Renegotiating leases requires attention to each tenant’s circumstances.
Due to the economic downturn, property owners and real estate companies that work with retailers and restaurants have seen a record number of requests for restructured leases or renegotiated rental agreements. According to real estate industry experts, the trend is likely to continue until 2012.
Until there is a full economic recovery, lease and rent negotiations will remain a necessary strategy for maintaining the viability of shopping centers and malls. In some instances, it even can provide a win-win situation for riding out the financial crisis. But with requests coming from every direction, it’s not always easy for landlords to identify the ideal situations for restructuring or renegotiating retail tenant lease terms. In addition, not all tenants are alike; in fact, most bring unique circumstances to the table that landlords must consider individually. Looking at tenants in terms of their financial health, leverage, and what they bring to the shopping center mix may help landlords and property owners determine the best course of action in retail lease restructuring.
The Big-Box Retailers
Nationally recognized big-box retailers often make for the most compelling case for lease restructuring. With deep pockets that run advertising campaigns, promotions, and sale events, these anchor retailers are the main attraction for most shopping centers. The case for lease restructuring lies in their large rents and even larger square footage. Properties such as power and strip centers thrive on low anchor vacancy rates and often offer reduced rent or co-tenancy clauses to smaller tenants if an anchor leaves the center. In the typical co-tenancy clause, once the center surpasses a certain level of vacancy or loses a tenant in an anchor space, often rent is reduced to a percentage of revenue or is abated altogether.
Big-box leverage starts with the waterfall effect. In a scenario where, due to excessive rental rates and slim retail margins, an anchor has no choice but to close its doors, the property owner could see contractual minimum rent replaced with monthly percentage of sales or, even worse, a complete abatement of minimum rent until the anchor is replaced.
Let’s look at an example center with 15 tenants and 130,000 square feet of rental space tied to a co-tenancy clause. At $18 per square foot, the landlord is collecting $2.34 million in annual rent. Suppose a 20,000-sf anchor vacates and causes the 14 remaining tenants with co-tenancy clauses to reduce rent to 6 percent of gross sales. If those tenants have an average sales level of $225 psf, the new minimum annual rent is $1.49 million. Compare the cost of allowing the anchor to stay on at a significantly reduced rent with this crippling 37 percent reduction in annual rental income and the leverage of the big-box retailer is clear.
However, the threat of vacancy may not be the most appropriate path to a successful restructure. In many cases, an anchor tenant may be in the middle of a lengthy lease term and may have fallen victim to current economic pressures. A rental increase may be acting as a ticking clock, counting down the next slice to the bottom line.
The solution can and should be a creative give-and-take with the property owner. The first option simply may be to hold off on increasing the rent for a few years. As an alternative, coupling a rent reduction with the introduction of percentage rent allows the tenant to receive immediate bottom line relief, while the landlord shares in any upside revenue growth.
The end result is to put both parties at ease. Working together and understanding each other’s situation is essential in a successful lease restructure. The anchor tenant may hold the leverage in the shopping center, but unit reduction is never the business plan of any nationally recognized retailer.
Smaller regional tenants certainly are not lacking importance in the retail world. The 5,000-sf to 10,000-sf restaurant operators and 2,500-sf boutiques and apparel shops are the capillaries that keep the action flowing through many shopping centers and malls. However, the difference with these tenants is often in the margin. While strong national retailers may be able to subsidize poor performance in a few unsuccessful outlets, regional operators will cut ties to stop profit leaks from sinking the ship.
When a center shows the onset of midsize to small tenant vacancy, opportunity arises in the form of simple economics. As the demand for space in the center falls, so should the price to remain in the center until vacancy returns to historical levels. This has become a reality for property owners as average rental rates for the three-year period through 2010 are forecast to decline by 13 percent, according to the National Association of Realtors. Recent lease restructures have provided reductions in the 15 percent to 20 percent range, adding 8 percent to 17 percent of relief beyond projected market conditions. As we arrive at the natural balance of demand and price we will begin to experience a turnaround in vacancy rates. However, they may reach 12.9 percent by the end of second-quarter 2010, NAR forecasts.
Going back to the troubled center example, suppose that, over the course of the year, six of the smaller tenants approach the property owner for a base rent reduction of 20 percent. With a total center share of 35,000 sf and $18 psf, the shopping center owner will lose $126,000 in annual rental income. Taken on a unit-by-unit basis, this ranges from $10,000 to $35,000 per tenant. Most shopping center owners would agree that spending $126,000 to keep the center full is well worth the alternative rent loss and marketing and legal costs they will face if the tenants are forced to terminate leases early. In exchange for the stability in vacancy that the owners receive, most small retailers and restaurant operators in today’s environment would bend over backward for an additional $10,000 to $35,000 added to their bottom lines.
Offsetting Income Loss
In a time when demand has fallen and costs have increased, shopping center owners must keep their eyes on the prize. Just as tenants are discounting and accepting less profit to keep the doors open, property owners must follow suit. Consumers will come back, but the semblance of the shopping center should be kept intact. This is the responsibility of the tenants and the owner.
The reality of lease renegotiations need not be a negative experience. Although we’ve focused on rent reduction and loss of income to the property owner, other actions can offset the transaction and encourage a fruitful outcome for both sides. When the anchor tenant is given a reduction in base term or base rent, this is a good opportunity for the landlord to request an increase in marketing, which in turn may boost the center’s consumer traffic. When midsize and small tenants are provided concessions, it is often an acceptable counter to ask for aesthetic improvements to their space. If tenants are looking for restructures and not outright terminations, they want to stay in the space. Asking for a dual effort to improve the center and keep it full of happy tenants is only going to make life easier for retailers and property owners.
Following the Paper Trail
Given that lease restructuring is a necessary part of doing business today, property owners need tools to determine if tenants simply are looking for a quick handout or clearly need lease restructuring. Regardless of retailers’ size, request that tenants make the case for lease restructuring or rent reduction.
Verifying the financial standing of the operating entity is the first step. If the tenant is publicly held, take a look at Security and Exchange Commission filings such as 10-K annual or 10-Q quarterly reports. These documents will help owners understand tenants’ financial well-being and the state of their specific businesses. When examining the financials, owners should look for potential bankruptcies and corporate restructures. The presence of a looming liquidation will leave a landlord with very little, whereas a restructuring could force him to agree to extreme concessions or face a lease rejection in bankruptcy court. In either instance, a little due diligence is a necessary preparation.
Second, ask tenants to provide a performance history of the specific location. Obvious signs of trouble include negative cash flow, significant year-over-year losses in earnings before interest, taxes, depreciation, and amortization, and/or large declines in sales revenue. Less obvious signs are cost ratios, such as total occupancy and rent expenses as a percent of sales. For example, in the restaurant industry’s quick service segment, occupancy costs in excess of 8 percent of sales are considered dangerous to a tenant’s financial health.
Finally, once you have the financials and are satisfied with the validity of the tenant’s request, think about how the lease renegotiation is going to affect the tenant in the long term. Landlords should feel comfortable with the solution and avoid any situation where the tenant may come back for more in the near future. For instance, if a tenant will break even with the addition of a few dollars psf in rent reduction, work out a long-enough reduction term so that the issue will be sufficiently corrected once rent resets to previously contracted terms. As a second example, if the owner is considering accepting a percentage rent offer, make sure that the potential for meeting the breakpoint is reasonable in the future but that the potential doesn’t put the tenant back in a bind at year-end when the first percentage rent payment is due.
Safeguarding the Future
In the end, the lease restructuring process is a simple one. The obvious facts dictate the right answer. If a tenant is distressed and there is a reasonable solution that keeps rent payments coming in and vacancy rates low, there is no reason to say no. If rental rates have been driven down in the market and a tenant is suffering the effects of signing a lease during the height of rental rates, consider a restructure. The worst case scenario for an owner is to lose a quality tenant at a time when preserving an asset’s value is paramount.
Current trends, including increased lease restructuring, will undoubtedly affect the future real estate market. There are numerous examples of vacant shopping centers turning into churches, medical offices, or community colleges. This is partially due to the tight credit market — even debtor-in-possession financing is unavailable for companies seeking bankruptcy protection. Retailers are consolidating or liquidating; the result is fewer tenants and less demand for space. Lessened demand for space will lead to a continued decline in rental rates and the potential that owners will need to relax tenant standards. The increased risk of tenants without the backing of a multimillion dollar company will certainly lead to continued defaults on both the tenant side and the owner/lender side.
While this outlook may be grim relative to the industry, it does prove that lease restructuring is an absolute necessity if we are to continue to provide quality shopping centers to the consumer. Perhaps the best way to safeguard the future is for landlords to develop and maintain open relationships with their tenants. Regular contact generates a greater sense of partnership that will minimize future problems, no matter what the economic climate.