Topics: Co-tenancy, leasing,

Unpacking Co-Tenancy Clauses: Are They Worth the Hassle?

Chris Ressa delves into the intricacies of co-tenancy clauses in retail leases. Discover landlords’ obligations, from maintaining occupancy levels to the potential remedies tenants can invoke. Chris discusses the high costs and effort associated with negotiating these clauses, the limited instances of lease termination, and proposes a need to evolve these provisions to better suit today’s dynamic retail landscape.

00:00 Introduction to Retail Retold
00:24 Understanding Co-Tenancy Clauses
04:34 Types of Co-Tenancy Clauses
07:00 Challenges and Negotiations in Co-Tenancy
14:10 The Future of Co-Tenancy Provisions
21:00 Conclusion and Final Thoughts

What You’ll Learn:

1. Co-tenancy from the way it reads in a lease and what the future of that will become
2. What are the two most common co-tenancies?
3. How many tenants terminated their leases in the US due to a co-tenancy violation?

About Retail Retold:

The Retail Retold Podcast highlights community retailer stories from across the country and gives a behind-the-scenes perspective from business leaders in both retail and real estate industries. The show’s episodes contain valuable insights that help solve the needs of entrepreneurs and real estate pros. Join host Chris Ressa and new guests weekly for amazing insights and thought-provoking stories.

Transcript:

[00:00:00] This is Retail Retold, the story of how that store ended up in your neighborhood. I’m your host, Chris Ressa, and I invite you to join my conversation with some of the retail industry’s biggest influencers. This podcast is brought to you by DLC Management. Welcome to Retail Retold, everyone. I’m your host, Chris Ressa, and I’m excited for you to join me today.

[00:00:24] This week, we’re going to talk about co-tenancy from the way it reads in a lease and what the future of that will become. So for those who don’t know, some leases in commercial real estate, in particular, retail real estate.

[00:00:45] Have what they call an occupancy clause or a co-tenancy clause. That clause is an obligation for the landlord to have a certain level of tenancy in the shopping center. And if they don’t, then some remedies take place. Something might read like, the landlord has to keep the shopping center at a minim 65 percent leased at all times.

[00:01:16] If not, then the tenant might have a reduced rent period for a while. And then, typically, it will do that. The clause will do what they call sunset. The reduced rent will end, and the tenant will have the right to go back to full co-tenancy rent or terminate. During that reduced rent period, the landlord typically has the ability to cure that co-tenancy violation.

[00:01:44] It might be that 65 percent just mean they have to lease some space to get over 65%. Well, this has been an interesting topic and I’ve spent a lot of time on this, studying this topic over the years. I have a research deck called “Win-Win co-tenancy,” which you, I wrote up for the ICSC. You can find it on their website and I taught it, for years throughout ICSC and I’ve continued to be fascinated by this topic of co-tenancy as it relates to leases, especially in an evolving landscape of, uh, shopping centers.

[00:02:33] So let’s start with a back it up and start with a little bit of a fundamentals of lease, which if there’s a, let’s talk about default and remedy. Most of the clauses of the lease don’t have a specific remedy for that clause. So if a landlord or tenant defaults, there’s a default provision. It says what happens.

[00:02:57] Maybe there’s a termination right now.  Maybe there is not. And it’s just the other party has to litigate. And typically for certain clauses, both landlords and tenants have agreed. We don’t want to have that be the case. We want a specific remedy. And so when either party violates that clause, there’s a remedy in the lease for what happens.

[00:03:25] Co-tenancy, it’s usually some reduced rent period. If the whole lease was remedies, specific remedies, then you’d have 500-page commercial leases and they’re already too long. So there’s not a remedy for every clause, but certain ones, landlords and tenants have kind of conceptually agreed in the marketplace.

[00:03:48] There’s probably better to have a remedy for this. And as much as they come. You know, market remedies. They’re specific to each center. And therefore landlords tend to spend a lot of time negotiating these, provisions. And I think it’s getting more and more interesting given that these shopping centers are really evolving.

When you take it, let’s talk about some different ones. So, the two most common co tenancies are opening co-tenancy and ongoing co-tenancy. Typically, if there is a co-tenancy clause, which I could say most leases do not have, but if there is. Then what will happen is I would say there are typically two types ongoing, which means there has to be a certain type of tenancy throughout.

[00:05:02] That’s ongoing throughout the period of the lease or opening. There should be certain type of tenancy when the tenant actually opens. So, I would say these clauses, Are obviously significant burdens on a landlord because if there’s a reduced occupancy, the tenant leaves and that causes a co-tenancy.

[00:05:27] There’s a double whammy for the landlord because they already lost one tenant and now the tenant that they still in the center. Now that lease isn’t what is contractually in the lease at some reduced rent period. So, a couple things have happened. over the years. There are really two types that you see.

[00:05:52] There’s anchor co tenancies and there’s occupancy thresholds. Those are like the two types of co tenancies. So let’s, let’s talk about an anchor co-tenancy. It’ll typically say something like, let’s say there’s like eight junior boxes in a center. It might say something like five of them have to be open and operating.

[00:06:20] Or there’s a co-tenancy violation for the landlord. On an occupancy, it might say, well, then there is, you know, the landlord has to keep 60 percent of the center occupied. Well, there’s a lot of things that are starting to come into play, have, and I think they’re just becoming more prevalent as we release this.

[00:06:47] One. The cure period. Cure periods, typically 12 months. Sometimes it’s 18. And then typically, like I said, the, the reduced rent sunsets, the cure period is interesting because in today’s environment, we’re talking about the words typically used are open and operating to go from signed lease to open and operating.

[00:07:21] Is in 12 months is for, you know, probably like for a box tenant, you know, on the anchor side is a real challenge in the small shop. If you’re like a, you dropped from 65 to 64 curing is probably doable in that time period. But you know, in times when an electric gear takes 48 weeks to get, to get the new tenant in, it’s, you know, let alone the amount of time it takes to negotiate the lease where It’s, you’re, you’re probably not ending up curing.

[00:07:54] So then that as a landlord, you have to think about if you’re going to agree to courtesy, what’s more important, your cure time or the time to get to sunset.

[00:08:13] And think about that. Do you want that termination right to come quickly? What do you want? To give yourself enough time to cure the co-tenancy so the tenant doesn’t have a right to terminate

[00:08:29] Well, I’ll answer that typically I could tell you In today’s environment you want The cure period to actually be shorter, even though it would take you longer the cure you want the period to sunset sooner Typically you might have financial Lender issues or something that makes that a challenge. But typically, you want that cure period to be shorter.

[00:09:00] Why? Because I would tell you here’s the secret that no one talks about the amount of tenants that have terminated their lease in America due to a co-tenancy violation. Is unusually small for the amount of effort that is put into this clause by our industry, the amount of dollars both parties spent on negotiating this clause, whether it’s the hourly rate to a leasing person, the lease administrators, the legal people, I would argue, I think The industry has spent more in G and A fighting on both sides than it’s saved in cost for any party.

[00:10:00] Now it’d be impossible for me to verify that, but I can tell you that you talk to any landlord, ask them how many tenants have terminated due to a co-tenancy clause. And I can tell you that most of them can’t remember one. Or it’s a, you know, on one hand. Now they’ve obviously been in co-tenancy violation and lost rent, but that is more rare than the times that they’re negotiating for it.

[00:10:31] The amount of dollars spent on negotiating this clause is uncanny. And we have scenarios where the tenant goes on co-tenancy. And sales rise for that tenant competitor might’ve left more market share

[00:10:56] and they get to go on remedy rent. Now they would argue that being in a vacant center and I use that word loosely because sometimes a co-tenancy clause can take into effect when it’s not even vacant when it’s just one or two vacancies and being in a less occupied center is probably a more appropriate word.

[00:11:17] Might be brand damaging consers come to see, you know, why is such and such a tenant in this property? That’s an argent I’ve heard. I would say, I don’t know to the general conser. I’m not so sure. Maybe, but I think this co-tenancy in how necessary is it to The amount of dollars we’re spending as an industry on fighting on both sides, how, how important is this provision because you can look in this provision is like two pages of the lease it is because here’s what you’re negotiating.

[00:12:04] What constitute a violation? That’s the okay. 65 below 65 percent accuracy. Well, when does the violation start? So start on that day. Does there need to be a notification between both parties who notifies who? Then once it starts, how long do you cure? How long is the cure period? What is the actual reduced rent?

[00:12:34] Is it a percentage of sales? It is just a fixed discount off the fixed rent.

[00:12:43] What happens on the sunset?

[00:12:49] You have to negotiate. What, what typically is. now getting negotiated and for a while is acceptable tenants that are replete that can be, that can replace them. You know, one of the issues we go into is like, well, that all the time is a use that’s not prohibited, not excluded by their lease. Does that count as a replacement tenant?

[00:13:20] Oftentimes some of these replacement tenant provisions. They require, they put a burden on the landlord for the specific tenant. They have to have at least 75 stores. They have to be this, they have to be that. Wait a second. I don’t need that to lease another space, but if you go into cure to co-tenancy, then I cured it with one of these tenants that’s not prohibited, but it doesn’t meet this new requirement.

[00:13:44] I’m still in co-tenancy.

[00:13:48] So, this has been a provision in leases for a long time for certain retailers. And when do retailers need it? I’ll tell you in a changing landscape of product types and that I’ve been on the bandwagon that brick and mortar is growing because everyone realizes that That’s so necessary in this digital world to, is the punishment, you know, worth the crime or is that there’s the, there’s the punishment fit the crime.

[00:14:42] I don’t know if as you read some of these provisions, so, I think this is going to start evolving for both parties. If anyone. Really studied the G and a, that it costs. And then how [00:15:00]  often do they actually go on co-tenancy? They’re spending more in G. It’s an insurance policy that I’m not sure is totally needed. Now, are there cases where it’s a Walmart center, 30, 000 square feet, a small shop, Walmart goes, they were driving traffic.

[00:15:14] Yeah. You see the negative impacts, but you know, in today’s environment, we’re living in a world where retailers don’t want to close stores. They want to grow store count. So even if there’s a vacancy, they’re probably gonna find a way to make the business work at a minim should the co-tenancy provision be tied to actual impact rather than guessing impact or making a guess that the vacancy will impact the business.

[00:15:53] It’s a guess every single time. Do not know. You could show me every fact in the world every time, blah, blah, blah. But this is a different, every time blah, blah, blah leaves, our sales go down 10%. Okay. Let’s see if it happens here because this market is different. The conser in this market might be different.

[00:16:14] And then, and therefore something different might happen. Maybe sales go up. So, if sales, if tenant leaves causes a co-tenancy violation, should tenant, tenant A leaves co-tenancy tied to tenant A. Tenant B’s sales rise when that tenant leaves. Should the landlord be in co-tenancy? You know, the cost to administer these provisions is high.

[00:16:45] Cost to negotiate these is high. So, I think. You know, it’s good business for landlords to try to protect tenants where they can. And therefore, you know, co-tenancy provisions will live on and co-tenancy should, you know, co-tenancy provisions will live on and co-tenancy provisions have a place in certain leases, right?

[00:17:18] Especially from landlords saying, Hey. I want you to come to this center. The reason for you coming to the center is because in this center is tenant A, tenant B, and tenant C. Well, tenant A, tenant B, and tenant C are no longer there. Well, they might not have gotten what they bargained for. Regardless of what happens, they were buying something based on a premise that doesn’t exist anymore.

[00:17:51] But I think the provisions should evolve because replacement tenants are becoming different. The reality of curing is becoming different. And what should the remedy be in that scenario? Probably is going to be adjusted. So, just like in, uh, anything. You know, a lot will probably stay the same, but I think, you know, I’m just putting thought provoking out there that I think it’s fascinating and interesting day, you know, my win win co-tenancy deck is not about eliminating co-tenancy.

[00:18:32] It’s about, uh, maybe a better co-tenancy in certain leases for all. And, you know, there’s going to be co-tenancy in certain leases. But I think it’s time to take a step back in a fast changing world and say, could this provision evolve to a place where, maybe one, the punishment fits the crime to start thinking about the changing nature of shopping centers in America today because they are changing and this provision has largely been unchanged. And you would think after COVID, after all these new uses going to centers that this provision would be more evolved and it hasn’t. And one of the things I want to tell everybody, the amount of dollars spent on this for the actually dollars gained by the industry is I’m telling you, there’s no research.

[00:19:39] This is totally anecdotal. But we’re losing as an industry on this provision, we’ve spent more trying to cure world hunger in this provision. I use that as a facetious meaning we’ve spent more trying to solve this provision between consultants and attorneys and everything. Then it’s, you know, then people have gained from it.

[00:20:07] That’s not a reason to eliminate it in certain leases. I’m not, you know, I would love to as a landlord, but I’m not saying that, but it’s a reason to look at it a little differently. So I hope this was a thought provoker for you gave a little secret, like very few tenants terminate their leases due to co-tenancy violations.

[00:20:29] Talk to anybody. I don’t have a stat check it out though. Think about it yourself. Think about if you’re a retailer, how many have you actually terminated. If you’re a landlord, how many of you gotten back terminated?

[00:20:42] And so that’s a little secret thought provoker. And then let’s talk about, can there be a way to actually evolve this provision to a better place given the changing landscape in the market? So that’s what I got today, everybody. I hope you enjoyed this thought provoker on co-tenancy. Stay tuned for more insightful. Discussions later this year. And tune in next Thursday for our, new episode.

[00:21:15] Thanks everyone. Bye. Thank you for listening to Retail Retold. If you want to share a story about a retail real estate deal that you are a part of on our show, please reach out to us at retailretold@dlcmgmt.com. This show highlights the stories behind the deals from all perspectives. So it doesn’t matter if you are a retailer, broker, entrepreneur, architect, or an attorney.

[00:21:45] Also, don’t forget to subscribe to Retail Retold so you don’t miss out on next Thursday’s episode.