It’s no secret that most retailers today are facing some of the most difficult economic challenges they have ever encountered, and as retail tenants go, restaurant operations have certainly suffered some of the worst of it. As a result, tenants have been forced to either diligently focus on reducing fixed costs or close their doors. Rent and labor costs are typically the first fixed cost line items to be scrutinized. Landlords of retail properties are clearly suffering as well what with record vacancy levels and a glut of space inventory (especially so for “B” quality and lesser properties). This article will discuss opportunities that tenants should consider toward reducing fixed rent costs, and obtaining more favorable lease terms.
Negotiating a rent reduction on an existing lease is all about relative leverage, and whether the tenant has it. The ability to extract concessions from a landlord depends on whether the tenant can credibly show that it would need to (and will) close up shop absent an immediate reduction in rent costs. That tenant needs to be prepared to support its case by showing landlord financial reports evidencing a substantial drop in tenant’s gross sales and a resulting inability to cover associated facility costs.
As a fundamental the tenant needs to be “desirable” to a landlord. Thus, it should first undertake an honest assessment of what it brings to the property to capitalize on positive points in the restructuring discussions with its landlord, and toward developing its strategy for those communications.
Put yourself in the landlord’s shoes, and then think carefully how you will respond to landlord’s questions about your operation’s financial position and future. Think about what will interest and motivate the landlord to cooperate with you to achieve a win-win workout.
Remember, though, that if you as tenant have a bad history of continually missed or late rent payments, lack of communication with the landlord’s property management, poor traffic building for the center, failure to fit into a good mix for the center, and/or repeated deficiencies in cleanliness and orderly maintenance of operations, then the landlord might well be just as happy to see you go.
When a shopping center or strip already has a number of dark storefronts the landlord will understandably be concerned about losing yet another tenant, with resulting loss of revenue and traffic. Too many dark storefronts make a retail property depressed, customer “unfriendly”, and uninviting.
And, the further erosion of tenant rent steams may put the Landlord in violation of its mortgage loan covenants, cause insufficient cash flow to make debt service payments, and trigger co-tenancy clauses (discussed below) that allow other tenants to reduce their rents. Landlords facing these undesirable outcomes will be motivated to consider your rent reduction proposal lest they lose you as a rent paying tenant.
By contrast, if the center or strip is in a low vacancy submarket with high traffic, or the subject space is a particularly attractive “end cap” with great frontage and exposure, then the tenant will likely have little leverage since there will probably be a ready supply of replacement tenants. The same lack of leverage for tenant will also appear if your financials show that, despite the economic downturn, you continue to have a robust, healthy operation.
Smaller retail operators need to be aware of exposure from their personal guarantee(s) of the business entity’s obligations on the lease. The threat and leverage of “going dark” (closing its doors) may not be nearly as viable an option for a tenant if the business owner’s personal assets will thereby be put in jeopardy.
Such personal guarantees will not allow for the relative convenience of a “walk-away” opportunity. Most personal guarantees expressly state that the landlord has its choice of going after the guarantor first, or simultaneously going after the tenant entity and the guarantor, for monetary damages resulting from the tenant’s defaults including its going dark.
Franchisees will also need to consider whether going dark will make them in breach of their franchise agreement, and thereby create exposure for damages claims on two fronts (with both their landlord and their franchisor).
In negotiating a rent reduction tenants need to be prepared to give landlords a “quid pro quo” which may be in the form of higher rent due later (deferred rent recovery) when times are better. If there is a percentage rent provision in the lease, then landlords may allow for a reduced fixed rent now in exchange for a lower break point for calculation of the percentage rent “kick-in” as measured by gross sales – this compromise makes intuitive sense since it allows a landlord to recover its immediate rent concession when the tenant’s gross sales finally recover and tenant is arguably then better able to shoulder that increased rent payback.
Other common deal restructure points that landlords may seek in exchange for reduced rent are:
The landlord’s objective in seeking the above is to lock in a longer and stable future rent stream that will provide it a better posture to negotiate with its mortgage lender now, or on a refinance cycle.
The ultimate viability of the tenant’s business model is the key here, because if the landlord (in doing its due diligence) doesn’t see an improving economy making the difference in light of a faulty tenant business model, then the landlord will see no upside (and perhaps even a worse outcome) in going with a longer lease term for that tenant.
As part of a rent reduction negotiation a landlord may also require that a tenant give up certain express rights in exchange for the rent concession. These may include the tenant’s agreeing to give up renewal rights, exclusives, or co-tenancy provisions. Contraction of the space the tenant occupies may be another possible means to achieve a viable rent structure.
Tenants can, if their respective leverage provides, secure at the “front end” of their leasing transaction certain protective clauses that anticipate economic down cycles. One of the most prominent of these is the “co-tenancy” clause that provides that a tenant’s minimum or fixed rent will be reduced or abated to the extent that an anchor tenant (or a certain percentage of other tenants in the retail property) is not operational or goes dark.
Co-tenancy clauses recognize the hardship that remaining tenants suffer when the traffic draw to a center/strip is eroded by the absence of an anchor or the presence of many dark storefronts. While difficult to get, a few tenants are able to secure a provision allowing them to terminate their lease if a co-tenancy violation exists for an extended period; however, such termination rights are generally not available due to mortgage lenders’ adverse reaction to such clauses.
Most co-tenancy provisions provide that for a tenant to enjoy the prescribed relief on rent due it must continually operate on a regular schedule, and not go dark. Also, many co-tenancy rent reduction provisions will afford the rent reduction only for a certain defined time period (limited to a year or two), after which the rent goes back to the unreduced, scheduled amount.
Early termination for a fee is another occasionally available tenant protection. While most landlords will not entertain such a tenant right due to the adverse impact on their ability to use the lease’s anticipated income stream as support for mortgage financing, some tenants can still negotiate for the ability to terminate their lease for a stipulated early “termination fee” payment. Such a provision can provide welcome flexibility for tenants that seek to eliminate under performing locations in their chain operations.
While perhaps not as common in retail leases as they once were, percentage rent provisions can be opportune for tenants experiencing a severe downturn in gross sales. Percentage rent provisions, if appropriately structured when a lease is first entered into, allow for a tenant and a landlord to both share in the potential upside of a good economy, as well as the risks of a bad one.
Percentage rent mechanisms provide for additional rent to be payable when the tenant’s revenue exceeds a certain threshold; thus, less rent is payable if the threshold is not met or exceeded. Percentage rent clauses are sometimes disfavored by tenants due to the additional sales reporting which a tenant must periodically make to its landlord; however, if the tenant is a franchisee then the regular sales reporting required to be given to its franchisor may make for minimal additional admin burden in reporting the same figures to its landlord.
Tenants seeking rent reductions need to remember that their landlords may, or may not, have a free hand to grant the tenant’s requested concessions due to restrictive mortgage loan covenants that require the landlord to maintain certain minimum gross rent and cash flow from a given property.
One course may be for the landlord to seek amendments or waivers from its lender that allow for the concession(s) to tenant; however, pursuing such relief can take time and may ultimately not be forthcoming from the lender. Also, some mortgage lenders will expressly require (in the underlying mortgage loan documents) their right to reserve approval for any proposed rent reductions such that a landlord’s “hands may be tied”.
Without the right “crystal ball” it is impossible to tell exactly when the hoped for economic recovery will occur. Though when it does happen, and employment figures show concrete improvement, the opportunity for leverage in getting landlords to restructure rents will quickly close. Thus, tenants’ advantage toward extracting landlord rent concessions on existing leases, renewals, and new leases is now.
Tenants that are within a year or two of their lease term end are also strongly advised to engage the assistance of a competent tenant broker knowledgeable about their submarket. That broker will provide invaluable input with aid of current market comparables and negotiating experience, and the broker may also well have critical information about the respective landlord’s current financial condition, existing financing on the property, and amenability to lease restructuring. If the lease is mid-term, with several years left to go, a tenant might consider engaging the assistance of a lease restructuring specialist that will be compensated on a percentage of savings (contingency) basis.
Tenants should avoid the sense that engaging discussions with a landlord about a rent restructure will necessarily cause friction in the tenant – landlord relationship. In many cases the reverse is actually true since landlords will recognize that you are trying to be up front with them in seeking to develop a solution that allows for your continued viable, and mutually beneficial, occupancy. The important thing is to carefully prepare for your conversation with the landlord by considering what leverage points and arguments you can convincingly put forth to cause the landlord to appreciate why the economic concessions you are seeking are justified and why they will result in a win-win resolution.
Any agreement to restructure a lease should, of course, be properly documented by an amendment to the lease that should be carefully reviewed by your attorney.
Lars Andersen is an independent practice attorney with over 23 years experience in commercial leasing and a wide variety of related business transactions. He may be reached at 703-349-1251, and via email at [email protected]. Please note that the above article is informational only, and should not be construed as legal advice with respect to your situation or matter – if such advice is required the services of an attorney should be engaged.