By Gerald H. Morganstern, Partner Goetz Fitzpatrick LLC
Retail leasing is not as straight forward as office leasing. Before you ask for a lease to be drawn, you should make some preliminary investigations and craft a detailed letter of intent. The following considerations should be your primary concern:
Any retail business needs a high traffic area. The nature of the business will determine how upscale the neighborhood and what price ranges the tenant can afford. Be aware that in some locales the basic rent will be significantly increased by additional charges, such as real estate taxes, utilities, common area maintenance or percentage rent.
First on any list is a check of the zoning. Standard retail zoning is enough for many businesses, but there are always exceptions. A sporting goods store may want the ability to sell hunting equipment (bows, arrows, guns, ammunition) which may require a special license or variance. Restaurants have special requirements. The parking ratio for a restaurant at a shopping center is higher than that of a dry goods store, and is based on the size and number of seats in the restaurant. A liquor license is customary for a restaurant. This entails assuring that the restaurant is not located too close to a church or school, and that the landlord has a clean record. Some municipalities automatically reject permit applications for restaurants, requiring the operator to obtain a variance (often called a conditional use permit) at a zoning board hearing before gaining approval.
Signage is extremely important for some businesses. Sign restrictions may exist in some municipalities. These include:
- Limitations on size and location;
- Uniformity in color and design in a shopping center or other designated area;
- Prohibition of LED, flashing or other garish signs;
- Prohibition on any signs on landmarked buildings or historic districts.
Landmark issues may also eliminate desired canopies or awnings. The tenant may be able to obtain a permit for a flag, banner or window sign, but should know this in advance. In New York City, landmarks commission approval is necessary in a landmarked district even if no exterior building changes are proposed. This approval can add six months to the process of obtaining a building permit.
Once one or two desired locations are found, a terms sheet or letter of intent with the landlord should be drafted so that there are no major surprises in the lease. The letter of intent should spell out all important provisions to be contained in the lease.
Basic rent, additional rent in the form of real estate taxes, common area maintenance (“CAM”) and utilities should be clear. Unlike an office lease, which provides for payment of increases in real estate taxes and operating expenses above those for the year the lease is signed, retail tenants pay their share of all real estate taxes and CAM for the land and building. The share of real estate taxes and CAM will be a negotiation point if the business is in a mixed-use building, and must be allocated between office, residential and retail uses.
A few landlords still seek to share in a successful tenant’s revenues in the form of percentage rent. The tenant would pay the percentage rent if sales exceed a stipulated “break point.” Further explanation of percentage rent, and an example of the natural breakpoint where percentage rent would take over is located at the bottom of the article. It is most likely used as a substitute for basic rent when the landlord violates a lease, and the tenant’s sales suffer. In this circumstance, the tenant only pays a percentage of actual sales instead of a fixed amount. This can occur if the landlord violates an exclusive use clause or the requirement that there be an anchor tenant (called a “co-tenancy” clause).
The letter of intent should spell out tenant’s assignment and subletting rights since retailers often want to sell successful businesses or transfer within the family. Often the letter of intent will have a renewal right, but even more important is the right to terminate the lease. If the business is not successful at this location, a tenant will not want to be locked into a long term lease. A right to terminate the lease after one, two or three years if sales don’t reach a certain level could be very important. The tenant may have to reimburse the landlord for some unamortized expenses or pay a fee and lose its security. This payment is better than continuing at a loss, or worse; going into bankruptcy. At the same time, the landlord may want an option to terminate the lease if the tenant does not meet expectations. A tenant with poor sales devalues the property and makes leasing or renewing other spaces more difficult.
Other subjects for a letter of intent are:
- Tenant’s exclusive right to sell certain merchandise;
- Tenant’s radius restriction as to other stores;
- Co-tenancy provisions;
- Continuous operation and hours of operation;
- If applicable, franchise requirements;
- Landlord construction or construction allowance;
- Rent commencement date;
- Delivery dates.
When all is investigated and determined, a letter of intent can be signed and used as a basis for the lease documents. A lawyer should review the letter of intent before submission to the landlord. Often a lawyer will look to negotiate changes from the letter if he or she has not first reviewed it. This can lead to delays or animosity. If all major lease points are covered, the letter of intent could be deemed itself a binding lease. Language expressly stating the letter is not binding should be included. Further, in some states such as California, when you sign a letter of intent, there is implied a duty on the parties to negotiate a lease in good faith. Check for whether or not there is an implied duty, and either plan on it being applicable or see if it can be negated. This article is not intended to give legal advice so it should be discussed with your counsel.
PERCENTAGE RENT – NATURAL BREAKPOINT
Retail Space $1,000/square foot
Rent $ 500/square foot
Total Annual Rent $500,000
Percentage Rent Breakpoint
2% $25,000,000
5% $10,000,000
8% $ 6,250,000
— Gerald H. Morganstern is a partner at Goetz Fitzpatrick, a New York law firm. He has been named a Real Estate All Star by Real Estate Weekly, a widely read New York area publication.