Should We Invest In That? Part 5 of 6 – Lease Terms

Mar 28, 2024

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Lease Terms

One of the most important aspects of shopping centers can also be one of the most difficult to underwrite — lease terms. The terms of the underlying leases can act to reduce income or abate income, prohibit other tenants from operating or even result in the termination a lease. As there is no standard retail lease form, the variety of terms in retail leases are almost infinite. However, we have listed several common lease terms below, along with an explanation of how we can mitigate certain risks associated with these terms.

  • Cotenancy. Cotenancy clauses allow tenants to reduce rent or terminate leases if key tenants leave or if a certain occupancy level is not maintained. We review the dependency of tenants on each other for foot traffic and, using our financial stability criteria, assess the risk of a domino effect where one major tenant’s departure could lead to others leaving or demanding lower rents.
  • Exclusive and Prohibited Use Clauses. In order to protect their interest and position in the property, tenants leases typically include exclusive and prohibited uses, which restrict the landlord’s ability to lease vacant spaces to competing or undesirable uses. Exclusive uses are usually found in leases for stores with very specific uses, (i.e. crafts, sporting goods, electronics) whereas prohibited uses generally prohibit non-retail uses or undesirable uses that do not contribute to shopping center traffic or demand too much parking.  We conduct an exhaustive review of tenant leases as well as operating and easement agreements to determine how limited our leasing efforts would be. These terms can be particularly important in an environment like today’s where many shopping centers are transitioning to a combination of retail and experiential uses.
  • Early Termination & Kick Out Clauses. Early termination and kick out clauses allow tenants to exit leases prematurely under certain conditions. We evaluate the conditions under which these clauses can be activated and the probability they will occur, the potential for increased vacancy rates, and the financial implications of having to re-lease the space, including lost income and re-tenanting costs.
  • Continuous Operation. Continuous operation clauses require tenants to remain open and operational for the lease term. Underwriting must consider the risk of leases not including this clause as well as the risk of tenants closing down despite this clause, potentially due to financial difficulties, affecting foot traffic and the attractiveness of the property to other tenants and consumers.
  • Percentage Rent. Leases that include percentage rent clauses base all or some of the rent on the tenant’s sales. While this can be beneficial for stores performing well, this can also result in lower rents for underperforming locations. Historical sales data of tenants, market trends, and the economic environment are included in our underwriting to forecast potential rent fluctuations and their impact on the property’s income.
  • Rent abatement. Rent abatement provisions allow tenants to withhold rent under certain circumstances, such as during initial fit-out periods or if the landlord fails to provide essential services. Risk assessment should quantify the potential financial impact of these clauses and the property management’s ability to mitigate triggers for rent abatement.
  • Force majeure. Force majeure clauses excuse parties from fulfilling their obligations under unforeseeable circumstances like natural disasters. When underwriting, we consider the potential for increased vacancy or reduced income during such events and whether the lease adequately protects the property owner’s interests without placing undue burden on tenants. Most force majeure clauses have included pandemic language in the wake of the Covid-19.
  • Assignment and Subletting Clauses. Without strict control, tenants might transfer their leasehold interests to less desirable subtenants or assignees, potentially undermining the tenant quality and stability of the retail environment. We make note of tenant’s assignment clauses and whether the landlord has approval rights to protect the owners interest in each lease before a property is purchased.
  • Lease Guaranties. For leases that are with franchisees, or not with national or regional tenants, the lease guaranty can provide financial security for a landlord. We examine these guaranties closely to determine exactly what obligations are being guarantied and whether the guaranty terminates after a certain number of years of the tenant’s operation. Often a guaranty may only cover the 12-18 months of lease payments accruing after a default.