COVER STORY, JANUARY 2012

CLAUSE & EFFECT
Co-tenancy provisions pit landlords against retailers.
Savannah Duncan

Last November, Syms Corp. and it’s wholly owned subsidiary, Filene’s Basement, filed for Chapter 11 bankruptcy. All 46 retail stores will be closed by the end of January, leaving behind vacant big-box space. During the past few years, several other major tenants including Linens ‘N Things, Borders and Circuit City have folded because of the economy as well. For landlords, the loss of a big-box tenant starts a race to fill the empty space before co-tenancy clauses take effect.

Co-tenancy clauses are one of the most important retail lease provisions, says Lori Kilberg, partner at Atlanta-based Hartman Simons. “Landlords have seen what has happened with co-tenancies and centers emptying out because of the domino effect of a couple tenants leaving.”

A co-tenancy clause gives a tenant certain options in the event that the shopping center in which it is located does not meet certain requirements. There are two kinds of co-tenancies: opening co-tenancy provisions, which are more common for centers under development, and continuing co-tenancy provisions, which are for retailers who are open and in operation.

In the wake of many big-box tenants closing their doors, co-tenancy provisions have been a hot topic of conversation among landlords and in lease negotiations. 

“Lately, co-tenancy provisions come up all the time in lease negotiations, particularly with big-box tenants,” says Shannon Dixon, vice president of asset management for Casto’s Raleigh, North Carolina, office. “For local and regional tenants, we provide them with the [opportunity] to be in [a center] with big-box tenants, so we typically don’t grant co-tenancies to them.”

While co-tenancy clauses are required by most strong credit tenants, there are many leases being signed today without co-tenancy clauses, says Oscar Riveria, managing shareholder of Siegfried, Rivera, Lerner, De La Torre & Sobel in the firm’s Plantation, Florida, office. “None of the leases we have done recently have had co-tenancy provisions for small, local or non-credit tenants,” he says.

There are a few issues that arise in co-tenancy negotiations when the landlord and tenant try to agree on what counts as a qualified replacement tenant. The biggest obstacles are the amount of space that has to be re-leased to another tenant and what kind of tenant it has to be, says Abe Schear, partner of Arnall Golden Gregory’s Atlanta office. Also, if a shopping center has a multi-floor anchor tenant, can the landlord just replace one floor?

The amount of time the landlord will have to fill the space and what the tenant will receive financially if the landlord is in violation are often sticking points of co-tenancy clauses as well, adds Riveria.

Dixon adds that it is common for shopping center owners to consult with each other about what kind of co-tenancy agreements were reached with a specific tenant. “When you are a larger shopping center owner, you are very careful about what you grant a tenant because you know it’s probably going to be carried on,” she says.

Most co-tenancy provisions give the landlord a right to find a qualified replacement tenant, says Kilberg. “The problem is, how many big-box tenants are still around to take those places? Depending on how stringent the qualified replacement tenant definition is, landlords can be really hard-pressed to find qualified tenants to take that space.”

The best way for landlords to protect themselves is to secure the most flexibility in terms of the time frame to replace a tenant, the types of uses permitted and the idea that it doesn’t have to be the exact space in terms of size, says Janis Schiff, partner at Holland & Knight’s Washington, D.C., office.

Because alternative-use tenants taking retail spaces is a growing trend, Kilberg says a well-crafted co-tenancy clause from a tenant’s perspective will ensure those qualified replacement tenants are retail tenants. However, if the clause doesn’t specify, it’s possible that a non-retail tenant may satisfy the co-tenancy requirement.

Additionally, termination rights are key to co-tenancy clauses to ensure that landlords are not losing money indefinitely. Schear says, “Good landlord leases are grafted so that while the tenant may have a remedy, at some point the landlord needs to have the right to force the tenant to either go back to full rent or terminate the lease. Sophisticated landlords are not allowing tenants to remain on reduced rent for an unlimited period of time.”

If a landlord is in violation of a co-tenancy, tenants are exercising their rights under their lease to enforce it, says Rivera. “The economy had a great impact on it. There was a lot stricter adherence to those types of situations as the economy grew worse,” he adds.

In fact, Schiff says she had one project where Linens ‘N Things and another big-box tenant went dark and Dick’s Sporting Goods received reduced rent because of its co-tenancy clause. “[Dick’s Sporting Goods] suffered no sales problems and it was a destination store. The fact that the other tenants weren’t there didn’t really matter to them, but they got a reduced rent anyway.”

When co-tenancy cases end up in court, the point of dispute typically centers on an ambiguity in the co-tenancy provision or a factual question as to whether the conditions have been satisfied to allow the tenant to pay reduced rent or terminate, says Kilberg. In cases where the tenant wishes to stay and is otherwise performing, the usual outcome is to settle because both sides share an interest in preserving the relationship. However, if the tenant is seeking to terminate the lease, the dispute might not be as easily settled.

Schear says co-tenancy clauses are not a passing trend, but that they will continue to be a part of retail leasing. “The idea of co-tenancy in leases will be a long-term expectation for the sophisticated tenant, but it’s one the landlord is used to and has learned to deal with. It’s certainly something that will be a long-term issue.”

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