By Kenneth S. Lamy
As shown by the Chapter 11 bankruptcy filings Nov. 1 by mall operators CBL & Associates Properties and Pennsylvania Real Estate Investment Trust, rent collection deficiencies during the COVID-19 era have created severe financial distress for many retail landlords. Landlords have obligations to pay mortgages, operating costs, and taxes.
Businesses around the U.S. have reopened, but some face new restrictions and shutdowns. And many tenants continue to operate at partial capacity — sometimes with sparse shelves from inventory on back order. Meanwhile, stimulus talks that could help them and their patrons get through the crisis have stalled.
To ensure a steady stream of rental income, particularly during the critical retail holiday season, landlords may be best served by devising and accelerating a temporary rent relief plan. Such a plan could base rents for distressed retailer tenants on a percentage of sales, rather than the traditional fixed minimum rent plus percentage after an agreed-upon breakpoint. But first landlords must take an often-neglected step that will radically change the lease process going forward.
Trust, but verify
Before agreeing to a percentage of sales as a form of rent relief, landlords need to verify tenant sales and establish a fair procedure for a temporary new rent structure by conducting a formal sales audit. These audits are relatively straightforward when conducted remotely by qualified retail real estate accountants.
This will result in more income for the landlords than they’d receive if a tenant stopped paying rent altogether until it went out of business laden with debt.
COVID-19 has exposed the weaknesses in setting new temporary rents without verifying sales. Tenants owe rent, regardless of government-mandated closures. However, with capacity limits in place, many retailers and restaurants don’t have the full potential for revenue to pay contract rent. Landlords need to determine which tenants are truly in distress and cannot survive without assistance.
Recent history offers an example that may prove fruitful for retail and restaurant landlords and tenants as they continue to navigate the challenges posed by the COVID-19 pandemic.
Preparing for nuclear disarmament talks in 1986, U.S. President Ronald Reagan sought a Russian proverb to better communicate with his U.S.S.R. counterpart, Mikhail Gorbachev. The one Reagan chose, Doveryai no proveryai (“Trust, but verify”), encapsulated his strategy of establishing good faith while ensuring that no one was going to be a pushover in negotiations.
From the early days of the shutdown in March, as tenants approached landlords for relief, many retail real estate companies saw that they had little data about which tenants were genuinely unable to pay even a fraction of rent that was due. Did it make sense to offer assistance to tenants who were struggling before the pandemic hit? Even so, landlords negotiated partial, deferred, or percentage-only rent abatement with their tenants to help them both survive the crisis. That’s the trust part.
With tenants in varying states of operation and capacity, landlords need to know that tenants are properly reporting sales and paying correct amounts according to temporarily renegotiated rent relief. This requires collection, analysis, and verification of sales-related data.
Each lease and rent-relief lease amendment is different in how it defines “gross sales” and what should be fairly standard information. Are discounted employee sales subject to percentage rent? Sales taxes are excluded from reporting, but what about credit card fees? Most leases require the tenant to report 100% of a credit card transaction to the landlord without deducting the 1% to 3% credit card processing fee from the total, which is a cost of doing business. Fees for delivery services such as DoorDash also should not be deducted from sales figures. Important areas of sales reporting of internet transactions to be addressed include the crediting of returns of items purchased online but brought back to a physical store, and the landlord receiving percentage rent credit for BOPIS sales.
Obtaining this information is especially important for leases with percentage-only rent, which I’ve advocated for restaurant tenants that will especially be affected during winter months, when outdoor dining is no longer feasible to boost capacity. In this circumstance, accurate, analyzed, and verified data is even more critical. Many retail categories tend to underreport sales for a variety of reasons. This is where verified sales data will help both sides of the financial partnership — tenant and landlord — come together and succeed during this challenging time.
The need for verified sales data is creating a new paradigm for negotiating leases going forward that’s transparent and fair. Replacing a tenant causes loss of income and could trigger co-tenancy issues with other tenants. Landlords want their tenants to succeed, and should participate in that success. Percentage rent arrangements address this.
Landlords, be proactive
During this health and economic crisis, landlords need to shift from reactive property management, asset management, and lease administration. They must take on more proactive and strategic thinking to avoid future financial distress of their own. Emphasis should be on their fiduciary role and responsibilities to partners, shareholders, investors, and lenders.
Owners and their property management team should manage the risks presented not only by today’s environment, but also by what we know to be industry best practices and fundamentals. That could be the best gift of all this holiday season.
Kenneth S. Lamy is founder and CEO of The Lamy Group, a financial management consulting firm based in Mandeville, La., U.S., that helps landlords quantify retailer sales for collecting rents.