"Co-Tenancy Rights – The Tenant’s Perspective" published in the Fall 2014 MSCA State of Retail Real Estate Report
The most commonly used co-tenancy 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 the right to terminate its lease, reduce its rent payments, or both. This article will focus on why a tenant would want a co-tenancy clause in its lease and how to make the landlord accept such a clause.
Benefits of a Co-Tenancy Clause
The ultimate objective of the typical tenant is to sell enough products or services in its store to make the leasing of its space an economic benefit to the tenant’s overall business. The driving force behind the success of a tenant’s business in a retail center is the customer traffic at the center, and a tenant’s business will suffer substantially if the retail center does not drive sufficient customer traffic. Such a driver could be a large anchor tenant like Target or Macy’s, or a small chain store with a substantial national presence or recognition. A tenant that ties its obligations under its lease to the presence of the anchor tenant or national retailer, or to the general performance of the mall, reduces its risk associated with downturns in the tenant mix or performance of the retail center. Such a term may make the difference between a tenant’s survival and its bankruptcy.
An additional concern with retail centers is that many of the big name tenants have the negotiating power to require a co-tenancy provision in their leases so most of these tenants will have the right to leave if an anchor or a key tenant closes its doors at the retail center. A smaller tenant with less clout does not want to be the only one without this right. If the tenant does not include such a provision in the lease, the tenant may find that it is leasing a space in a building with few tenants and no customers under a lease with a term that does not expire for several years. Such a scenario will cause the tenant to bleed cash until its proverbial death.
Making the Landlord Accept a Co-Tenancy Provision
For those retail centers with spaces that are highly competitive and lucrative a tenant will have little success in negotiating a co-tenancy provision, but such a provision may not be necessary as the mall itself is the driving force behind the customer numbers (e.g. the Mall of America). For other malls it will be a question of negotiating power and how badly the landlord wants you to lease its space. There are ways that a tenant can help the landlord to swallow the very large pill that is a co-tenancy provision. The first would be to give the landlord substantial opportunity to find a replacement tenant before the co-tenancy clause kicks in. A tenant that agrees to such a concession will want to limit the language so that the replacement tenant has the same reputation and draw that the prior tenant had or the co-tenancy provision will become worthless. A tenant that ties its lease obligations to a large anchor tenant will also want to guarantee that the replacement tenant has the same or similar square footage as size does often matter in the retail world.
A second negotiating point that a tenant could try is to eliminate the termination option present in many co-tenancy provisions and replace it with a base rent reduction. As stated above, the goal of the co-tenancy provision is to reduce the tenant’s risk associated with a poorly performing retail center. By removing the termination right, the landlord keeps its tenant, but the tenant does not have the burdensome monthly rent payment that it needs to meet if the retail center tanks. Such a clause may be more advantageous than a termination right to many smaller retail tenants as the tenant may not have the funds to build out a new space if the lease is terminated. If a tenant agrees to such a provision, the tenant should also consider whether it wants to limit its liability under common area maintenance charges. First, the tenant should attempt to limit the landlord’s ability to pass on certain costly expenses (e.g. capital improvements). Second, the tenant should attempt to eliminate the landlord’s ability to “gross up” other operating costs (clauses that permit the landlord to increase a tenant’s proportionate share of occupancy-dependent operating costs). Such limitations will reduce the tenant’s economic risk and monthly rent burden.
A third concession could be to limit the co-tenancy provision to situations where the tenant demonstrates that the tenant’s sales have actually fallen after the anchor tenant or national retailer vacated its space. This last concession will be burdensome for the tenant as some time will need to pass before the tenant will be able to demonstrate that its sales have fallen. Such a concession will also lead to issues with how sales will be calculated as our world is increasingly becoming online and as there may be anomalies in the tenant’s sales figures. The burden will also shift to the tenant to prove the drop in sales and the tenant can guarantee that the landlord will attempt to discredit the tenant’s figures. This last concession should be used sparingly.
Despite gallant efforts, many tenants will not be successful in adding a co-tenancy clause to their leases. An indirect method for accomplishing the same goal is to convert the base rent provision in the lease to a percentage rent provision so that the tenant’s rent burden is tied to the performance of the tenant in its space. Most landlords will not cap the tenant’s total monthly percentage rent amount to the same base rent amount that the landlord previously agreed to so a tenant may end up paying more in a good market. However, this should not be a concern for the tenant as the tenant will be earning more in such a market and will receive a beneficial concession in a down market.
A co-tenancy provision can definitely be a benefit to a retail tenant. A tenant should do what it can to include one in its lease. By reducing the risk to the landlord as described above, a tenant should be able to convince the landlord to accept such a clause.
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.