Structuring the Co-Tenancy - Avoiding the Self-Fulfilling Prophecy
 
May 13, 2003
 

In response to the advent of “new urbanism” and the nostalgia for the downtown retail experience of yesteryear, developers are fashioning lifestyle shopping centers, main street developments and town square projects.  Such projects are configured in an open-air format, with quaint storefronts, ornamental street signs and lampposts, cobblestone sidewalks, and convenient parking, all intended to evoke the casual, charming and intimate shopping environment of days gone by.  Notably absent from such projects, however, is the traditional big box anchor tenant. In lieu of such traditional anchors, an elite, but ever-expanding, cadre of upscale specialty retailers serve as the mainstay of such anchorless projects. However, these tenants are typically unwilling to act as a traditional anchor tenant, as they are not true destination tenants, and will depend on shopping center synergies to fuel their retail success to a far greater extent than traditional anchor stores.  Accordingly, such tenants customarily demand the presence of a critical mass of favorable tenants, both at the scheduled opening date and throughout the term of the lease.  As a result, such retailers are seeking and securing opening and continuing co-tenancy protections.

Co-Tenancies Generally

A co-tenancy can take two similar, but different, forms:  an opening co-tenancy and a continuing co-tenancy.  An opening co-tenancy provides the tenant some measure of relief if, at the time the tenant is prepared to open, certain named tenants have not, or a certain amount of floor area within the project has not, opened for business to the public.  A continuing co-tenancy provides the tenant an opportunity for relief if, after the tenant initially opens, certain named tenants have closed for business or a specific amount of square footage is not open for business at the project.  Remedies in the case of either form of co-tenancy can include a reduction in minimum rent, the right to go or remain dark, the right to terminate the lease, or any combination of the foregoing.

The tenant’s purpose in seeking co-tenancy protection is to ensure that it has the company of other operating tenants of a specific type and caliber and that the tenant is not surrounded only by an ocean of asphalt and the occasional tumbleweed.  In a development that lacks a traditional anchor to attract large numbers of shoppers, smaller retail operators seek the comfort of numerous other operating tenants to provide a sufficient level of foot traffic.  In an existing development, the prospective tenant can examine project dynamics and assess customer volume and demographics prior to lease execution.  If certain operating stores are of particular interest to the prospective tenant, it may seek to require that these tenants be operating at all times during its lease term.  In a new development, however, lease execution often occurs more than a year in advance of project opening, preventing a prospective tenant from observing traffic flow and tenant mix.  In either case, a prospective tenant may seek an opening co-tenancy, a continuing co-tenancy or both in an attempt to provide it some measure of relief if the desired tenant mix is not obtained and maintained.

Certainly, the landlord wants to see a fully occupied project with healthy customer traffic, which makes the tenant’s and the landlord’s co-tenancy objectives not completely dissimilar; however, a landlord must be cautious in structuring the co-tenancy.  And nowhere is caution required more than in the case of a new development, where multiple retailers may require parallel opening co-tenancies.  For example, if the opening co-tenancy in Tenant A’s lease provides that Tenant A is not required to open until Tenant B is open; the opening co-tenancy in Tenant B’s lease provides that Tenant B is not required to open until Tenant C is open; and the opening co-tenancy in Tenant C’s lease provides that Tenant C is not required to open until Tenants A and B are open, then none of such tenants will be required to open and the center will limp along without sustaining a critical mass of retailers necessary to realize full income-producing potential.  This creates a potential domino situation where store managers may be staring at each other through locked doors not wanting to be the first tenant to open.  When combined with a termination right, the tenant’s co-tenancy concerns can quickly become a self-fulfilling prophecy, resulting in a gridlock that stymies a project’s momentum and tarnishes what may otherwise be a successful development. 

Developers also should be mindful of the attention prospective lenders and purchasers will give to co-tenancies.  In the case of a merchant developer planning to sell the project soon after the grand opening, the developer’s and the construction lender’s co-tenancy interests are aligned and focused on the opening co-tenancies.  For the developer to sell the project, the tenants must be open, operating and paying rent.  In the event a substantial number of tenants are not open or are not paying rent as a result of failed opening co-tenancies, the developer’s disposition of the project (and its equity) will be jeopardized.  In similar fashion, the construction lender realizes that its best opportunity for a painless loan repayment lies in the sale of the project.  Thus, to protect the value of its debt, the construction lender will focus on opening co-tenancies, keeping a keen eye on project marketability.  The construction lender will not be willing to initiate construction draws and disbursements until such time as leases satisfying critical co-tenancies are executed.  Until this occurs, the construction lender is unwilling to advance funds on a hope and a prayer that the tenants ratify the site’s viability by electing to open.  On the other hand, prospective purchasers and permanent lenders will, as a condition to their closings, require that a certain percentage of project tenants be open and paying rent.  Thus, they will not be financially involved in the project until after the opening co-tenancies are satisfied and will concentrate, instead, on the continuing co-tenancies.  If a continuing co-tenancy failure results in the closure of numerous tenants or triggers significant rental abatements, the new owner may suffer a combination of reduced project cash flow, a decline in rental rates for prospective tenants, and an erosion of project equity.  As a result of such failure, the permanent lender’s debt service may be jeopardized by reason of the diminished cash flow while the value of its security is eroding.  Accordingly, prospective purchasers and permanent lenders will closely evaluate continuing co-tenancies.  

The Opening Co-Tenancy

Who Is a Co-Tenant? In structuring an opening co-tenancy, the developer should focus on three primary areas of concern: the identity of the co-tenants, the tenant’s remedy if the co-tenancy condition fails, and the time period for the developer to satisfy a failed co-tenancy condition. 

First, with respect to the identity of the co-tenants, the developer should determine whether the tenant’s co-tenancy rights are tied to named co-tenants or a certain amount of floor area being open to the public for business.  A typical lifestyle center tenant, for example, would prefer naming acceptable co-tenants, such as Restoration Hardware, Pottery Barn, Abercrombie & Fitch, Williams-Sonoma and the like, and requiring that all or a significant number of them be open as a condition to the tenant’s obligation to open.  This gives the tenant some comfort that not only will there be other operating tenants, but also that such tenants will be of a certain type and caliber consistent with other tenants in similar projects to create the synergies necessary to make the location successful for the tenant.  The developer, on the other hand, would prefer tying the tenant’s opening co-tenancy rights to the opening of a certain amount of square footage of floor area at the project, measured either as an absolute number of square feet or as a percentage of the total planned square footage of the development.  In this manner, the developer has greater latitude in satisfying the opening co-tenancy condition and is not pressured to have certain tenants operating. 

Depending on the relative negotiating strength of the parties, however, the developer may be required to accept named co-tenants.  If so, the developer should seek to preserve as much flexibility as possible.  In the case of a new development, the developer should attempt to limit the universe of co-tenants to those tenants who have committed to the project, i.e. have an executed lease with a firm opening covenant and without contingencies allowing the tenant to terminate.  At the pre-development stage of leasing, however, this is not always possible.  Thus, the developer should seek to include a large number of prospective tenants as acceptable co-tenants and be required to have only a certain number of them, such as seven of 10 named tenants, open or prepared to open simultaneously with the applicable tenant.  If the tenant will not agree to the pick-and-choose feature, but insists instead on having three or four named co-tenants open, the landlord should be permitted to satisfy the co-tenancy condition even if the named co-tenants have not opened by having one or more suitable replacement tenants open in the place of the named co-tenant. 

Thus, if a named co-tenant fails to initially open or soon after opening shutters its doors, the developer has an opportunity to replace the named co-tenant and still satisfy the co-tenancy condition.  As far as what constitutes a suitable replacement tenant, the parties can agree either to provide an extensive list of tenants that would be deemed to be a suitable replacement, or the parties can agree that if a tenant satisfies one or more of certain criteria, then that tenant will be deemed to be a suitable replacement for the named co-tenant.  Such criteria may include a requirement that the replacement tenant lease a minimum floor area, be a national or regional tenant, or specialize in a particular product line, such as shoes, women’s apparel or sporting goods.  For tenants with the greatest leverage, the developer may ultimately be required to grant the tenant the right to consent to any proposed replacement, even though it takes a measure of project control out of the developer’s hands. 

In the case of an existing development, the developer should limit the universe of co-tenants to those tenants already operating at the development with covenants of continuous operation or adequate operating history.  If possible, the developer would prefer to list three or four such tenants, but require that only two or three from the list be open or prepared to open at the time the incoming tenant is required to open.  This eliminates the risk that a named co-tenant will fail to open, and substantially reduces the risk that an insufficient number of the named co-tenants will not be operating prior to the time that the incoming tenant is required to open.  Again, if the tenant will not accept the pick-and-choose feature, the developer should be permitted to substitute one or more acceptable replacement tenants. 

Also, in the case of a new development, the developer should exercise care when negotiating the leases of potential co-tenants and secure both an opening requirement and an operating covenant, even if such covenant is for a period of one day.  This will permit the developer to require its potential co-tenants to initially open before a date certain and, given such tenants’ fixturing, inventory and employment costs associated with opening their stores, will ensure that such tenants will remain open for a sufficient period of time to satisfy the project’s co-tenancies.

Finally, the developer should be permitted to satisfy a tenant’s opening co-tenancy requirements not only by having the co-tenants open, but also by having the co-tenants prepared to open simultaneously with the tenant.  If two tenants are each waiting on the other to open for business before opening for business themselves, the developer can end the standoff by notifying each tenant that the other is prepared to open, thereby satisfying the co-tenancy.  The tenants would then be required to open, preventing the co-tenancy from becoming a self-fulfilling prophecy.  This also allows the developer to coordinate a grand opening of the shopping center without running afoul of co-tenancy rights and protections.

Remedies.  Another significant area of concern to the developer in structuring an opening co-tenancy is the remedy available to the tenant if the co-tenancy is not satisfied.  In the opening co-tenancy, the tenant-preferred remedy is the ability to delay opening, permitting the tenant to take a wait-and-see approach, with the right to terminate the lease if the opening co-tenancy is not satisfied by some outside date. Such a remedy would permit the tenant to remain dark while determining whether to terminate the lease.  To avoid having dark space, and potentially triggering other tenants’ co-tenancy remedies, the developer-preferred approach is to require the tenant to open, notwithstanding the fact that the opening co-tenancy condition has not been satisfied.  To induce the tenant to accept such a position, the developer typically agrees to reduce the tenant’s rental obligations during the time that the opening co-tenancy condition has not been satisfied.  The parties can agree to reduce or eliminate minimum and additional rent obligations or to permit the tenant to pay a total rent tied to a percentage of sales during the time that the co-tenancy condition has not been satisfied.  The developer also may seek to require the tenant to pay its share of real estate taxes and common area costs during all times that the tenant is open in the development, an unappealing prospect to many tenants.  If the tenant has sufficient leverage and objects to paying such charges, the developer can structure the tenant’s total rent obligation during the time the co-tenancy condition remains unsatisfied as a sufficiently high percentage of sales to approximate the anticipated amount of such pass-throughs.  By structuring the remedies in this manner, the developer can maintain positive momentum at the project by requiring tenants to open, can have the operating costs of the project paid by the tenants who are open, and possibly receive some amount of minimum rent. 

Of course, the developer will not want to permit the tenant to pay a reduced minimum rent indefinitely and the tenant will want to preserve an exit strategy should the project not progress as anticipated.  One way to satisfy both parties is to establish a cure period with a termination right at the expiration of said period, which, if unexercised, would result in the tenant returning to full rental obligations.  This “fish or cut bait” approach forces the tenant to evaluate whether the store is viable in the absence of the co-tenants.  If viable, the tenant would not terminate and should commence paying full minimum rent and waive the benefit of the co-tenancy clause.  However, if the store is not viable in the absence of the co-tenants, then the tenant can terminate the lease. 

If the tenant exercises its termination right, the developer would have the opportunity to re-market the space and would not be forced to accept below-market rents throughout the lease term.  Naturally, the developer is then left with dark space and no way to recoup its capital costs, including design and legal fees, unamortized tenant improvement costs, and brokerage commissions.  As for the tenant, by exercising its termination right, it has preserved its exit strategy and is not forced to operate in a development with an unsatisfactory tenant mix.  However, the price to the tenant is the sum of its out-of-pocket fixturing and inventory costs, advertising expenditures, employment costs, and related expenses.  Clearly, this is not a winning scenario for either party.  Thus, the co-tenancy clause should be structured to encourage the exercise of the termination right only as a last resort. 

Cure Period. A third area of concern in structuring the opening co-tenancy is prescribing an appropriate period of time for each party to assess the vitality of the project in the absence of the requisite co-tenants.  In this regard, the developer should consider the amount of time needed to remarket the space to suitable replacements, and the tenant should estimate the amount of time it will need to determine whether or not the store will be economically feasible without the presence of the negotiated co-tenants.  If this period is too short, the developer will not have enough time to re-lease the space and the tenant will not have enough time to evaluate the long-term viability of the project without the prescribed co-tenants.  If the cure period is too long, the developer is forced to accept below-market minimum rent and the developer’s construction lender may view the lease as contingent due to the duration of the termination right and not consider it when underwriting the project.  In practice, a cure period of nine to 18 months, beginning on the date the tenant’s rental obligations commence, should balance these competing considerations. If the co-tenancy condition has not been satisfied by reason of the tardy opening of a few co-tenants, such tenants presumably would open within a few months of their target date, thus quickly satisfying the co-tenancy condition.  Conversely, if one or more co-tenants has defaulted and will not open in the project, the developer has preserved adequate time to negotiate a lease with a suitable replacement tenant and to permit such replacement tenant to open, again permitting the co-tenancy condition to be satisfied.  The tenant, on the other hand, is given the opportunity to observe traffic and customer volume at the project for a meaningful period and should be able to determine whether it can be profitable at the project without the co-tenants.  Thus, by structuring a cure period of appropriate length, the parties are given the opportunity to make the project work, discouraging the exercise of the termination right. 

The Continuing Co-Tenancy

The principal difference between the continuing co-tenancy and the opening co-tenancy is the period of time addressed by each.  The opening co-tenancy clause is triggered when the opening co-tenancy conditions have not occurred on or before the date the tenant’s rental obligations commence.  The continuing co-tenancy clause, on the other hand, provides the tenant relief if one or more of the continuing co-tenants or a certain portion of the project goes dark after the tenant opens.  Otherwise, the structure of the two clauses is substantially similar.  The continuing co-tenants are either named or are to occupy a certain portion of the floor area at the project (though floor area is the typical yardstick), and the tenant would be permitted to exercise similar remedies upon the occurrence of the continuing co-tenancy event, including terminating the lease after the expiration of a cure period.  As a result of the timing differences between the two co-tenancies, two additional matters should be considered and warrant careful consideration in structuring the continuing co-tenancy.

First, the developer should require the tenant to be open and operating in substantially all of the premises in order to enjoy the benefit of the continuing co-tenancy.  If the tenant has satisfied its operating covenant and elects to close its premises in the absence of a failure of the continuing co-tenancy condition, the tenant’s business at the project would not be damaged by the subsequent failure of the continuing co-tenancy condition.  Further, the tenant’s failure to remain open may directly or indirectly contribute to the closure of other tenants in the project, whether pursuant to continuing co-tenancies or otherwise.  This domino effect may trigger a failure of a continuing co-tenancy condition in other tenants’ leases and ultimately permit the tenant to pay a reduced rent pursuant to the tenant’s own continuing co-tenancy.  Accordingly, the developer should not permit the tenant, and the tenant should not expect, to leverage its way into paying a reduced rental as a result of its own actions.  Moreover, the alternative rent remedy based on a percentage of sales would be rendered meaningless if the tenant were not operating in the premises.

Second, for leases with both opening and continuing co-tenancies, the tenant should not be permitted to exercise any rights under the continuing co-tenancy clause unless and until the opening co-tenancy has been satisfied.  The tenant should not be permitted to double-dip in the exercise of remedies for what is essentially a single triggering event.  If the tenants required to satisfy the opening co-tenancy have not opened by the expiration of the cure period, then, in the absence of the continuing co-tenancy, the tenant would be forced to decide whether to terminate the lease or waive the benefit of the opening co-tenancy.  If, however, the tenant were permitted to waive the benefit of the opening co-tenancy and instead rely on the continuing co-tenancy (assuming similar co-tenant requirements), the tenant could defer its ultimate decision by immediately exercising its continuing co-tenancy rights, thereby emasculating the spirit and intent of the opening co-tenancy.  The tenant would then begin a fresh cure period while continuing to pay reduced rent.  Instead, the continuing co-tenancy should only become operative after the opening co-tenancy conditions have been satisfied. 

Additional Considerations

For both opening and continuing co-tenancies, the developer should be careful in negotiating a handful of other matters as part of the applicable co-tenancy.  First, if the co-tenancy condition is not satisfied, the developer should seek to preserve the full rental rate for the negotiated lease term.  In other words, if the co-tenancy condition is not satisfied when the tenant opens and the tenant pays a reduced rental for a period of time, then the expiration date of the lease should be extended for the period of time that tenant pays such reduced rent.  This permits the developer to fully amortize its capital lease costs over the full term and avoids potential underwriting concerns of the project lender.  Similarly, the developer should decide whether to delay rent escalations, if any, set forth in the lease for the period of time that the tenant pays reduced rent pursuant to the co-tenancy or whether to leave the rent escalation dates in place and apply the last rental rate to the additional period added at the end of the term. 

Second, the co-tenancy rights should be personal to the tenant, such that if the tenant were to assign its lease or to sublet its space, the co-tenancy right would expire.  After all, the developer granted the co-tenancy right to the assigning tenant, and the successor entity may simply not enhance the tenant mix or have sufficient bargaining strength to warrant co-tenancy protection.  Additionally, a lease providing the successor tenant with continuing co-tenancy protection is more valuable, all other things being equal, than a lease without such protection, and therefore, more readily marketable and assignable.  Moreover, if other project tenants have continuing co-tenancies tied to the presence of the assigning tenant and the assigning tenant leaves, such departure may trigger the exercise of numerous continuing co-tenancy rights, with the successor tenant ultimately being able to exercise co-tenancy rights as a result of the departure of the assigning tenant and, in turn, such other tenants, an unintended and counterintuitive result. 

Third, if the tenant fails to timely notify the developer of tenant’s desire to terminate the lease under the applicable co-tenancy, such failure should be deemed a waiver of the termination right.  A co-tenancy is a concession to the tenant and, as such, it should not be the developer’s responsibility to monitor.  If the applicable co-tenancy is sufficiently valuable to the tenant, it should determine whether and when it is entitled to exercise any rights thereunder. 

Fourth, in the context of a continuing co-tenancy, the tenant should not have the right to exercise any continuing co-tenancy remedy occasioned by a casualty or condemnation event.  The casualty and condemnation clauses of the lease should adequately address termination rights, restoration obligations and rent abatements, and the tenant should not expect to be able to aggregate remedies.

Fifth, if either the opening co-tenancy or the continuing co-tenancy condition is not satisfied prior to the expiration of the cure period and the tenant elects to terminate the lease, the developer should attempt to obligate the tenant to pay full minimum rent and all pass-through charges from the expiration of the cure period through the effective date of the lease termination.  This will encourage the tenant to exercise its termination right promptly, if at all, and persuades the tenant to vacate the premises quickly, making it available to the developer to remarket.

Finally, the tenant should not be able to exercise any rights under the co-tenancy clause if the tenant is otherwise in default under the lease.  For example, with respect to an opening co-tenancy, if the lease requires the tenant to submit interior store drawings for the developer’s approval on or before a certain date and the tenant misses the date by four weeks, the tenant, while obligated to pay rent, may not be able to open its store at the time contemplated by the lease.  This failure to timely open may hinder a smooth opening of the shopping center and may trigger other tenants’ termination rights granted pursuant to their co-tenancies, stalling the development momentum of the project.  Accordingly, the tenant should not be able to exercise its co-tenancy rights if it creates the project’s gridlock. 

Conclusion

With an ever-increasing number of lifestyle centers, main street developments and town square projects relying on a core group of upscale national retailers, project synergies have become a key to fashioning a successful development, with co-tenancies serving as the principal arrow in the tenant’s quiver.  By being mindful of the risks involved and structuring co-tenancies accordingly, the careful developer can satisfy the co-tenancy concerns of an upscale national retailer while preventing such concerns from evolving into a self-fulfilling prophecy. 

This article first appeared in the December 2002, January 2003 and February 2003 issues of Commercial Leasing Law & Strategy.

For more information, call Al Daspin or James Marshall, toll free, at 1-888-688-8500.