Article

Retail Legal Issues

June 11, 2007

Compiled by Randall Shearin

REBusinessOnline's sister publication, Shopping Center Business, recently asked real estate attorneys across the country, "What is the most pressing issue in your practice?" We asked the group to apply the question to their area of knowledge to get a variety of answers, whether they pertained to their particular market, to retailers or to developers. Here’s what they said:

Mixed-use

“Flexibility,” always a landlord concept, has never been more important. Larger projects are aging and newer projects are built with multiple components, often incorporating office and/or residential components. Today’s projects are, in many cases, built in phases, encompassing design elements that are incomplete and owners who are long on enthusiasm and short on experience. Much of this development and lease up is documented on lease forms which fail to address the many moving parts, particularly as such relates to complicated construction exhibits, parking plans and rent allocations. For the sophisticated tenant, this creates a problem in accurately setting forth the lease terms. Conversely and as such relates to the interesting local tenant who will create that needed buzz, the document is often under-negotiated and fails to include predictable events, however unpleasant. Projects with multiple components, incorporating verticality and density, often with multi-story tenants and deck parking, are inherently complicated. These projects will be difficult to remodel, increasing the pressure to “get it right” the first time. It is paramount that landlords and tenants maximize the likelihood that the many moving parts are properly anticipated and documented.

— Abe Schear, Arnall Golden Gregory, Atlanta

Increasing Returns

The unending pressure on landlords to increase returns (i.e. boost rents) is having a deleterious effect on local or regional tenants who don't have the luxury of subsidizing 10 non-performing stores with another 90 that are doing well. In fact, the more successful local retailers are being punished for their success: landlords are insisting on rents based upon an occupancy cost-to-revenues ratio approaching 15 percent with little attention paid to tenant costs other than rent. This punishes retailers trying to minimize the customary employee turnover by paying more and offering benefits. Some folks like the fact that the mall or lifestyle center in Des Moines looks exactly the same as a comparable property in Charlotte; I find it depressing that we've lost forever any concept of regional flavor or buying from your neighbor. Ten years ago, the local or regional tenant retained some leverage by threatening to go across the street. These days, the properties on both sides of the street are frequently owned by the same entity. Conversely, the major national tenants continue to flex their muscles with the national landlords, negotiating significant allowances and favorable lease provisions unheard of in the 1990s. As shoppers tire of the same old, same old, perhaps there will be a return to individuality, with concessions granted to those tenants who need them most. Don't hold your breath.

— Matt Epstein, Goulston & Storrs, Boston

Finding Sites

In recent years, one of the most disconcerting trends, which has become more and more troublesome to retail real estate owners/developers, is the inability of the private owner to locate and acquire existing properties. With the increasing availability of investment capital and the interest in shopping centers by private equity funds and national REITs, very little retail properties are available for purchase. These funds and trusts are not interested in investments with the expectation of a cyclical market where they can buy low and sell high in order to earn substantial appreciation. Rather, the investment in retail properties is seen as a source of a steady income stream and as a balance to investments in stocks and bonds. Therefore, these new investors are snatching up all available mall portfolios as soon as they come on the market and are holding on to these properties for long terms. The private owner/developer faces a shortage of available centers to purchase and when anything becomes available, they must quickly decide to purchase without prolonging the contract negotiations or requiring typical due diligence periods, which are becoming shorter and shorter. As a result of this problem, many private owners are forced to purchase less desirable shopping centers with potential for expansion and redevelopment, or merely purchase vacant land and construct ground-up developments.

— Ira Fierstein, Seyfarth Shaw LLP, Chicago

Rising Rental Rates

I think that the most prevalent issue facing retailers in the New York City metropolitan area is skyrocketing rental rates and competition for good locations. For instance, in the last few years there has been a virtual explosion of new bank branches in retail locations all across New York City and its surrounding suburban markets. It is not unusual to see four different banks on the four corners of one street. As the competing banks attempt to outdo each other in terms of location (as well as sheer number of locations), landlords are enjoying an unprecedented boom in the retail rental market. Banks are outbidding one another for choice locations and many other retailers are simply unable to put in viable competing offers. Despite the rise of Internet banking, consumers often feel safe putting their funds in brick and mortar institutions, and the rents that the banks are willing to pay prices out of the market all except the most well heeled retailers. The competition for locations is driving rents up to stratospheric levels. The bank branch presence has made an already tight market all the more difficult to break into.

— Richard J. Brown, Herrick, Feinstein LLP, New York City

Lease Negotiations

One of the most prevalent issues in my retail practice is handling the peculiarities of ground-floor retail leasing in mixed-use buildings in New York and other major cities. While street-level retail has a natural synergy in office buildings, there is no such synergy in residential buildings with ground-floor retail. Hours of operation, types and location of signage, noise, odors and music emanating from the stores, loitering of customers in and around the building are just the beginning of the dissonance experienced in trying to negotiate successful retail leases in mixed-use properties. The situation gets further complicated where the mixed-use buildings are co-op and condominium buildings run by boards of directors or boards of managers who are typically unfamiliar with retail leasing and the needs of their retail co-habitants. In those situations, logic and reason rarely prevail. I recently closed a transaction where a developer client bought a former drug store space on the ground floor of a co-op building. Despite a major upgrade in the quality of the tenant, the co-op refused to allow my client to rent the space to a national coffee retailer because it wasn't the preferred brand of a couple of the board members. Other retailers who cook or reheat on-premises find similar disfavor in many residential buildings. But frustrations do not end there. National retailers — whose units are commonly found in regional malls or strip centers where the buildings are usually designed for retail use — find themselves trying to fit their model store, the proverbial square peg, into the round hole of early 20th Century urban residential construction where no two buildings are the same, support columns get in the way and valuable basement storage space can be appropriated solely for the residential tenants. Despite these many difficulties, in the current economy, the foot traffic available to retailers on the streets of New York more than justifies the extra hassle and expense of finding the ideal ground-floor retail space in this city and other major cities around the country.

— Matthew Kasindorf, Meister Seelig & Fein LLP, New York City

Residential Collapse

The most prevalent issue facing retail developers in the Chicagoland area is the collapse of the new residential construction market. Over the past few years, new residential developments were springing up faster than you could count. As small exurban towns were converted from quiet farm communities to higher density suburban communities, a need for new retail development followed. Residents of new communities needed places to buy groceries, clothes, and household goods. Residents also demanded all the modern conveniences. Retailers were more than happy to serve the new need. The housing market bubble popped. This has two major effects on retail development. First, the need for new retail construction in exurban locations is reduced. Second, retailers are waiting to see whether consumers slow their spending due to the slowdown in home price appreciation. There are still plenty of reasons to be optimistic about retail development. While housing values are no longer escalating at a record-setting pace, the stock market is doing very well, the labor market is tight and wages are going up. Furthermore, retailers still need to grow. Retailers can find underserved markets in urban locations. Urban sites pose new challenges for developers. We look forward to some exciting projects.

— Brian Kozminski, Levenfeld Pearlstein LLC, Chicago

Leases For New Developments

The continuing trend toward more high-density developments is an important issue facing retailers today. Urban infill projects, which are increasingly mixed-use in nature, present new opportunities for retailers. However, retailers are being forced to modify their traditional perceptions of the retail shopping environment. Mixed-use and infill projects are believed to serve as a draw for customers and end users and result in increased traffic for retailers, but these projects sometimes require that retailers adjust their prototypical buildings by utilizing smaller, more specialized structures and designs or multiple level concepts. This can result in increased construction costs. Also, the proposed neighbors of the retailers and their competing interests must be considered, such as parking uses of and ‘after hours’ traffic generated by bars, nightclubs, restaurants and movie theaters. The operational documents governing the project must be carefully reviewed to understand permissible uses in the development, limits and restrictions on those uses, and the obligations of, and cost sharing among, the various owners and users with respect to common facilities. As with more traditional shopping center projects, location within the development is still a primary issue, but visibility becomes a more serious concern due to the concentration of retailers and other occupants. While pylon sign locations and height, and the size of sign panels, remain critical, the availability, location and size of building signage and directional signs within the development are of increased importance. Further, non-traditional methods of advertising a retailer’s location, including the installation of branding on parking decks, retaining walls and other structures visible to vehicle and pedestrian traffic, should also be considered and government approvals should be pursued. Finally, an increased amount of attention must be paid to parking. The sometimes competing uses within the development make the configuration of the parking facilities a key issue to be considered, including the overall availability of parking, proximity and ease of access to a retailer’s location, and the exclusivity of parking serving a retailer’s location.

— Kwame Benjamin, Seyfarth Shaw LLP, Atlanta

Tax Tip

As a result of mounting criticism, many local governments are becoming more cautious in granting tax increment financing, economic development grants and other financial incentives to private developers. For those developers that are able to obtain such financial benefits, the form and structure of the development entity will be a crucial consideration. For many years, the most popular form utilized for the development entity has been a limited liability company, due in part to the availability of pass through tax treatment and flexibility in structuring ownership and allocations. That popularity, however, may drop as a result of an Internal Revenue Service directive issued January 3, 2007, instructing IRS directors to look for abuses of Section 118 of the Internal Revenue Code.

Under that Code section, a contribution to the capital of a corporation by a non-shareholder (which could include financial incentives paid by a local government to and for the benefit of the corporation) may be excluded from the gross income of that corporation if certain requirements are satisfied. However, that potential exclusion applies only to corporations. As a result, developers may want to consider using a Subchapter S corporation as the development entity where government financial incentives are sought. But while a Subchapter S corporation offers pass through tax treatment, there are ownership and allocation limitations that make it less flexible than a limited liability company.

— V. Edwin Stoll, Stinson Morrison Hecker LLP, Kansas City

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