What is a Co-Tenancy clause and how do they impact Shopping Centers?
A Co-Tenancy Clause (also known as a Co-Occupancy Clause) is a negotiated provision in a Retail Lease that requires Landlord’s to maintain certain critical tenants (anchor tenants or high traffic attractions) that are favorable for the retailer, or an occupancy percentage during the retailer’s lease term at the shopping center. Most retailers want a contractual margin of safety against market factors outside their control, or Landlord decisions that they deem would be detrimental to their business performance throughout their lease term. In plain English, they want more people visiting the shopping center, and they don’t want to be stuck in a vacant shopping center, aka the “Dead Mall.”
Avoiding the Dead Mall
For example, if the largest tenant and the primary draw to the shopping center is a large nationally recognized grocery store (an “Anchor Tenant”), the retailer may require this grocery store or similar grocery store to occupy and operate during their lease term. A more simplified example would be requiring the Landlord to maintain the shopping center at a minimum of 60-70% total occupancy during their term. Or, in some situations, it can be a blend of both examples referenced above.
Retailers pay higher rent to be located with high traffic co-tenants.
Why do tenants request a co-tenancy? The simple answer is traffic. Think of it like NASCAR and all the drivers behind the leader drafting in the slipstream to cut resistance. Anchor tenants and some popular stores/restaurants generate traffic, and the other tenants in the shopping center benefit from sharing the parking lot. They also benefit from the typically larger add budgets of the anchor, which brings the customers to their front door.
Long term leases have benefits as well as risk.
Retail leases are traditionally anywhere from 5-15 years for the primary term with multiple renewal options that could extend out another 10-20 years. Leases are long term contracts that create an excellent level of long term certainty because the rent is fixed, and the tenant knows they have a good location for a number of years without having to worry about moving. The bad news with the multiple year, locked in terms, is that other tenants that were great and the reason the retailer chose the location goes out of business or moves to another location.
Tenants in a retail center mutually benefit from other quality neighbors.
In the above example, if the grocery store anchor tenant is replaced with a church or trampoline park, this will most likely negatively impact the traffic patterns of the shopping center. The number of patrons and weekly traffic that had been generated by the grocery store would markedly decrease. If there is substantial vacancy, this would also reduce the traffic to the shopping center, which would impact the retailers and service providers’ financial performance. Shopping center tenants are codependent on one another, and Co-Tenancy clauses force landlords to maintain a tenant mix that generates their preferred type of traffic to their front door.
Brand name tenants have negotiating power.
Why do Landlord’s agree to co-tenancy clauses? It’s important to distinguish that not all retailers are created equal. Most retailers don’t have the financial strength, brand clout, or negotiating leverage to push Landlords into these unfavorable co-tenancy clauses. So, usually, only large national or regional brands can successfully convince landlords to agree to them. The value of the shopping center is directly tied to the traffic, generating brand strength and financial credit of the tenants. A large national or regional anchor tenant will have greater value (even at a reduced rental rate) compared to a local operator. So, shopping center landlords have to use experience and judgment to make the best decisions on how to maximize the value from a “Credit” tenant with difficult lease provisions or find a less valuable tenant with more favorable lease provisions.
Lenders are not big fans of co-tenancy clauses.
Why do lenders hate co-tenancy clauses? Usually, a large percentage of the property’s loan is tied to one or two anchor tenants. If the anchor tenant closes, even if they are still paying rent, all the remaining tenants with co-tenancy clauses could convert to reduced rents or vacate the property. The closing of one or two tenants creates a domino effect, and the shopping center can empty out in 2 years. This usually requires the lender to protect their margin of safety, which comes from increased due diligence on tenant sales and analyzing demographic/traffic patterns. In certain cases, the lender might require extra reserves or an increased interest rate to make the loan.
What happens when a co-tenancy is triggered?
The tenant with a co-tenancy clause usually has a few options. Normally, the rent drops to a reduced rent for a period of time (6 months to 2 years), giving the landlord time to find a suitable replacement tenant or multiple replacement tenants. The reduced rent can be a percentage rent (percentage of sales) or NNN charges (real estate taxes, common area costs, and insurance) or a fixed reduction amount for the rent (i.e., half rent). Usually, after a specified time during the “Reduced Rent” period, the tenant has the right to terminate the lease. After the expiration of the Reduced Rent period, the tenant will either need to make a choice to stay in the center at the originally contracted rent or terminate the lease and vacate the space.
Experience and relationships are important mitigators for co-tenancy risk.
Co-tenancy provisions and other specialized lease clauses highlight why retail real estate requires expertise and experience. The principals at Concordia Equity Partners have successfully mitigated co-tenancy risk in a number of ways during major tenant lease negotiations, including tying the provision to two or three tenants instead of one single tenant. The other way to mitigate risk when a co-tenancy has been triggered is by having great relationships with other national tenants and specialized retail tenant representative brokers to backfill the space expediently.
Retail is far from dead; it is, and always has constantly been evolving.
Discretionary spending habits, demographic shifts, convenience, perception, and experience, have drastically changed in the last decade alone. Navigating co-tenancy clauses that were implemented a decade or two ago generally don’t reflect the environment we are in today, which can lead to difficult decisions in 2020 and beyond. Experienced Retail Real Estate operators that are open-minded, forward-thinking, flexible, and willing to work with tenants will thrive. Finding suitable anchor replacement tenants that still maintain the quality and codependency standards will be paramount for retail operators from here on out.
Jason Ricks and Michael Flight