C is for Co-Tenancy
Jeffrey Margolis Dec. 8, 2016, 3:12 p.m.
With ICSC deal making just behind us, I was looking to write about a complex, heavily negotiated, not freely given by landlords and potentially disastrous in its consequences to the overall fiscal health of a shopping center, clause and one easily hit every button. Namely, co-tenancy.
Co-tenancy in the shopping center context highlights the interdependent nature of retail: that a Coach, for example, is most successful when in a milieu populated by other luxury brands. Thus, it welcomes Louis Vuitton, Tiffany and Fendi et al. In fact, not only welcomes these luxury retailers as mall neighbors but insists on their presence both as to opening requirements and continued operations.
On a more modest scale, we think of the Papa John’s pizza joint that depends on the Cinema Lux being open and operating for the bulk of its nighttime patrons: the pizza guy demands that the movie theater is operating for its business to survive.
The bottom line is that many retailers believe that certain types of stores reach their full potential for sales only in the presence of other complementary retail uses. Co-tenancy clauses are a way for tenants to ensure a beneficial tenant mix. How are these business needs translated into the retail leasing context?
The co-tenancy clause conditions a tenant’s obligation to open, or—once opened—remain open and operating through the term by requiring that a certain number of named tenants (anchors and/or line tenants) or a certain percentage of the mall tenants (or some combination of anchors and in-line tenants), be open and operating. The other side of this coin—and the most contentious—involves remedies that the tenant might exercise if the co-tenancy provisions are not met: an anchor closes, the movie theater goes dark. The promised levels of occupancy—so glowingly touted in all the promotional literature—are not met. (Considering the state retail is in these days, not an uncommon occurrence.)
To give an overview, these remedies might include reduced rent (either fixed rent or switch over to a percentage rent arrangement only), the right go dark (stop operating in the mall) or, in some extreme cases, a right to terminate the lease.
As you might imagine, to the landlord, whose economic lifeblood depends on its tenants opening, operating, and paying the bargained for rent, the exercise of any of these remedies is anathematic, life threatening, and, in some cases where the dreaded “domino effect” comes into play (one store’s closure triggers a domino-like series of closures until the center becomes a ghost town), the death knell for the shopping center. This is clearly the most hot button issue, as far as landlords are concerned.
And just to add to this pressure cooker, lenders certainly become extremely wary of a center where co-tenancy might present a major fissure as to paying the scheduled rent—the vital rent stream the lender has assumed will continue uninterrupted in making its credit decisions on the loan.
Before invoking its remedies, tenants should be required to give reasonable notice so a landlord has an opportunity to find a suitable replacement. What will that replacement tenant look like? A well-drafted co-tenancy clause will spell out specific criteria.
One (very large) trap for the unwary landlord is to agree to a named replacement. Landlords will avoid a clause that locks a landlord in to a list of specified stores. Even a cursory look at the current retail landscape shows it is littered with closings and bankruptcies. Many suitable replacements are, frankly, no longer available. From a landlord’s POV rather than name retailers a landlord will want to specify a category of replacement tenant, one comparable to the tenant being replaced.
From the tenant’s point of view, if there is an opening co-tenancy violation, a tenant is allowed to delay the opening and/or rent commencement date. As a practical tip: tenants should add the right to open but with a modified (lower) rent. If a tenant does open, and then there is a breach, its primary remedy is rent abatement; either a percentage of the fixed rent or conversion to a percentage rent basis only. As to the ultimate, tenant invoked termination, the co-tenancy violation must go on for a very substantial period of time—six months to a year—whereas rent abatement might kick in after 90 days of violation.
As some final thoughts, tenants should take advantage of their opportunity to get protection should an anchor or important regional tenant—one with the draw that will bring customers to the center—fail (today, certainly not uncommon). Landlords also face an uncertain future and so co-tenancy clauses must be drafted in a way such that a single tenant failure does not domino into a largely empty, failed, center.
Jeff Margolis is founding principal of The Margolis Law Firm in New York City, where he specializes in “dirt” law—buying, selling and leasing. Jeff’s web site is http://www.newyorkleaselaw.com.