About 700 shopping center owners and managers across the United States recently received form letters from a major big-box retail tenant. "Since times are tough, we've decided to unilaterally reduce our rent by 25 percent," the letter read. Enclosed in the envelopes were checks to the landlords for the newly decreased amounts. In all, that 25 percent slashing of rent translates into a $30,000 annual reduction per lease and total annual savings of $21 million for the retailer in question.

One owner who received the letter (who didn't want to be named in this story) wavered between disgust and admiration for the retailer's "chutzpah". He says he's never been in a position where a retailer simply asserted a rent reduction and assumed it would fly with no input at all from landlords.

"I can't accept the check and just move on," the owner says. "I can't allow my tenants to change the terms of their leases at will and set their own rent. If they need relief, they should come to me and ask for it. Then I can make a decision about whether they get it or not."

These are uncharted waters. Faced with arguably the deepest and longest recession since World War II and the worst financial crisis since the Great Depression, the tenant/landlord relationship is being tested in new ways. How both sides respond could go a long way in determining the health of the industry in years to come.

Both owners and retailers are hurting. Each side is trying to survive. On the surface, it looks like they have opposing objectives: one wants to preserve rent and the other wants to reduce rent. And both parties are suspicious of each other--owners fear retailers are trying to take advantage of them, while retailers feel owners simply are being unresponsive to their struggles. That may make it hard for landlords and tenants to be able to put themselves in each other's shoes and find a way to work together.

Yet many owners and retailers are slowly coming to realize they are not in contretemps, and in fact share the same goal--they both want the retailer to be successful and to continue to operate in the center. With this common ground, they're taking a collaborative approach in dealing with today's market and are working through rent relief requests as a team.

"I am seeing more of a partnership between landlords and their tenants," says Henry Pharr III, an attorney with Charlotte, N.C.-based Horack Talley who specializes in landlord/tenant litigation. "They are saying 'We're all getting hit hard so let's try to work together as best we can.' The games played during the go-go times… the egos and pride… that has all gone away."

To be sure, these troubles are coming after an extremely robust run for landlords, who enjoyed a long boom in the sector and capitalized with healthy rental gains for years. Over the 10-year period spanning 1999 thru 2008, effective rents rose 23.2 percent, according to Reis. Owners suffered negative rent growth only one year during that period--a decrease of 1.1 percent in 2008. Over the past five years alone, effective rents spiked 10.8 percent, Reis reports.

Today, that situation has reversed. Retail vacancies are rising, reaching levels not seen in a decade. At the end of 2008, the blended retail vacancy rate (which looks at regional malls and community and power centers) hit 8.3 percent, according to Reis Inc. (See chart.) At neighborhood and community shopping centers, the vacancy rate rose to 8.9 percent from 8.4 percent in the third quarter, the highest since Reis began publishing quarterly data in 1999. Regional mall vacancies rose to 7.1 percent last quarter from 6.6 percent in the third quarter. It was the highest vacancy rate since Reis began tracking regional malls in 2000.

Yet, it's impossible to ignore how much retailers are also suffering. Retail sales in January 2009 were down 11.0 percent year-over-year, according to the U.S. Census Bureau. To put that in perspective, during the last recession, retail sales didn't drop at all. In 2001 retail sales rose 3.5 percent and in 2002 they rose 2.8 percent.

Because of such dismal sales, retail tenants have seen their occupancy costs as a percentage of sales increase. In the 1990s, for example, occupancy costs were typically below 10 percent. Throughout this decade, they've escalated (as rental rates have increased), yet remained manageable at 10 percent to 12 percent. Today, it's not unheard of for a retailer's occupancy costs to exceed 15 percent or even 20 percent--an amount that makes most stores unprofitable, according to Mez Birdie, director of retail services at NAI Realvest in Maitland, Fla.

For many retailers, the situation is desperate. Industry experts are predicting between 10,000 to 20,000 store closings in 2009, and a number of retailers including Circuit City and Linens'n'Things have already filed for bankruptcy and handed the keys back to their landlords. (For a list of announced closings to date in 2009, go here.

Overall, that creates a difficult environment that landlords and tenants will have to negotiate in 2009 and beyond.

Necessary tenants
Today, owners are receiving rent relief requests from retailers of all shapes and sizes.

"Even in good times, some mom and pop retailers ask for help with their rent, but now it's even worse because we have smaller retailers and national retailers hitting up their landlords at the same time," says Scott Frank, a partner in Arnstein & Lehr LLP's West Palm Beach, Fla. office and a member of its real estate practice group.

Experts advise that landlords need to first evaluate their own situations before considering retailer requests, Pharr says. First, owners should think about how much they need that particular tenant in their center. Landlords have to consider, for example, if losing a tenant could put the center's cash flow in more jeopardy than accepting reduced rent. "In today's market, a little money is better than no money," Frank says.

Moreover, owners should consider a center's tenant mix and the position the tenant fills. They need to have a clear understanding of the options if a tenant defaults or terminates a lease, experts suggest. For example, losing particular tenants could trip co-tenancy clauses, potentially causing more harm to a center's occupancy and cash flow. Of equal concern, if a retailer closes shop, how quickly will the owner be able to lease the space and at what rate?

"When the market was stronger, owners had no problems evicting their tenants because they had tenants waiting in the wings to take the space," Pharr says. "No one is waiting in the wings today."

Pharr recently helped an owner negotiate a recent reduction package with one of its restaurant tenants. The owner was willing to work with the tenant because the restaurant anchored the small strip center and because the space adjacent to the restaurant was already vacant. The modified lease allows the restaurant to pay a rent equal to 10 percent of sales for six months, and the difference between that amount and the original rental rate would be amortized over the life of the lease.

"Overall, the decision wasn't that hard to make because the owner said: 'I'd like to have this tenant because it attracts people, and that's good for my center,'" Pharr says.

Review the numbers
When it comes to making rent relief decisions, most owners consider both quantitative data such as historical sales reports and financial statements and qualitative information including the long-term viability of the retail concept.

The information used to make a decision regarding rent relief is similar to the due diligence that owners conduct when they first negotiate a lease to bring in a new tenant, according to Frank Tobolsky, an attorney with Philadelphia, Pa.-based Astor Weiss Kaplan & Mandel LLP. At the top of his list is a Dunn & Bradstreet report, along with letters of credit and personal guarantees.

Owners also look at historic sales data. While some only review sales data for one particular store, experts suggest they also review historic chain sales, as well as average store level sales. This information will give owners a clear view of how the retailer's store in their particular center measures up to other stores within the retailer's chain, Birdie says.

Publicly-traded retailers and large national chains usually have this information readily available, so the only roadblock is their willingness to share. Smaller retailers and mom and pop operations rarely have extensive data, so owners might have to be creative in getting access to financial information.

For example, Woolbright Development looks to the sales tax reports its tenants file with the state of Florida, according to CEO Duane Stiller. The Boca Raton, Fla.-based company, which owns and operates a shopping center portfolio totaling 3.5 million square, prefers retailers' rental expense to be 10 percent of sales or less.

"Retail tenants need to be completely transparent with their landlords," Birdie says. "Owners will work with retailers that provide detailed information."

Unfortunately, retailers are not in the position to demand the same level of transparency from their landlords (unless their leases are coming up for renewal). Yet, they still need to do their own evaluation to determine whether their landlords are in a position where they can offer rent relief.

Retailers that occupy space in centers owned by REITs will be able to access their landlords' earnings reports and financials. These documents will give tenants an idea of how much pressure their landlords are facing.

Obtaining information on private landlords will likely be more difficult. In this case, retailers might have to rely on word of mouth. Alternatively, retailers could ask their landlords about their financial situation and hope the landlord will answer the question honestly.

Retailers also need to determine if their landlords can make rent modifications without involving any lenders. In many cases, owners aren't always the final decision makers when it comes to rent relief requests. Owners with mortgages on their properties often cannot negotiate rent reductions without the blessing of their lenders.

Pharr, for example, has worked with owners who have wanted to offer rent relief, but have run afoul of their lenders. "In a lot of situations, lenders are preventing owners from helping their tenants," he says, adding that he has found himself in the unenviable position of playing referee between lenders and owners. "Most lenders start off saying they can't do it, but we try to loosen them up and sometimes our message resonates with them."

Stiller has become a big critic of the way lenders deal with owners and tenants who need rent reduction. "Saying no to every request is such an absurd stance for a lender to take," he says. "We're rapidly approaching the day when we're going to see some owners have to make a choice: do I respect what my banker is telling me to do or what my long-time tenant is asking me to do?"

For his part, Stiller says he's going to do "what's right for the company and the tenant," regardless of what his lenders tell him to do.

Hardball tactics

However, landlords are unhappy with the hardball tactics they feel some retailers have resorted to. Owners expect retailers with upcoming lease expirations to be tough negotiators and push for lower rents for their lease renewals. But owners say that the majority of rent relief requests are coming from retailers that have several years left on their leases.

Retail property owners that consent to rent reductions or abatements are putting their incomes at risk and likely decreasing the overall return on investment. "If we give up rent, we have to figure out where else we can find the savings to make up for it," says Jim Mastandrea, CEO of Houston-based Whitestone REIT, which owns and operates a portfolio of more than 3 million square feet of commercial property across the Southwest.

In other cases, retailers are threatening to close stores if abatement demands aren't met. For example, Fort Worth, Texas-based Pier 1 Imports last month went public with its push for concessions warning owners it would terminate leases on up to 125 underperforming stores if landlords deny its requests for lower rents.

And in Manhattan, Sierra Realty Corp. President Jim Wacht is dealing with a local retailer that is downsizing from 11 stores to seven stores as part of its bankruptcy reorganization. "This retailer is using bankruptcy to cherry-pick the leases and has basically given its landlords an ultimatum--the stores that will stay open are the stores that have the lowest rents," he says. "They're really putting the screws to the landlords, and if my client loses this tenant, it's really going to cost him. He feels like he has no choice."

Beware sinking ships

Stiller estimates about one-third of his tenants have asked for rent relief, so he's busy trying to figure out not only which ones need it, but which ones deserve it. The numbers only tell part of the story, he says, and don't provide any insight into the relevance of the retail concept and the quality of the retailer's operations.

"Some of the evaluation is numbers based, but some of it has to be subjective where you use your best judgment," Stiller says. "If a retailer has a concept that just isn't working, it needs to remake itself, and that's something I can't help."

Birdie of NAI Realvest says owners have to be careful not to make the mistake of bailing out a sinking ship. "You don't give a lifeline to a Titanic because you're just delaying the inevitable," he contends. "You just have to bite the bullet and take the space back."

In Manhattan, Wacht recently advised one of his owner-clients against providing rent relief to a tenant that sold high-end antiques. The tenant, which had already gone through its working capital and savings, needed a substantial reduction on its space (which was already priced at below-market rates).

"I made the recommendation to let the tenant go out of business and re-lease the space because his business is not going to get any better and he's not going to make it anyway," Wacht explains. "It was based on instinct, but the owner decided to give the tenant the rent relief. He said 'Let's try to keep him in business because there's too much uncertainty in the market.'"

Wacht admits the dismal market conditions are influencing how owners approach requests for rent relief. "For some owners and some situations, the devil you know is better than the devil you don't," he says, paraphrasing the well-known religious idiom.

Working together

Wacht and his owner-clients have acquiesced to about half of the requests they've received for rent relief. Some requests were denied because the retailers weren't willing to work with their landlord and offer anything in return for the landlord's flexibility.

"You can always tell which retailers really need help because they're willing to give up some of the options they have in their lease," Wacht says. In exchange for rent reductions of 10 to 15 percent, for example, retailers routinely give up their first right of refusal on expansion space or accept more stringent subleasing restrictions, among other things.

Wacht and his clients rejected some requests because the retailers didn't really need any concessions and were just trying to take advantage of the situation. In fact, many landlords suggest retailers are being opportunistic when they approach landlords, although retail sales data suggests otherwise.

"Some tenants are asking for rent relief just because other tenants are asking for it and brokers are recommending they do so," Whitestone REIT's Mastandrea says. "We're trying to determine whether they need some help or if they're asking because the guy next door got it."

Mastandrea points to a recent situation in which one tenant paying $30 per square foot for space in an Arizona shopping center petitioned the REIT for a reduction. The tenant was only a couple of years into his multi-year lease. "His business is doing well, yet when he found out the new tenant next door is paying only $24 per square feet, he wanted us to bring the rate down," he recalls. Whitestone's answer was a resounding "No!"

These baseless, opportunistic requests frustrate and anger landlords and make it even more difficult for retailers with real problems to get the help they need. Mastandrea likens these requests to landlords breaking their contracts with their tenants and changing the leases to raise rents when rates are increasing.

If the retailer's request does have merit, then landlords should act, Stiller says. "I believe it's in everyone's best interest that we come up with a solution and work with tenants to adjust the rental rate to something they can afford," he contends. "We can't be rigid because that's not going to work. We can't use an on-off switch and just kick them out; we need to use the dimmer switch."

That's why Woolbright Development has crafted a three-pronged approach to help its struggling tenants. The firm is working with retailers to provide rent relief; launching and paying for new marketing programs; and working with retailers to help them cut their expenses.

"Now is the time to come together because the alternative is failure, as an owner and as a retailer," Stiller says. "It's important that all of us make some sacrifices and respond to this economic crisis."