Chapter 4 | The Fundamentals of Commercial Leases

BRUCE KIRSCH: The other thing that you comment upon, relative to leases, other than rent– everyone always thinks rent and term are the most important elements of a lease. You suggest that the use of the space, as defined in the lease or not defined in the lease, can be the second most critical element in a lease. And–

PETER LINNEMAN: Oh, I’d even say in a retail lease it’s the most important element. And in a commercial lease, it’s probably the third most important after rent and term. Use of space is important. Think about it. This is my asset. And I’m not going to find– the first question is, what are you going to do with it?

BRUCE KIRSCH: Right.

PETER LINNEMAN: I mean, and you can– even in an office building, what, you’re going to grow mushrooms in it and use– bring in truckloads of manure in my office building every day and grow mushrooms in it? That’s going to have odors and so forth on other users. And it’s going to make my building a lot less attractive.

That’s my asset. And yes, you’re paying me, but you’re paying me a flow. I own the whole asset. The issue becomes even, you can imagine, in warehouses, if I have a nonsprinklered building, you can’t store flammables or fireworks or ammunition. Because I can’t have that.

Or you can have restrictions that you– I won’t take radioactive stuff and store it in my office buildings. I don’t want somebody doing radioactive research. And I mean, I don’t mean radioactive in the sense of formulas, I mean real research, splitting atoms. That’s my space.

Now, yes, these are extreme. But that’s why you take care of the extreme. Use is critical. You couldn’t pay me enough for some of the noxious uses. What, I’m going to let to Ku Klux Klan and the Nazis, and they’re going to be able to put their signs all over the place on my high-quality office building? Of course not. I mean, it will drive my business– it’s fine.

So I get an extra $3 a foot from the Ku Klux Klan and the Nazi to be in my prime building. And I have guys with white hoods and swastikas walking in all day– they’ll kill my building. I won’t be able to lease it. That’s my asset.

And then in retail, it’s just totally transparent that it all depends on synergies– great retail, at least, all depends on creating synergies– the shoe stores and the clothing stores and the sporting goods stores and the general good stores and the food and so forth and so on. And the example I always use is signage and the usage of my space becomes critical. Because you might do something that attracts a lot of people.

Let’s say, we put a firing range in the middle of the best shopping mall. You know, you rent 2,000 feet. You put a target range inside your 2,000 feet in my center. And then you put a big sign of naked people out in front of it.

You’ll destroy all of my normal retail business in a million square foot mall, because people are going to be offended by the pictures of naked people, though you might draw a bunch of 18 and 20-year-old guys with tattoos who want to shoot pistols. And so fine, they pay me $2 a foot extra on 2,000 feet, and 990,000 feet are being destroyed in the process.

It’s my space. What you do in my space, I got to make sure doesn’t destroy value. Now, as long as it doesn’t destroy value, then that’s less important. And that’s why in retail it’s more important because you don’t just– in office and warehouse, it’s noxious, it’s dangerous type of stuff I prohibit.

In retail, I got to make sure you don’t tell me that you’re opening up a food store, and then open up a shoe store instead. Because I’m trying to balance the number of shoe stores I have and the number of food stores I have. And that’s my job, and I need to control that.

BRUCE KIRSCH: It’s impossible to talk about the physical manifestations of properties without talking about leases. And so one of the things that we learn in the text is this notion of overage or percentage rent with respect to retail plazas. Can you just give a basic description of, why does it make sense for a landlord to essentially be able to take a tax on sales in a plaza?

PETER LINNEMAN: Well, it’s not a– it’s interesting. It’s more from the retailers point of view, namely, again, when I’m a retailer, and I’m renting from you– especially complex retail, highly interactive, highly spontaneous consumption retail– what I’m paying you for as a retailer is creating an environment that attracts customers. In other words, my Orange Julius stand or my little pizza stand is probably not going to attract a lot of people. Therefore, I need an environment that is quite rich.

And of course, every landlord is going to tell you, my retail environment attracts all these people, and everybody’s going to shop at your place. So you say, OK, fine, put your money where your mouth is. If you believe that people are going to come, then make some of the rent dependent on them coming, that is to say, on sales, because I believe I’ll get my sales if you can get people there. So to create a retail environment, to create those synergies, those positive spillovers between retailers, you make that rent.

Well, since– and if you think about, why aren’t there percentage rents in office? Well, everything’s internal. It’s not about, you created an environment where my business can occur. My business is occurring as Microsoft out there in the market somewhere, or if I’m an accounting firm, out there in the market. It’s not occurring because of your office space, whereas with retail, it is occurring because of the retail environment you create.

Similarly, my boxes are not being stored because you created a place where boxes can be stored. I got to store my boxes somewhere. So that’s why you’ll see percentage rents with the retailer basically telling the landlord, prove it to me. And that’s why the more complex the retailing is, the more I depend on a retail environment, the greater that there’s a reliance on percentage rents.

BRUCE KIRSCH: And so under that logic, in practice, do we see percentage rents ever in leases for the anchors, or is it just limited to the in-line tenants?

PETER LINNEMAN: It’s generally limited to the in-line tenants, because if I’m the anchor, I’m telling you, hey, I’m making the place. I’m the one bringing the customers with my sale advertisements, in particular. The anchor, yes, brings them, partly because I’m Macy’s or I’m a name that people recognize, but also partly because I’m the one who puts ads in the newspapers and on television and in stuffers saying, come shop, and our location is. I’m the one bringing them. So you don’t charge me percentage rents. You subsidize my rent, in fact.

BRUCE KIRSCH: The devil’s in the details in all business. And the same goes for in leases and signing a contract for space. And one of the things that I would ask my students is, just for a show of hands, how many of you have ever truly read your apartment lease word for word, from start to finish? And you’ll get maybe 10% of the people.

And you know, it’s a boring, dry document. And so why would you read it? Well, you would read it because you’re promising to carry certain things out. And you don’t realize the seriousness of that until you get burned, like–

PETER LINNEMAN: Yeah, your percentage is higher than my percentage in my classes. Usually it’s maybe one person, sort of sheepishly. And then you find out they were a law student, and they were forced to do it for their class or something.

But it is. It’s a serious document. It’s a very serious document. You’re agreeing to some very serious things, and then you always get– even with the lease, you always get the people who said, oh, I didn’t know that I couldn’t leave early, or gee, I didn’t know I’m responsible for the damage if it’s greater than my deposit. I thought my deposit was all I was liable for. Or, you know, there’s a whole laundry list.

And not reading your lease is not a smart thing. It’s like not reading your loan document or your credit card. If you’re going to sign a credit card agreement with a credit card company, read it. And yes, most of it’s boilerplate. Fine. Know what it says your obligations are as a good idea in life.

And then on commercial leases, every once in a while you’ll run into somebody who hasn’t read their commercial lease. And either they’re buying a building and they haven’t read it, or they’re developing a building and they didn’t read it, and there are horror stories out there. And like most horror stories, they don’t happen very often, because most people have somebody who is knowledgeable really reading the lease, not just a lawyer, even, in some cases, an outside lawyer, but somebody in the firm who knows the normal way they conduct business.

And the horror stories are always things like, gee, I buy a building, I didn’t really read the leases carefully, nobody really went through them carefully, and I find out that one of the tenants has the right to leave with no penalty if their sales drop below a certain number, or a tenant– even in an office building, right, if their sales– or by the way, I find out that I just assumed it was Coca-Cola on the lease because Coca-Cola is renting, but it turns out it’s not Coca-Cola. It’s a special purpose entity company created by Coca-Cola for the sole purpose of leasing this space for Coca-Cola. And then you find out, gee, they couldn’t sell enough Coca-Cola in the country to stay in business, or they want to move to a new office building in the city they’re in, and they roll up that special purpose entity and close it down, and you’ve got no asset to collect against, and it’s not Coca-Cola.

Or the other one is right of first refusal. You find that a tenant has been given by a landlord or a developer years ago the right to have a right of first refusal to buy the entire building. So you go put the building on the market, and you get notified by the tenant that they have a right of first refusal, which means you go out, get the best offer you can get, and the tenant can buy it at that.

You say, well, why does it matter? It matters because what outside bidder is going to go through all the brain damage of figuring how much to bid for the building if they know all anybody has to do is meet their price and they have a legal right for the building?

BRUCE KIRSCH: Right.

PROFESSOR 2: Therefore, a building encumbered by a right of first refusal will never attract a top price, because it scares away most bidders. And those are the kind of horror stories that you run into. I don’t want to say it’s the norm, but it is why you have a knowledgeable person read those leases.

BRUCE KIRSCH: I agree. You know, when I did a very small real estate transaction, you go to the closing table, and then you’re presented with a stack of documents. And I guess that sort of the expectation is that you just sort of gloss over them and you sign the papers.

PETER LINNEMAN: Right.

BRUCE KIRSCH: But I mean, if you’re really taking it seriously, you should say, all right, guys, leave me alone for a couple hours. I’m putting my net worth on the line here, and I’d like to read these.

PETER LINNEMAN: Interestingly, in Germany, by law, they go to the opposite extreme. By law, you have to have a notary read everything in the contract and all attachments, which can often be quite lengthy, like leases can be attachments, has to read them all out loud in the presence of a corporate officer, because they don’t want, under their law, anybody to come back saying, well, I didn’t know.

BRUCE KIRSCH: It’s not a crazy thing to do.

PETER LINNEMAN: Yep. It’s a– no, I think it’s a– think the German is a bit extreme, but it does cut out this, gee, I didn’t know, right?