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LEASE LAND MINES

Exclusive uses can poison efforts to update tenant mix, experts warn

By Joel Groover

Standing in the parking lot of a typical shopping center, an observer might conclude that it is a straightforward affair: a supermarket or big-box store surrounded by a few complementary tenants. Sitting in a lawyer’s office reading through all the leases, however, one might consider that same center to be as uncomplicated as, say, the human genome.

Landlords know all too well that “exclusives” — the critical clauses that grant retailers mini-monopolies within a shopping center — can turn leases into land mines. Poorly drafted lease language can lead to costly legal battles, scare off key lenders, hurt efforts to recruit coveted anchors, force developers to make draconian payments to aggrieved tenants and more. Experienced owners (read: those who have been burned) ask their attorneys to weigh the consequences of every legally binding word.

“It gets to the point where a comma or an ‘and’ or ‘or’ can make a huge difference,” said Gwen MacKenzie, CLS, senior vice president of retail investments at Irvine, Calif.-based Sperry Van Ness.

Because the shopping center business is changing so quickly, the already challenging dynamics of retail exclusives are, if anything, becoming even more complex, experts say.

With the rise of one-stop shopping, the lines separating one retail category from the next are blurring as tenants try to provide more convenience by selling ever-wider varieties of goods. MacKenzie cites Old Navy’s now-defunct Torpedo Factory experiment, in which some of its stores, including its San Francisco flagship, sold coffee and submarine sandwiches.

“I had a friend who had an Old Navy deal almost done, but there was a Starbucks at the center that had a coffee exclusive,” she said. “Old Navy’s committee turned the deal down based solely on the coffee situation.”

Grocery stores, of course, now sell such disparate stuff as barbecue grills, daylilies and DVD players. Yet, though these chains rarely demand exclusives for their less profitable ancillary categories, they continue to be uncompromising about profit centers like health-and-beauty aids and prescription drugs, says real estate lawyer Richard R. Goldberg, a partner at the Philadelphia office of Ballard Spahr Andrews & Ingersoll.

“Supermarkets used to almost exclusively sell center-of-the-store items — the things from which they made 2 cents a carton,” he said. “Today the supermarket is no longer a low-margin operation. Just walk into a supermarket today and look at how large they are and at how much profitable merchandising there is around the perimeter of the store: specialty departments, prepared foods, pharmacy, flowers, health-and-beauty aids. Those are as profitable for a supermarket as for any other retailer.”

In fact, the exclusives demanded by supermarkets are part of the reason such drugstore chains as CVS and Walgreens have morphed into stand-alone stores with drive-through pharmacies — and their own ever-more-diverse product offerings, says real estate attorney Alfred G. Adams Jr., a partner in the Atlanta office of Sutherland Asbill & Brennan. “A grocery store and a drugstore used to be the classic anchors of a neighborhood center, but now all the grocery stores have pharmacies.”

With their growing leverage, supermarket chains such as Publix can, and do, play hardball by insisting that their exclusives apply for the entire length of their leases, even if they have closed the store in question, Adams says.

“Their theory is that other operators, who have lower overhead because they do not operate to Publix’s quality, could make money in those spaces,” he said. “Publix has gotten tougher on their exclusives recently, maybe because they are feeling their oats with Winn-Dixie going bankrupt.”

Circuit City, Linens ’n Things and other big boxes are equally fierce defenders of their exclusivity, and yet a growing trend is for big boxes to move into regional malls where, through sheer necessity, exclusives have always been downplayed.

“The rubber that’s going to hit the road in the mall world is the consolidation of the department stores and how well the big-box exclusives translate there,” Goldberg said. “The tenant mix at a mall just does not permit them to be the only one in their category.”

The digital revolution complicates the situation even further by raising the prospect of unpredictable yet important changes in merchandise lines, says real estate lawyer Abraham Lieberman, a partner in the Sheffield Village, Ohio, office of Baumgartner & O’Toole. The challenge for electronics stores is to craft an exclusive that is vague enough to include the iPod of tomorrow, whatever that may be, while remaining palatable to landlords who rightly resist signing vaguely worded leases, he says.

“The tenant does not want to get saddled with [an exclusive clause limited to] old technology that may be obsolete in two years, so that they may be unable to effectively compete,” Lieberman said. “By the same token, the landlord does not want to grant something that is too broad.”

Then there is the growing trend toward large-scale mixed-use projects built in phases by multiple developers.

“Exclusives can become an issue, because very often you do not quite know what you’re going to do in the next phase,” said lawyer Sheldon A. Halpern, a partner in the Los Angeles office of Pircher, Nichols & Meeks who handles department store, big-box and supermarket transactions. With the mixing of uses, what happens if Starbucks, for instance, takes space in the retail portion of a second-phase residential tower? Does that violate a first-phase retail tenant’s exclusive on coffee? If so, who is liable?

The competing impulses of landlords and lawyers working together on shopping center deals might be described as speed versus thoroughness. Landlords often want to sort out the details later and close the deal as quickly as possible; their attorneys, on the other hand, seek to prevent future problems by working out all the implications of the lease and by being extremely conservative about the number and kinds of exclusives they will draft.

“I find many developers are still too eager in making the deal to grant exclusives that they do not really need to grant,” Lieberman said. “They think, ‘Oh, it’s no big thing. You can just grant them an exclusive.’ ”

Some have learned the hard way to exercise caution.

“Speed means you spend less money on legal fees, and you do get the deal signed faster,” said retail developer Charlie Hendon, owner of Atlanta-based Hendon Properties, which takes particular care to study all co-tenancy and exclusives clauses when buying or developing properties.

“But when the next tenant comes along, you may be unable to sign that tenant because you have already painted yourself into a corner with the exclusives to which you have already agreed.”

Grant Hallmark the exclusive right to sell greeting cards at your center, in other words, and T.J. Maxx might later balk at taking that dark Kmart space. That is, unless you can get Hallmark to agree to let T.J. Maxx sell greeting cards. Landlords usually accomplish such a feat through what Hendon jokingly refers to as “extortion payments.”

“You go back to the tenant and say, ‘Look, we want to put in this other tenant. It would be good for the center and for you, but, technically, it would be a violation of your lease,’ ” said Hendon. “They will either refuse or say, ‘Well, for a reduction in rent or for 50 grand … .’

“We have had situations where we have had to pay a tenant to allow us to sign another tenant where, frankly, we felt like the existing tenant really did not mind the other tenant coming in,” Hendon said with a chuckle. “In fact, in many respects [the existing tenant] probably wanted the new tenant coming in, but chose to extort some money out of us anyway. Sometimes I wonder if the retailers are just in retail on the side and their real profit margin is extortion!”

A lease full of generous exclusives can cause landlords major headaches even before the center opens.

“The risk of violation can be very high, and there can be some fairly draconian penalties, like rent reduction,” Halpern said. “That can become a financing issue. Lenders look at cash flow very closely. If a tenant has in its lease that its rent could go down by 50 percent, that is a major financing problem.”

Furthermore, when a shopping center is being sold, the lender’s due diligence process could reveal exclusives violations of which neither landlord nor tenant has been aware. In such cases, Adams says, lenders will tell the tenant about the violation, thereby providing yet another opportunity for the tenant to say to the landlord, “What are you going to do for me?”

And if that’s not a line straight from the mouth of Tony Soprano ...

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