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Restoration Risks

Any agreement to restore improvements in a shopping center after a casualty is risky because the costs may be substantial and the obligation arises at an unpredictable time. Restoration may not be economically justifiable under the market conditions in effect at the time of the casualty. A restoration commitment by a developer (as a landlord in a lease transaction or as a party to an REA transaction) to a department store or similar anchor creates unique risks, even when the department store agrees to restore its own improvements.

During Operating Covenant Period The nature and scope of the developer's obligation is often dependent upon the time at which the casualty occurs. If the casualty occurs during the department store's operating covenant period, both the department store and the developer frequently are obligated to restore their improvements without regard to whether the casualty is insured (or required to be insured) and without regard to the remaining term of the operating covenant. The developer's obligation frequently involves substantially all of its improvements (not just those near the department store).

The developer might be required to restore space that is very difficult to lease because of market conditions without any assurance that the department store will be operating for a substantial period of time. The prospect of finding capital sources, in the absence of insurance proceeds, to fund such restoration is not encouraging, but the developer nevertheless remains contractually obligated.

After Operating Covenant Period A department store is usually not required to restore its improvements after the expiration of its operating covenant. Nevertheless, a department store can often force the developer to restore by agreeing to restore, if it is also damaged, and extending its operating covenant another ten years or so.

There is, however, some negotiating room in this area, and a developer might successfully avoid a restoration obligation in the event of a substantial uninsured casualty and might successfully limit the geographic scope of its restoration obligation. The scope is often determined by the location and number of department stores willing to extend their covenants. The problem is that agreeing, far in advance of the casualty, upon an appropriate matrix of restoration configurations requires foresight few of us possess.

Exculpation Provisions The issues described above are often difficult to negotiate. Some department stores view the obligation structure described above as standard and non-negotiable, particularly since they are also incurring substantial restoration risks and are covenanting to operate under a specified name for a substantial period of time regardless of economic feasibility. The only real comfort a developer may have is the exculpation provision in the document.

The good news, from a developer's perspective, is that even department stores which have taken a firm position about a developer's restoration liability have often been sensitive to a developer's request to have its liability limited to the real property or to a single purpose entity, at least after the shopping center has opened for business, and have often been willing to put their own net worth behind restoration and operating covenants.

My own speculation is that future transactions (among consolidated, more institutional developer and department store entities) are likely to provide for more restoration flexibility but less sensitivity to the need for a developer's exculpation.

Lender Requirements Although shopping center lenders are familiar with the substantial restoration obligations imposed upon their borrowers, lenders' forms of loan documents typically permit the lender to decide whether to utilize insurance proceeds for restoration or to pay down the loan. It is important that the loan documents contemplate (or in the case of existing leases, recognize) the restoration requirements of department stores, both as to the leased premises and the remainder of the shopping center. On the other hand, the lease or REA with a department store should acknowledge that a lender may only be willing to commit to restore to the extent of available insurance proceeds.

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