s lender, as the landlord is benefited by obtaining the financing that the lender provides. Lenders want to make sure that their lien on the landlord’s property is superior to the lien of the lease. The SNDA subordinates the lien to the lien of such mortgage.

In return, the tenant receives an assurance that so long as the tenant pays their rent and complies with the other requirements of the lease, regardless of whether the original landlord is still around or the bank has taken title to the property through foreclosure, the tenant will remain undisturbed in the premises. In the present economic climate, it is important that the SNDA be negotiated as rigorously as the lease, since the SNDA dictates how legal rights may be exercised by the lender. Too often, little thought was given to the long term effect of SNDAs, and some tenants and lenders are now seeing the results to waive of rights. What at one time might have been a simple form required by the landlord’s lender has taken on a more important role in the modern retail lease and will continue to play a prominent part so long as commercial foreclosures continue to be high.

Retail leases are complex legal documents, and should be reviewed in order to adapted to changing economic environment.

Michael McNatt is the founder of the McNatt Law Firm, P.A. located in Orlando, Florida. Michael is a U.S. Green Building Council LEED Accredited Professional (LEED AP) and practices in the area of commercial real estate, finance and general business law.