Managing Change Through Proactive Lease Language and Detailed Occupancy Reviews
by Rick Burke, President; Lease Administration Solutions, LLC
It is said that change is inevitable but progress is optional. Most of us know that online retailing is forcing the evolution of malls and shopping centers. But what the change will look like and how retailers adapt to it is still a mystery. It’s hard not to have heard about some of the retail casualties such as Sears, Macys, and JC Penney to name a few, with more predicted to come. However, most experts believe that the malls and shopping centers are not on the endangered species list, but are rather in a transition of reinventing themselves to coexist with online retail. Some compare it to the movie theaters when cable and Netflix became available. Most thought it was the end of going to the movies. But movie theaters reinvented themselves by offering dinner, alcohol, comfortable seating, concerts and events creating a new experience for their customers in order to compete.
In many cases the success of a mall or shopping center is based on the geographic area, type and age of property, product mix, and the experience the shopper receives while shopping. For example, urban retail and many high end malls and shopping centers, that offer a more unique shopping experience, appear to be less affected by online competition. On the other hand, older malls and shopping centers with traditional layouts and brand names, are losing shoppers at a rapid pace. What this is telling us is that today’s shopper is not satisfied with the traditional idea of mall shopping and is looking for something more. It also gives us a clue as to what pulls shoppers away from their computers and mobile devices to physically walk into a store and shop.
On the contrary of what most people think, there have been several studies that have concluded that the majority of Millennials prefer shopping at malls instead of online shopping. I also asked my 15 year old daughter and her friends what they preferred, buying online or going to a mall. Interestingly, they overwhelmingly said, “going to the mall.” Their reasons were that it is more fun to be with friends, trying on clothing together, or sitting down to eat together. This is something that online shopping cannot offer.
However, to compete with online retail, the malls and shopping centers will need to exploit this weakness in online retail, and offer more. They need to be a destination with a look, feel, and experience that attracts the shopper. As evidence to this, landlords are investing large amounts to create unique experiences in their retail properties by upscaling and offering high end well known restaurants, movie theaters, upscale bowling and sports bars, periodic special events and even concerts, in hopes of making them a destination and attract more foot traffic. Some landlords are creating a more “artsy” shopping environment by utilizing older buildings or unconventional configurations and having a more local tenant mix to create a unique shopping vibe.
For quite some time, landlords have been investing in mixed use properties with office, residential and even hotel space alongside the retail space to create a live, work, and play environment. Landlords with urban properties are looking at the idea of vertical malls with several floors of retail in a mixed use building; an idea that first began in Hong Kong called, “Mall Skyscrapers.” All these new ideas and developments to help attract shoppers and compete with online retail will be a huge investment for landlords, coming at a time when REITS are seeing stock prices drop. As landlords scramble to re-invent their properties or develop them into mixed use, occupancy cost will increase for both the landlords and tenants.
As landlords invest to make their malls and shopping centers competitive with online, proactive tenants are preparing for the increases in occupancy cost by adding lease language to protect themselves. Tenants will also need to be forward thinking when negotiating leases in order to incorporate their short and long term strategies in this transitioning period. Lastly, tenants should also create an occupancy cost review process to avoid paying the possible extra cost that may be passed through in CAM cost.
Negotiating Lease language for the Change:
Lease language should always include a clear and concise property definition that includes the building and the common area. This becomes very important if the property has future plans to expand to include mixed use. Expenses that are pooled and allocated with mixed-use space need to be detailed in the lease. Questions that need to be asked are: Will the landlord be commingling cost together or cost pool allocating from mixed use space? If so, what accounts will be pooled and shared? What tenants will be included to calculate the gross leasable area? How will the real estate taxes and insurance be allocated across mixed use space?
The person responsible for negotiating the lease will need to understand what the property will look like now and in the future to protect the tenant from overcharges from biased cost allocations. Any square footage that is deducted out of the gross leasable area within the subject property, needs to be clearly stated in the lease. Landlords must be responsible to support all square footage deductions, expense allocations, and tenant contributions.
In addition to detailing which expense accounts will be allocated across mixed use space in the lease, it will also be important to list out which common area costs the tenant will be responsible for. For example, expenses that are capital in nature, such as those that are related to the building, structure, expansion, initial installations or construction for the property should explicitly be disallowed in the lease.
If the lease is subordinate to a Reciprocal or Operating Easement Agreement (REA or OEA), then the cost exclusions should also be detailed in a manner consistent with the lease disallowances. The REA should also be included as part of an exhibit to the lease. Lastly, documentation and audit rights need to be clearly spelled out for all lease and REA cost.
As noted above, many landlords are trying to create a unique or local tenant mix to attract more shoppers. As landlords change the mix of their shopping centers, tenants may choose to change the mix of their products or even have a different name and profile geared to that type of mall. Accordingly, the Use Clause will need to be well thought out based on the tenant’s future objectives. Other important lease language is related to early termination, assignment sublease, kickout rights, tenant expansion and reduction, and co-tenancy violations. Each of these clauses need to be negotiated with a “what if strategy” in mind.
Reviewing Occupancy Cost (CAM, Real Estate Taxes and Insurance):
After the lease is signed, tenants will have to expand the scope of their review to avoid possible overcharges from landlord investments in the malls or shopping centers. Year-end CAM, real estate taxes and insurance reconciliations will need to be thoroughly reviewed to avoid possible overcharges by the landlord. Lease analysts will need additional knowledge of the subject to perform these audits. Reviewing for the “typical overcharges” of non-common area expenses will not be enough to pierce through the allocations. Overcharges from possible incorrect or biased allocations due to expanded and reconfigured centers or added mixed use tenants are more complicated and time consuming. A teaching conference such as National Retail Tenants Association (NRTA) will be even more valuable as companies will want to give their lease analysts additional training related to occupancy cost review.
Expense allocations can come in many different variations and from diverse situations. For example, allocation at the pro-rata share level for some tenants in the same center may include certain expenses, while for others it may not. These expenses are usually carved out of the cost pool for a few different reasons. It could be that the tenant pays for its own cost, or the site that the tenant is on is separately owned by another landlord. However, no matter what the reason, trying to substantiate whether the allocation is correct and fair can be a challenge.
Another type of allocated cost we see is for buildings that are divided into different uses such as in mixed use. Expenses for properties with mixed use are often comingled and then allocated back to all properties on a percentage basis. Specific expense accounts that are often pooled across different space types are labor, utilities, management, administrative, and insurance. The lease analyst is faced with many questions when reviewing a mixed use property. Questions such as: Is the retailer on the first floor responsible for the elevators that serve the office space? Are the office tenants responsible for the electricity used by late night retailers? How is the labor such as maintenance and security allocated to the common area? Is the sum of the allocated expense greater than the total expense amount? These are just a few of the many questions that arise with mixed use.
Reviewing occupancy cost may not be the only process to get tougher for tenants during this transition period. Getting a credit or reimbursement from the landlord when an overcharge is discovered will also become more difficult. It is common sense that as the economic times gets tougher for landlords from online competition, tenants will experience an increase in aggressive CAM billings from landlords as well as more difficulty collecting identified overcharges.
There is no doubt that retailers face some troubling times ahead, but that doesn’t mean brick and mortar will become extinct. In fact, many experts believe retail is moving towards a new chapter, reinventing itself and offering more unique products and options with a more exciting shopping experience. The retail we will see in the future will look very different from what we see today. With these changes come new challenges and expenses for the tenant. Tenants need to be proactive and prepare for these changes, if they want to survive, because change is inevitable but progress is optional.
For questions on this subject, please contact Rick Burke at Lease Administration Solutions, LLC at 1.781.750.3078 x 201 or email him at RBurke@LeaseAdminSolutions.com. Rick also presented two classes on Expense Allocation Overcharges at the 2017 NRTA Expanding Knowledge Conference in New Orleans, LA.