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Making Leases Work for Landlords and Tenants in the New EconomyBy Jay Hollander

Jay Hollander, Esq. is the principal of Hollander and Company LLC, www.hollanderco.com, a New York City law firm concentrating its efforts in the protection and development of property interests relating to real property, intellectual property and commercial interests, as well as related litigation.

The content of this article is intended to provide general information relating to its subject matter. Providing it does not establish any attorney-client relationship and does not constitute legal advice. Personal advice in the context of a mutually agreed attorney-client relationship should be sought about your specific circumstances.

Summary: Traditional leases between retailers and shopping-center landlords may not work well in the era of e-commerce. If a retail store conducts significant sales online, a landlord that takes some rent as a percentage of in-store sales may be dissatisfied. This article explains some alternative approaches to make these leases work for e-commerce.


How E-Commerce Affects Traditional Leases

The growth of e-commerce over the last few years has caused quite a stir when it comes to evaluating what impact the escalating sales from virtual storefronts have had on their brick-and mortar-counterparts.

For awhile, traditional storefront retailers were terrified that their sales would dry up in favor of the new "George Jetson" style of click and shop.Commercial landlords also were understandably concerned about how growing Internet sales would impact their retail tenants, especially in shopping centers, which traditionally have served as destination addresses for retailers. Would e-commerce drive them out of business? Would it result in empty or underutilized shopping centers?Fast forward to the present and, to everyone's surprise, it is actually many of the brick and mortar retailers that have most successfully adapted to the Internet, supplementing and facilitating their traditional sales with online information, the ability to buy merchandise online and pick it up at a store, or a host of other innovations that, in retrospect, show the Internet to have been largely a good thing for traditional retailers with physical storefronts.Still, every solution brings a new problem, and now the success of this outlet for retailers has led to disputes between tenants and their landlords.What do Internet sales have to do with shopping center leases? Plenty.The perceived problem for tenants lacking an Internet presence, or who sell products or services that don't benefit from Internet sales as greatly as others, is that substantial Internet sales may keep potential customers away from the center and, as a result, their stores, driving down their sales in the process.To date, there aren't enough reliable statistics to conclude authoritatively if this fear is justified at all or, to what extent, since the impact may vary widely from shopping center to shopping center and from one type of business to another. Then, there's also the issue of what's to blame for any particular decline in sales from any given physical stores: the Internet's impact or the slowing economy in general.While landlords are sympathetic with this tenant complaint, the problem for landlords is actually different. Once fearful of losing tenants to Internet competition, landlords now want to make sure they are cashing in appropriately on the benefits that Internet sales have brought their retail tenants.How do they do this? Mostly through the use of two extremely powerful lease clauses common to shopping center retail leases: the "percentage rent" clause and the "radius" clause."

Percentage Rent" Clauses and E-Commerce

In its simplest form, the "percentage rent" clause works like this: Landlords will select a mix of tenants for a shopping center that they think will draw the most traffic and, ultimately, sales. Then, landlords typically will charge a tenant a little less than the going rate in monthly rent in exchange for getting a specified percentage of the store's monthly gross sales as additional rent.While it's true that this can work against a landlord in slow times, the risk is limited in that the base rent still represents a minimum income to the landlord. But, the benefit in good times is potentially unlimited as the landlord gets a percentage of increased sales made.The issue with Internet sales in this context is whether -- and how much -- to include sales that a store generates on the Internet as part of the gross sales attributable to a particular store. The resolution to the issue has been made more difficult because many leases with percentage rent clauses in them were drafted before anyone contemplated Internet sales.So, tenants have argued that such sales should not be included, while landlords have taken the opposite tack.The mainstream compromise that is increasingly being struck, and which you can use to guide your own negotiations, is one reminiscent of the resolution that came out of a previous economic battle fought between landlords and tenants over mail order, telephone and catalogue sales.Yes, hard to believe, but the Internet is not the first instance of fights over cannibalization of in-store sales by means of remote shopping. Ever since stores began distributing catalogs and circulars, allowing people to place their orders by telephone, the same fights about percentage rent occurred -- until a truce was called.In the case of catalog and phone orders, the resolution involved including, in gross sales, those remote sales that involved the brick and mortar store in one way or another.For example, orders placed by calling a phone number in the store and buying by credit card would be included. Similarly, if a toll-free catalog number were called and the merchandise picked up at a particular store, that order might be included as well. In this way, a connection with the store could be reasonably inferred to justify qualifying these remote sales to be included in the store's gross sales in a way that's consistent with the theory of a percentage rent clause.To fully implement this approach with respect to Internet sales, however, landlords and tenants need to take note of another lease clause that traditionally also has been part and parcel of brick and mortar shopping center leases where percentage rent was involved."

Radius" Clauses and E-Commerce

That clause, known as the "radius" clause, was used by landlords and tenants to place some limitation on outside remote sales attributable to the store's percentage rent by placing geographical boundaries on which remote sales would be deemed allocable to a particular store location and which would not.For instance, if someone from Idaho called the Sears catalog, the same catalog used by a Sears store in New York, the New York store would not want to have the Idaho sale included in its rent.Thus, one of the purposes of a radius clause is to attribute sales from within a given geographical area to the particular store involved, while not unreasonably imputing unrelated sales to it.How should this be implemented in the Internet era, where orders can come from anywhere?There are a couple of ways, the specific one chosen depending on the nature of the business and the negotiating leverage of the parties.One method, alluded to earlier, is to count sales, no matter where the customer is located, if the sale was procured through or with the use of the particular store. So, if the product was ordered on the Internet from another state, but fulfilled through the store, that sale could count as being generated within the agreed-upon geographical area of the store and, hence, includable for percentage rent purposes.Alternatively, and arguably with more justification, one could try to put both parties in the same position they would be in if the Internet was not involved, by only counting Internet sales coming from customers living within a certain geographical zip code denominated area, in driving proximity to the store involved.Both of these possibilities -- and others -- are being applied increasingly to help redress the balance between landlords and retail tenants in commercial shopping center contexts.No doubt, newer leases have adapted quickly and have taken pains to include Internet sales as components of percentage rent, with negotiations centering on the issues identified in this article.Where older leases, lacking Internet-specific language, are being examined, it is the expressed intention of the parties to include certain types of remote sales, whether by telephone, mail order, catalog or otherwise, which are being relied upon in interpretations favoring or disfavoring inclusion of Internet sales.Going forward, landlords would do well to expand their percentage rent clauses not only to take Internet sales into account, but also to further make it clear that the percentage rent clause is neutral with respect to the medium used to communicate the order. This will provide protection against future technology innovation to some degree.On the tenant's side, as technology advances, allowing a store's marketing message to reach further and further, care must be taken to avoid having potentially worldwide sales drawn into the ambit of percentage rent clauses.

In a world where more and more businesses can market to customers from anywhere, some of the traditional assumptions about what drives traffic to shopping centers and sales to individual stores in them will need to adjust to new realities of e-commerce. For their parts, landlords and tenants also will need to adjust their historical leasing arrangements in a way that accommodates the legitimate objectives of percentage rent clauses with the legitimate restrictions of radius clauses, to continue to reward landlords for shopping center infrastructures that improve store sales, while not unfairly penalizing tenants for sales generated without any aid from the landlord.

Copyright © Jay Hollander, 2007. All Rights Reserved.

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