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Co-tenancy Clauses Push Shopping Center Owners Toward Bankruptcy

As retail chains close unprofitable stores across the country, remaining tenants at the shopping centers are increasingly invoking clauses in their leases that give them the right to pull out of a center without penalty, placing new financial strain on the property owner. At times the added burden of losing additional income is so great that it pushes the owner toward bankruptcy.

Called co-tenancy clauses, the legal passages in tenants’ contracts often say that if a major anchor such as Macy’s or Best Buy leaves the center, then they have the right to a remedy — from rent reduction to withdrawing from the center in order to seek a more profitable location. That is posing a widespread problem for shopping center owners, says real estate attorney Irwin Fayne, a partner at Holland & Knight in Fort Lauderdale, Fla.

The International Council of Shopping Centers estimates that 73,000 stores will close through June 2009. If co-tenants at each mall or shopping center decide to leave, that means major disruption at thousands of centers.

Whether a co-tenant cancels a lease and departs or demands a deep discount, it has a serious financial impact. “Either way, it’s often devastating for a landlord,” says Fayne. If one retailer cancels its lease, that vacancy can trigger more co-tenancy clauses. “You could almost wind up with a house of cards. As one card falls, a few more fall, and eventually there’s just a collapse.”

The co-tenancy clauses also give retailers powerful bargaining chips when they choose new store sites. Fayne represented retailer Big Lots when it moved into the Midvale Plaza in Tucson, Ariz. with a lease calling for a 50% rent reduction if the shopping center’s occupancy falls below 70% for nine months or longer. “It’s a pretty bitter pill to swallow” for the landlord, the attorney says, though fortunately the center has remained at high occupancy.

Dark stores deter new tenants and shoppers, because they make a center look unhealthy. As its cash flow dwindles, at some point the landlord becomes unable to make its debt service, and bankruptcy becomes a more likely outcome.

Today 90% of new shopping center tenants are demanding co-tenancy clauses in their lease agreements, says Barry Ross, president and CEO of Ross Realty Investments, based in Fort Lauderdale, Fla. The company owns about 10 shopping centers located from North Carolina to Florida.

Ross has seen fellow shopping center owners face bankruptcy when co-tenancy clauses are invoked following the departure of a big-name anchor. “It can be tragic,” he says. “One tenant goes out of business and another gives notice, and then a third.”

“If a Ross Dress for Less comes into your shopping center and they come in because you have Marshalls or Target, that’s why they want to be there. If one or both of them leaves they want that option to give six months’ notice.” In today’s recessionary environment, when new, paying tenants are hard to come buy, landlords can’t say no to the contracts, Ross says. “In this market, you can’t afford to call their bluff,” he says.

Some tenants ask for a kick-out clause based on sales, allowing them to leave if their sales dip below a certain level. “If a landlord is desperate for a particular tenant and the tenant says, ‘I’m only interested in staying there if I do $5 million worth of business a year, and if I do less I want the option of giving six months’ notice,’ the landlord can’t say no,” Ross says.

The retailers’ powerful co-tenancy weapon isn’t likely to go away anytime soon, Ross adds. “Co-tenancy’s a fact of life. There’s nothing you can do about it.”

For a look at more issues that are pushing some shopping center owners toward bankruptcy and the steps they are taking in response, please see National Real Estate investor’s upcoming March issue, available in print and online.

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