For much of the last decade, lifestyle centers were all the rage among developers. But even at the height of their popularity, there was a looming concern about the structure of their leases and the widespread use of co-tenancy clauses.
Co-tenancy clauses are provisions under which retail tenants are granted concessions if one or more tenants in a center leave or the project goes dark. Leases at regional malls and grocery-anchored shopping centers typically feature co-tenancy clauses in connection to project anchors.
But because lifestyle centers typically do not have anchors, in order to ensure top tenants sign onto projects, developers allow generous co-tenancy clauses. In many cases, these clauses are granted on lists of up to 10 retailers.
What that means is that if any of the 10 retailers on one tenant’s list end up leaving a center, it could trigger concessions such as rent reductions or the right to go dark. As a result, these clauses are adding an extra wrinkle as lenders and receivers attempt to resolve distressed lifestyle centers. The use of these clauses means it’s more difficult to project property income because a lender or receiver won’t know if the retailers in place now will remain, even if they have long-term leases.
Throwing their weight around
Back in 2006, the retailers that were demanding—and receiving—co-tenancy clauses in lifestyle centers including names like Chico's, J. Crew, Anthropologie, Ann Taylor Loft, J. Jill, Coldwater Creek, Hot Topic, Talbot's, Z Gallerie and White House/Black Market. At the time, these were the most successful apparel chains operating. These retailers would commonly demand that all the others be locked into a center as a condition of their leases.
But times have changed. Many of the hot tenants in 2006 are troubled operators today. Z Gallerie closed 21 stores in early 2009, leaving it with 56. It then conducted a bankruptcy restructuring between April and October of last year. Ann Taylor announced early in 2009 that it would close up to 163 stores by the end of 2010. J. Jill said it would close 75 stores. Also in 2009, Chico’s shuttered 25 stores and Talbots closed 20.
These moves have affected lifestyle centers across the country. The question of how big a problem they represent, however, depends greatly on how the leases were structured when the projects were built and the ultimate success of the projects.
Three kinds of co-tenancy
There are three distinct phases during which the provisions can take effect. The first is during the lease-up period. After a tenant signs a letter of intent to occupy a project, it may have the option to pull out of the project if the other retailers or restaurants on their list don't sign by a specified deadline.
A second kind of co-tenancy covers the opening of a project. At this point, a tenant has signed on and undertaken the build-out of its space and training of its staff. But if the other retailers on a tenant’s list don't open by an agreed-upon date, the tenant does not have to open its store either (and therefore, it doesn't have to start paying any rent on that space).
Neither of those situations present issues for receivers or lenders today. It’s the third scenario where things become dicey. In some cases, tenants were granted ongoing co-tenancy provisions that cover the entire life of the lease. Here co-tenancy can take two forms.
In the first case, the named co-tenancy is dropped in favor of occupancy thresholds. Instead of being triggered by a specific set of retailers leaving a center, the overall vacancy rate is what matters.
In other cases, tenants retain named co-tenancy rights. In these cases, tenants can obtain concessions if just one of the tenants on its list ends up leaving a project early. In these cases, the tenant might have its rent reduced from a fixed rent down to paying a percentage of its sales. Or it might even have the option to vacate its lease.
Sometimes the landlord can recover damages, usually written into the lease, for a signed tenant's failure to follow through on its contractual promise. Other times the desired tenant can insist there be no charge for failure to deliver.
Lenders’ quandary
Josh Poag, president and CEO of Poag & McEwen Lifestyle Centers based in Memphis, Tenn., says his firm does not grant tenants ongoing named co-tenancy and focuses instead on occupancies. Recently, however, he did evaluate an investment opportunity where the tenants had ongoing named co-tenancy rights.
“I looked at the leases and saw that the developer had given named co-tenancy going forward,” he says. “All of a sudden, one tenant can close and it would kick in clauses for everyone else, even though the center could be 95 percent occupied.”
What this means for lenders and receivers is that lifestyle centers have an added level of risk that can reduce what a buyer might be willing to pay for a distressed asset. As a result, you have to underwrite centers with heavy use of co-tenancy clauses differently than other centers, says Greg Maloney, president and CEO of Jones Lang LaSalle Retail and head of the firm’s value recovery services team.
“If you look at underwriting assets, that absolutely goes into the underwriting when you are trying to determine the center’s value,” explains Maloney. “Buyers are going to risk-assess that and come up with some kind of deduction on the price.” In some cases, in which retailers are finding success even if one of their named co-tenants has failed, they will be content to continue operating their store, Maloney says. “If just one isn’t doing well, it doesn’t mean that all would close.”
But it does mean that in practice, when underwriting lifestyle centers, tenants with co-tenancy rights have to be treated as if they have short-term leases, Maloney says. “You can’t just assume that the income is going to be in place.”
Scope of the problem
Research firms that monitor distressed assets don’t monitor the number of lifestyle centers in the retail pipeline, but industry observers say they are out there. During the past decade, lifestyle centers spread rapidly. In 2001, lifestyle centers comprised just 0.8 percent of total U.S. retail GLA, with 192 properties, or approximately 49 million square feet, according to data compiled for ICSC by CoStar Realty Information.
Today, lifestyle centers make up 1.77 percent of the retail universe, with 455 centers totaling 127.8 million square feet. While the amount of total shopping center space in the U.S. grew 18 percent to 7.2 billion square feet during the past decade, the amount of lifestyle center space increased 160 percent.
Given the new market realities, however, roughly 40 percent of those centers might ultimately prove unviable and will have to be converted to another use, says Jeff Green, president of Jeff Green Partners, a Mill Valley, Calif.-based real estate consulting firm. And here size matters. Centers that contain less than 500,000 square feet of space may prove to be vulnerable.
“You look at the lifestyle center as a magnet. The smaller the center, the smaller the magnetic attraction, therefore it’s more vulnerable,” Green says. “If retailers are going to close stores, those are the centers where they are going to close stores first.”
Elaine Misonhznik contributed to this story.