Retail Is Not Dead Yet: Adapting to the Changing Landscape of Retail Leasing

Real Estate Report

May 03, 2018

Ecommerce has forever changed the construct of retail leasing. Gone are the days of big-box anchor tenants using hundreds of thousands of square feet in suburban shopping malls. In are the days of customers buying products in store but not leaving with them in hand. There is no debate that Millennials—born between the early 1980s and mid-1990s and now reportedly the largest consumer group—are a major reason why online retail has gained traction over the years and why negotiations between retail tenants and landlords have transformed in both downtown and suburban markets.

The “live, work, play” concept has promoted an environment in urban areas where city dwellers have access to new multifamily housing, unique office spaces, restaurants, bars, and shops all within a short radius. Indeed, this lifestyle has become more prevalent among all generations, allowing for certain retailers to thrive and creating new markets for landlords and developers that otherwise did not exist. Adapting to the change in market is critical for landlords, as consumers want to buy many of their goods online while also able and willing to spend their money going out with friends within close proximity to their homes. Retail tenants, on the other hand, recognize the high demand in certain areas and may be willing to concede on certain items during lease negotiations in order to occupy a desirable location.

Negotiating Leases in the New Environment

When drafting and negotiating lease terms, landlords and tenants must account for the changing market and demand, or lack thereof, for space. Accordingly, what once were standard lease provisions are now changing due to the new retail landscape. Simply being in a neighborhood, or having a certain tenant mix, can make a significant difference to the bottom line of both the tenant and the landlord.

Landlords cognizant of how quickly retail trends can change have been less inclined to include multiple extension rights for non-premier tenants, and more inclined to renegotiate, typically with substantial leverage, a new lease at the expiration of a term. Such maneuvering allows landlords flexibility to bring in trendy, more desirable tenants to increase their building’s status.

More commonly, landlords may offer either one or no extension rights, and if such a right is offered, many landlords are prevailing in negotiating base rents for that extension term at the greater of (i) the last annual base rent or (ii) the fair market value, creating a “floor” and a chip for negotiations. In that regard, retail landlords are also negotiating base rent increases every year as opposed to every three to five years. Tenants may be more willing to agree to those increases provided the breakpoints for payment of percentage rent related to gross sales are unachievable. Thus, breakpoints (i.e., any threshold of gross sales over a certain amount, calculated either naturally (using base rent divided by a percentage) or artificially (using a sum certain)), are also being more closely scrutinized by both parties.

Addressing Sales Provisions

A provision more heavily negotiated now in light of the ecommerce boom is the definition of “gross sales.” Landlords may attempt to include in such definition any sales made online by the tenant, or sales deriving via the internet, but either retrieved or mailed from the location in question. In addition, certain e-retailers that went from “clicks to bricks” by opening small brick-and-mortar stores, may not actually carry any inventory. Such stores may be only a location where consumers either try on or test products, but they purchase it later from a smartphone. Landlords have a more difficult time trying to capture or track that type of sale. As a result, landlords should endeavor to include extensive audit rights for reviewing and defining what constitutes a “sale” for the tenant. If a retailer is using a location as a pick-up location for online sales, or has a separate warehouse exclusively serving a small retail space in a more expensive market, a landlord should try to reap the benefit of those sales. Tenants on the other hand should attempt to negotiate less intrusive audit rights for a landlord with respect to the calculation of gross sales, and be wary of what the landlord defines as a “sale”.

Where a sale transpires is also a more closely negotiated provision. Retailers may now choose to open two smaller stores in close proximity to one another to protect against competitors in the market, as opposed to a single store with twice the square footage. In response, landlords may either try to restrict a second store from opening by inserting a radius restriction clause into the lease, which prohibits a tenant from owning, operating, or having a financial interest in a competing store, or may allow the other store to be leased within a certain radius but count any such sales at the other store toward the gross sales under the lease.

One way for tenants to try to protect themselves from competitors entering the surrounding area is for a tenant to require an exclusive use clause in the lease, where the landlord cannot lease to any other retailer that has a similar use to the tenant. With the current trend of developers buying and/or redeveloping city blocks, an exclusive use clause may provide the tenant with comfort that it will not have a competing company in the immediate vicinity. Likewise, to an extent, an exclusive use clause may not adversely affect a landlord as the gross sales of the tenant requesting the exclusivity provision will not be curtailed by the presence of a competing tenant, and such a clause allows for a better tenant mix at the property since a landlord will not be able to lease, for example, to two coffee shops on the same strip. Landlords should, however, attempt to reasonably restrict a tenant’s use at the property to have more flexibility with exclusivity clauses for their other tenants. For example, a landlord and tenant may agree that the tenant can only operate the leased store as a branded, national fast-food chain and that the landlord cannot lease to other national fast-food chains, however, the landlord could lease to a variety of other restaurants.

Conversely, tenants should always seek to have broad use provisions. With the changing nature of retail, in five or ten years business models may change, the tenant may want to sell its business, or the tenant could be absorbed by a parent company. In any event, the tenant should negotiate that such a change in use would not be an assignment or transfer under the lease requiring landlord consent. Of course, landlords desire greater control over what is an assignment under the lease, and should include profit-sharing provisions if an assignment or sublease transpires. If a retail subtenant subleases or licenses a portion of its space, the landlord should be sure to include such sales as part of the gross sales under the lease.

In sum, the new landscape of retail is shifting the way leases are negotiated. Both landlords and tenants should each be aware of the other’s interests, and how each party can protect itself during lease discussions. The foregoing issues are just a few of the terms that are being affected by current retail trends. With the emergence of new technologies and consumers’ changing tendencies, however, landlords and tenants should be prepared to deal with them.