- Shopping centers are filled with a combination of tenants whose businesses are complementary to each other.
- In most cases, there is an anchor tenant who draws traffic to the center, and a series of smaller tenants who benefit from it. Together they form a sort of community. Like any community, if one of them leaves, the whole thing suffers.
- To protect themselves, tenants may choose to negotiate a co-tenancy clause.
- A co-tenancy clause is language in a lease agreement that allows a tenant to request some sort of relief if total occupancy drops below a certain threshold.
- The relief typically takes the form of reduced rent until such time as the space is filled.
- The existence of co-tenancy clauses in retail leases raises the risk profile of a transaction for the property owner because one tenant leaving can result in other tenants receiving rent reductions.
- For this reason, a review of existing leases is an important component of the pre-purchase due diligence process.
At First National Realty Partners, we are retail real estate investors and our preferred asset is a grocery store anchored shopping center. In nearly all cases, there is one or more “anchor tenants” – the grocery store – and a series of smaller tenants whose businesses are complementary. The general idea behind this mix is that the anchor tenant’s presence drives traffic to the shopping center while the smaller tenants benefit from it.
The combination of the anchor tenants and smaller tenants creates a community of sorts. And, like any community, if one or more of them leaves, it can suffer. To address this issue, many retail tenants ask to include a Co-Tenancy clause in their lease.
What is a Co-Tenancy Clause?
A co-tenancy clause, sometimes called a co-tenancy provision, is language in a typical commercial lease agreement that provides the lessee (tenant) with rent relief or some other remedy if a certain number of tenants leave the property or if total occupancy falls below a certain level.
To illustrate how a co-tenancy clause works, an example is helpful. To make it as realistic as possible, we will use one of our own properties for the demonstration. Acme Commons is a 83,724 SF shopping center located in New Jersey. The anchor store is an Acme grocery store who leases 54,468 SF or 65% of the available space.
The other tenants, or co-tenants, are businesses who can benefit from the foot traffic generated by the grocery store. They include retailers like: Starbucks, Wells Fargo, UPS, Supercuts, Verizon Wireless, Mattress Firm, and GameStop. All of these businesses lease between 1,500 and 4,000 SF so their stores are significantly smaller than the anchor. If the Acme grocery store decided not to renew their lease or if a handful of the supporting tenants decided to leave, the business prospects for the remaining tenants could be damaged until the vacant space is re-leased.
In such a situation, the tenant could invoke the co-tenancy clause in their lease that could entitle them to some sort of relief until the space is filled.
Key Negotiating Points in a Co-Tenancy Clause
A co-tenancy requirement is not a standard clause in all commercial real estate leases. It is typically something that the tenant pushes for to mitigate the risk of the retail community breaking down during the term of their lease. If the landlord and tenant agree to it, there are three key negotiating points that must be determined:
- The Threshold: The co-tenancy agreement language must define the threshold at which the tenant has the right to invoke the clause. For example, the language could read something like: “… in the event that less than seventy percent (70%) of the tenants in the Shopping Center, are open and operating…” In this sample language, 70% is the threshold at which the tenant can request relief. The threshold can be measured as a percentage of leasable square feet or as a percentage of the total tenants. This is an important distinction that can have ramifications for whether or not the tenant can invoke the clause.
- The Fix Period: The Fix period, also called the cure period specifies the period of time that the property owner has to find a replacement tenant. Typically, it begins on the day the threshold is crossed. For example, the language in the lease could state that the property owner has 90 days to find a new tenant before relief is available. In other words, occupancy could drop below the threshold, but if the property owner fills the space within 90 days, no relief is available.
- Available Relief: If the threshold is breached and the property owner fails to fix it, the clause should specify what types of relief are available to the tenant. In most cases, the relief comes in the form of rent reduction. Typically, there could be multiple options for reducing the rent. There could be a specified dollar reduction, like the rent will decline by $1,000. The reduction could be a percentage of the total rent, like 15%. Or, the rent could be reduced to a percentage of the tenant’s gross sales.
Why Co-Tenancy Clauses Matter
The existence of co-tenancy clauses in retail tenant leases raises the risk profile for the property owner. Why? Because the impact of a tenant leaving can be magnified if it causes the property to breach the co-tenancy threshold and it can cause a chain reaction of negative events. In a worst case scenario, an anchor tenant could leave and it could trigger rent reductions in the remaining leases, magnifying the revenue loss.
To protect their downside, the property owner may negotiate that the tenant cannot invoke the clause if they are in default on their lease, may limit the number of available remedies, and may require them to provide some sort of evidence that their business has been materially harmed as a result of the vacancy.
Interested in Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We leverage our decades of expertise and our available liquidity to find world-class, multi-tenanted assets below intrinsic value. In doing so, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
When evaluating potential properties for purchase, we always review existing leases for co-tenancy clauses to get a clear picture of the transaction’s risk profile.
If you are an Accredited Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.
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