7 Sins To Watch For In Co-Tenancy Clauses In Mall Leases

August 17, 2015Articles Law360

Reprinted with permission from Law360. (c) 2015 Portfolio Media. Further duplication without permission is prohibited. All rights reserved.

In the fashion world, landlords and brokers are always anxious to bring their brands into the mix of stores in a mall. A mall is a unique situation, whereby the marketing of a brand is sublimated to the greater whole of the mall; if the mall is a success, its stores supposedly will also be a success. But this sublimation leads to a fundamental conundrum: When does the marketing for the mall in toto, inclusive of brands that may be not on the same level, detrimentally affect the good will of a brand? If the answer is that the marketing and demographics of the mall are oriented toward a customer not willing or able to patronize a brand, except on an aspirational level, entry into the mall will be a negative, both in terms of return on capital expenditure as well as dilution of the brand.

This seems obvious enough as far it goes. An agent or landlord walks the mall, reviews its occupancy, requests representations as to sales per square foot and, voila, they know if it’s a fit. However, what do brokers and landlords do if approached for a space in a new mall construction? Obviously the developer and its agents will try to prove that a brand is not only a good fit but also, on the flip side, they will use that brand to entice others into the mall. One could say a virtuous cycle ... unless the cycle is broken by misrepresentations of potential tenancies.

To ensure that a brand will be a good fit and not the anchor in the marketing process, a co-tenancy clause is an insurance policy to keep the cycle virtuous. While each co-tenancy should be calibrated to the particular project, there are the proverbial seven deadly sins — when someone is not, shall we say, fully forthcoming — to consider.

First, the list. A company must make sure that the landlord lists as potential co-tenants the main brands that seduced the company to enter into the lease negotiations in the first instance. Since this is a moving target, there may be a list of ten from which the landlord has to secure, say, five to seven signed leases before a company is obligated to commence operations.

Second, from the list there may be anchors, the brand(s) that must sign leases. Otherwise, other retailers would not proceed. Usually it is one or two and may include a major anchor. But the reasoning is obvious: One brand does not want to be the linchpin leveraged for success. Since the brand positioning is sublimated to the mall, it must be insulated by having core co-tenancies in sync with it.

Third, timing. When does a company have to start spending money on construction? Immediately in anticipation of the projected grand opening date? Or only after the landlord has signed a minimum number of the co-tenancies? Clearly a company/brand wants breakpoint so its CapEx is not wasted.

This can be ameliorated by the fourth point, a tenant improvement allowance, the TI. TIs are common enough, but are more aggressively promoted in new mall projects. Depending on the size of the store and importance of the brand, full build-out costs inclusive of hard and soft costs are negotiable. If the landlord is bearing the cost, then timing is ameliorated except companies have to float the costs pending proof of completion.

Fifth, quality of the purported leases. This is the tricky part. How does a company ensure that the signed co-tenancy leases are “real” leases? Are they short term pop ups, licenses or leases with favorable kick out provisions? In effect, companies should make sure that even if for the grand opening date, the co-tenancy requirements are technically met, they reflect true commitment commensurate with your own lease term — if not, the value of the co-tenancy clause is totally vitiated. So to hedge, a company would require that the co-tenancy leases meet certain standards; as a simple example, the leases must be for terms of no less than five years without a kick-out provision. An early kick-out provision on favorable terms to the co-tenant is merely an option not the commitment commensurate to insulate your risk.

Sixth, location. The mere fact that the co-tenancy requirements are met does not mean you have immediate value if the brands are located on a different levels or areas of the mall. If a brand is in the north second floor of a mall and its co-tenants are in the south first floor, the co-tenants’ traffic is unlikely to accrue to the brand’s benefit.

Seventh, what happens if the co-tenancy is not met even colorably by opening day. Termination? Probably not. The remedy should be to go to percentage rent only until the co-tenancy is met, with a drop dead date of between 12 to 18 months. If the co-tenancy is not met by the drop dead date, the tenant usually has the right to terminate.

New projects can be exciting and economically incentivized when the developer is highly motivated to secure tenancies. But the devil is in creating the traction and making sure you are not alone in the vanguard of the developer’s project. A carefully crafted and modulated co-tenancy clause, while not a panacea to an inductive analysis of the merits of the particular project, can be a safety net to ensure the economic viability of a company and brand.