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(This story, in slightly different form, originally appeared in Incisive Media’s Daily Business Review.)

MIAMI-As the list of store closings grows exponentially so does the pain felt by landlords because of a common but little known clause in retail leases. And with bankruptcies in the retail sector expected to spread as spending remains depressed, experts say these so-called co-tenancy clauses could drive landlords into bankruptcy along with many of their tenants.

The clauses allow store owners to take several options–including not paying rent–when key tenants leave a shopping center. The clauses sometimes make leases contingent on certain anchor tenants because those big-box stores often drive most of the traffic to smaller stores. Other options triggered by co-tenancy clauses can include lease termination, reduced rent for a certain period or payment of a percentage of sales only.

Lease modifications because of co-tenancy ultimately can create a cash-flow domino effect for the landlord, says real estate lawyer Irwin Fayne, a partner at Holland & Knight, who focuses on commercial leasing. “Co-tenancy clauses are a big issue in the threat of bankruptcy to the landlord,” he says. The more vacancies that arise in a mall or shopping center, the more co-tenancy kicks in. That brings more rent reductions, and steadily decreasing cash flow for the landlord. That in turn affects the landlord’s ability to maintain the property. The lack of maintenance can violate other lease provisions. And the rundown appearance of the property discourages other prospective tenants. “It spirals downward and the trigger for filing bankruptcy is when the landlord can’t make the debt service,” Fayne explains.

In good times, co-tenancy wasn’t much of an issue. Anchors could be replaced fairly easily, and often were lined up before the prior retailer had even left. But these are bad times, and the situation is expected to get even worse. With Circuit City, Macy’s, Linens ‘n Things, Home Depot and others in dire financial straits and shuttering stores, the likelihood of easily finding a new big-box anchor is increasingly slim. And in some malls and centers, several anchors may be leaving at the same time. That makes co-tenancy–and avoiding it–even more critical.

“When a lot of these tenants got co-tenancy, it was at a time when landlords thought they were safe,” says Greg Lotzar, South Florida leasing director for Weingarten Realty Investors, a Houston-based real estate investment trust that owns more than 400 malls and centers nationwide. Weingarten and every other retail owner is struggling with co-tenancy, Lotzar reveals. “Who would have thought you’d have this number of retailers going bust at the same time? If you have a power center with seven anchors and the co-tenancy in your leases say at least four of the seven have to be open, who would have thought you’d have that problem?”

The key for landlords and tenants is flexibility, advises Mark Gilbert, executive vice president of Cushman & Wakefield’s investment sales group in Miami. “Landlords don’t want to be forced into situations where they remain under the co-tenancy threat forever. So the modified approach is that the co-tenancy window is open only for so long. Landlords and tenants have agreed that not all tenants suffer in business because another tenant closes,” he says.

Big Lots, with 19 stores within 100 miles of Miami, is a case in point. The California-based discount retailer signed a 10-year lease earlier this month for 23,649 square feet of space in the Midvale Plaza shopping center in Tucson. If the occupancy of the center drops below 70% and remains at that level for nine months, Big Lots’ rent will be reduced 50 %, says Fayne of Holland & Knight in Fort Lauderdale, who represented landlord Midvale Marketplace. That reduction doesn’t include property management fees or taxes. But Big Lots would get the break for up to a year. After that, the storewould have to leave or return to its full payment.

When asked if Big Lots cuts a similar co-tenancy deal in South Florida, Faynespeculated that it does. “In this market, Big Lots is the 900-pound gorilla and can pretty much dictate how the deal will go,” he explains. “Landlords are dying out there andhave no choice but to ask ‘how high?’ when Big Lots says ‘jump.’”

The first step is to prevent the co-tenancy, says Marc Faust, a shareholder in Katz Barron and head of the firm’s real estate group in Miami. That’s increasingly tough to do, but tenants can be approached to restructure leases instead.

In Miami, co-tenancy questions arose for three remaining anchors at the 105,000-square-foot Shoppes at Dadeland across from the Dadeland Mall after Linens ‘n Things declared bankruptcy last year. Old Navy, Office Depot and the Container Store questioned what recourse they had if a replacement tenant didn’t meet conditions in their lease agreements, says Michael Gallinar of Adams Gallinar in Miami, who represents landlord Hayman Co. of Troy, Mich. Issues include preferred replacement tenants, the new tenant’s type of business, use of the space and creditworthiness.

“You have a list of pre-approved parameters and then generic criteria” that existing anchors demand of replacement tenants, he points out. “With the challenge of identifying tenants who will be around, the general criteria becomes all the more important.”

At the 147,281-square-foot Fountains of Miramar shopping center in Miramar, former owner Barry Ross says anchors Marshalls, Ross Dress for Less and Office Depot wanted what he called a “kick out clause,” allowing them to leave if any of the other anchors closed. “We said that’s not fair, how about if two leave?” he reveals. A joint venture involving Ross Realty Investments sold the mall early last year for almost $40 million to the Morris Cos. of Rutherford, NJ.

Co-tenancy clauses may affect enclosed malls the most, Ross says. Regardless of store size, retailers all seem to have clauses that allow them to cancel leases if a certain percentage of the mall is vacant or if certain anchors leave. “There’s a lot of talk about 2009 being much worse because of co-tenancy clauses,” he says.

Terry Sheridan can be reached at [email protected]

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