Call them the chains gang: They're the top big box tenants in the nation and when it comes to where they choose to locate, whom they will accept as co-tenants and what they will pay, these powerful players call the shots. They are Wal-Mart, Target, Lowe's, Kohl's, Costco, Office Depot, Staples, Best Buy, Home Depot and a handful of others. When they come to negotiate a lease, they do the talking, says Kent Newsome, a partner with Fulbright & Jaworksi LLP's Houston office who specializes in retail real estate development and leasing. “They know good and well that they bring a lot to the table.”

“If you want the good credit tenants, you're going to pay for them,” adds Marshall Mills, president and COO of The Weitzman Group, a Dallas-based developer.

These credits pay half as much in rent as non-credits. They also refuse to budge on rent increases. They won't sign operating covenants. They want exclusivity, barring a whole range of other retailers from their centers. And they want to be able to control their space, even if they choose to vacate before the ends of their terms.

Retail leasing is about leverage. This group has it and the competitive environment gives them more. Development is so strong right now that there are usually two to three projects vying for the same tenants in an area, according to Mickey Ashmore, president & CEO of Dallas-based United Commercial Realty. “As long as the market stays this competitive, then retailers will have even more leverage,” he notes.

Industry experts estimate that a non-credit retailer pays 50 percent to 100 percent more rent than a credit tenant. A large tenant like Best Buy pays somewhere in the ballpark of $12 to $13 per square foot per year nationally, while a small regional or local tenant pays in excess of $25 per square foot.

Part of the differential is based on sheer size — a tenant that leases 70,000 square feet would never pay $25 per square foot. But credit tenants are also balking at any kinds of increases. For example, according to Developers Diversified Realty Corp.'s annual report, Wal-Mart grew to account for 10.1 percent of its company-owned shopping center GLA in 2005, from 7.8 percent in 2004. But its share of DDR's base rent grew to just 6.1 percent from 5.0 percent. On the flip side, Gap Inc.'s share of space remained constant at 0.8 percent, but it's percentage of DDR's base rent rose to 1.3 percent.

With developers and landlords losing the power struggle, they often end up taking on significantly more risk when they lease to a credit tenant than they do when they enter into an agreement with a local retailer. “The idea is that leasing space to a credit tenant protects you in case of default, but most of the leases with credit tenants create so many other entanglements that you're exposed,” explains Sally Vogel, managing director of retail for RiverRock Real Estate Group, a South Coast Metro, Ca.-based leasing and management firm.

It also puts owners in a difficult position when securing financing. On one hand, lenders prefer strong credits, but that benefit can be outweighed when financial institutions see the lease concessions.

“All of these special lease provisions are a problem,” says David Nackoul, senior managing director in Holliday Fenoglio Fowler L.P.'s Pittsburgh office. “They make the underwriting more difficult and it will be reflected in the pricing.” He estimates that borrowers pay a premium of 25 basis points or more to assuage the lender's concerns about operating covenants and kick-outs.

Power struggle

Twenty years ago, there were far more brand-name retailers with strong credit. Department stores were in much better shape than today, for example. But consolidation within the retail industry not only diminished the number of retailers, it also limited the number of retailers that agencies like Moody's Investors Service and Standard & Poors actually rate.

Today, there are only a handful of true “credit” retailers, especially among the big boxes. According to Moody's, Wal-Mart, Target, Lowe's, Kohl's, Costco, Office Depot, Staples, Best Buy and Home Depot are the only investment grade big box tenants. (see chart, page 26). Among those, only six have A ratings.

“For power centers, developers are all chasing the same retailers, which just gives them more power as tenants,” says Tara Scanlon, partner and co-chair of the national retail leasing and development team for Holland & Knight LLP. “These retailers are very adept at figuring out how much a center needs them.”

Most of the retailers contacted by Retail Traffic for this story either refused to comment or did not return calls. A few, like Target, cited company policy of not talking to trade magazines.

These retailers know their drawing power and are using it as leverage in negotiations with developers and landlords. “They have an advantage because they are market dominant tenants,” Vogel says. “They have this huge brand recognition and they really set the tone for the center. That's why they have the ability to negotiate the favorable terms.”

Anchor tenants have always received preferred treatment when it comes to leasing, paying sweetheart rents for long terms. But what the big box credits are getting today far exceeds what department stores received, even at their height. Department stores, for example, did sign operating covenants — often for continuous operations. Moreover, there were no co-tenancy or exclusivity clauses, and no specific language about recapturing space. Department stores also didn't have the right to sublease space without landlord consent.

One immediate effect on landlords is an inability to pass on the expenses related to rising construction costs, industry experts say. Although construction costs have doubled in some cities, retailers are pushing back when owners try to raise rents to compensate for the increased costs.

Over the past six months alone, new construction costs increased 7.2 percent for nonresidential buildings, according to the Bureau of Labor Statistics. Materials with the steepest increases over 12 months included copper and brass mill shapes (up 53 percent), asphalt (up 43 percent) gypsum products (up 24 percent) and concrete products (up 11 percent).

Rents are up as well — about 6 percent in 2005 with projections for a similar increase this year — but big boxes aren't part of that trend. Developers have had to raise rents on other tenants to make up for credits that pay preferential rates.

“[Retailers] don't care that it costs more money to build a center today than it did 12 months ago,” says one retail broker who declined to be named for fear that his retail clients would drop him like a hot potato. “They are willing to pay a certain rent for a certain type of center in a certain area, and that's it.”

In fact, this broker says he has seen several retail projects fall through recently because the retailer wasn't willing to pay more rent. “I really think it's hard for these developers because they need these tenants to create the best mix and draw, but they also need a certain amount of rent to make the deal pencil,” he explains.

There's really only one situation where a retailer may be more willing to negotiate, says Gary Glick, a partner with the Los Angeles office of Cox, Castle & Nicholson LLP. “If you're a developer and you have a great location, then you definitely have leverage, and you can command fairly decent rents and lease terms,” he notes.

Developers and owners with top-quality locations and premier centers have something that retailers need, so both parties are on more even footing and the lease negotiation becomes more of a give-and-take, Regenstreif notes. “The desirability of your center and location will dictate how much bargaining power you will have,” he says.

But even then, most big-name credit retailers are so secure in their attractiveness that they have trouble giving an inch. “You could have the best center in the best possible location and Target still would not lease from you,” Glick says. “Target wants to own their real estate and is willing to walk away from a deal if a developer won't sell. Target will just look for a comparable site — unless the site is truly one-of-a-kind.”

Moreover, most credit retailers will only use lease documents generated in-house. “When you deal with a Target or Wal-Mart, they come in and say that they're using their own lease form and every landlord capitulates right away,” Regenstreif notes. “Their forms are very tenant favorable and it's difficult for the landlord to make changes.”

Barring the competition

Today, more and more credit and national retailers are also demanding broader exclusivity clauses, which are used to protect a retailer's competitive position. For example, an electronics chain previously would have required exclusive rights to a category of merchandise, say, television sets. Now, that same retailer will try to get a landlord to give exclusive rights to sell appliances, computers and mobile phones, too That means that a landlord could not lease space to Apple, Home Depot or Verizon Wireless if an electronics retailer like Best Buy held all of those exclusives within a center.

“Without a doubt, retailers are trying to get more out of the landlords with the exclusive language,” notes Steve Frishman, principal with Mid-America Real Estate Corp. “They will continue to expand it into uses that may seem relatively minute to their sales, but they believe those sales are important so they'll do everything in their power to prevent another retailer that sells the same products from coming into the center.”

Experts say that landlords rarely deny any big boxes their exclusivity requests, even though exclusivity clauses can jeopardize a center's performance. “They make it very difficult and very cumbersome to finish out your tenant mix,” Ashmore points out, adding that the length of the exclusivity is also important. “Over time, retailers want to be able to reinvent themselves and will eventually encroach on these exclusivities.”

Indeed, a developer or landlord is giving away his control of the center's tenant mix when he agrees to an exclusivity clause, Vogel says. “A lot of landlords get in trouble with exclusives,” she cautions. “Because some retailers are powerful enough, they get very broad exclusives, and that can be great while they're doing well, but what if that changes? More viable tenants will come along later on, and you're stuck with the other one.”

Vogel also points out that negotiating exclusives can be really difficult because they need to be very specific — both in terms of merchandise and timeframe. “These exclusives box you into a corner,” she says. “And, don't think that litigation doesn't happen. If you infringe on a legal right, you're going to have a battle and it will be expensive.”

At their mercy

The chains gang also has a powerful lever in operating covenants — agreements between the property owner and tenant about how long the retailer must be open. Operating covenants are occasionally referred to as the “right to go dark,” because once a retailer remains open for a specified amount of time set forth in the operating covenant, it can shut off its lights and leave the center, although the tenant is still committed to paying rent for the entire length of its lease term.

While lengthy operating covenants used to be standard, it's becoming more common for credit retailers to demand limited operating covenants, experts say. Credit tenants rarely, if ever, agree to the same lease terms that a non-credit tenant agrees to, says Scott Grossfeld, a partner with the Los Angeles office of Cox, Castle & Nicholson LLP. Smaller players will still get stuck with continuous operations clauses, he adds.

“If you're dealing with a credit retailer, you'll only get a one-day covenant,” Glick says, adding that some credit retailers will not even agree to sign a one-day operating covenant — meaning that they have no commitment to ever open the store.

“Retailers will always ask for ability to go dark at any time,” Vogel says, “but it's critical to have open doors in your center, and you don't want to give that away.”

Many retailers now are adding their own provisions to the operating covenant, Glick points out. For example, a retailer will stipulate that it won't have to follow its operating covenant unless a certain percentage of the center is occupied and open. If the center loses other tenants, the retailer can either pay a reduced rent or go dark.

An added worry for developers and landlords is what to do with the space once it goes dark. Many retailers will call for the ability to sublease the space, which is known as assignability. This allows a retailer to fill dark space with a tenant of its choosing, without the landlord's consent.

Clearly, assignability can cause some serious damage to a center, scrambling the tenant mix and breaking other exclusivity clauses. Still, more big box retailers are demanding unlimited assignability today. Smaller tenants can't ever dream of that: “Never in a million years would a local or regional retailer have the right to sublease,” Newsome says.

Attorneys say that developers and landlords should anticipate that at least one of their tenants will shutter its stores. To that end, they recommend obtaining the right to recapture the space so it can be re-leased to the landlord's specifications. “If the biggies won't give you the continuous operations, you have to fight over the terms of the space recapture,” Regenstreif says. “If you don't get the rights to recapture that space, your center will die.” The problem is, today more tenants are asking for owners to buy them out of the lease at market rate rents and also demanding that the owner pony up any unamortized costs related to tenant build-out.

At this point, many experts are beginning to question whether credit retailers are the best tenants. “When we've had big box space to lease and when we went to the typical credit retailers, we found that their deals were very difficult,” Vogal notes. “We went out and looked at the alternatives and found retailers that were less economically onerous for the landlord and fit the community better.” She concludes: “If you're looking at difficult lease terms and very low rents, you should think outside the big box.”

SEPARATE AND UNEQUAL

Lease terms Credit Rated Retailers National Chains Mom-and-Pop
Exclusivity Usually Rarely Never
Assignability without landlord consent Occasionally Rarely Never
Operating Covenant 1 day or less Years Continuous
Letter of Credit/Personal Guarantee No Occasional guarantee from parent company Always
Rent increases to offset market conditions No Yes Yes
Source: Retail Traffic

BIG BOX RATINGS (AS OF NOVEMBER 2005)

Best Buy Company, Inc. Baa3
Costco Wholesale Corp. A2
Guitar Center, Inc. Ba3
Home Depot, Inc. Aa3
J.C. Penney Company, Inc. Ba1
Kohl's Corp. A3
Lowe's Companies, Inc. A2
Michaels Stores, Inc. Ba1
Office Depot, Inc. Baa3
OfficeMax Ba1
Petco Animal Supplies, Inc. Ba2
PETsMART, Inc. Ba2
Shopko Stores, Inc. B1
Staples, Inc. Baa2
Target Corp. A2
Toys ‘R’ Us, Inc. B2
Wal-Mart Stores, Inc. Aa2
Source: Moody's Investor Service

For a Rainy Day

Owners seek financial protection against small retailers

Developers and owners may be willing to give up a lot to get a credit tenant in their center, but they have a different attitude toward small, local retailers.

Without fail, almost every developer and owner will require a letter of credit, personal guarantee or deposit before it will lease space to the local pizzeria, dry cleaners or nail salon, says Sally Vogel, managing director of retail for RiverRock Real Estate Group in South Coast Metro, Ca.

“If we can't get a guarantee or letter of credit, we won't do the deal and we'll wait for a national brand,” she notes.

Because new retail concepts and local chains usually have no sales history to document their viability, guarantees and letters of credit go a long way in reassuring owners that they're protected if a tenant defaults on the lease, explains Steve Frishman, principal with Mid-America Real Estate Corp. in Oakbrook Terrace, Ill.

But, a letter of credit or personal guarantee is no small deal to a tiny operator, says Bill Miller, senior vice president & director of retail leasing for Transwestern Commercial Services Inc. “I can't tell you how many times I've run into the ‘dreaded’ personal guarantee,” he says. “They are all about the owner and offer no protection to the tenant because it could end up putting someone's financial wellbeing in jeopardy — it gets into house and home.”

The way guarantees are used today, however, is different from just two or three years ago, Miller notes. Previously, tenants signed guarantees for their entire lease term; today, tenants are putting limits on the guarantees. Known as revolving guarantees, they limit a tenant's accountability to a period that is usually shorter than the original lease term.

Deposits are easier to manage, says Bradley Muro, a partner with Danziger & Danziger LLP, a boutique law firm in New York City. He notes that most owners prefer letters of credit or personal guarantee to protect themselves throughout the term of the lease. Deposits, which range from three to five months of rent, offer minimal protection, but are also easier for small tenants to manage.

Frishman contends that owners and tenants are both better off with a letter of credit. “If a tenant goes into default and you have a letter of credit, you've got a note with that tenant's bank that allows you to draw funds immediately,” he explains. “It's much easier to go that direction than it is to chase down an individual and get your money from their assets.” Most mom-and-pop retailers have only one thing to guarantee a lease — their house. “Trying to force someone through the courts to sell their house is a lengthy process and one that isn't always successful,” he claims.
JP