Retail Perspectives - Practical Tips

Sleeping Well at Night: Important Considerations when Drafting Retail Leases in a Multi-Family Development

With the need for more housing in California, new multi-family projects are being constructed at a record pace.  These new projects create very exciting opportunities for retailers because they provide a “built-in” customer base.  The retail tenants are also extremely important to multi-family developers because they provide necessary and important amenities for the residents.  The most favored classes of retailers for these projects are supermarkets, health clubs and other exercise-related tenants, restaurants, salons (massage, nail, etc.) and coffee shops.

Retail leases for these types of tenants are very similar to those commonly found in shopping centers, but there are some very significant differences that multi-family developers should be aware of when negotiating these leases.  These key differences are discussed below.

1.         Parking

As opposed to most shopping centers, the parking in a multi-family project is usually within a structure and gated.  In most cases it is subterranean.  The residential parking spaces are typically segregated from the retail parking spaces.  Multi-family developers should segregate employee parking spaces for retail tenants from the spaces that are set aside as non-exclusive parking spaces for retail customers.  In some cases, certain designated parking spaces in the retail parking areas may be expressly designated for the benefit of a particular retail tenant.  When such designated spaces are provided, a multi-family developer should make sure to include in any retail lease that it will not be responsible for policing these exclusive parking spaces.  If a retailer wants to impose a system for policing such spaces, it will have to work out a mechanism with the developer for doing so, the cost of which should be borne by the retailer.  In some cases, multi-family developers permit the employees of retail tenants to park in designated spaces in the residential parking areas, but this is not preferable because oversight can prove difficult. 

In most multi-family projects, the parking area set aside for the retail tenants will be gated and require the retail customers to obtain a ticket upon entrance.  In some leases, the retailer’s customers will be charged for parking at either a stated amount set forth in the lease or at the then market rate that landlord is charging all or a majority of the customers of the retailers in the project.  In some cases, charges for parking will not be imposed unless the customer parks at the project for longer than a stated period of time.  In other leases, a retailer’s customer will not be charged at all and will have its parking ticket validated by employees at the retail store.  It is common in supermarket leases in a multi-family project for the developer to pay for the parking validation equipment to be located in the tenant’s premises.

Because parking can vary greatly based upon the nature of multi-family projects, and the parking provisions of the retailer’s lease in a multi-family project are markedly different than in a shopping center, it is extremely important that the multi-family developer document these differences correctly in its retail leases.

2.         Operating Expenses

Operating expenses in a multi-family project (including real property taxes and insurance) that are “passed-through” to the retailer should be dealt with differently than in a conventional shopping center because many of these expenses do not benefit the retail tenants.  Operating expenses are usually accounted for by utilizing one of two different methods in a multi-family project.  The first method involves retail tenants paying for a pro rata share of all of the operating expenses for the multi-family project.  In this method, the retailer’s pro rata share of operating expenses would be a fraction, the numerator of which would be the floor area within the retailer’s premises, and the denominator of which would be the floor area of all of the leasable space within the multi-family project.  This is probably not the best way to determine the retailer’s pro rata share of operating expenses because the retailer is paying a share of expenses relating to common areas for the residential tenants, but without the right to use that common area, including the parking for the residential units.  In addition, the denominator used to determine the pro rata share includes the floor area of all of the residential units, along with the floor area of all of the retail premises.  Depending on the density of the project and the number of residential units, this calculation may not accurately account for the retailer’s share of operating expenses.

An alternative method of determining the retailer’s share of operating expenses is to have the landlord reasonably determine those operating expenses that should be allocable to the retail tenants.  The retail tenant would then pay its pro rata share of these expenses based upon a percentage determined by comparing the floor area within the retailer’s premises to the floor area of all of the leasable retail space within the multi-family project.  This is a more accurate way to determine the retailer’s share of operating expenses, but it requires the retailer to trust that the developer will accurately allocate the operating expenses that relate to the retail project.  Certainly, the parties can attempt to define these expenses.  For example, it is commonly accepted that operating expenses relating to exclusive common area amenities for the residential tenants (e.g., pool area, concierge service, exclusive parking) should not be chargeable to the retail tenants.

3.         Operating Covenant; Change in Use

In most leases with retailers in today’s market (other than in regional malls or lifestyle centers), retailers are required to open for one day only.  In this scenario, they have the right to close for business after the one-day requirement is satisfied, although they continue to be required to pay rent and “triple net” charges even if closed.  In these circumstances, the landlord almost always has the right to recapture the premises if the tenant has not operated for a continuous period of some pre-determined length, which failure to operate is not the result of remodels or force majeure events.  In a multi-family project, the retailers are providing very important amenities to the residents.  Therefore, it is critical that the multi-family project landlord obtain a covenant from the retailer that it will continuously operate from its premises for a set number of hours per day, other than in connection with closures for reasonable periods of time due to remodels or force majeure.

As with the operating covenant, the retail tenant-mix in a multi-family project is extremely important to its success.  Therefore, it is also critical that multi-family project landlords retain greater control rights over any change of use, whether by a retail tenant or in connection with an assignment or subletting.  The landlord will want to make sure that any such use provides the correct mix of retail amenities for the residents.

4.         Noise and Vibration

Noise and vibration, or lack thereof, are of critical importance to the developer of a multi-family project.  If some of the retail tenants are workout facilities or other high-noise/high-vibration tenants, it is critical that the construction of the retail facility be done in a manner that will attenuate the sound and vibration emanating from such premises because, in most multi-family projects, residences are directly above the retail.  Most prudent landlords should have sound and vibration attenuation provisions in their leases that are meant to address the need of the retailer to minimize noise and vibration during construction and operations, including any use of a loading dock.  For example, a grocery store will usually have a large loading dock.  If the loading dock is located near the residences, the landlord will want to prevent loading from 10:00 pm through 8 am, and to minimize idling by loading trucks.  The lease should also impose significant penalties upon the retailer for noise and vibration violations of the lease after one or two notices during a six or twelve-month period.

5.         Restaurants

It is critical to multi-family developers that their leases with food users with on-site cooking facilities require regular and adequate cleaning of all exhaust systems.  This cleaning should include degreasing of all hoods, fans, vents, pipes, flues and grease traps.  In the event any food user fails to clean such systems, the landlord, upon written notice to such tenant, should have the right to arrange for the cleaning of such system, and the tenant should be required to reimburse the landlord for all of these costs.  In addition, restaurants should be required to install proper venting and pollution control filtration systems (which may also be required by governmental requirements).  Multi-family developers do not want any of their residential tenants to experience strong odors from restaurants in the project.

The retail lease should also prohibit a restaurant from washing its floor mats outside of its premises.  The restaurant should be designed with a dedicated area within the premises for such cleaning.

It is also critical that leases with food users require them to keep their premises free from insects, rodents, vermin and other pests.  The lease should require these food users, at their expense, to engage reputable professional exterminators to provide pest extermination to their premises on a monthly basis (or at such greater frequency as landlord may reasonably require) and as otherwise may be necessary to keep the premises free of pest infestation so as to avoid infesting the common areas or any of the residential units.

6.         Casualty

The retail lease casualty provision for a retailer in a shopping center is much different than in a multi-family development.  For example, if the multi-family development contains 300 residential units and 60,000 square feet of retail, and a casualty destroys 50% of the project, the developer has to have the right to choose not to rebuild the project even if the loss is due to an insured event.  It cannot have one 4,000 square foot retail tenant dictating that the developer needs to reconstruct a massive project.  In most events the developer will rebuild following an insured casualty because its lender will require it.  However, it cannot be in a position where the “tail is wagging the dog,” and it has to rebuild a large multi-family project because of provisions in its retail leases.

7.         Maintenance.

Any drafter of a lease with a retailer in a multi-family project has to be mindful of the fact that the retailer does not have a roof as it would in a shopping center.  It will have a ceiling, which most likely is the underside of a poured slab separating its premises from the residential units above the premises.  Therefore, its heating, ventilation and air conditioning units (“HVAC Units”) will be on the roof of the residential development, above the top floor residential units.  Its rights to access its HVAC Units will be different than if the HVAC Units were on its roof in a shopping center.  The developer will not allow a retail tenant to access the HVAC Units without reasonable advance notice to the developer, so that the developer can have a representative present during such access to minimize disruption with the residential units below the roof and to preserve the roof warranty.  The same would hold true if a retail tenant desires to place a communications dish on the roof of the project, although any newer multi-family project should have the ability to bring broadband directly to the retailer’s premises.

In addition, many other utilities brought to the retailer’s premises may be through a riser (i.e., a shaft that runs the length of the project vertically).  The retail lease needs to clearly spell out the party that is responsible for the repair and maintenance of these utilities, and how any such repairs will be implemented.

*          *          *

As is evident from the items discussed above, a retail lease in a multi-tenant project is different in many material ways than a retail lease in a shopping center.  It is critical that the developer of a multi-family project clearly understand the differences and draft a lease in a manner that protects it from many of the problems that are likely to arise from the mixing of these two very different product types.

ORANGE COUNTY
3121 Michelson Drive, Suite 200
Irvine, CA 92612

949.260.4600    949.260.4699

SAN FRANCISCO
50 California Street, Suite 3200
San Francisco, CA 94111

415.262.5100    415.262.5199