Negotiating retail leases for long-term value.

A casual observer may not notice the evolution that has swept the corner of 57th Street and Fifth Avenue in Manhattan during the last five years. Indeed, to many, nothing has changed. The crowds, the traffic and the hustle-bustle that characterize the city still exist. However, any real estate developer knows one crucial change has taken place - the price of real estate has doubled.

Current Market Environment

A spot on Fifth Avenue that once leased for $200 to $225 per square foot now commands $500 to $550. In addition, the type of space being leased and the tenants have changed. Just compare 57th and Fifth to the Gold Coast of Madison Avenue between 57th and 72nd streets. Fifth Avenue has attracted "big box" retailers like Disney, Warner Brothers, and the Gap. Taking advantage of the lower rates of the 1980's, these mega-retailers developed larger (30,000 square feet-plus) multi-level spaces. By leasing premium street-level space and additional floors, some retailers have been able to negotiate blended rates averaging only $140 per square foot.

The "Gold Coast" in comparison is rated as one of the most expensive retail streets in the world. In part, it is because the retail spaces, if available, are smaller and range in size from 1,000 to 3,000 square feet. Because of this exclusivity and visibility, Madison Avenue has attracted many European couture retailers, which view the location as a prime advertising and public relations opportunity, and they are satisfied if their shops break even. It has been such a strong market that often several companies vie for the same space, and winners are content to get any space at all, regardless of cost.

This phenomenon is not just localized to Manhattan. In fact, the real estate market in major urban centers all over the country is as hot as it has ever been. The reason for this, of course, has been the steady growth in the economy, which has contributed to the health, welfare and expansion of retailers. As a result, vacancy rates in these urban centers are at an all-time low.

Tenant Needs

With such a tight market, both tenant and landlord should have a clear agenda when negotiating a lease. For a retailer, rent often comprises 8 to 10 percent of the total sales volume, so required square footage may be calculated based on sales projections. While any reputable broker can supply the prospective tenant with fair market value information, it is important to investigate the current hot shopping area with examples of recent transactions, and study the entire market for future hot-beds of activity. Rent increases should be negotiated with capped-out escalation rates, such as a rate increase that is 3 percent compounded annually, or 12 percent over four years. This is preferable to a rate increase tied to the consumer price index, which is related to inflation.

Lastly, retailers should negotiate for ample free rent to cover the time (not to mention, exorbitant construction costs) needed to fit-out their space to their specifications. Beyond achieving maximum street frontage for a strong identity at the best rent, a retail tenant should be aware of other issues. In addition, retailers should be sure that utility services are metered directly rather than sub-metered off the rest of the building. This allows for an exact measurement of utility consumption. Also, prior to any lease commitment, a tenant should receive an ACP-5 certificate from the landlord to guarantee that all asbestos has been removed from the premises.

Retailers should be aware of any possible conflicts with the landlord's own concept of image for the desired space, and then negotiate for the ability to ensure proper signage and visibility. Similarly, an exclusivity clause to block competition from infringing on the same property also guarantees higher visibility at a given location.

Other clauses for a retail tenant to negotiate include:

* Subordination and non-disturbance clauses that prohibit the new landlord from prematurely removing the tenant from a space in the event the property is sold.

* Lease term and commencement clauses that ensure that a tenant's lease does not officially begin until the landlord has made all the space available as required by the tenant and as outlined in the lease. This clause is necessary when the required space is not immediately available.

* Tax clauses define the pro rata share of taxes for increases over the base year. In the case of a sublease, it is important that the current base year is used to calculate the increase; this will minimize the sublessor's tax bill.

Landlord Needs

The landlord, too, has priorities when it comes to lease negotiations. Firstly, there is tenant selection itself. After appropriate research, a landlord should develop a strategy for the most logical users for the building, and then establish certain criteria for the tenant and lease prices. Since tenants that occupy space above street-level comprise a majority of any building and, therefore, contribute to a greater portion of the building's income, landlords may take steps to leave the retail leasing for last. While this strategy only tightens the market further for retail tenants, it precludes the possibility of a prospective corporate tenant passing on the space because of the type of retail tenants that occupy space below. This strategy may also attract a higher caliber of retail tenant.

Finally, the landlord should take care to maintain building identity by pre-approving logos, signage and other graphics prior to the lease signing.

Credit-worthiness is also a priority issue, since the best credit client (AAA) will be the best guarantee on the lease for the entire term. Having tenants with excellent credit quality can bring financial strength to the property. If a parent corporation isn't available to co-sign the lease and assume the financial responsibility, landlords should ask for a building security deposit equal to six to 12 months of rent, which can be in the form of a letter of credit. Landlords should also negotiate levels of protection in the event of a retail business downturn that requires the tenant to vacate early. An assignment clause, which reassigns the lease obligation over to a new tenant, may also require the sublessor to guarantee the remaining term of the lease. A sublease clause places the responsibility of finding an equal or better replacement tenant on the outgoing tenant. While the outgoing tenant can actually profit from a sublease (if rates allow the sublease to be higher than the original lease), the landlord should have final approval on all incoming tenants. In this instance, the landlord has no obligation to provide rent relief during any space refitting for the sublessor.

Needless to say, for both tenant and landlord, the real estate market is complex and mercurial.

Going forward, it appears as if rents have peaked and will remain at their current levels for the next year or two. Across the country in Boston's Back Bay, New York, Philadelphia, Dallas, North Michigan Avenue in Chicago, and San Francisco, every metro hub is very hot, and with a strong economy, the action should continue. While an advantageous lease involves hard negotiations, in this environment, it is well worth the effort.