Negotiating Retail Leases

Wolff: How does the retail leasing market look generally compared to a year ago, 5 years ago?

Ankenman: That’s a tough question, because there are lots of markets. More than was true 10-15 years ago, the market is local. There are strong landlord markets in some areas, and strong tenant markets elsewhere.

Wolff: Where are a few strong landlord markets currently?

Ankenman: Walnut Creek and downtown San Francisco are strong markets for landlords currently, because a lot of retailers want to be located in those places. Customers tend to be affluent, higher end. Other areas have tried to duplicate these models. It takes a lot of money and coordination to develop an area like Walnut Creek - a confluence of zoning, enough space, sufficient parking, critical mass of complimentary operators -- and, of course, the appropriate customers in neighboring areas. Silicon Valley is more of a tenant’s market currently. Silicon Valley still hasn’t recovered from the dot com bust. It has to do with the glut of space that was available. The space didn’t go away, but the demand did.

Wolff: Why is a negotiated retail lease an important consideration for landlords and tenants?

Ankenman: Whether you are a landlord or a tenant, there are numerous potential pitfalls in negotiating a lease. Some people think you just grab a form and fill in the blanks. But a lease defines a lot of rights that are critical to landlord and tenant. It’s important that all of those issues are considered, that they tie together, and that they represent the true intent of the parties.

Wolff: Give an example of terms that should be negotiated.

Ankenman: As an example, tenants generally want flexibility in the permitted use, so they will negotiate that. But inexperienced tenants will frequently neglect the permitted use clause completely. A use clause defines what the tenant can and cannot use the space for. A tenant will want the permitted use clause to be as broad as possible. A landlord will generally want to keep it narrow, in order to maintain as much control as possible. A tenant who negotiates flexibility in assignment clause and other lease terms but ignores the permitted use clause may find its ability to develop or sell its business is significantly hampered.

Possible future events is another thing that tenants should think about. Tenants who have one store or one office may think they can negotiate on their own. They don’t sign a lot of leases, so they might not be concerned about future possible events, like casualty damage - what rights and obligations does each party have in the event of fire, earthquake, or other disaster? A tenant who just signs a form handed to them by a landlord is not likely to be protected in case of disaster. A lease that is purely landlord-driven is likely to cause trouble for a tenant somewhere down the line. Tenants should have their own experienced leasing attorneys to help them negotiate. Leases are just too complicated for a layperson to negotiate.

Wolff: Some unsophisticated tenants probably think leases are neutral.

Ankenman: Sure. They think they’re boiler plate. That a lease is just a standard thing that people don’t negotiate. If a landlord hands you a lease and asks you to sign, it’s probably very landlord-oriented, and it should be reviewed and negotiated.

Wolff: What are the five top tenant priorities in negotiating a retail lease?

Ankenman: Well, each situation is different but here are some common areas of concern:

1. Flexibility for changes in business. A tenant needs flexibility in the use clause and assignment provision, and the right to make alterations to the space during the tenancy, so that as a business grows or develops the tenant is able to adjust its operations and the space to meet its changing needs. 2. Controls on payment of operating expenses. Retail leases are typically “triple net,” where the tenant pays a share of common area expenses, insurance, and property taxes. A tenant may find it is paying more and more as the years go on, if controls aren’t written into the lease. A sophisticated tenant will limit those charges by including caps and/or carefully defining included expenses. 3. Protection against changes in the shopping center. Access, visibility and parking are key factors that draw a retail tenant to a particular location. The tenant will want protections in the lease so that neither the landlord nor some other tenant can make changes to the layout and improvements in the center or conduct activities that will materially diminish these features. 4. Protection against loss of key co-tenants. Often another big draw of a shopping center is anchors or other co-tenants. Where possible, tenants will want to negotiate some kind of protection into the lease. This may take different forms such as termination rights or rent reduction. 5. Maintenance and repair obligations. A tenant should ensure that it is not stuck with unanticipated obligations and expenses, and that the landlord will be responsible for taking proper care of the common areas and of the basic structure of the Premises. Generally, among other things, the lease should be clear the landlord is responsible for the roof, the parking lot, basic utility systems, and all standard components and for alterations and repairs required by law (unless due to the tenant’s specific use).

Wolff: What should be the five top priorities for landlords when negotiating a lease?

Ankenman: Again, situations vary, but a landlord will generally be interested in the following priorities:

Flexibility in making changes to the center. A landlord needs freedom to make changes to the center, and to lease to desired users. A landlord will not be able to effectively operate and develop the center if it permits tenants to impose numerous restrictions on physical alterations or choice of other tenants.
Control over tenants’ use and improvements. The landlord will want to control what tenants can and cannot do with their leased spaces and in the common areas. Landlords should control the tenant mix and permitted uses of each tenant. In addition landlords want to control the character and quality of their centers. For example, landlords may want to restrict banners or sidewalk displays to preserve proper appearance in an upscale shopping center, to prohibit incompatible improvements and uses, and to build in damages and other remedies in the event of breach.
Assurance of adequate remedies and tenants’ financial solvency. As a landlord, you must understand tenants’ financial and business background, and make sure that the person(s) who are responsible for paying the rent are financially solid. A landlord should always ask for financial statements and satisfy itself that a tenant is not just a shell entity. In questionable situations, a landlord should consider asking someone else to guarantee the lease, and/or increase the security deposit. The landlord also needs to take care that appropriate remedies for breach are included in the lease.
Tenant operating requirements. Landlords of course want their tenants to be open during shopping center hours, and will build in a remedy for failure to maintain operating hours during regular center hours. Landlords also want to prevent tenant from “going dark” and so will want to include an operating covenant and appropriate remedies and disincentives for violation. Tenants with bargaining power will resist.
Conditions of the premises on surrender. Landlords should be sure that tenants are required to leave the premises in good condition when the lease terminates and to remove all personal property, fixtures and, at the landlord’s election, any improvements made during the tenancy. Many improvements will be of no use to the subsequent tenants, and will cost the landlord money to remove. On the other hand, if an improvement is of value to a replacement tenant, the landlord may want to have the flexibility to elect to keep it.

Wolff: Do you see any interesting emerging trends in retail leasing?

Ankenman: I see two that are interesting. The first is consolidation. A lot of retail landlords are merging or acquiring others, so that there are fewer and fewer national retail landlord/developers. Also retailers are consolidating, hence there are fewer tenants with greater power. Chain tenants increasingly will be dealing with the same landlords over and over again. Landlords may be dealing with the same tenants over and over again. I think attorneys representing landlords and tenants should be aware of that trend, and watch it from either side. This will affect bargaining power and make it more likely that a concession in one deal will have ramifications for future deals for other locations.

A second trend is a movement toward fixed CAM (common area maintenance) costs. The way it has traditionally worked, tenants pay a proportionate share of the actual CAM. This has become the subject of a lot of negotiation and disputes, before and after lease execution. More and more tenants came to feel that landlords overcharged on CAM and to seek to negotiate CAM provisions and to conduct CAM audits. The controversy has resulted in a trend towards fixed CAM costs based on a fixed per-square-foot amount with a fixed escalator for annual increases. The fixed CAM approach gives both sides predictability and simplicity, but there are risks. The risk to landlords is that if the fixed amounts turn out to not be enough, they will have to come out of pocket for things for which they would otherwise be reimbursed. Tenants should take care in negotiating the fixed amounts and annual increase so they are not overpaying too much. Also tenants are concerned that fixed CAM can result in an incentive for the landlord to take short cuts on maintenance. To address this tenants can seek to define required maintenance standards. Tenants with sufficient bargaining power also seek the right of self-help to take over maintenance, if landlords are not doing it properly.