Co-tenancy or so called “inducement clauses” have long been a part of modern shopping center development and retail leasing strategies. The rationale supporting a tenant request is fairly simple—the tenant is relying upon certain anchor tenants or other national or regional tenants to be a draw for customers to visit the shopping center and is expecting a certain “tenant mix.” The requesting tenant is counting on that traffic and tenant mix to increase its visibility and sales. If those “magnet” or inducement tenants fail to open (or fail to operate after opening, the so called “continuing co-tenancy” obligation), the requesting tenant requires a concession from its landlord. Typically, such concessions include either a termination right or reduced rent obligations, or both.

As much as most landlords prefer not to grant co-tenancy rights, in the recent boom times of retail development, landlords have increasingly agreed to these provisions. In part, this acquiescence was driven by the reality of the day which was that most tenants were in expansion mode, and the likelihood of a store not opening (or even closing after opening) was considered minimal. That risk analysis, coupled with intense competition for tenants, resulted in those clauses becoming fairly common in many retail shopping center leases.

If we fast forward to today’s turbulent times, it is clear that landlords must seriously rethink granting co-tenancy rights, or at a minimum, carefully analyze the likelihood and effect of a co-tenancy failure. Obviously, the retail industry has experienced some remarkable events that, eighteen months ago, were almost unthinkable. Many retail tenants who fit into the class of the “magnet” tenants whose names appeared in many co-tenancy clauses have either gone bankrupt, consolidated operations and closed stores, defaulted on signed leases, not signed fully negotiated leases, suspended construction, completed construction but did not open the stores, and/or ceased negotiating leases or letters of intent. All of these actions and inactions have triggered serious repercussions under existing co-tenancy clauses.

To the extent that a prospective tenant will not give up on its request to obtain a co-tenancy clause, the following are some points and issues to consider in providing co-tenancy rights to a prospective tenant:

• Replace Opening Requirement with Construction Requirement. Due to timing issues, instead of providing that an opening co-tenancy obligation is met only when a designated magnet tenant opens for business to the public, try to provide that the condition is satisfied once such magnet tenant commences construction or fit out of their premises. The theory is that once a retailer commits to building a store (or fitting out a landlord built store), they have made a decision to go forward with that location, and the landlord has done as much as can be expected.
• Limit Rent Reduction. If a tenant has a right to pay a reduced rent in the event of a co-tenancy failure, limit the amount of time that such rent reduction can be in place. Without a time limit, a rent reduction may last until the co-tenancy condition is satisfied, which may be never. Consider providing that a tenant must decide within twelve months to either resume paying full rent or terminate the lease. If the location is successful despite the co-tenancy failure, it will force the tenant to make a decision. Although no landlord likes exposing itself to a termination risk, this forced decision strategy may prevent a tenant who has a successful location from receiving the unfair advantage of a rent reduction. Alternatively or additionally, consider requiring that there be a demonstrated reduction in tenant’s sales, expressed as a percentage over the previous year, or a three-year average, and if not, the rent reduction and termination right would lapse and terminate.
• Provide for the Ability to Replace Tenants. A required magnet co-tenant should also include the ability to satisfy to the co-tenancy obligations with qualified replacement tenants. This gives the landlord the ability to relet the space to another tenant who could satisfy the co-tenant standard. A couple of issues to consider here include trying to include a recapture right in the original magnet tenant’s lease so the landlord can regain control of the space in order to release it. Additionally, care should be taken about getting caught in the definition of a “national” replacement tenant that is too limiting. There are many regional tenants who provide the same drawing power as national tenants. Finally, for larger spaces that need to be relet, consider negotiating the right to split the size of the larger space to bring in more than one replacement tenant to meet the co-tenancy standard.
• Limit Rent Reductions to Base Rent Only. This sounds fairly simple, but be careful since many tenants request that their rent reduction relate to all rent. Obviously, failing to receive full pass throughs for CAM and real estate taxes will only put the landlord further under water.
• Require a Magnet Tenant to Open and Operate. A typical provision would require a magnet tenant to open and operate fully stocked and staffed for at least one day within a certain period of time after the premises are delivered to such magnet tenant with all of landlord’s work obligations substantially completed. Although this is not perfect, requiring the magnet tenant to take the effort to be fully stocked and staffed could cause them to place your location on an open list as opposed to a closed list.
• Tighten Upon “Closing” Definition. For operating co-tenancy clauses, exercise caution in defining what is a “closure” that would trigger the tenancy rights. A well drafted clause would carve out closures due to fire, casualty, remodeling and standard operating shutdowns for things like taking inventory, remodeling for reasonable periods of time, or the need to close temporarily to effectuate the substitution of a qualified replacement tenant.
• Lender Issues. A landlord must seriously consider its lender when agreeing to co-tenancy rent reductions or terminations. With the rules of real estate lending tightening, many lenders may require landlord guarantees or reserves to offset any lease termination or reduced rent stream.
• Negotiate Some Termination Fee. Many times a landlord has invested significant dollars in building out the tenant’s location. At a minimum, most landlords have paid a brokerage fee for procuring the tenant. If that tenant terminates due to a co-tenancy failure, the landlord should be entitled to recover some of these costs. Typically, the termination payment is based upon the landlord’s unamortized costs of the transaction. It may be reasonable to request that the tenant pay at least some percentage of these unamortized costs if they ­terminate due to a co-tenancy failure.
• Do a better job of underwriting. A landlord should take greater care in analyzing the financial condition of an inducement tenant instead of relying on past history or past reputation. Although no one has a crystal ball, landlords should drill as deep as possible to uncover as much information as possible to make an informed decision as to the financial health and operating plans of a magnet tenant.

It may be naïve for landlords to believe that co-tenancy requirements will not be a standard part of retail leasing in the future. However, the risk created by the domino effect of lease terminations or reduced rent that may result from a co-tenancy failure can be catastrophic. This is especially true in light of what appears to be a future trend in real estate development that is requiring more landlord equity and/or more recourse. It is imperative that landlords understand co-tenancy risks and do all that they can to negotiate changes to help minimize or eliminate that risk.

Notice: The purpose of this newsletter is to identify select developments that may be of interest to readers. The information contained herein is abridged and summarized from various sources, the accuracy and completeness of which cannot be assured. The Advisory should not be construed as legal advice or opinion, and is not a substitute for the advice of counsel.