More often than not, shopping centers are constantly changing. With the shifts in consumer trends come new retail concepts and the need to adapt to changing demographics and consumers’ needs and wants. This cycle creates opportunities for shopping center and retail property owners looking to take advantage of development, renovations, and adaptive uses occurring within the marketplace. Managing shopping centers is similar to managing office buildings in that it involves the longer lease term, a greater complexity of rent payments, and an increased involvement with tenants.
A shopping center has a unified image, and the property is planned, developed, owned, and managed on the basis of its location, size, and types of shops as they relate to the trade area the shopping center serves—the area from which customers are drawn. Shopping centers are classified into two types: (1) malls and (2) open-air centers—each of which is further classified into many subcategories.
In addition to shopping centers, other retail properties and retail components can be located in mixed-use developments (MXD), where retail components have been added to office buildings and high-rise apartments. Just like office buildings, shopping centers are classified by their size, tenant mix, anchor tenants (main traffic draw), and their roles in the community.
Unlike the property analysis for office buildings, shopping centers do not involve an analysis by class structure. Instead, they are categorized according to the nature and variety of merchandise they offer and the size of their trade areas (Exhibit 13.1). The following lists the other considerations to take into account when analyzing the property:
The definitive measure of retail space is its square footage, which is expressed as gross leasable area (GLA) in reference to both the shopping center as a whole and the individual store interiors. In an enclosed shopping mall, the gross floor area includes the mall’s GLA plus the common areas—courtyards, escalators, sidewalks, parking areas, etc.—that are not used exclusively by individual tenants.
Most shopping centers have at least one anchor tenant, such as a department store or supermarket that has large space requirements. Ancillary tenants occupy the smaller store spaces in a shopping center and, because of their specialization (jewelry or stationery), they attract additional customers to the center. Ancillary tenants rely heavily on the customers generated by the anchor tenant and serve to complement the product or services of the anchor. Shopping centers can be further differentiated by a variety of marketing and management strategies since they influence how each center is perceived.
Malls are more than just places to buy merchandise—they are gathering places for their communities, providing fashion, mass merchandising, entertainment, and sometimes educational activities. A successful mall usually has few vacancies and new tenants each year. New or renovated amenities such as benches, restrooms, children’s play areas, and landscaping are continually evaluated, upgraded, and added. Because of a mall’s size and complexity, real estate managers are constantly reevaluating the tenant mix and physical setup to make the necessary changes to remain competitive.
The very first malls were built in the 1950s, but the greater number were not developed throughout the United States until the late 1970s. Since the first malls, many generations of malls have developed. Two of those generations are the (1) regional mall and (2) the super-regional mall, which are recognized as two different types, but are both categorized within the enclosed setup.
Regional Mall. These large shopping centers have one or more full-line department stores as anchor tenants. The presence of a department store tends to attract such ancillary tenants as men’s and women’s apparel stores, optical shops, electronic equipment stores, and jewelers. If the anchor tenants are high-end department stores, the other tenants should offer medium- to high-end merchandise. Several stores of one type—for example, three to five shoe stores—are often located throughout these centers. The majority of regional malls include small fast-food outlets arranged in a food court, while others might also have cinemas. Regional malls contain 400,000 to 800,000 sq. ft. of GLA. Their trade area has a radius of seven to 10 miles, and they usually serve a population of 150,000 to 300,000.
Super-Regional Mall. These malls are similar to regional malls, but because of their larger size, super-regional malls have more anchors and ancillary tenants offering a wider selection of merchandise. They draw from a larger population base, including four or more full-line department stores and 100 to 150 small shops. Super-regional malls, as well as some regional malls (and large community shopping centers), may include separate buildings on-site called outlots—out parcels or pads. Banks, restaurants, automotive service centers, and movie theaters are also common tenants for these spaces. A super-regional mall has more than 800,000 to 3 million sq. ft. of GLA. Its trade area has a radius of 10 to 20 miles, and it serves a population of 300,000 or more.
Although the first generation of the mall was the open-air, single-level regional mall, it became an even more popular choice for retailers and shoppers in the late 1990s. Some of the open-air malls actually became hybrids that combined the features of regular malls with lifestyle shopping centers and power shopping centers. The typical square footage of an open-air mall ranges from 400,000 to one million sq. ft. of GLA and is anchored by two or three major retailers—usually full-line department stores or other specialty stores. A major advantage of open-air malls is that the maintenance costs for the main common areas are significantly lower than regular enclosed malls—the common areas are essentially a component of the property’s landscaping. Compared to regional malls, landscaping is required along with the additional maintenance for the indoor common area. The following sections provide more detail into the eight subcategories of open-air, single-level malls.
Neighborhood Shopping Center. The most common anchor tenant in a neighborhood shopping center is a supermarket or super drugstore—or a combination of the two. Neighborhood shopping centers usually have 15 to 25 small shops, and the ancillary tenants include dry cleaners, bank branches, beauty salons, and smaller gift shops. The GLA of a typical neighborhood center is between 30,000 and 150,000 sq. ft., serving a population of 5,000 to 40,000. The neighborhood center is initially developed to provide local goods and services for the day-to-day needs of consumers in the immediate neighborhood. These centers are usually configured in a straight line or are L-shaped and do not contain enclosed walkways—although sometimes the canopies may connect the storefronts to maintain a pleasant, unified image.
Community Shopping Center. Anchor tenants for community shopping centers can be supermarkets, large hardware stores, or even discount department stores—sometimes a super drugstore like Walgreens or CVS. The 25 to 40 ancillary tenants frequently include apparel stores, bookstores, card shops, family shoe stores, and fast-food operations—either in-line or built in an L-shape. Community shopping centers range in size from 150,000 to 400,000 sq. ft. of GLA and usually require a population of 100,000 to 150,000 to sustain them. Community shopping centers are similar to neighborhood shopping centers, but are much larger and offer a wider range of apparel and other goods, such as home improvement/furnishings, toys, electronics, and sporting goods.
Convenience (Strip) Shopping Center. The smallest type of shopping center is the convenience shopping center, which usually has a convenience market anchor (such as a 7-Eleven) or other grocery store with a few small shops (two to 10 stores)—a combination gas station and food store is also common. Similar to neighborhood shopping centers, convenience centers are often designed in a straight line, and are most often referred to as strip shopping centers. These centers usually have 5,000 to 30,000 sq. ft. of GLA; the anchor tenant is usually open 24/7. The ideal location is on a corner or anywhere along a high-traffic street. If it is well located and fully leased, a convenience center can succeed in an area with a population of 1,000 to 2,500.
Lifestyle Shopping Center. Even though lifestyle shopping centers were developed in the early 1990s, the beginning of the new millennium marked a significant increase in these centers, which appear as strip shopping centers but are composed entirely of destination tenants—offering specialty shops such as beauty salons, barber shops, or shoe repair services. Lifestyle centers normally represent the upscale end of commercial development and often have a main street design with high-quality outdoor features, ranging from 150,000 to 500,000 sq. ft. of GLA. Although the community role of these centers is similar to regional malls, they provide a broader selection of high-end fashion, jewelry, and gifts—along with fine-dining restaurants and entertainment options.
The trade area may vary greatly from one center to another, depending on the local competition. For the most part, these centers have few small shops because they lack the traditional anchor tenants. These centers typically rely on customers with disposable income, versus neighborhood centers where shoppers usually buy necessities.
Power Shopping Center. A type of super community shopping center, the power shopping center gets its name from each anchor tenant’s ability to attract customers from a wide area. Several large anchor tenants and strong, high-volume, heavy-advertising retailers occupy most of the space. Some of the following are typical anchor tenants in power shopping centers:
Power centers have GLAs ranging from 250,000 to 600,000 sq. ft. and at least four category-specific, off-price anchors—each occupying 20,000 sq. ft. or more of GLA. The trade area may extend up to 30 miles, depending on local competition—they need a minimum population of 150,000. However, power shopping centers have some disadvantages. A minor disadvantage is that there is limited landscaping. A larger problem is that most of the tenants offer merchandise that shoppers specifically seek out, rather than items purchased on impulse as seen in lifestyle shopping centers. This is an issue because power shopping centers lack the ambiance of a community shopping center or a regional mall, where the tenants benefit from surrounding businesses. For this reason, most power shopping centers have grouped together and are often located near regional malls to benefit from the nearby traffic.
Specialty Shopping Center. Also known as theme or festival shopping centers, specialty shopping centers are often characterized by a unified theme and located in a high-traffic area—tourists are the major component of their customer base. Those in downtown areas are often the result of an adaptive use of a historic building; they usually have an architectural theme based on the old design or original use of the building or location. Their uniqueness is truly their main attraction. However, specialty shopping centers do not always have an anchor tenant. Instead, the main attractions include food services; entertainment establishments; and smaller, one-of-a-kind boutiques. Specialty shopping centers usually vary in size from 150,000 to 500,000 sq. ft. of GLA. The specific use defines the trade area, and it may extend beyond the radius usually associated with centers of this size. Specialty shopping centers require an area population in excess of 150,000 to survive. A few examples of specialty shopping centers are the Faneuil Hall Marketplace in Boston and the Ghirardelli Square and Pier 39 in San Francisco.
Outlet Center. Usually located in rural areas, 50 percent of outlet centers consist of factory outlet stores that offer name-brand goods at lower prices by eliminating the intermediary wholesale distributor. These centers can give such large discounts because the merchandise consists of factory overruns, seconds, dated items, overstocks from other stores, and consignment purchases from manufacturers. Outlet centers have the ability to attract customers from a radius of 20 miles to as far as several hundred miles in certain rural areas, but they traditionally require a minimum population of 200,000. The square footage of outlet centers typically ranges from 50,000 to 400,000 sq. ft., but since the late 1990s, the number of outlet center developments has decreased substantially due to the industry relying heavily on the expansion of existing toptier outlet centers. Outlet centers do not have anchor tenants, but they may be enclosed or arranged in an open-air, single level.
The geographic area from which shopping centers draw most of their customers is referred to as the trade area. The size of the trade area depends on the type of shopping center, location of competition, and other factors. The actual trade area analysis includes a demographic profile, which details the social and economic statistics of the population, such as size, density, growth, and decline, and its vital statistics that evaluate age, household size, education, and income. The demographic profile shows the number of people who are likely customers and their purchasing power. The analysis also includes a psychographic profile, which goes beyond the numbers to examine the interests and shopping habits of the people who live in the shopping center’s trade area.
The trade area analysis also indicates the potential for a shopping center to succeed in a particular location. A new shopping center does not create new buying power. It must attract customers away from other shopping centers, so evaluation of the competition in the trade area is important.
Most trade areas are subdivided into three zones: (1) primary, (2) secondary, and (3) tertiary. The primary trade area is the immediate area around the site and accounts for 60 to 75 percent of the shopping center’s sales. The secondary trade area usually extends three to seven miles from the site (for a regional shopping center) and accounts for 10 to 20 percent of sales. The tertiary trade area extends 15 to 50 miles from a major shopping center and accounts for five to 15 percent of sales. Every shopping center, whatever its size, has a trade area and trade zones—the sizes of which vary with the type of center and its location. People will usually travel only one to two miles to shop for groceries, but they will travel three to five miles for apparel and household items and eight to 10 miles to comparison shop for appliances and other major purchases.
Aesthetic Appeal, Location, and Accessibility. The aesthetic appeal of the center plays a strong role in attracting customers, particularly for regional and super-regional centers. People who shop at convenience and neighborhood centers live nearby, and proximity is their primary reason for shopping there. Small centers are not dependent on attracting people from a considerable distance, so aesthetic factors are not as critical. Larger centers must blend function and design to create a safe and attractive place to attract people. Important decorative features are architectural elements, fountains and other gathering places, lighting, seating, colors, landscaping, and flooring.
The value of one location compared to another depends on the customers’ means of transportation within that trade area. Because most people who shop at large suburban centers travel by car, those centers must be easily accessible and should provide ample parking. However, being adjacent to a major thoroughfare does not guarantee accessibility—especially if traffic patterns make entering or exiting the property difficult or dangerous. Therefore, distinctive and appropriate signage to identify the center, clearly marked entrances and exits, and stop signs also contribute to accessibility.
Parking. First and foremost, parking should be convenient. When creating plans for a parking lot or garage, a great deal of preparation and a solid strategy are essential. Parking for downtown shopping centers is usually provided in multistory garages incorporated into or adjacent to the retail building; shoppers sometimes receive a discount on parking if they make a purchase.
Parking for suburban shopping centers is usually built surrounding the shopping center. The amount of land necessary for parking can be estimated in two ways: (1) local zoning ordinances specify a relationship between the size of the parking area and the size of the retail building in sq. ft. (parking area ratio), or (2) the number of parking spaces may be based on the gross leasable area (GLA) of the shopping center (parking index). The Urban Land Institute (ULI) recommends four parking spaces for each 1,000 sq. ft. of GLA for centers that have less than 400,000 sq. ft. of GLA. A center that has 400,000 to 599,999 sq. ft. of GLA should have between four and five spaces per 1,000 sq. ft. of GLA. One that has 600,000 or more sq. ft. of GLA should provide at least five spaces for every 1,000 sq. ft. of GLA.
Parking ratios and indices are merely guidelines—many other factors must be considered in developing a viable parking plan. In fact, the required parking ratios are usually included when creating the lease with major tenants. Different parking angles and varied widths of driving lanes between parking bays affect the numbers of stalls that an area can include. In addition, shopping centers must provide parking for disabled shoppers, so wider stalls and access ramps are needed near building entrances. Traffic flow, circulation patterns, and entrances and exits are other concerns.
The actual management of a shopping center requires intensive work and a tireless staff. In addition to ensuring that the shopping center is up to date, clean, and safe, real estate managers will deal with the tenants and their concerns on a daily basis. Essentially, the tenants’ economic survival depends on customers coming to the shopping center and visiting their stores. Competition among tenants can sometimes be intense and might result in strained relations unless the tenants are treated in a fair and consistent manner.
In addition to the physical and financial management of the property, the real estate manager will become intensely involved with the general marketing of the site and the marketing of each store. In general, real estate managers will be more involved with the ongoing activities of tenants compared to managing office buildings, residential, or industrial properties. Oftentimes, real estate managers will acquaint themselves with the actual retailing and merchandising of each tenant.
It’s important to be aware of the number of shoppers that visit the site every day—depending on the shopping center, thousands of shoppers is not unusual. Such large numbers of people can lead to concerns about crime and vulnerability to other forms of criminal activity. Some anchor tenants employ their own security forces, but most shopping centers of significant size contract with a security agency to guard the premises. In many cases, real estate managers have educated tenants and their employees about ways to prevent crime and reduce criminal activity. Simple measures should be taken, such as securing HVAC systems, locking down roofs, being more cognizant of delivery schedules, and using concrete barricades. Further, information from the RAND Corporation (Research And Development)—a nonprofit organization that helps improve policy and decision making through research and analysis—indicates traditional security approaches like installing bollards at pedestrian entrances, searching bags, and/or encouraging suspicious package reporting. Other features that increase safety include good lighting, limited escape routes, and security support from police in the surrounding community.
When choosing tenants for retail space, there are many factors that must first be weighed. Since the main goal is to attract customers to the shopping center, the ideal tenant will offer appealing merchandise in order to create synergy with the other tenants. In addition, the ideal tenant’s merchandise should fill a need in the market that competing shopping centers do not meet. Requirements for store space and support services, as well as products or services that the retailer offers, must be considered—particularly as they affect where the retailer can or will be located in the center. All of these factors are in keeping with the demographic and psychographic profiles of the trade area. Real estate managers must scrutinize the retailer’s reputation and financial status to determine the prospect’s quality, responsibility, and ability to pay the rent—which is also relevant in keeping up to date on the ever-changing trends in the retail business and current economic conditions as part of the tenant-selection process. The following lists the main elements involved and the type of questions to ask when evaluating the retail tenant selection:
Retailer’s Reputation. One of the most important factors to consider when choosing a retail tenant is the company’s reputation. Because reputation results from public perception, learning how a retailer treats their customers is important. This is easy to ascertain for a store that is part of a franchise or chain—or from a company that is planning to move from one site to another. A visit to the prospect’s present store (or multiple stores if the company is a chain) will always reveal much about the business’s customer service practices. Observation of the treatment of other customers in the store and asking those customers about their perceptions of the store can also validate how the prospective tenant conducts business.
Another consideration is merchandise presentation. Obviously, a slim inventory of dusty items reveals a poor sales record, but fresh merchandise presented attractively implies the opposite. Salespeople who know their stock and present themselves well are assets to the retailer and will be the same for the shopping center in general. The level of advertising also indicates the retailer’s reputation and the efforts they make to maintain it.
Most shopping centers can gain a competitive edge if they include a unique business that sets them apart from the other well-known businesses; they can quickly gain a healthy customer base strictly due to their uniqueness. Although the risks involved with a new business are greater, the rewards can often outweigh the risks. A new or developing enterprise may not have an existing identifiable reputation, but finding out how it plans to operate is not an impossible task; in fact, it’s very simple. If a new company provides a clear plan of action for their new business, and the plan includes an investment in inventory and a pricing structure, they will most likely be a better prospect than one whose plans are vague. Having the knowledge base of its probable clientele and an understanding of its competition are also important, along with prior retailing and business experience.
Financial Stability. There was a time when the decision to accept a prospective tenant could be based primarily on reputation. For instance, the name Bloomingdale’s was once sufficient to solidify a deal. However, in an age of buyouts and takeovers, it’s important to carefully investigate the financial health of all prospects. While an established store in a chain may be doing exceedingly well, that one store may not be an accurate reflection of the success of its parent company. If the related enterprises are failing, the parent company may sell the individual store to raise funds. While such an occurrence may not affect a prospective tenant’s business, any change in the ownership of a complex retailing operation increases the risks to the individual store and may create a vacancy in the shopping center.
The greatest cause of business failures is undercapitalization, which is one reason for carefully investigating new or proposed retail businesses. The costs of operating a retail business include not only rent, utilities, and maintenance of the store area, but also inventory, payroll, store design, fixtures, and advertising. For an established business, moving costs and the loss of business resulting from the move must be considered as well. Prospects should have sufficient reserve funds to be able to weather an initial lean period after they relocate. In order to gain a strong sense of the company’s financial stability, request a copy of their financial statement that contains information regarding their liquid assets and monthly obligations. Obtain a Dun and Bradstreet credit report, especially when dealing with a new business. Some novice retailers expect immediate success from the day they open; realistically, it can take from one to three years to gain the level of success expected.
Tenant Requirements. The retail tenant’s primary concerns are the availability of adequate space for its business, visibility of its location, and the volume of customer traffic that the shopping center generates. However, some tenants have special requirements. Food service operations have unique garbage disposal and pest control problems that must be taken into consideration.
Furniture and appliance stores require specialized loading docks. Supermarkets need large areas for short-term parking and enough space for storage of shopping carts. Most banks want to provide drive-up services for their depositors. How these unique tenant requirements can be met are topics discussed during lease negotiations. It’s important to be familiar with these special accommodations to avoid making unrealistic promises during prospecting. Be aware of the specific attributes of each space, such as whether the space has the potential for certain upgrades, the size and capacity of HVAC units, and even the water pressure and grease traps for restaurant tenants.
In situations when tenants require improvements to the owner’s property, it’s extremely important to obtain space plans and even as-built drawings, which indicate the presence and location of certain utilities for future use. If that tenant is no longer at the center, the information collected from the as-built drawings will be useful or even critical for re-leasing that space. From a real estate manager’s perspective, it can be frustrating when the necessary information is not readily available and it costs money to investigate the present setup.
Special services arranged for a specific tenant—beyond those normally provided—can lead to a concern for other tenants, even if the tenant pays for the special services they need. The best way to counter these concerns is by explaining positive outcomes. For example, if a movie theater in a shopping center has a last showing that begins at closing time for the other stores, the common areas leading to the theater could remain open so its patrons can exit after the show. Even if the entrances to the stores are closed and locked, tenants whose stores are adjacent to the theater may be fearful that late-hour theater patrons might damage their stores. A good way to address this concern could be to provide a security guard during late hours or until all of the patrons leave. Another option could be to limit access to a single entrance during the late hours. It might help to point out to other tenants that the theater’s last showing could spark a swell in business before the stores close.
Tenant Mix and Placement. The combination of retailers and service vendors that lease space in a shopping center constitutes its tenant mix. A shopping center anchored by an upscale department store will attract shoppers that seek—and can afford—its lines of merchandise, whereas a shopping center anchored by a discount department store will attract people seeking bargains. The best tenant mix for each shopping center will always follow the anchor’s lead. Therefore, the merchandise of the ancillary tenants should never clash with what the anchor tenants offer. To put things into perspective, a lingerie shop will probably not succeed in a shopping center anchored by a supermarket or a hardware store. Instead, a dry cleaner will most likely flourish in that type of center because it, too, serves immediate needs and conveniences.
Another consideration that relates tenant mix to merchandise is destination shopping versus impulse shopping. People usually have a specific purpose in mind when they visit an optical shop or a pharmacy in a shopping center—their search for a particular item or service has led them there. If they buy an ice cream cone in the process of going to or coming from their destination store, that is considered an impulse purchase. A good tenant mix serves both destination and impulse shoppers and increases sales of the center as a whole.
Shopping centers that have more than one anchor tenant must ensure that the merchandise each offers is a good match and is complementary to the offerings of the ancillary tenants. An effective way to create a workable tenant mix is to view the specialty shops and department stores in the shopping center as parts of one big store.
In some situations, retailers try to persuade the owner to provide them with an exclusive use. That means the owner cannot lease space to another tenant who provides the same merchandise or use, and if they do, penalties for the violation are usually severe. Owners, on the other hand, are reluctant to provide exclusive uses because they may preclude leasing space to another business that has the same type of use—even though such use constitutes a relatively small percentage of (or is incidental to) that tenant’s overall product or service.
The placement of tenants in the shopping center is also vital. For example, shoe stores are a natural complement to clothing stores. An ice cream parlor often does well next to a sandwich shop or movie theater. When developers build new shopping centers, they pay careful attention to the placement of tenants in order to maximize their potential to attract customers through the shopping center as a whole.
Rents for retail space are based on the GLA of the individual spaces. Like office spaces, stores are usually rented as open shell space (or vanilla shell space). Unlike the practice in office buildings, the tenant, not the owner, is usually responsible for completing the interior beyond the shell stage—subject to the owner’s preapproval of plans as well as other parameters. Comparatively, for office tenants, the interior work is usually a main item of negotiation with the owner prior to solidifying the lease terms.
Base Rent. Shopping center leases state rent for the space as base rent, or minimum rent, which is usually calculated on a per-square-foot, per-year basis and is commonly stated in the lease as equal monthly incremental amounts. Base rent assures the property owner a minimum income, regardless of the merchant’s sales success. In addition, retailers usually pay pass-through charges that cover the cost of operating the center, including taxes and insurance, plus common area maintenance (CAM) charges. Shopping center leases are typically triple-net (NNN), explained later in this chapter.
Percentage Rent. In some leases, retailers may also be required to pay a portion of their sales revenue as percentage rent. When percentage rent is charged, the owner actually shares in the success of the retailer’s store space on the property. Percentage rent is generally based on gross annual sales, but most tenants pay percentage rent monthly or quarterly—except anchor tenants, who pay it annually. Because this type of rent is based on the retailer’s sales volume, the amount can fluctuate significantly from month to month, so percentage rent is usually paid in addition to base rent. Some retailers try to negotiate to pay percentage rent only, but owners rarely make this exception—and usually only for large establishments with high sales levels.
Since there is no universally applied percentage rent rate, it is determined by the type of business and the locale. Supermarkets have a large sales volume and low-profit margins, yet one percent of their gross sales will yield a large amount of percentage rent. On the other hand, gift shops have comparatively small sales volumes but high-profit margins, and 10 percent of their gross sales may be appropriate.
The actual percentage is always negotiated and is usually collected on sales in excess of the amount of base rent and referred to as overage rent. In other words, the base rent for a store could be $120,000 a year, payable in equal monthly amounts of $10,000; if the percentage rent is five percent of gross sales, the tenant’s gross sales must exceed $200,000 a month before percentage rent applies ($10,000 ÷ 0.05 = $200,000). The tenant pays the greater of the percentage of gross sales or the base rent. It is best to calculate the percentage rent on a monthly basis, as opposed to annually, due to the seasonality of shopping.
According to the previous example, the $200,000 a month in sales is the natural breakpoint. If the store produces $250,000 in gross sales in a month, its rent will be the $10,000 base rent plus five percent of sales above the natural breakpoint—in this case, five percent of $50,000, or $2,500, meaning the total rent for that month will be $12,500. However, the prospective tenant or the owner may negotiate an artificial breakpoint to use as the threshold for paying percentage rent. The artificial breakpoint may be higher or lower than the natural breakpoint—a downward adjustment of the breakpoint would increase the owner’s income. An advantage of an artificial breakpoint is that it can be used to accelerate payback to the owner of funds advanced for tenant improvements, lease concessions, or even in exchange for a reduced rental rate in the early stages of a new tenant’s lease. However, as the base rent increases over the term of the lease, the natural breakpoint will rise accordingly. Either way, knowing the exact meaning of the lease clause and how the percentage rent is calculated is extremely important to properly collect what the tenant owes. Finally, leases typically allow the owner to audit a tenant’s gross sales—annually or at some other time—to confirm their accuracy and truthfulness in their reporting.
Pass-Through Charges and Net Leases. When dealing with a gross lease for retail space, all operating expenses are the responsibility of the property owner, who must recover them fully in the rent. Most retail tenants have net leases, meaning that some expenses of operating the property are passed through to the tenant. The type of net lease the owner offers determines what the tenant pays, and pass-through charges are prorated based on the GLA of the individual store as a percentage of the GLA of the shopping center as a whole. The types of net leases follow:
There are numerous other—mostly regional or local—definitions of the expenses that are passed through to the tenant under a particular type of net lease, so delineation of the pass-through charges is essential when describing a type of net lease.
Major retail tenants might also negotiate with owners to set a cap (an expense stop) on certain expenses—most often on common area expenses. This ceiling assures that the retailer will pay only a certain dollar amount per year for the particular pass-through expense or expenses to which the cap applies. Unlike an expense stop in an office lease, which sets a ceiling on how much the property owner pays, a cap in a retail lease defines a limit on how much the tenant pays.
When collecting NNN (triple-net) expenses from tenants, real estate managers dealing with retail properties must consider the following critical factors:
Escalations. Because retail leases have long terms, escalations have to be written into the lease in order for them to take effect automatically. For an anchor tenant, a 20- or 30-year lease is common, and for ancillary tenants, leases usually have three- to 10-year terms. Similar to office space leases, provisions for rent increases may be negotiated as a periodic percentage increase, or they may be based on the consumer price index (CPI), along with base-year and expense-stop provisions.
An escalation provision typically applies only to the base rent, but escalation provisions sometimes apply to expense stops or base-year expenses. The lease for an anchor tenant whose sales generally surpass the agreed-upon breakpoint may mandate an escalation in base rent only once every five years. For an ancillary tenant, the lease usually calls for an annual increase; the specifics depend on market conditions at the time of the lease negotiation.
Retail leases can include the simple option to renew or vacate the premises. The option will usually state that notice has to be given to the owner at some point, but no less than a certain number of days before the lease expires, and it usually specifies the length and the rental rate of the extension. For leases that have long initial lease periods, it’s important to keep in mind that the market at the end of the lease is unknown. If the initial lease term is 10 years, there is no way of knowing what a market rent will be at year 11. Therefore, the option period could state that the rent will be at market rates, but no less than three percent more than the rent paid during the last period of the lease. The option period could also include a cap of five percent so the tenant is assured that market rent will not dramatically increase during their option period.
The standard lease for a shopping center includes a number of clauses that are specific to this type of property and addresses concerns and contingencies that can arise over the number of years covered by the lease. Additionally, leases for a freestanding store or for space in a small convenience shopping center might not have such specific provisions. Along with the specification of rental rates and how payments are to be made, the following lists the other specific clauses and considerations included in the standard retail lease.
Use. A shopping center is carefully designed and leased to appeal to a specific market in a specific location. If a tenant were to change its merchandise or its image—such as from specialty lines to general merchandise or from upscale to discount—that change could alter the tenant mix of the center. Therefore, a use clause prevents tenants from using the premises in a different way than was originally intended.
Exclusive Use. To minimize competition among tenants, prospects might seek a clause covering exclusive use to prohibit other tenants in the shopping center from selling a similar product. However, some competition within the center is generally beneficial, and an exclusive use clause can be counterproductive. It’s important to be aware of certain exclusive-use clauses that might violate antitrust laws enforced by the Federal Trade Commission, which make restraint of trade illegal. Regardless, temporary limits on certain product lines or on competing store sizes might help a retailer meet their rent payment or give a new business a head start. Because it is desirable to have several types of tenants in each retail category in a regional or larger center, and because the merchandise carried by each retailer in a category tends to complement the others’ merchandise rather than compete with it, owners rarely grant exclusive use.
In open-air shopping centers, it is common for parcels of land to be owned by different entities or to be built by the developer with that in mind. In such cases, there will usually be documents—or covenants, conditions, and restrictions (CC&Rs)—that affect the management and maintenance of the center as a whole. These documents dictate everything from pro rata shares of CAM by parcel size, building, and construction limitations, to the parcel owner, or maintenance director, for all common area services that benefit all parcel owners as well as other provisions on the conduct and requirements of each. The following lists the additional uses that CC&Rs can restrict at the shopping center:
Simply being aware that these documents exist is the most important step, but understanding how to administer them is another. CC&Rs can be quite cumbersome and sometimes require an attorney to interpret, but on the real estate manager’s end of the spectrum, it’s important to be diligent in ensuring that these restrictions adhere to all documents that govern the shopping center.
Radius. The radius clause prohibits a tenant from opening a similar store or from developing a similar chain of stores within a certain distance from the shopping center—typically three to five miles. Its intent is to prevent the tenant from directing customers to a nearby store in order to reduce percentage rent. The radius provision also requires the tenant to add sales from similar stores it operates—within a certain distance of the shopping center—to the sales of its store in the shopping center when calculating percentage rent.
Store Hours. Among tenants of the same shopping center, variation in store hours should be minimal. This clause authorizes the management of the property to set store hours for the center as a whole. Some anchor tenants such as supermarkets or large drugstores may remain open 24 hours a day. These stores are usually located in open shopping centers where the ancillary tenants maintain their own hours. A store-hours clause may also include provisions for seasonal adjustments and special hours for holiday shopping periods.
Common Area Maintenance. The common area maintenance (CAM) clause specifies exactly what constitutes the common area of the shopping center and what expenses the tenant will pay. In addition, it spells out the property owner’s responsibility to maintain the common areas and repair any damage to them. The CAM clause also gives the owner the right to expand, reduce, or otherwise alter the common area. The common area in an enclosed mall includes the mall corridors, parking lots, escalators, landscaped areas, and other parts of the property that the tenants use in common. In addition to maintenance, CAM charges include expenses for security personnel and alarm systems that protect the shopping center, its tenants, and their customers. These charges can also include some replacement items that some may see as capital improvements (e.g., parking lot or roof replacement) and fees for management of the common area as a direct pass-through of that expense, as a percentage (administrative fee) of the base rent, or as a percentage share of the CAM charges in lieu of management expense.
As previously mentioned, CAM fees are normally prorated based on the percentage of GLA of the center the individual store occupies. On that basis, a store with 3,000 sq. ft. of GLA in a 300,000 sq. ft. shopping center would pay one percent of the center’s CAM costs; a separate clause usually specifically states the tenant’s pro rata share of CAM and other expenses. CAM clauses also include provisions on when a reconciliation should be completed and delivered to each tenant, and they provide an opportunity for the tenant to audit the owner’s books at the tenant’s expense—if they should choose. Some leases further dictate that if the landlord does not provide a reconciliation within a certain number of days after the applicable accounting period, the tenant will not have to pay any additional operating expenses. Therefore, it’s important to be aware of and adhere to these clauses to ensure that the ownership receives the highest revenue possible and allowable by the lease. Most owners would not be very forgiving if certain deadlines were missed and/or precluded collection of monies due.
Advertising, Signs, and Graphics. The owner retains the right to restrict the size, location, lettering, manner of installation, and language of all signs in the shopping center. Large malls establish uniform graphic images and seek to maintain consistency in the caliber of signage. This is especially important for signs that are permanently mounted on the exterior of the building or are placed in the center’s interior. Tenants may be required to spend a certain percentage of their gross income on advertising to promote their stores—and the shopping center. Most large shopping centers have promotional campaigns for the center as a whole, and to support those campaigns, they might require tenants to participate in a marketing fund or merchants’ association—usually through a specific lease clause. Options similar to those described for office leases—to renew, expand, or cancel—may also be part of retail lease negotiations.
Concessions. Comparatively, leasing office space is similar to shopping centers—the owner usually offers concessions to secure a new lease or to retain an established tenancy. Because concessions are a special part of the lease negotiation process, they are usually stipulated in the applicable clauses rather than included as a single specific clause. If there is no applicable clause to amend, they may be listed in separate documents incorporated into the lease by reference (or addenda). Ideally, any concession granted will not lower the quoted rent. It’s important to remember that any reduction in rent also reduces the value of the property.
One type of concession, a tenant improvement (TI), is money the owner provides for modification of the leased space before the tenant moves in. This may be a dollar amount per square foot, and the tenant may have to repay this as additional rent prorated throughout the lease term. Store space is typically leased as a “vanilla shell,” consisting of a storefront, demising walls, and HVAC. The TI provisions usually state that the funds can only be used to improve the leased premises, and not for the tenant’s signs, fixtures, or personal property. Depending on the area and market conditions, the demised premises may include (or specifically exclude) other items such as utility lines to the interior of the space, a dropped ceiling, and a restroom. Tenants usually finish the interiors of their store spaces and install appropriate display fixtures themselves.
Unlike office buildings, retail TIs rarely have direct impact on structural components or mechanical systems of the shopping center building. However, the tenant will be required to submit a construction or remodeling plan for the owner’s approval before work begins. Other concessions include payment of a new tenant’s moving expenses, a higher artificial breakpoint for percentage rent, or a period of free rent. Free rent is a good alternative to a TI since it eliminates the out-of-pocket need to move a new tenant into the space—especially if there is no TI reserve in-house or with the lender.
Other Clauses. Other common clauses in retail leases are requirements for continuous occupancy, staying in business for the full term of the lease, and continuous operation, keeping the business operating smoothly and consistently. Shopping center owners usually include sales reporting and sales auditing clauses to ensure that tenants report and pay percentage rent accurately and on time. Provisions regarding alterations to the store space, insurance coverage for the retailer’s business, ADA compliance, and related indemnification are also common. For some businesses, a separate clause might also address the tenant’s specific rights and limitations on parking.
Since defaults can be monetary or non-monetary, it’s important that the default clause in a retail lease clearly explain what constitutes a default. Failure to pay rent is obviously a monetary default, and failing to open the store for four days is an example of a nonmonetary default. Both types should have remedies stated in the lease, along with the rights of the owner, should the tenant fail to cure the default within a stated period of time. If the default remains, the lease should outline the owner’s rights for an eviction, obtaining possession, collection of debt, and other expenses for which the tenant is responsible (e.g., re-leasing fees or leasing commissions). The default clause should also include what constitutes a “notice” to the tenant of their default. Failure to properly notify the tenant, as stated in the lease, can severely interfere with the owner’s ability to evict the tenant—therefore, it’s important to be familiar with the default clauses.
Addenda. The following lists addenda that are usually included in retail leases:
Other professionally managed commercial properties include medical buildings, industrial sites, and warehouses. Each poses distinct challenges to the real estate manager because of the unique requirements of its tenants.
Industrial properties include large single-user buildings, incubator space for small business start-ups, multitenant business parks, self-storage facilities, and business continuity services (records maintenance). They often have a mix of uses that combines office, retail, light manufacturing, distribution, and storage at a single site.
Certain technologies have affected space needs in some ways as they have with office and retail uses. For the most part, manufacturers can maintain minimum stocks of materials, parts, and packaging since updated inventory systems—coupled with overnight shipping services—allow just-in-time delivery that keeps pace with their production levels.
Most new industrial rental space consists of single-story structures that can be configured to accommodate a single tenant or multiple tenants (flex space). Often built in a business park setting, such spaces have no lobbies or fancy fixtures, and they have no load factors or add-on charges—rents are lower and parking is ample. Some tenants such as e-commerce and telecommunications firms that set up data centers, have companies that need large blocks of inexpensive space.
Other firms need their offices in the same building as their manufacturing or warehouse operations. Research facilities and factories are often built to tenants’ specifications, which are detailed in a build-to-suit lease. Truck access and rail lines may be among their requirements, along with reliable sources of electricity and other utilities such as gas and water.
Existing commercial facilities that are open to the public as well as renovations and new construction are required to meet accessibility requirements of the Americans with Disabilities Act (ADA).
Businesses and individuals may choose to store and secure their goods in self-storage facilities containing rows of attached garages. Some facilities include living quarters for an on-site manager; however, other storage facilities that are not climate controlled pose a threat not only as living quarters, but also for the tenant’s items in storage. Self-storage units have various requirements and lease clauses that cover issues of abandoned property, lockouts, nonpayment of rent, and even prohibited items that cannot be stored in the units. The lease should clarify how to deal with the disposal of goods left by a tenant, along with the protocol used in locking the storage units.
Warehouses sometimes exist in cities, but most are in suburban areas. Warehouses are leased for storage of inventory, records, or excess raw materials. Real estate management services include shipping and receiving, with charges based on gross weight of materials handled or the number of packages shipped and received. The storage environment (e.g., control of temperature and humidity) is critical for many materials, and federal and other laws mandate labeling to identify specific hazards of materials transported in interstate commerce. Such requirements will affect typical management procedures.
Industrial leases include many clauses similar to those in office and retail leases. To maintain the owner’s control over the property, the use clause should be specific about the tenant’s type of business. The tenant often has direct responsibility for maintenance—especially if a single tenant is in a building.
Storage is another important consideration. Industrial tenants often use hazardous materials that require special storage facilities and special waste disposal equipment and procedures. To reduce risk and protect the value of the property, the leases of such tenants should require an annual environmental inspection of their leased spaces—at the tenant’s expense. The insurance clause will usually be specific as to type and amount of coverage the tenant must maintain.
Tenants in a research and development park or similar campus-style property might establish a tenants’ association to oversee road maintenance and groundskeeping, budgeting, and collection of fees for common area operations and maintenance, along with any other routine management activities. In a master-planned development, tenants in a single-use building are offered some form of net lease, but in multitenant properties, the tenant is responsible for maintaining the interior of the leased space, including the HVAC.
Generally, the owner is responsible for the roof, structural elements, and common areas and bills the tenants—both large and small—for their pro rata shares of CAM charges, real estate taxes, and property insurance.
It’s common for tenants in a single-tenant building to be responsible for their own interior and exterior maintenance—including that of the common area parking lots and landscaping. These types of leases usually require the tenant to insure not only their interior improvements and personal property, but also the building structure itself and to provide liability coverage for the common areas as well.
Businesses are not inclined to frequently relocate. Even if a business moves, the initial intention was usually to remain at its location for a long time. Because of the infrequency of moves, and because a multiple-year lease translates into many thousands or millions of dollars in rent over its term, commercial tenants are commonly recruited directly—although conventional advertising and promotion cannot be overlooked.
To ensure optimum occupancy, a property representative must make direct calls on potential tenants. This is particularly important for proposed developments because lending institutions usually require a certain percentage of a planned property to be preleased—leased before construction of the building begins or while the construction is taking place—before construction loans will be approved.
A real estate management firm sometimes employs a leasing agent—either temporarily or permanently—whose sole purpose is to seek out potential tenants. The leasing agent accomplishes this through a process known as cold calling or prospecting, which involves direct calls on the principals of businesses—individuals or corporations—to discuss the possibility of moving their operations to the subject property. In order to achieve success with such a program, the leasing agent is expected to conduct research on various businesses to ensure that their efforts are directed toward the right prospects. This is especially important for retail properties that seek specific types of tenants to provide a certain product or service niche in the tenant mix of a large shopping center. Information regarding businesses that may be considering a move can come from many sources such as the chamber of commerce, company annual reports, and referrals from business acquaintances. The most promising prospects are businesses that anticipate expansion or those whose leases are nearing expiration.
Various online resources list commercial properties for lease by brokerage firms nationwide and even internationally. Such resources help bring prospective tenants to inquire about the site. Other regional websites post vacancies throughout local areas as well. Posting vacancies through these resources is relatively inexpensive; it’s simply a matter of collecting the specific data from the property. The following list of information should be provided when posting available spaces:
Along with these online resources, it’s important to develop a website specifically for the shopping center. Countless resources are available for developing a unique website. As mentioned in Chapter 8, website development can easily be outsourced. When doing so, it’s important to remember the seven Cs of website design:
Similar to residential marketing, make use of a prospect report that records information about prospective tenants for office space, their space needs, current space and lease expiration data, how they were contacted, whether they were qualified for tenancy, and their status as prospects—if they received a brochure or were given a tour of the property. These prospect reports are a cumulative record of the prospects brought to a building by a particular leasing agent. For retail space, information about the type of business, expected lease terms, and TI work is similarly documented along with the source of the contact and the status of individual prospects—if the lease is under negotiation, it’s a dead deal. Such records determine the leasing agent’s commission—especially when outside brokers are used—as well as the overall progress in leasing available space.
Certain states require licensing for real estate managers who negotiate the terms of a lease and for those that might share in any leasing commissions for new leases or renewal leases. Always stay updated with state laws when performing any leasing activity.
Unlike residential property, which is usually marketed on personal appeal, the marketing emphasis for commercial space is usually on the dollar value the prospect will receive for the rent paid. In this case, value directly affects the prospect’s profit margin. The four principal ways to market space based on value are to emphasize (1) price advantage, (2) improved efficiency, (3) increased prestige, and (4) economy.
Negotiations with commercial prospects are much more common in comparison to residential properties. Through legal counsel, the owner and the tenant may specifically negotiate many lease clauses. Negotiation of leases for commercial space is complex because the financial risks are greater on both sides—for the tenant and the owner. Those risks require much more diligence in order to help protect the owner’s rights and interests.
When an investor makes a “small investment” in commercial property, the purchase price of the store or office building may be several million dollars. “Large investments” do not necessarily have upper limits, but property valued between $100 million and $1 billion is available in most major cities. Whether the investment is small or large by industry standards, the expectation is for the property over its lifetime to generate income in excess of its purchase price. In fact, the purchaser’s ability to retain ownership usually depends on the periodic income the property generates.
If the lifespan of the property ended abruptly because of damage, even a so-called small investment could bankrupt the investor. Comprehensive insurance coverage provides protection from financial ruin due to the loss of use of the property. However, no single policy can completely protect the investor; even if such a policy were available, the premium cost would be prohibitive.
As with income-producing residential property (Chapter 11), the owner insures commercial property against loss of income, structural damage, and liability. The policy identifies the owner as the named insured party and lists the manager as an additional named insured. However, a major difference for commercial property is that insurance premiums are an operating expense that the owner may prorate and pass through to the tenants.
While almost anything can be insured, the owner must balance the cost of the premium against the risk of leaving all or part of the value uninsured. To illustrate this concept, think of how fragile certain windows can be and the expense involved in replacing them—most basic insurance policies exclude coverage of plate-glass windows or limit the amount paid per year for window breakage. If every policy included this coverage and placed no upper limit on the amount the insured could claim, owners of skyscrapers could easily take advantage of the cost of repair and would benefit more from this coverage compared to owners of buildings with few windows that rarely need replacing. The insurer would have to charge high premiums in order to pay the claims, and the cost to insure a small building would be prohibitive. To avoid such an inequity, insurers exclude plate-glass coverage from basic policies altogether. However, a separate plate-glass policy can be purchased, or an endorsement can be added to the primary policy to pay for plate-glass damage. The owner of a building that has thousands of windows would probably investigate the value of paying for the coverage. For a smaller building, the owner might leave the windows uninsured and pay for the occasional replacement as an operating expense.
On the other hand, retail leases in open-air centers generally require the tenant to be responsible for their own storefronts, which includes front doors, hardware, and plate glass. The nature of the tenants’ business determines the amount of use that the store’s front doors incur on a daily basis. A fast-food restaurant may have dozens of patrons every hour as opposed to an insurance office that may have just a few customers per day. Obviously, the fast-food restaurant will have a higher degree of repair and maintenance that should not be shared among the rest of the tenants. This is generally another reason that owner insurance policies do not insure plate glass or tenants’ store fronts.
After September 11, 2001, owners and managers of commercial buildings in New York City, in particular, discovered that their insurance coverage did not include acts of terrorism, and their claims were denied. In response, Congress passed the Terrorism Risk Insurance Act (TRIA), which requires insurers to make that coverage available. Insurers sell terrorism insurance coverage separately from other coverages, and the premiums are expensive. However, owners of commercial properties, especially properties located in urban centers, should at least consider purchasing it. Lenders are likely to require such coverage if the building is mortgaged. The owner’s insurance agent can advise on how much coverage would be appropriate.
Because insurance for the property as a whole does not cover the contents of tenants’ individually leased spaces, most commercial leases require tenants to carry enough insurance to cover their inventory and whatever furnishings and equipment they have in their leased space. The commercial tenant’s insurance coverage should be sufficient, both to preserve the business and to meet the obligations of the lease in case of disaster. Tenants may need other types of insurance as well—such as crime coverage. Commercial tenants are usually required to carry their own liability insurance, and the lease might require them to list the owner of the property and real estate manager as additional named insured parties. Retail leases specifically require tenants to have insurance against plate-glass damage and business interruptions, and state law requires that employers carry workers’ compensation insurance to cover on-the-job illness and employee injury.
The relationship of an insurance company with its customers technically gives it the right, or subrogation, to sue an entity in the name of the insured party in order to recover a settlement it has paid if evidence shows that the other entity may be liable. Suppose, for example, that an electrical fire damages a building, and the property owner’s insurance pays the claim. If later evidence proves that a tenant’s employee left a space heater on overnight and it ignited the carpeting, the owner’s insurance company might file a suit against the tenant or its insurance company to recover the amount of the claim. The existence of this right can make obtaining insurance difficult for both the tenant and the owner, so both parties are usually obligated to sign a waiver of subrogation to prohibit the exercise of this right.
Real estate managers are generally exempt in their management agreements from having to obtain or acquire insurance coverage for their clients. It’s important to always be knowledgeable in all insurance-related matters in order to properly advise clients. The insurance agent for the owner can be of great help in reviewing and recommending lease language or for routinely shopping for better coverage at reduced premiums. Groups of properties under a single ownership can save thousands of dollars by insuring those properties under one blanket policy, as opposed to each property having an individual policy.
Most shopping centers are classified by size and by the types of tenants they contain, but the types of shopping centers are constantly evolving. Each shopping center is planned as a single project, usually has a unified image, and provides on-site parking—especially in suburban centers. As with office buildings, shopping center rent is based on the square footage of the leased space, and some operating expenses of the shopping center are passed through to the tenants as a separate charge in addition to base rent; retailers may also pay a percentage of their gross sales as additional rent.
Other types of commercial property include industrial properties, storage facilities, and self-storage facilities. Along with financial and administrative issues, managers of these types of properties must often deal with issues related to storage and disposal of hazardous materials as well as tenants’ special needs. In addition to taking care of special items, marketing for shopping centers is more aggressive compared to marketing for residential properties. With the real estate manager’s assistance, a leasing agent will attempt to target specific businesses as prospects and will even call them directly to sell the benefits of the property.
As with residential space, the diversity of commercial property types does not permit development of a definitive insurance policy to cover all the damage that may occur at an individual property. When planning a unique combination of policies and endorsements, the property owner and the real estate manager must balance the premiums against the cost of self-insuring in order to design an insurance program that is economical and effective.
In today’s market, simply defining an anchor tenant is tricky. In the past, anchors were typically supermarkets and department stores, but today’s anchors can be anything from full-service department stores, mass merchandising retailers and grocery stores, to movie theaters, restaurants, bookstores, electronic stores, upscale retailers, and gourmet food and wine markets. Anchor tenants will not only drive traffic and sales to the center, but they can also influence the remaining in-line tenant mix of the center. Keeping up-to-date with certain trends is important to secure a solid and functional shopping center, which increases revenue and provides a pleasant addition to the areas in which they reside.