One Thing They Don’t Tell You About Co-Tenancy in Retail Leases
Topics: leasing, co-tenancy, retail real estate
Chris Ressa 0:00
This is Retail Retold, the story of how that store ended up in your neighborhood. I’m your host, Chris Ressa, and I invite you to join my conversation with some of the retail industry’s biggest influencers. This podcast is brought to you by DLC Management.
This week is part two of co-tenancy. Last week we touched on co-tenancy as it relates to what uses are going to be in shopping centers in the future. This week, we’re going to talk about co-tenancy from the way it reads in a lease and what the future of that will become. So for those who don’t know, some leases in commercial real estate, in particular retail real estate, have what they call an occupancy clause or a co-tenancy clause.
That clause is an obligation for the landlord to have a certain level of tenancy in the shopping center. And if they don’t, then there are remedies that take place. Something might read, like, the landlord has to keep the shopping center at a minimum 65% leased at all times. If not, then the tenant might have a reduced rent period for some period of time.
And then typically, it will do that, the clause will do what they call sunset, and the reduced rent will and and the tenant will have the the right to go back to full rent or terminate. During that reduced rent period, the landlord typically has the ability to cure that co-tenancy violation. It might be that 65%, just being left the leased some space to get to over 65%.
Well, this has been an interesting topic. And I’ve spent a lot of time on this, studying this topic over the years. I have a research deck called ‘Win Win Co-Tenancy’, which I wrote up for the ICSC, you can find it on their website, and I taught it for years throughout ICSC, and I continue to be fascinated by this topic of co-tenancy as it relates to leases, especially in an evolving landscape of shopping centers.
So let’s start with a, back it up and start with a little bit of a fundamentals of lease, which if there’s a little about the fault and remedy. Most of the clauses of the lease don’t have a specific remedy for that clause. So if a landlord or tenant defaults, there’s a default provision, it says what happens, maybe there’s a termination, right? Maybe there is not it’s just the other party has to litigate.
And typically, for certain clauses, both landlords and tenants have agreed, we don’t want to have that be the case, we want a specific remedy. And so when either party violates that clause, there’s a remedy in the lease for what happens. CO tenancy, it’s usually some reduced rent period. If the whole lease was remedy, specific remedies, then you’d have 500 page commercial leases, and they’re already too long.
So there’s not a remedy for every clause but certain ones, landlords and tenants have kind of conceptually agreed in the marketplace, there’s probably better to have a remedy for this. And as much as they come, you know, market remedies. They’re specific to each senator and therefore, landlords pend a lot of time negotiating these provisions. And I think it’s getting more and more interesting given that these shopping centers are really evolving.
When you, when you take, so, let’s talk about some different ones, sorry. So, the two most common co-tenancies are opening co-tenancy and ongoing co-tenancy. Typically, if there is a co-tenancy clause, which you could say most leases do not have. But if there is, then what will happen is, I would say there’s typically two types, ongoing, which means there has to be a certain type of tenancy throughout that’s ongoing, throughout the period of lease, or opening, there should be certain type of tenancy when the tenant actually opens.
So I would say, these clauses are obviously significant burdens on a landlord, because if there’s a reduced occupancy, the tenant leaves, and that causes a co tenancy. There’s a double whammy for the landlord because they already lost one tenant and now the tenant that is still in the center, now that lease isn’t what is contractually in the lease at some deduced rent period. So a couple things have happened over the years.
There’s really two types that you see, there’s anchor co-tenancies, and there’s occupancy thresholds. Those are the two types of co-tenancy. So let’s let’s talk about an anchor co-tenancy, it’ll typically say something like, let’s say there’s like eight Jr. boxes in a center, it might say something like, five of them have to be open and operating. Or there’s a co-tenancy violation for the landlord, or occupancy, it might say, well, then there is, you know, the landlord has to keep 60% of the center occupied.
Well, there’s a lot of things that are starting to come into play, have, and I think they’re just becoming more prevalent as relates to this. One, the cure period. Cure periods are typically 12 months. Sometimes it’s 18. And then typically, like I said, the reduced rent sunsets. The cure period is interesting, because in today’s environment, we’re talking about the words typically used are open and operating. To go from signed lease to open and operating is in 12 months is for, you know, probably for a box tenant.
You know, on the anchor side, it is a real challenge, in a small shop, if you dropped from 65 to 64, curing is probably doable in that time period. But you know, in times when an electric gear takes 48 weeks to get the new tenant in it’s, you know, let alone the amount of time it takes negotiate the lease, where it’s, you’re probably not ending up cured.
So then, as a landlord, you have to think about if you’re going to agree to co-tenancy, what’s more important, your cure time, or the time to get to sunset? Think about that. Do you want that termination rate to come quickly? Or do you want to give yourself enough time to cure the co-tenancy so the tenant doesn’t have a right to terminate?
Well I’ll answer that, typically, I could tell you in today’s environment, you want the cure period to actually be shorter, even though it would take you longer to cure, you want the period to sunset sooner. Typically, you might have financial lender issues or something that makes that a challenge.
But typically, you want that cure period to be shorter. Why? Because I would tell you, here’s the secret that no one talks about. The amount of tenants that have terminated their lease in America due to a co-tendency violation is unusually small.
For the amount of effort that is put into this clause, by our industry, the amount of dollars both parties spent on negotiating this clause, whether it’s the the hourly rate to a leasing person, the lease administrators, the legal people, I would argue, I think the industry has spent more in GNA fighting on both sides than it saved in cost for any party.
Now, it’d be impossible for me to verify that. But I can tell you that you talk to any landlord, ask them how many tenants have terminated due to a co-tenancy clause. And I can tell you that most of them can’t remember one, or it’s a, you know, on one hand, now, they’ve obviously been in co-tenancy violation and lost rent. But that is more rare than the times that they’re negotiating for it, the amount of dollars spent on negotiating this clause is uncanny.
And we have scenarios where, we’ve had scenarios where tenant goes on co-tenancy, and sales rise for that tenant, competitor might have left, more market share. And they get to go on remedy rent.
Now, they would argue that being in a vacant center, and I use that word loosely, because sometimes a co-tenancy clause can take into effect when it’s not even vacant, when it’s just one or two vacancies, and being in a less occupied center is probably a more appropriate word might be brand damaging. Consumers coming to see you know, why is such a tenant in this property? That’s an argument I’ve heard.
I would say, I don’t know. To the general consumer, I’m not so sure. Maybe. But I think this co-tenancy in how necessary is it, the amount of dollars were spending, as an industry, on fighting on both sides? How, how important is this provision?
Because you can look in this provision is like two pages of the lease. It is because here’s what you’re negotiating. What constitutes a violation? That’s the, ok 65, below 60 represent accuracy. Well, when does the violation start? Does it start on that day? Does there need to be a notification between both parties? Who notifies who? Then once it starts, how long do you cure? How long is the cure period? What is the actual reduced rate as a percentage of sales?
It is just a fixed discount off the fixed rent. What happens on the sunset? You have to negotiate what what typically is now getting negotiated and for a while, is acceptable tenants that can replace them. You know, one of the issues we go into is like, well, that all the time is, a use that’s not prohibited, not excluded by their lease. Does that count as a replacement tenant?
Oftentimes, some of these replacement tenant provisions, they require, they put a burden on the landlord for the specific tenant, they have to have at least 75 stores, they have to be this, they have to be that, wait a second, I don’t need that to lease another space.
But if you’re going to cure that co-tenancy than a cure with one of these tenants, that’s not prohibited but doesn’t meet this new requirement, I’m still a co-tenancy? So this has been a provision in leases for a long time for certain retailers, and, one, do retailers need it will tell you in a changing landscape of product types.
And I’ve been on the bandwagon that brick-and-mortar is growing because everyone realizes that it’s so necessary in this digital world. Two, is the punishment you know, worth the crime, or does the punishment even fit the crime? I don’t know if you read some of these provisions. So I think this is going to start evolving for both parties, if anyone really studied the GNA that a cost, and then how often do they actually go on co-tenancy? They’re spending more. And it’s an insurance policy that I’m not sure it’s totally needed. Now, are there cases where it’s a Walmart center, 30,000 square feet of small shop, Walmart goes, they were driving traffic.
Yeah, you see the negative impacts. But, you know, in today’s environment, we live in a world where retailers don’t want to close stores. They want to grow store count. So even if there’s a vacancy, they are probably going to find a way to make the business work.
At a minimum, should the co-tenancy provision be tied to actual impact, rather than guessing impact or making a guess that the vacancy will impact the business to get every single time? I do not know, you could show me every fact in the world every time blah, blah, but this is a different every time blah, blah, blah, leaves our sales go down 10% Okay, let’s see if it happens here. Because this market is different, the consumer in this market might be different.
And therefore, something different might happen. Maybe sales go up. So if sales go up, if a Tenant A leaves, causes a co-tenancy violation, should tenant, Tenant A leaves co-tenancy tied to Tenant A, temp sales rise when that tenant leaves the Landlord B co-tenancy.
You know, the cost to administer these provisions is high. cost to negotiate these is high. So I think, you know, it’s good business for landlords to try to protect tenants where they can, and therefore, you know, co-tenancy provisions will live on and co-tenancy should, you know, cutting into provisions will live on and co-tenancy provisions have a place in certain leases, right, especially for landlords saying, hey, I want you to come to this center.
The reason for you coming to the center is because in this center is tenant a tenant B intensive, often a and b and c are no longer there. Well, they might not have gotten what they bargained for, regardless of what happens. They were buying something based on a premise that doesn’t exist anymore. Okay, I think that’s fair. But I think the provisions should evolve, because replacement tenants are becoming different.
The reality of curing is becoming different. And what should the remedy be in that scenario? Probably it’s going to be adjusted. So just like in anything, you know, a lot will probably stay the same. But I think, you know, I’m just putting thought provoking out there that I think it’s fascinating, an interesting day, you know, my ‘Win Win Co-Tenancy’ deck is not about eliminating co tenancy. It’s about
Maybe a better co tenancy and certainly sprawl. And, you know, there’s going to be co tenancy and certain leases. But I think it’s time to take a step back in the fast changing world and say, Could this provision evolve to a place where maybe one, the punishment fits the crime, two, start thinking about the changing nature of shopping centers in America today?
Because they are changing and this provision hasn’t, has largely been unchanged, and you would think, after COVID, after all these new uses, going to centers that this provision would be more evolved than hasn’t. And one of the things I want to tell everybody, the amount of dollar spent on this, for the actual dollars gained by the industry is, I’m telling you, there’s no research. This is totally anecdotal. But we’re losing as an industry on this provision.
We’ve spent more trying to cure world hunger in this provision, I use that as a facetious meaning, we spent more trying to solve this provision between consultants and attorneys and everything, then it’s, you know, then people have gained from it. That’s not a reason to eliminate it in certainly since I’m not, you know, I would love to as a landlord, but not saying that. But it’s a reason to look at it a little differently.
So, I hope this is thought provoking for you gave a little secret like very few tenants terminate their leases due to co tenancy violations. Talk to anybody, I don’t have a stat. Check it out, though. Think about it yourself. Think about if you’re a retailer, how many of you actually terminated your landlord? How many of you have gotten back terminated? And so that’s the secret thought provoker.
And then, let’s talk about can there be a way to actually evolve this provision to a better place, given the changing landscape in the market? So that’s all I got today, everybody. I hope you enjoyed this thought provoker on co-tenancy. Stay tuned for more insightful discussions later this year. And tune in next Thursday for our new episode. Thanks, everyone. Bye.
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