"Co-Tenancy Rights – The Landlord’s Perspective" published in the Spring 2014 MSCA State of Retail Real Estate Report
Co-tenancy clauses in leases can take many forms, but the most commonly used clause ties one tenant’s obligations under its lease to another tenant’s continued occupancy or to the general performance or makeup of the retail center, and once these clauses are triggered they usually grant the tenant with the right to terminate its lease, reduce its rent payments, or both. This article will focus on ongoing co-tenancy clauses that tie performance to the continued occupancy of another tenant, which is usually the anchor tenant at the applicable retail center.
Pitfalls of a Co-Tenancy Clause
A co-tenancy clause may seem like an innocuous lease provision that attracts those highly coveted national chains to your retail center. As with many optimistic developers, you may take the position that these clauses will never be triggered. The anchor tenant is locked into a fifteen year lease and has constructed millions of dollars’ worth of tenant improvements in its space so there is little or no risk with the tenant leaving. This mentality is dangerous and can lead to your retail center imploding. Imagine a scenario where all the national chains in your center have a co-tenancy provision directly or indirectly tied to a Target store. Nobody would expect Target to close up shop and leave, especially if the economy is good. However, the same could have been said of Kmart twenty years ago and look where Kmart is today. We do not know what the future holds for Target regardless of its strength today. Target may also be a party to a merger that obligates the new company to close stores due to antitrust concerns or synergies. Now imagine that Target does close. This closure triggers each of the national chains’ co-tenancy provisions, who slowly leave your center. The closure of the retail chains and Target reduces foot traffic and all of your independent stores’ sales drop so they can no longer pay the rent. Before you know it you are booking Kevin Smith’s next movie at your mall because you have no tenants and your mall is empty. This horrific scenario has occurred throughout the United States and is all the result of an indifferent or negligent treatment of co-tenancy provisions.
Limiting a Landlord’s Exposure
A landlord’s first response to any tenant requesting a co-tenancy clause should be to say no. If the tenant has sufficient leverage and is willing to walk without such a clause, a landlord should find ways to limit its exposure. First, a landlord should propose a rent reduction upon the co-tenancy triggering event, and the reduction should be limited to base rent. As an alternative the landlord could propose to convert the base rent provision to a percentage rent provision so that the landlord would not lose income if the retail center continues to perform. Even if the tenant demands that all rent abate once the co-tenancy provision is triggered, the overall impact on the retail center under a rent reduction approach will be minimized as the tenant will not have a termination right and will still attract customers to the center. The landlord will also not have a series of vacant premises. That makes attracting new tenants difficult. If the tenant still insists that it needs a termination right, the lease should obligate the tenant to exercise the right within a set period of time or the right expires so that the tenant’s option does not hang over the landlord’s head indefinitely.
Second, a landlord should have the right to find a replacement co-tenant if the original co-tenant leaves, particularly if the tenant has a termination right. For example, Banana Republic should be fine with either a Macy’s or a Nordstrom’s as both should have a sufficient draw to the retail center so Banana’s co-tenancy termination right should not be triggered if Macy’s leaves and Nordstrom’s takes the premises within one year after Macy’s leaves. The landlord may even want to list the permissible replacement co-tenants or types of co-tenants so that the tenant cannot subsequently claim that the replacement co-tenant is inadequate. The amount of time that a landlord should have to find the replacement tenant should increase with the size of the co-tenant’s premises as it is far more difficult to find a tenant for a 50,000 square foot store as it would be for a 10,000 square foot store. A landlord should also add language that gives the landlord with the flexibility to break up the co-tenant’s space and lease to two or three smaller tenants if no one tenant is willing to take all of the space, although many tenants will baulk at such a request. The lease should further state that the rent reduction or termination right expires immediately if a replacement co-tenant signs a lease even if the landlord is unable to find a replacement co-tenant within the time period specified in the lease.
Third, a landlord should add language that prevents the co-tenancy provision from triggering if the tenant’s gross sales exceed a specified amount. Alternatively, the landlord should require that the tenant demonstrate that the vacancy of the co-tenant lead to a decrease in revenue compared with prior years before it is triggered. The justification for a co-tenancy provision is that a tenant’s financial health is tied to the existence of the co-tenant so the tenant should not object to limiting the applicability of the co-tenancy clause to situations where the tenant’s financial health is, in fact, negatively impacted.
Fourth, the lease should exclude situations where the tenant is either currently in default under the lease or has gone dark. A tenant that has violated its lease or which is no longer operating in the premises should not have the right to object to another tenant vacating.
Fifth, the landlord should confirm that the co-tenancy clauses makes it clear that the tenant’s only remedy is termination or reduction in rent, as the case may be, and not damages. A landlord will want to avoid any litigation where the tenant claims that a landlord made certain representations as to the makeup of the retail center and the representation was violated upon the vacancy of the co-tenant.
Finally, a landlord should request concessions out of the tenant that requests a co-tenancy clause. It is only fair that the tenant agree to a go-dark prohibition, additional percentage rent requirement, a longer lease term, or other provision that benefits the landlord if the landlord is granting a co-tenancy clause. Such a clause puts most of the risk on the landlord when the economy declines so the landlord should be able to enjoy some of the perks of a good economy and the tenant should do all that it can to make sure that the retail center continues to perform.
Co-tenancy provisions can be helpful, and sometimes essential, for attracting many of the national retail chains, but a landlord should be careful when granting such a right, and should limit the clause’s scope as much as possible. A landlord should also always consider its overall exposure so that one closure does not lead to the chain reaction that bankrupt’s the landlord’s retail center.
DISCLAIMER: This article is to be used for general information purposes only, not as a substitute for in-person evaluations. The information contained herein is not legal advice and no attorney-client relationship is formed through this article.