I Am Negotiating With A Retail Tenant That Doesn’t Want To Open Or Operate Continuously – Now What?
In today’s retail environment, landlords have been faced with a growing number of tenants who either choose not to open for business, or who open initially for a short period of time, only to close their doors while electing to keep the lease in effect. Such actions have obvious impacts on not just the landlord (e.g., lost percentage rent opportunities), but also on the leases with other tenants who may have negotiated co-tenancy provisions based on, for example, the presence of one or more major or anchor tenants in the shopping center. From the tenant’s perspective, a situation may arise where a tenant has over-expanded by signing too many leases and is unable to mobilize by the date rent is supposed to start. In such a case, it may be sensible for the tenant not to open for business (and pay the cost to hire staff and fully merchandize the store), despite the fact that the obligation to pay rent will commence. Those tenants will not want the fact that they failed to open by a certain date to be a default under their lease. In addition, it may make economic sense for tenants whose sales are not meeting expectations to close for business and continue paying rent, rather than pay the additional costs associated with running the store (payroll, merchandise, advertising, etc.). Tenants who are not willing to agree to continuously operate sometimes argue to the landlord that their primary obligation should be to pay rent on a monthly basis, and that closing shop should be immaterial to the landlord so long as the rent is paid. Apart from arguing that those tenants may generate foot traffic for other merchants, and that a shopping center with a lot of empty spaces will likely be less attractive to shoppers than one that is fully leased, what does a landlord do to protect itself if an otherwise attractive tenant insists on not being required to open or operate, or, put another way, on the right to be able to “go dark”?
For starters, the landlord should consider the following:
Give the tenant extra time to open before remedies take effect. Many leases provide that the tenant is required to open, and that rent will commence, a certain number of days following the delivery of the premises to tenant, to give the tenant time to prepare the store for opening. If a tenant balks at the potential for a default if it is not open within, for example, 90 days following delivery of the premises, a landlord may agree to allow more time before a tenant is deemed to have breached its lease. Sometimes, an additional 30 or 60 days will give a tenant who is willing to open some comfort that it will not be in default early in the term if it misses a required opening date. Of course, the landlord will want the rent to commence, notwithstanding the grace period for the tenant to open.
Require the tenant to at least open for one day. Although the tenant may not agree to operate continuously, it should agree to open for at least one day, fully fixturized, staffed and stocked with merchandise. This may not seem like much, but a tenant that is required to spend the time and money to get a store in a position to open and operate, even for one day, is probably less likely to close after opening its doors, at least for a while.
Make sure the tenant is required to perform all of its other obligations under the lease. Even if it gives up on requiring the tenant be open continuously, the landlord should make sure that the tenant is still obligated to perform its other obligations under the lease, regardless of whether or not the tenant’s store is open for business. Paying rent (including operating costs, taxes and insurance) is an obvious requirement, but the tenant should also be obligated to perform its maintenance obligations under the lease. Just because the premises are closed does not mean that they should look shoddy or run down from the exterior, which could potentially drive away customers from the remainder of the shopping center. Also, it makes sense to allow a tenant to “go dark” only if it is not then in default of its other obligations under the lease. The right to close should be viewed as a “benefit” to the tenant, and should only be exercisable if the tenant is, for example, current on its rent.
Give yourself the right to “recapture” the premises. One general rule that landlords should try to live by is that, for a landlord, it is of utmost importance to “control the real estate”. With that in mind, a savvy landlord will want to negotiate the right to “recapture” the premises (essentially, to terminate the lease with the tenant) if the tenant is closed for business for an extended period of time (i.e., 60 days or more). The landlord’s “recapture” right should be ongoing, unless the tenant re-opens for business. The landlord will most likely exercise its recapture right only if it has another viable tenant, or thinks it can quickly find one. The amount of time a tenant needs to be closed before the landlord can “recapture” is negotiable, but a basic recapture right should be a starting point in the negotiations. The right to recapture is also a viable option in the event the tenant will not agree to open for business even for one day. At some point, it may make sense for the landlord to terminate a lease where the tenant has not opened, even if that tenant is paying rent. In such case, if the tenant has not opened for business for (for example) 180 days or more, the landlord may want the right to take back the space and work on a deal with a new tenant who will open and help generate the foot traffic in the shopping center that the landlord desires.
If a landlord is able to get a “recapture” right following a tenant opening for business, it may also want to negotiate for the reimbursement of certain costs if it elects to exercise its right to take back the tenant’s space. For example, a landlord may spend a significant amount of money on leasing commissions to secure the tenant and agree to provide the tenant with an improvement allowance so the tenant is able to build out the space to its current specifications. If a tenant elects to “go dark” early in the term and, in turn, the landlord “recaptures” the premises, it is reasonable for the landlord to seek the unamortized value of the leasing commissions and improvement allowance from the tenant to attempt to make itself whole. The landlord will likely need to spend additional money on leasing commissions and tenant improvements in the course of negotiating a new lease for the premises vacated by the original tenant. In addition, if the tenant knows that it will be required to come “out of pocket” if it elects to close its doors and the landlord “recaptures” the space, it may think twice before shutting down. While not intended to be punitive in nature, such repayment obligation may be a deterrent to a tenant considering exercising its right to “go dark”.
Don’t let a tenant’s right to “go dark” impact the economics of your deal. A tenant’s right to close for business may seem innocuous enough, but it could have far reaching effects on other sections of the lease. For example, if the tenant has the right elsewhere in the lease to pay modified rent (i.e., 5% of its gross sales in lieu of contract rent) because of a landlord misstep due to a co-tenancy failure or failure to adequately maintain a critical component of the shopping center, it may suddenly have the right to pay nothing, because a closed space generates no gross sales. In this case, the landlord will want to come up with an alternative “modified rent” mechanism to make sure that the tenant is not off the hook for its rent payment just because it is closed for business. This type of potential pitfall could have a dramatic impact on the landlord’s bottom line and the landlord’s leverage against a tenant who has “gone dark,” and thus should be carefully considered.
The foregoing addresses what a landlord should do if it has to grant a tenant the right either not to open or, once opened, to “go dark” to get a lease signed. Of course, the starting point for the landlord should be a requirement that the tenant open and operate continuously throughout the lease term (subject to industry standard closures for holidays, casualty, condemnation, etc.). However, if a tenant is insistent on the right either not to open or, once opened, to close for business, the landlord should try to address as many of the foregoing issues as possible in the letter of intent stage (optimally), or in the lease itself.
This article discusses just a few basic points that arise in retail lease operating covenant negotiations. There are other nuances and complications that may arise in this context, and the Retail Team at Cox, Castle & Nicholson LLP is made up of experts in navigating these issues.