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House Of Cards

There's always been a level of skepticism surrounding lifestyle centers. In an industry not known for innovation, suddenly a new mold has taken hold. Properties have been turned inside out. Developers are spending more on design, materials and landscaping. The projects have few or no anchors. And, gasp, some even allow vehicular traffic down the middle of the center. But the concept has caught on like wildfire and even traditional mall developers who said they'd never build lifestyle centers now have them in their pipelines.

So everything's worked out, right?

Not so fast.

It turns out there's a secret about lifestyle centers that few of those in the know like to talk about and if things don't work out, projects across the country face the prospect of collapsing like so many houses of cards.

The problem: With few large anchors at lifestyle centers, some of the most popular and powerful in-line tenants have taken to seeing themselves collectively as a project's new anchors.

Working together, a cadre of retailers are dictating terms in their leases and demanding generous cotenancy options. Today, it has become common for a retailer to get these “kick-out” or “pick-up” clauses in their leases with a list of five, six or even 10 names of other tenants that have to be in the center. If inferior retailers replace them, they reason, the center could deteriorate in quality, reducing traffic from the upscale kind of shopper they want.

“It's not the exception. It's the rule now,” says Ross Glickman, CEO of Urban Retail Properties. “Not only are they for new centers and not only do you have them for opening, but this is now ongoing. …It's a problem in that it's another hurdle that an owner/developer has to cross.”

Paying the piper

If a landlord doesn't deliver as promised, tenants have the option of opening late, paying reduced rent or even pulling out of a project altogether. But it's not just on the front end. If any of the retailers named on the cotenancy list leave the project before the end of their term, concessions kick in, all the way up to early termination. The result: if one key retailer ends up leaving a project, landlords could find themselves losing a number of their tenants and all of a sudden a seemingly vibrant project may be plagued with mass vacancies.

Landlords, often desperate for the up-front tenants they need to secure financing, reckon they'll grant the provisions and worry about the repercussions later, lawyers say.

So far, no project is known to have collapsed from a mass exodus of tenants, but the existence of these clauses makes it an ever-present threat and most think it's just a matter of time before it happens. It's also adding a lot of time to the lease negotiation process, especially when a valued store does drop out or delay its opening, and it's creating a lot of work for real estate lawyers.

What's more, it almost guarantees a certain uniformity of shopping centers by discouraging landlords from signing on rookie tenants that have yet to prove themselves to the most sought-after retailers.

“This is why you see the same rosters over and over again,” says Joann Podell, senior director in Cushman & Wakefield Inc.'s national retail group. “I'm not sure you can afford to bring in a new and upcoming retailer. … It's too bad, because it impacts the mix and doesn't allow for interesting and new concepts.”

The retailers on the cutting edge of the phenomenon are primarily apparel chains, but some owners say that restaurants have now gotten in on the act as well. Companies, including Chico's, J. Crew, Anthropologie, Ann Taylor Loft, J. Jill, Coldwater Creek, Hot Topic, Talbot's, Z Gallerie and White House/Black Market all demand these provisions and are usually the names that appear on other tenants' lists.

(We contacted several retailers for the story, none of whom would comment. Some developers and brokers also wouldn't comment because they see this as too controversial.)

“It's really in the tenants that constitute the better price points,” Glickman says. In addition to apparel tenants, “it's the restaurants and the destination retailers.”

Depending on the tenant, the conditions may vary. Some may ask for five of seven or seven of 10 of their list to be met. They also may be willing to negotiate for a “suitable replacement,” which would typically be a national or regional tenant with a similar merchandise mix. But others are stricter, asking for all seven or all 10 and not leaving any room for negotiation.

“I try to make it as broad as possible,” says Rosie Rees, an attorney with Pircher, Nichols & Meeks, a Chicago-based law firm that represents landlords. “The tenant likes to make it as inflexible as possible so they don't have to spend money to make plans, buy inventory or design a store if half the stores on their list are not opening or operating.”

Tara Scanlon, partner and co-chair of the national retail leasing and development team for Holland & Knight LLP says some retailers refuse to leave room for negotiation if one of the stores on their list doesn't make it. (For more pointers, see Expert Analysis p.56.)

“They want specific other tenants,” she says. “They don't want a situation where a judge may be deciding who a ‘like’ tenant may be.”

On the flip side, the most desired tenants aren't granting landlords any kind of protection. Many are refusing to grant operating covenants, meaning they won't face penalties if ultimately they fail to open or leave early.

“Most won't give you more than an agreement to open, but then they have the right to go dark,” Scanlon says.

When lifestyle centers hit the scene, tenants naturally wanted some assurances. But without anchors, traditional cotenancy clauses were out of the question.

That's when some retailers got the idea to develop these cotenancy lists. Dawn Greiner, an associate broker for Staubach Co., which specializes in tenant representation, defends the practice as a form of security for tenants.

“Lifestyle centers don't have that traditional anchor. We're just protecting them, mainly for reasons of ongoing tenancy,” Greiner says. “We don't want to place a tenant only to find six cell phone stores filling in the available space.”

Tenants don't want to be in situations where they committed to a vision of a project promised by a developer only to find that the owner couldn't deliver and instead filled the space with whatever retailers would sign leases, thus diminishing traffic.

“With this, a tenant can say, ‘You told me that this was going to be a certain kind of center. I don't want you to replace the Old Navy with a jewelry store,’” Rees says.

A concern for tenants is that the future success of a lifestyle center is often connected with residential growth in the region. Many times developers sell their projects based on projected population and income growth. But there's no guarantee that things will play out. So cotenancy clauses become a way to provide an out for tenants.

Acting like anchors

The newfound strength these retailers are wielding stems from their increased prominence and the diminishing importance of department stores. In the past, in-line retailers were seen as complementary to the anchors.

Now they themselves have become the destinations. Moreover, by pooling their strength, they can act just like the department stores of old. And they are very aware of that fact. They talk to each other.

“An Abercrombie will call Anne Taylor and say, ‘Are you doing this deal?’” Glickman says. “They don't need us to give them any details. They talk among themselves. It's all an open book.”

They tell each other the terms they are getting. They name each other in their leases. They are going to ask for the same rents, Glickman says.

On the other hand, with the number of lifestyle projects going into the pipeline, developers have no choice but to grant the clauses if they want their projects to be financed and built.

“The reality is that there are so many lifestyle centers being built today so tenants don't have to go in unless it fits their criteria,” Podell says.

The only exception to this is in space-constrained markets where the possibility for new development is limited.

“Where there's a finite amount of land available and the markets are extremely tight in terms of vacancy and occupy levels, tenants may want to push back, but there are not a lot of places to go,” says Marc Yavinksy, branch manager of the Boca Raton regional office for GMAC Commercial Mortgage. This would be the case in Southern California, New York, Chicago and other strong retail markets, he says.

Taubman Centers, for example, has a upscale lifestyle project in the works in Oyster Bay, N.Y. that would have no real equal in the region.

“Their only competition would be Fifth Avenue. My guess is that they will be able to be selective and independent in who they bring in,” Podell says.

But Glickman doesn't think that's likely to be widespread.

“You can try to get rid of cotenancy clauses, but if you do, you're not going to get tenants,” he says.

Further repercussions

There are other implications to the rampant use of cotenancy clauses. It can impact financing, for example. On the surface a center may look strong and have an ideal roster. But the cotenancy clauses add a layer of risk, which then needs to be factored into the financing package. The result is that lenders may include provisions to reduce financing should a center lose tenants as a result of cotenancy clauses.

Managing cotenancy lists during a project also adds a lot of work to the developer's team, both for leasing professionals and real estate attorneys.

Says Scanlon: “It used to be that you had to track space leased. Now you have to track names too. You have to see where you are on all fronts. It's very time-consuming.”

Cotenancy is not a new issue. What's changed is how it's being applied. Traditionally, in-line tenants would ask for named cotenancy clauses in connection to a mall's anchors, both in regional malls (with department stores) and in strip centers (with grocers).

Another common structure was for such clauses to be structured around occupancy levels. If a center fell below a certain occupancy level — usually 75 percent to 80 percent — tenants would have the option to vacate their space.

This provision was originally used in the 1970s and early 1980s at regional malls, but then fell out of use. In the mid-1990s, though, cotenancy clauses began to come back and then took off in a big way when lifestyle centers hit the scene.

They first came about as a means of insurance. Lifestyle centers didn't have track records. Moreover, both tenants and lenders saw the lack of clear anchors as a risk. “Without anchors, tenants want pick-up clauses and that can create problems,” said Jim Ratner, executive vice president during a panel discussion at a recent Urban Land Institute meeting. He suggested that traditional anchors be included at lifestyle centers for that reason.

An anchor promises tenants that a certain quality will be maintained. Also, with a big store taking up much of the space, the owners have more bargaining power and aren't banking as much on inline tenants to make or break the project.

With lifestyle centers, tenants began asking for new kinds of cotenancy conditions. Tenants wanted assurances that they weren't stepping into a disaster. First they asked for specific leasing targets. They wouldn't commit to a project until it reached a certain pre-leasing percentage. As lifestyle centers have evolved and developed a bit of a track record, tenants have shifted again. That's where the lists come in.

“In malls, cotenancy clauses are about the percentage of space that needs to be leased and occupied at certain times. In lifestyle centers, it's these must-have lists, which are much more problematic,” Scanlon says.

What the future holds

With so many tenants named, there is a greater risk that one or more companies will eventually run into problems or change its strategy or need to close stores. For example, J.Jill — which is frequently named in these lists — announced in early December that it was exploring strategic alternatives, including a possible sale.

If it is acquired by a retailer with a different audience that wants their real estate — say, to Lane Bryant — that could trigger cotenancy options.

“What happens if two years from now those stores are closed?” Rees asks. “In regional malls, this was never mentioned. Landlords never agreed to naming cotenants except for department stores. And even with ongoing cotenancy clauses, they tried to avoid that.”

Another possibility is that if a new and better project comes into a market, tenants may use cotenancy clauses to try to force their way out of the project they are in to jump to the new one.

Lastly, Glickman adds that the proliferation of these properties could contribute to the problem.

“They have to be supported by the market they are situated in,” he says. “If it is not expanding from a residential density, then these kind of kick-outs will happen and perpetuate themselves.”
With reporting by Beth Karlin.

Three Faces of Cotenancy

Part of what makes cotenancy a pressing issue is that it can come into play different ways throughout a project's life. There are three distinct phases during which the provisions can take effect. First is during the lease-up period. After a tenant signs a letter of intent to occupy a project, it may have the option to pull back out of the project if the other retailers or restaurants on their list don't sign by a certain deadline.

The second phase is opening cotenancy. At this point, a tenant has signed on and begun build-out of their space and training their staff. But if the other retailers on their list don't open by an agreed-upon date, the tenant does not have to open its store either (and therefore, it doesn't have to start paying any rent on that space).

It can lead to a situation where Tenant A doesn't have to open until Tenant B is open. But Tenant B doesn't have to open until Tenant C is open. Meanwhile, Tenant C may not need to open unless the others are open. The result is that all three tenants could theoretically end up waiting on each other and hamper a center's early performance, but meanwhile, not be forced to pay any damages back to the landlord. To prevent this scenario, some owners offer tenants incentives such as free or reduced rent if opening cotenancy goals are not met. A common recourse is to have a tenant only pay a percentage of their sales as rent during this period rather than their negotiated fixed rent.

Lastly — and the most dangerous caveat — are ongoing cotenancy provisions that cover the entire life of the lease. If one of the other tenants on the list ends up leaving a project early, then concessions can kick in, including reduced rent or the option to vacate. Sometimes, the landlord can recover damages, usually written into the lease, for a signed tenant's failure to follow through on its contractual promise. Other times the desired tenant can insist there be no charge for failure to deliver.

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