Legal and Contractual Strategies for Minimizing Risk and Overcoming Challenges
The retail industry is dynamic, constantly evolving to meet consumer demands. Retailers face intense competition from other brick and mortar stores as well as online retailers, such as Amazon. Consequently, previously thriving companies may be forced to close stores and/or file for bankruptcy in response to competition and changes in consumer shopping patterns (e.g., 99 Cents Only, Bed Bath & Beyond, and Party City have filed for bankruptcy since the beginning of 2023, and several national retailers such as Macy's, Family Dollar, and Rite Aid have announced that they are closing at least 50 stores each). Store closures pose significant challenges for landlords, principally, the potential loss of revenue and property value.
The departure of a long-standing tenant, however, may also present an opportunity for the landlord to secure replacement tenants that pay higher rents, particularly when a departing tenant had been operating under an older lease with below market rent rates. New tenants can also enhance a shopping center's appeal by attracting new consumers, which can benefit all tenants within the shopping center and has the potential to increase property value.
Retail landlords often face a number of challenges in reletting space vacated by anchor tenants and need to be creative and strategic in their approach. Below, we describe four common challenges that landlords face and how to address them to successfully relet space vacated by major tenants.
Challenge #1: Use or distance restrictions contained in the leases of other tenants.
Existing restrictions within the shopping center may limit a landlord's ability to fill vacant space with the landlord's preferred replacement tenant. These restrictions could be in the leases of other tenants or may be in the governing documents recorded against the property.
A landlord should be fully informed of relevant restrictions that would limit its ability to fill vacant space with a replacement tenant. This requires analyzing the existing leases to pinpoint all restrictions and formulating strategies to creatively overcome the restrictions. If the landlord wants to amend the restrictions, we recommend engaging real estate counsel, who will collaborate with the landlord to introduce exceptions and/or secure consent from the parties with the authority to enforce the restrictions.
One hurdle that shopping center landlords commonly face is that the lease of an existing tenant may prohibit a potential replacement tenant's business. Some of these restrictions are in the form of "exclusive use" provisions which are designed to shield an individual tenant by preventing its competitors from opening a store in the same shopping center. In addition, many national and anchor tenant leases prohibit certain uses that were considered to be incompatible with a traditional shopping center at the time that the existing tenants' leases were executed. For example, an existing anchor tenant's lease may prohibit theaters, entertainment uses, and office uses. Alternatively, an existing tenant's lease might allow the foregoing uses, but require that any business engaging in those activities be situated a certain distance away from the existing tenant's premises. For example, an existing tenant's lease may prohibit certain "parking intensive uses" (such as restaurants and health clubs) within a radius from the existing tenant's premises. As a result, landlords may be restricted from leasing space to businesses and retail uses that are presently in high demand and prominently featured in thriving shopping centers, particularly those that have adapted to fulfill consumers' cravings for "experiential" retail. To address these issues, landlords can enlist the help of real estate counsel who can perform a comprehensive analysis and devise strategies to navigate the restrictions.
Challenge #2: Restrictions contained in the governing documents recorded against the property.
Shopping centers are frequently encumbered by covenants, conditions, and restrictions (CC&Rs) or similar recorded documents [1] that dictate how the shopping center may be operated, including prohibiting certain businesses or activities. These CC&Rs often contain prohibited uses and other restrictions that were required by the original anchor tenants of the shopping center. Similar to the existing lease restrictions discussed above, landlords must either work within the restrictions in the CC&Rs or seek alternatives.
If a landlord cannot work within the existing recorded restrictions, then the landlord will need to seek approval to change them. Where multiple parties own parcels within the shopping center (such as anchor tenants that own their respective parcels), many CC&Rs require that all or a certain percentage of designated "approving parties" must approve a modification or waiver of a restriction in the CC&Rs. In such cases, the landlord can attempt to negotiate with these approving parties for exceptions to the objectionable restrictions on a one-time basis to allow for the operation of specific tenants or, alternatively, the landlord can pursue amendments to the CC&Rs so that the restrictions are permanently changed.
The foregoing process begins with identifying the parties authorized to approve or reject changes to the CC&Rs, followed by determining the procedural requirements for negotiating and executing an amendment, or one-time consent, as desired. In some cases, the approving parties may readily grant their approval to proposed modifications (particularly if they also want to modernize the shopping center); whereas other times, the approving parties may condition their approval upon receiving a concession or payment in exchange. In either case, the existing recorded restrictions may be obstacles to the landlord's goals, but they can be navigated in ways that meet the needs of all parties involved.
[1] The recorded restrictions may be contained in documents with names such as operating and easement agreements (OEAs), construction, operation, and reciprocal easement agreements (COREAs), or declaration of restrictive covenants. For simplicity, we will refer to such documents as "CC&Rs."
Challenge #3: Addressing co-tenancy issues contained in the leases of other tenants.
Many anchor or national tenant leases contain "co-tenancy" provisions that require a specified number of the anchor tenants to be open and operating and/or that require the shopping center to maintain a certain occupancy level. If an anchor tenant ceases operations, it could trigger a violation of the co-tenancy provision contained in one or more existing tenants' leases. Such a violation may entitle certain tenants to various remedies, such as the right to pay reduced fixed rent (or rent based upon a percentage of the tenants' sales) until the co-tenancy requirement is satisfied, or even the right to terminate the lease.
In most co-tenancy provisions, the landlord is afforded a designated period of time to "cure" the co-tenancy violation by securing a replacement tenant or achieving a certain occupancy level in the shopping center before the existing tenant has the right to pay reduced rent and/or terminate its lease. In some leases, however, the tenant may have the immediate right to pay reduced rent if an anchor tenant closes. Complications can arise if, for example, the co-tenancy requirement specifies that the landlord must replace the vacated space with a single national retail tenant of a certain square footage, but the landlord can only find multiple smaller tenants to fill the space, thereby potentially falling short of fulfilling the requirements of the co-tenancy provision.
Retail landlords may face the challenge of balancing the need to fill the vacant space with maximizing occupancy and profitability. Accordingly, the relevant lease documents should be scrutinized to make a determination of the potential risk to the landlord, as well as to try to generate strategic solutions to solve co-tenancy issues. Retail landlords encountering this challenge can enlist the expertise of real estate counsel to engage in negotiations with tenants eligible for the remedy. A resolution may be reached in which the tenant entitled to remedies agrees to an alternative "cure" other than what is required in its lease, such as replacing one anchor tenant with multiple tenants that generate sufficient foot traffic or that enhance the tenant mix. This strategy aims to halt further losses in situations where the landlord cannot immediately cure the breach of the co-tenancy provision.
Challenge #4: Renovations, remodels, and tenant improvements.
Re-tenanting space can be costly. Repairs and renovations may be necessary to make the space suitable for re-leasing, and the replacement tenant may require specific tenant improvements. For example, in some cases, the vacating tenant may have left fixtures or other items that are expensive to remove, such as a safe or other structural improvements like escalators or mezzanines. At the same time, the replacement tenant will likely require a new build-out, tailored to its particular business. Moreover, the space may need to be upgraded to satisfy "green" (i.e., energy efficiency) or other new building code requirements since the space was originally constructed.
As with a lease for first generation space, the parties may determine during the letter of intent (LOI) stage which party will perform the necessary work and at whose expense. For instance, the tenant may agree to cover all construction costs related to the tenant's build-out, provided the landlord offers a tenant improvement allowance or reduced rent. However, other significant issues may not be addressed during the LOI negotiations, such as a new tenant's need to install a loading dock or the cost of separating utilities if the new tenant's use will use a disproportionate amount of water or electricity. These issues present complexities that need to be addressed beyond the initial LOI negotiations, as the lease is negotiated. An attorney can help analyze the unique set of facts of each deal to help anticipate and successfully address post-LOI issues.
This article is a brief overview of a few issues a landlord may face when major tenants vacate their space. There are many other nuances to consider and complications that may arise beyond those discussed above, and the Retail Team at Cox, Castle & Nicholson LLP is made up of experts skilled in navigating these issues. Please feel free to contact any member of our team if you have questions or would like assistance with any aspect of your shopping center leasing needs.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.