Tenant-financed shopping centers on the rise.

As the retail sector in New Jersey continues to grow and today's lending environment remains volatile, the financing of retail locations requires the cooperation and imagination of landlords and tenants alike. A landlord can no longer assume that it will sign several leases with Triple-A and non-credit tenants and obtain the bank financing necessary to construct a shopping center. Likewise, a tenant can no longer assume that signing a lease guarantees a new location.

Recently, many tenants have found new locations and met expansion goals by assuming the financing role themselves through creative transactions. Each type of transaction presents risks and rewards for both the landlord and the tenant.

As one example, a tenant may offer financing for the development of its store and secure repayment by a note, mortgage and assignment of its own rentals. The tenant can also retain the right to deduct the sums payable under the note from rents if the landlord default under the note.

Both tenant and landlord should observe certain caveats. When agreeing to accept financing the landlord should ask for assurances that funds will be available. A tenant's letter of credit may assure the landlord of the availability of funds. Likewise, the tenant should be sure that any mortgage it obtains is valid. In particular, if the tenant is taking a mortgage only on its building pad, subdivision issues should be addressed.

In another example, a tenant can agree to execute a master lease of the shopping center if a landlord has difficulty securing financing. In essence, the tenant leases the satellite store premises as well as its own store. The tenant's payments under that master lease are then used to secure construction and permanent financing.

Such an agreement can remain in effect until the landlord is willing to release the tenant from the resulting master lease obligations, at which point the tenant maintains the direct lease for its own store. A participation agreement providing that the tenant receives a large percentage of the shopping center's net profit until released and a significantly smaller percentage after the release would serve as an incentive for the landlord to release the, tenant as soon as is feasible.

While the master lease transaction provides mutual benefits, each party has divergent interests. For example, while the tenant wants a limited master lease term, it is in the landlord's best interests to keep the lease in effect until a lender is willing to loan on the credit of the master lease tenant and other tenants.

In another "win-win" arrangement, a tenant with readily available funds and excellent credit can join forces with a landlord who lacks the funds to construct the shopping center yet is reluctant to sell the property. The tenant agrees to construct the entire shopping center including satellite stores - a major incentive as they can provide substantial profit for the landlord. The parties negotiate a ground lease for the tenant's store, providing the payment of a typical ground rental. The landlord may retain the right to convert the ground lease to a so-called "build-to-suit" lease by paying the tenant for the tenant's building. At that point the rent increases and the landlord obtains a different return on its investment.

Credit enhancement offers another option to the tenant-landlord team. Simply stated, the tenant agrees to provide sufficient security to a lender to help the landlord either obtain the loan or negotiate a more favorable interest rate. The obligation to enhance credit would only be triggered if the tenant is rated at lower than investment grade. Presently, Moody's rates investment grade as Baa3 and Standard & Poors rates investment grade as Triple-B. The tenant may then, for example, post a letter of credit.

When arranging credit enhancement, the landlord should obtain a reasonable amount of rental coverage in the letter of credit. Conversely, the tenant should demand limitations on both the term of and the amount of rent secured by the letter of credit.

Another financing technique is the traditional sale lease back through which the tenant develops the property and then finds an investor who will purchase and lease it back to the tenant at a greater than normal return. The tenant's best bet is to obtain a sale lease back investor and contract executed prior to the commencement of construction, since the contract will serve as a take-out for the tenant's construction 3an. These types of transactions have become more prevalent in the last few years.

Regardless of the transaction option, participating parties should consider the following:

* The tenant should be aware of possible risks associated with landlord bankruptcy. In particular, the concept of set-off/recoupment in bankruptcy might enable the landlord to avoid any rental offset which die tenant is using to recapture the funds owed to it. The lease should provide that it cannot be terminated except for a rent default until the tenant has been paid in full or require the landlord to pay the entire amount owed at the time of termination.

* In negotiating any mortgagee nondisturbance agreements, the tenant should protect its right to offset rental by modifying the typical, non-disturbance language which provides that offsets against a prior landlord would not be effective against the mortgagee.

* The landlord should make sure the letter of credit is as simple as possible, providing that the landlord may draw down funds solely on its statement that the funds are due and owing. The tenant, on the other hand, should seek notice with a dispute mechanism. This, however, is generally difficult to obtain.

Landlords and tenants must be aware of their financing options and can work together to achieve a mutual goal - a profitable shopping center for the landlord and a favorable location for the tenant. In New Jersey's challenging environment these unconventional financing tools may be required to achieve such goals.