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LEASE LANGUAGE: Leases caveat emptor

You're considering investing in a shopping center and things look great. Nationally recognized tenants including a home improvement center and several other highly desirable tenants anchor this center. At first glance, the center is in a desirable location, attractive, and traffic counts are favorable. You have the rent roll and a proforma and the price seems reasonable. What could go wrong?

Without reviewing the leases, reliance on rent rolls can be extremely dangerous, because rent rolls don't disclose many important provisions of the leases. It is possible by relying only on the rent roll you might well be faced with a domino-effect of vacancies in all-too-quick succession.

Background check

Most investors are wise to the basic fundamentals of real estate when acquiring a shopping center; being diligent to analyze the quality of the location — the demographics of the area, highway accessibility, visibility of the property, mix of tenants, etc. But there are times when these fundamentals are not enough. All these may be in order, but quirks in the leases at that center may have been written in a way that makes a seemingly good deal shaky.

Say, for instance, the original developer needed to attract some high-profile tenants to a developing, but nonetheless speculative, location. Or maybe, in a seasoned, in-fill location, the market was somewhat saturated, but the developer thought his new center would supersede earlier ones. What the developer may have done is attract the well-known anchor stores to the center by providing them with several escape provisions permitting tenants to terminate their leases before the expiration date, sometimes with penalties and sometimes without any penalty at all.

Escape provisions

The major home improvement store noted in this example is the major draw to the center. However, in order to attract the office supply store, the developer offered a lease provision granting an option permitting the smaller tenant to terminate, pay a reduced rent or other negotiated concession, should the anchor tenant stop conducting business or vacate the center. This type of escape provision is known as a co-tenancy provision and is often found in power center and life-style centers, but is not uncommon to neighborhood shopping centers as well.

Another type of escape provision is one based on sales volume, or use of square footage of the store. In this scenario, the tenant says, “We like the place, but we're not quite sure the demographics of the area are right for us.” The developer cuts a deal providing for an early termination if sales don't reach a certain level.

A third method of bringing in a hesitant tenant is to allow the store to pay an early termination fee in order to exercise an option to terminate its lease at a specified time. In this scenario, some remuneration is forthcoming, but the highly desirable tenant that attracted you to the center in the first place is gone. If other tenants are linked to this one, the domino-effect of vacancies begins.

Does facing these types of situations, mean you should just turn and run? Not necessarily. The appropriate due diligence may arm you with a strategy allowing the deal to go through with sufficient comfort. First, take an inventory of the same types of stores in the market already. This serves two purposes. It will show what the competition is for the store in your potential investment and whether that store is vulnerable — thus, potentially may use the clause to get out of the lease. Secondly, it will give an idea of what stores may not be in this market and who may be able to take over the space should the original tenant leave.

Store size is also important. Perhaps the tenant with the escape clause requires an unusual store size. If they do opt out, will that odd size be an impossible fit for anyone else? Take an inventory and develop a hit-list of potential tenants for that store size as a defensive strategy.

You may be surprised to hear how many times investors or developers say, “Oh, don't worry. Someone will step up to the plate to rent.” But when its a multi million-dollar investment in a fluid market, that type of unsubstantiated optimism may be a disaster.

The bottom line is always the bottom line, and even when an investment looks great on the surface, remember caveat emptor — let the buyer beware.

Joseph Pasquarella, MAI, CRE is the Managing Director of the Philadelphia Office of Integra Realty Resources, Inc. Integra is a national real estate firm operating 45 offices specializing in valuation and counseling of commercial real estate.

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