In volatile retail market, negotiate for real estate
The ongoing shakeout in the retail sector has put renewed focus on the importance of structuring leases to avoid the potentially costly risks of being stuck in a poor location.
"Market conditions can and most likely will worsen over time with continued retail closures. So, a long-term lease needs to be bulletproof to hedge against these changes,” says Jennifer Watson, a senior managing director at Newmark Knight Frank in Chicago. “In particular, it is important to lock into lease terms that will protect against retailers closing, downsizing and relocating, which ultimately can shift shopping patterns in a marketplace.”
Class B malls are ground zero for the shakeout in the retail arena with the closing of department stores such as Bon-Ton, Sears and Macy’s along with smaller shops ranging from Payless Shoes to Brookstone. However, store closures have been widespread across the industry with numerous vacancies that include major anchor tenants such as Toys R Us and Sports Authority. Some industry experts see more closures ahead in the grocery sector due to rising pressures from online grocery sales.
Tenants are relying more on sophisticated data and analytics to evaluate locations, and they’re doing their homework on real estate market conditions to make sure they are going into the right site, says Rory Cameron, a senior managing director in the Washington, D.C. office of Savills. When it comes to structuring lease terms, tenants also are keenly focused on mitigating potential downside risks. “There has definitely been a more cautious approach these days, but it really depends on the submarket and type of development a retailer is looking at, whether it is a grocery-anchored suburban strip centers or an urban office building,” says Cameron.
Pushing for key lease terms
The best advice for tenants is to work with an experienced retail or restaurant broker or agent that has market knowledge and expertise to help negotiate favorable terms. Brokers are quick to point out that it is always important to structure lease terms to manage potential risks. Some of the key negotiating points include co-tenancy clauses, limiting personal guarantees, and negotiating lease term and rental rate structure that gives tenants flexibility to account for external market changes or internal changes to a franchisee’s business.
Co-tenancy clauses give tenants the right to reduce rent payments or even seek early termination of a lease if co-tenancy requirements are not met. Those co-tenancy clauses can be triggered by the loss of an anchor tenant, or if occupancy at a center falls below a certain threshold.
Landlords are usually reluctant to agree to these types of stipulations since it creates more risk that they inherit higher vacancies immediately upon an anchor going dark, notes Watson. But anchors tenants, such as a grocer or department store, are usually the biggest traffic generators to a mall or shopping center and can make or break a franchisee’s business. So, it is important to fight for those co-tenancy provisions, she adds.
“All tenants should seek co-tenancy clauses, without a doubt,” says Cameron. Co-tenancy or occupancy clauses are especially important in new developments where a tenant might be early to open in a new property, whether that is a shopping center or some other type of mixed-use development. In those cases, it is important to structure the lease so the tenant is not paying the full rent until a certain minimum threshold occupancy is reached, such as 75 or 80 percent. A lease also could be structured so that a tenant does not pay full rent until a key anchor tenant opens.
Personal guarantees: Consider limiting personal guarantees or finding creative ways to structure personal guarantees in order to reduce personal risk in the event of a decline in business, advises Jonathan Hicks, a senior vice president and market leader at SRS Real Estate Partners in Houston. It is common for landlords to ask for a personal guarantee over the full length of a lease. However, tenants can push to limit a guarantee to only part of the lease term, such as 12 to 36 months.
Shorter-term deals: Retail leases are commonly structured as 10-year deals with two five-year lease extensions. Doing shorter-term leases might provide greater flexibility if tenancy or the trade area changes. However, short-term deals can be difficult to do for tenants that need to amortize costly tenant improvements over a longer lease term. One way to create flexibility in a longer-term lease is to include a sales “kick-out” clause. If the tenant doesn’t hit a pre-set sales threshold, then a tenant has the option to pay either reduced rent or even exit the lease.
Managing rent risk: One way to manage rent risk is to push the landlord to put their money where their mouth is, so to speak, notes Cameron. In some cases, a tenant can negotiate a fixed rent that is slightly below the market and then layer on percentage rent clause. “So, if the tenant does well and exceeds expectations, then the landlord will get the rent that they think they deserve as well,” he says.
Make the most of bargaining power
Even with retail store closures, many franchisees are finding that landlords are holding firm on lease negotiations. “I really don’t see many landlords being willing to give much to tenants in the event vacancies increase,” says Hicks. “My market has less than 5 percent vacancy, and anchor spaces in decent locations are usually back-filled fairly quickly.” In particular, franchises with a lesser-known brand or one or two units have a harder time proving their have good credit. “Landlords are more willing to bend on TI, but they want rents to remain high because the capital markets remain strong,” he adds.
Hicks also advises tenants to take time to understand the motivations of the landlord. The strategy for a particular property can impact lease structure. Are they looking to sell the asset? Are they a long-term holder? Those looking to sell will be concerned about maximizing their rental rates, so they often give more TI dollars or free rent up front. Those looking to hold long term are focused on tenant mix and the relationship, which can result in lower rental rates and more creative terms, he adds.
Bargaining power also depends on the type of tenant or business use, as some tenants are more in demand than others. “Experiential retail tenants and food users have strong bargaining power now. They are the uses all landlords want because they see these uses as internet-proof,” notes Nick Banks, a principal and managing director in the Gainesville, Florida office of Avison Young. Soft goods are struggling to gain traction with certain landlords who are wary of the effect internet sales may have on their business models, he adds.
Franchisees also need to recognize that lease negotiation involves some give and take to come up with a deal that works on both sides of the table.