Independent Developers: A Resource for Retail Expansions
April 29, 2002
Kenneth B. "Ken" Hoffman- Boston
As the number of retail chains turning to independent developers to locate and turnkey
their retail stores increases, the legal and practical issues involved in
getting a store up and running grow more complex. Mostly confined to retailers
targeting stand-alone locations or small, strip centers, the use of independent
developers affords the retailer the opportunity to have much of the development
risk and investment in time shifted to the developer. It also enables the
retailer to conduct its search for locations in better ways than only through
commercial retail estate brokers. Developers can negotiate deals directly with
the sellers or potential ground lessors, where brokers can only be
intermediaries in the deal making.
To make efficient use of this system of turnkey expansion, many retailers establish
a special relationship with a few select developers. The relationship is based
upon the developer's extensive knowledge of the retailer's site and building
requirements, demographic profiles and profit expectations.
For the retailer, this familiarity makes it easier to replicate its expansion
program without having to educate brokers, potential sellers and ground lessors
about the company's site needs and how much the company is prepared to pay for
rent. Indeed, some retailers encourage those developers with whom they have a
long-standing history to travel out of state or out of the region in which they
normally operate to search for suitable locations.
Although in concept the use of "preferred developers," as they are known, has
significant advantages over the chain retailer, there are added issues and
complexities that can cause significant delay, expense and sometimes the loss of
opportunities for retail expansion.
Many potential projects require zoning relief and often liquor or other regulatory
permits. Where zoning and licensing is mostly local and discretionary,
preferred developers can have an impact on the reputation of the retailer and
the manner in which the retailer conducts its business in other locations in the
state or region. Similarly, the local or regional reputation of the retailer
can influence the success of the preferred developer. A preferred developer who
fails to take the time to prepare an adequate political foundation for entry
into a particular local or regional market, or who runs roughshod over the local
planning professionals or gives little heed to neighborhood groups, risks not
only the project being rejected, but can burn bridges for the retailer who needs
the good will of the community to conduct business at its other locations.
Local officials or neighborhood groups often do not distinguish between the retailer
and the preferred developer. Therefore, just as the developer can harm the
retailer's reputation, a developer that enters a market without knowing what the
community's experience has been with a particular retailer or its franchisees,
can run into opposition for reasons that are unrelated to the particular
location in question.
Recently, the Boston office of Holland & Knight conducted a training session for
a national retailer that simulated meetings with local officials, neighborhood
groups and statewide officials. The retailer learned to focus its presentation
on community benefits and use as examples of such benefits successful alliances
with police departments in other municipalities and in other states. Incentives
were created for the municipalities that, when put into practice, resulted in
the officials suggesting locations to the retailer, which made it easier to
secure permits for those locations. This made for better reception for the
retailer and the preferred developers. Of course, the developer must know what
the retailer is doing in this regard and vice versa, lest the effort to create a
positive image by the retailer be undone by short-sighted tactics or an
insistence on a particular location, notwithstanding neighborhood and other
political considerations. Succeeding at a single location may serve the
preferred developer's immediate agenda, but may not always be in the long-term
best interest of the retailer if success was achieved at a political cost.
In addition to permitting considerations, the insertion of the preferred developer
between the retailer and the land owner brings with it greater legal
complexity. If the original landowner will not part with the land, the most
common strategy is for the preferred developer to ground lease the site from the
owner and sublease it to the retailer or, if the site can accommodate more than
one retail unit, sublet the site to multiple subtenants. Multiple subtenants
can create problems for the preferred developer if the chain retailer to which
the developer owes its principal allegiance acts as guarantor of the ground
lease, as frequently occurs. The ground lessor will look not to the developer
for assurances that lease payments will be made, since the developer is usually
a single-purpose entity formed solely to hold the ground lessee's interest in
the ground lease, but will look to the chain retailer. This guarantee, while
unquestionably the linchpin that makes the deal attractive to the ground lessor,
doesn't come without a price. The chain retailer and its affiliated guarantor
will require that its subtenancy be financeable and therefore impose limitations
on the right of the ground lessor to terminate the ground lease in the event of
a developer default. These limitations may be palatable to the ground lessor as
long as its rent stream is not interrupted. The negative consideration for the
ground lessor in eliminating the developer as the ground lessee in the event of
the ground lessee's default, is that under the retailer's nondisturbance and
attornment agreement, the ground lessor, who believed it was buying an annuity
by signing a long-term ground lease guaranteed by a nationally known retailer,
may have to step in and become an active landlord of a subtenant under a
sublease, the terms of which it did not negotiate. By doing so, however, the
ground lessor may salvage the economic benefit of the ground lease and may even
obtain the benefit of the developer's upside, since the lease payment being made
by the retailer will exceed the rent payments due under the ground lease.
Negotiating a ground lease that can satisfy these issues can be daunting.
One of the most difficult issues that the parties to such multiparty lease transactions
may face is balancing the requirements of the retailer and its lenders with
respect to their rights to cure the developer's default in a ground lease.
Ground lessors and their lenders will seek to terminate the lease if the rent
payments are not being made or in the event of a nonmonetary default. On the
retailer's side, the right to cure is generally given first to the guarantor, if
any, of the retailer's sublease, and where given, to the guarantor of the ground
lease, which may also be the parent company of the retailer, then to the
leasehold mortgagee. The leasehold mortgagee often requires the landowner to
wait until it has exercised its rights to realize on the developer's interest in
the ground lease before the landowner can exercise its right to terminate.
In that case, the landowner stands at the end of a long line of stakeholders
desiring to step into the developer's shoes and "cure the default" or to
acquiesce in the termination of the lease. For the landowner and its lender,
this is not a particularly inviting situation. Certainly, the landowner's
lender will not be willing to suspend its debt service while the retailer and
the developer's lenders sort out the consequences of the developer's default.
One solution that may answer this dilemma is the agreement of the landowner and its
lender to tender a new lease directly to the retailer's lender or to the
guarantor in exchange for the prompt cure of any existing defaults. Failure to
accept such tender enables the landowner to terminate the lease without
significant delay. Hopefully, this assures the landowner's lender that by
doing so, debt service will not be interrupted.
While this situation is helpful where the retailer is the sole subtenant, it cannot
necessarily help when the preferred developer has subleased to multiple retail
tenants. No single new lease can be substituted for the original ground lease
unless the lender or guarantor to whom the new lease is tendered is prepared to
step into the shoes of the developer as to the multiple subtenants. If the
principal creditor of the transaction is the national retailer, the developer's
lender may be willing to accept a new lease, but if the lease payments,
particularly over time, rely on rent stream from the additional subtenants, the
developer's lender may not be willing to accept the risk of being landlord to
less creditworthy subtenants.
Assignment and subletting clauses raise many of the same issues concerning the
permanence of the ground lessee to the transaction and what happens if the
ground lessee's interest should change hands. The right of the developer to
assign the ground lessee's interest in the ground lease to the guarantor, as
long as the guarantee remains in effect, it is generally acceptable to the
ground lessor. Such an event, however, does not have the same economic effect
on the ground lessor as when the ground lessor's interest merges with the ground
lessee's in the event of a default by the ground lessee; but it does assure that
the entity whose credit was instrumental in the lease being signed remains
directly obligated to the ground lessor.
In agreeing to unlimited subletting, the ground lessor's principal concern is
whether the guarantee remains in place. Because the guarantee may be limited to
the initial term of the sublease of the guarantor's affiliate or, may remain in
effect only so long as the affiliate's sublease is in place, the ground lessor
could find itself, in the event the guarantee terminates, with subtenants that
are considerably less creditworthy than the guarantor's affiliate with no
guarantee. For this reason, where the ground lessee has sublet to multiple
tenants, the ground lessor frequently requires some level of approval to protect
against the eventuality that the ground lessor may end up as the direct landlord
of such multiple tenants. Approval often takes aim at credit concerns, and the
desire of the ground lessor to make certain that such subleases are triple net
leases.
Conclusion
The practice of national retail chains to use preferred developers to locate and
turnkey retail stores can increase the number of site opportunities that
retailers can explore at one time and thus may result in more store openings.
This method of operation, however, is not without risk to the retailer where its
longer term interests may outweigh the number of retail openings it can count on
its balance sheet for any given fiscal year. It also makes the business and
legal arrangements more difficult because it introduces parties to the
transaction, especially in leasehold transactions, where the perspectives are
different and where lenders with distinct interests may play a pivotal role.
The risks ground lessors take when there is a single key guarantee by the "anchor"
chain are multiplied when the developer sublets to additional retailers whose
term may be extended beyond the initial term of the "anchor" retailer or of the
"anchor's" guarantee. Weighing these risks make the lease negotiations more
difficult, but not insurmountable.
For more information, contact Kenneth B. Hoffman at 888-688-8500
or via e-mail at khoffman@hklaw.com.