The Impact of E-commerce on Retail Leases and Lease Exit Strategies

By: S.H. Spencer Compton and Diane Schottenstein

EVERY REAL ESTATE INDUSTRY HEADLINE TODAY SEEMS to trumpet the decline of retail leasing and the advent of e-commerce: the so-called “Amazon Effect.”¹ One recent article recounts the impact of Amazon on traditional retailers such as Walmart and concludes that:

It is apparent the Amazon Effect has left America with far more storefronts than needed. Stand-alone stores are being shuttered, with no alternative use for most buildings. Malls and shopping centers go begging as traffic drops, tenants leave, lease rates collapse and the facilities end up wholly or nearly empty. This may mean you don’t want to invest in retail real estate REITs. But it also may mean that neighborhoods, and sometimes entire towns, will be impacted as these empty buildings reduce interest in housing and push down residential prices.²

Amazon has changed the way consumers shop. Shopping center owners have reacted by repositioning their properties in a variety of ways. Some traditional malls are being used as back offices³ or medical facilities.⁴ Other large mall operators have upgraded their properties to create experiential retail spaces with attractive entertainment options such as restaurants, meeting spaces, theaters, and skating rinks.⁵ Some landlords are now more willing to have short-term tenants such as pop-up stores than they might have been in the past.⁶

Ironically, Amazon has purchased the site of the former Randall Park Mall in Ohio (briefly the largest mall in the world when it opened in 1976) to use as a fulfillment center. On a cheerful note, Amazon intends to hire as many as 100,000 full-time and 30,000 part-time employees in the United States by mid-2018.⁷

Will e-commerce and changing consumer patterns result in a permanent negative impact on the retail market? Can failing retail centers be rehabilitated, or are there too many brick and mortar stores chasing too few live retail customers? Whatever the answers to these questions may be, economic downturns in the past have taught us that a tenant should consider a lease exit strategy when entering into a lease. Although most leases contain assignment and subletting provisions, if they are not carefully crafted they may not result in a satisfactory lease exit strategy. Provisions such as terminations rights, gross sale thresholds, and co-tenancy requirements should be considered and negotiated before the lease is executed.

Keep in mind that time-honored leverage factors (business track record, size of premises, balance sheet / desirability of tenant, desirability of premises, etc.) will always control all negotiations.

Termination Rights

Unless the tenant is a government agency, the landlord is unlikely to agree to a blanket termination right. After all, any bank evaluating a loan to that the landlord will assume the lease will be terminated and give it minimal value in assessing the property’s income stream. However, a lease with a termination right narrowly tied to a particular event (such as the death of a key operator or the merger or acquisition of the business in a larger corporate transaction) will receive a higher valuation. This calculus is highly fact-specific and should be carefully considered.

The tenant might also request a termination right if the landlord becomes insolvent. Although a subordination, nondisturbance, and attornment agreement (SNDA) may give the tenant some comfort where the landlord is foreclosed upon, the SNDA will probably not require the bank to fulfill certain landlord obligations, including those relating to unpaid work allowances. The tenant may want the SNDA to provide it with a rent credit equal to any such unpaid allowance. A powerful tenant could require escrowed funds to cover the same.

Gross Sales Thresholds

Under certain circumstances, a landlord might agree to a termination right where a specified sales point is not achieved by a certain date. This makes sense both for a tenant concerned about the viability of a location and for a landlord who seeks to share in a tenant’s sales through percentage rent. The landlord will require prior notice of a termination election and recoupment of costs such as improvement allowances and brokerage. No termination right would be available to a tenant who failed to operate at full capacity; otherwise an intentional slowing down or going dark could trigger a termination right.

Co-tenancy Requirements

A co-tenancy provision requires the landlord to have certain occupants open and operating at its mall as of the tenant’s lease commencement date and throughout the term. For example, a high-end fashion retailer may require that its lease not commence until specified other high-end retailers are open and operating. Today it is customary for a space lease in a new mall to require that the anchor stores and a negotiated percentage of retail stores be open and operating as of the commencement date. Sometimes a lease will commence but only percentage rent will be payable, with base rent not due until the co-tenancy threshold has been met. The agreed rationale is that sufficient foot traffic (e.g., customers) at a mall is necessary to justify rent payments for a tenant.

Similarly, a co-tenancy requirement can apply throughout the life of a lease. A mall tenant pays rent based upon an agreed set of circumstances. If a key anchor tenant goes dark, there will be less foot traffic and the location will become less valuable. To protect itself, the landlord will often negotiate for time and flexibility in order to get a replacement anchor tenant (or percentage of other tenants, as the case may be) before a termination right is triggered. Since department stores are on the decline, a landlord may negotiate that an anchor department store can be replaced by two or more smaller stores or other draws to the mall such as a destination restaurant. When negotiating the lease provision relating to a hypothetical anchor replacement, the retail tenant must determine if the new tenant will generate the right kind of foot traffic for its business. The landlord, too, needs to be careful in the drafting or it may be left with no viable replacement. For example, if the lease provides that a departing Barnes & Noble must be replaced with an equivalent national bookseller, such a retailer will be difficult to find. Likewise, a replacement tenant provision that is too narrowly drawn can backfire on the landlord: where a provision requires a national food retailer, a strong regional food store such as B.J.’s Warehouse will not qualify as a replacement. To ease the landlord’s anchor replacement process, a reduced rent period can be the tenant’s remedy before its actual termination right is triggered. Some landlords will require a tenant to demonstrate economic harm before a co-tenancy termination right can be exercised.

Subletting and Assignment

Assignment and subletting rights can be reliable exit mechanisms, but the devil is in the details. In an economic downturn, it is likely that the tenant is competing to sublet with several other tenants and may not be able to obtain a suitable sublessee to pay all the rent. Generally, the landlord will not release the tenant from its lease obligations. Besides the actual assignment and subletting provision, the provisions relating to use, trade names signage, and alterations can also create hurdles to subletting or assigning.

In any event, the tenant will want as broad assignment and subletting rights as possible. If the lease imposes no restriction at all, then the tenant has an unlimited right to assign or sublet because the law generally does not favor restrictions on the alienability of real property. However, in New York, if the lease just requires the landlord’s consent, the courts have ruled that the landlord may refuse consent arbitrarily and for any reason or no reason at all, and it may even extract a payment as a condition for the consent. There is no inferred landlord obligation to act reasonably unless the lease specifically so requires.⁸

The tenant will want the landlord to agree not to unreasonably withhold, delay, or condition consent to an assignment or sublet. As expected, there are hundreds of cases interpreting what constitutes reasonable behavior in different circumstances, so a trier of fact is the ultimate arbiter of what is reasonable. In American Book Co. v. Yeshiva University Development Foundation, 297 N.Y.S. 2d 156, 160 (Sup. Ct. 1969), the court set out four factors that are reasonable for a landlord to consider in determining whether to agree to an assignment or sublet: (1) financial qualification of the proposed subtenant, (2) the identity or business character of the subtenant (i.e., its suitability for the particular premises), (3) the proposed use, and (4) the nature of the occupancy. We shall consider each factor below.

Financial qualification is the most objective criteria. A landlord is entitled to satisfy itself that the proposed subtenant has the economic ability to fulfill its obligations to pay rent and to perform the lease obligations. This can require an evaluation of net worth and liquidity. Reviewing the subtenant’s identity / business character, considering whether the proposed subtenant has relevant business experience or is a current tenant of the landlord, has been found to be reasonable. For use: is the proposed use prohibited by other tenants’ exclusive rights? Will such use overburden the premises or parking?

What factors might a court deem unreasonable? Unreasonable grounds for denying consent include considerations of mere taste and personal idiosyncrasies of the landlord. In Am. Book Co. v. Yeshiva Univ. Dev. Found., Inc., 297 N.Y.S.2d 156 (Sup Ct. 1969), the court found that the landlord could not withhold consent based on a philosophical and ideological objection to the proposed tenant’s business.

To avoid uncertainty as to what is a reasonable withholding of consent, some leases specify permissible factors that the landlord may consider in deciding whether or not to refuse consent to an assignment or sublet. These lists can be long and detailed. For example, a landlord may require a particular net worth threshold, restrict assignments to government offices such as the department of motor vehicles, or reject any proposed subtenant that had previously negotiated for space directly with the landlord in the last six months.

Additionally, a landlord usually requires that a tenant reimburse the landlord’s expenses in connection with an assignment or sublet and pay any sublease profit to the landlord. In any such provision, the tenant should be sure that profit is defined as net profit so that brokerage, alterations, marketing, legal, free rent, and other expenses incurred in connection with the sublet are offset against the income. Further, the tenant’s profit participation payments to the landlord should be due only to the extent the tenant actually receives them. If there are installment payments and the subtenant or assignee defaults, the tenant should be able to stop paying and perhaps be entitled to claw back any payments already made.

Process and timing of a consent request can be critical. The lease will often require a fully executed assignment or sublease to be submitted to the landlord for review. Try to have the lease provide that a signed term sheet will suffice to initiate the consent review period instead of waiting for a final fully executed sublease that ultimately may not be approved. Similarly, notwithstanding landlord pushback, try to have the lease provide a time certain by which the landlord must respond to an assignment or sublet consent request. Failure to so timely respond will be deemed consent granted. Remember, delay can foil a deal.

Even if there is a broad assignment or subletting right, a retail tenant can be thwarted by a narrowly drawn use clause that can block an otherwise satisfactory exit transaction. It is typical for a retail lease to specify a limited use for the property. However, if a tenant can only sublet to a store with the same use, and all stores with that use are under economic pressure, the tenant could be effectively left with no exit. Tenants should try to negotiate a broader use provision in the event of an assignment or sublet even though the landlord may resist, claiming that it knows best what retailers should be in its mall.

A lease provision requiring the tenant to operate its business under a specified trade name only can also hinder assignment or subletting. Such a requirement may block a satisfactory exit plan unless the tenant sells its business to an entity who will continue to operate it under the same trade name.

Keep in mind that landlords typically reserve certain rights relating to exterior and interior signage and alterations. Similarly, some leases provide that renewal rights and expansion options do not accrue to a sublessee or assignee. Such restrictions might make the tenant’s space less palatable to a replacement tenant.

Other Solutions

If a tenant is not strapped for cash but is unhappy with a particular location, it could offer to buy out its lease. The buyout price would be determined by negotiation and would turn on several factors, including the landlord’s ability to find another tenant, the remaining term of the lease, and the landlord’s unamortized construction and brokerage costs.

Sometimes a struggling tenant will ask for a temporary rent reduction or decrease in percentage rent. The landlord might consider such a request given the totality of the circumstances but might couple it with a termination option if the landlord finds another tenant. The landlord would likely not allow the tenant to sublet at the reduced rent without the profit going to the landlord notwithstanding any rent concession.

A tenant should review the lease and current circumstances for a landlord default that could allow the tenant to terminate the lease. For example, if the landlord is not providing all services required under the lease, the tenant might have the right to terminate the lease. Note that it is just as likely that an attempt to terminate the lease for a landlord default will end up in litigation, absent a clear right or egregious lease violation.

The Lender’s Role

A behind-the-scenes party in a lease exit negotiation can be the landlord’s lender. Applicable loan documents may require that certain debt service covenants be met. Similarly, there may be certain reserve requirements in connection with brokerage commissions and tenant improvements that can hinder the landlord’s flexibility. Likewise, a lender may have approval rights over any lease modification. The tenant should evaluate the lender’s role before embarking on any lease exit strategies.

Conclusion

Although the Amazon Effect has changed the course of retail leasing, other events over the years have disrupted retail markets: economic downturns, fads, and even inventory shortages. Both retail tenants and landlords need to be optimistic and nimble to succeed in their businesses. In the past, many lease terminations occurred because shoppers did not want to buy what the retail tenant was selling. Today, many lease terminations occur because shoppers don’t need to leave their homes to buy almost anything. Given the magnitude of both a landlord’s and a tenant’s investment in a retail store at a time of such uncertainty, both sides should be creative and accommodating when faced with failing results. Pre-negotiated, creative, and even-handed lease termination provisions can save both sides a lot of pain and expense.

S. H. Spencer Compton has been a vice president and special counsel at the New York office of First American Title Insurance Company since 2001. Prior to that, he was a real estate attorney in New York City, with an emphasis on commercial leasing and real estate financing transactions. Diane Schottenstein is a real estate attorney practicing in Manhattan for over twenty years. She has experience in office and retail leasing, financing, and the acquisition and sale of residential and commercial real estate.

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