United States: Independent Developers: A Resource for Retail Expansions

As the number of retail chains turning to independent developers to locate and turnkey their retail stores increases, the legal and practical issues involved in getting a store up and running grow more complex. Mostly confined to retailers targeting stand-alone locations or small, strip centers, the use of independent developers affords the retailer the opportunity to have much of the development risk and investment in time shifted to the developer. It also enables the retailer to conduct its search for locations in better ways than only through commercial retail estate brokers. Developers can negotiate deals directly with the sellers or potential ground lessors, where brokers can only be intermediaries in the deal making.

To make efficient use of this system of turnkey expansion, many retailers establish a special relationship with a few select developers. The relationship is based upon the developer's extensive knowledge of the retailer's site and building requirements, demographic profiles and profit expectations.

For the retailer, this familiarity makes it easier to replicate its expansion program without having to educate brokers, potential sellers and ground lessors about the company's site needs and how much the company is prepared to pay for rent. Indeed, some retailers encourage those developers with whom they have a long-standing history to travel out of state or out of the region in which they normally operate to search for suitable locations.

Although in concept the use of "preferred developers," as they are known, has significant advantages over the chain retailer, there are added issues and complexities that can cause significant delay, expense and sometimes the loss of opportunities for retail expansion.

Many potential projects require zoning relief and often liquor or other regulatory permits. Where zoning and licensing is mostly local and discretionary, preferred developers can have an impact on the reputation of the retailer and the manner in which the retailer conducts its business in other locations in the state or region. Similarly, the local or regional reputation of the retailer can influence the success of the preferred developer. A preferred developer who fails to take the time to prepare an adequate political foundation for entry into a particular local or regional market, or who runs roughshod over the local planning professionals or gives little heed to neighborhood groups, risks not only the project being rejected, but can burn bridges for the retailer who needs the good will of the community to conduct business at its other locations.

Local officials or neighborhood groups often do not distinguish between the retailer and the preferred developer. Therefore, just as the developer can harm the retailer's reputation, a developer that enters a market without knowing what the community's experience has been with a particular retailer or its franchisees, can run into opposition for reasons that are unrelated to the particular location in question.

Recently, the Boston office of Holland & Knight conducted a training session for a national retailer that simulated meetings with local officials, neighborhood groups and statewide officials. The retailer learned to focus its presentation on community benefits and use as examples of such benefits successful alliances with police departments in other municipalities and in other states. Incentives were created for the municipalities that, when put into practice, resulted in the officials suggesting locations to the retailer, which made it easier to secure permits for those locations. This made for better reception for the retailer and the preferred developers. Of course, the developer must know what the retailer is doing in this regard and vice versa, lest the effort to create a positive image by the retailer be undone by short-sighted tactics or an insistence on a particular location, notwithstanding neighborhood and other political considerations. Succeeding at a single location may serve the preferred developer's immediate agenda, but may not always be in the long-term best interest of the retailer if success was achieved at a political cost.

In addition to permitting considerations, the insertion of the preferred developer between the retailer and the land owner brings with it greater legal complexity. If the original landowner will not part with the land, the most common strategy is for the preferred developer to ground lease the site from the owner and sublease it to the retailer or, if the site can accommodate more than one retail unit, sublet the site to multiple subtenants. Multiple subtenants can create problems for the preferred developer if the chain retailer to which the developer owes its principal allegiance acts as guarantor of the ground lease, as frequently occurs. The ground lessor will look not to the developer for assurances that lease payments will be made, since the developer is usually a single-purpose entity formed solely to hold the ground lessee's interest in the ground lease, but will look to the chain retailer. This guarantee, while unquestionably the linchpin that makes the deal attractive to the ground lessor, doesn't come without a price. The chain retailer and its affiliated guarantor will require that its subtenancy be financeable and therefore impose limitations on the right of the ground lessor to terminate the ground lease in the event of a developer default. These limitations may be palatable to the ground lessor as long as its rent stream is not interrupted. The negative consideration for the ground lessor in eliminating the developer as the ground lessee in the event of the ground lessee's default, is that under the retailer's nondisturbance and attornment agreement, the ground lessor, who believed it was buying an annuity by signing a long-term ground lease guaranteed by a nationally known retailer, may have to step in and become an active landlord of a subtenant under a sublease, the terms of which it did not negotiate. By doing so, however, the ground lessor may salvage the economic benefit of the ground lease and may even obtain the benefit of the developer's upside, since the lease payment being made by the retailer will exceed the rent payments due under the ground lease. Negotiating a ground lease that can satisfy these issues can be daunting.

One of the most difficult issues that the parties to such multiparty lease transactions may face is balancing the requirements of the retailer and its lenders with respect to their rights to cure the developer's default in a ground lease. Ground lessors and their lenders will seek to terminate the lease if the rent payments are not being made or in the event of a nonmonetary default. On the retailer's side, the right to cure is generally given first to the guarantor, if any, of the retailer's sublease, and where given, to the guarantor of the ground lease, which may also be the parent company of the retailer, then to the leasehold mortgagee. The leasehold mortgagee often requires the landowner to wait until it has exercised its rights to realize on the developer's interest in the ground lease before the landowner can exercise its right to terminate.

In that case, the landowner stands at the end of a long line of stakeholders desiring to step into the developer's shoes and "cure the default" or to acquiesce in the termination of the lease. For the landowner and its lender, this is not a particularly inviting situation. Certainly, the landowner's lender will not be willing to suspend its debt service while the retailer and the developer's lenders sort out the consequences of the developer's default.

One solution that may answer this dilemma is the agreement of the landowner and its lender to tender a new lease directly to the retailer's lender or to the guarantor in exchange for the prompt cure of any existing defaults. Failure to accept such tender enables the landowner to terminate the lease without significant delay. Hopefully, this assures the landowner's lender that by doing so, debt service will not be interrupted.

While this situation is helpful where the retailer is the sole subtenant, it cannot necessarily help when the preferred developer has subleased to multiple retail tenants. No single new lease can be substituted for the original ground lease unless the lender or guarantor to whom the new lease is tendered is prepared to step into the shoes of the developer as to the multiple subtenants. If the principal creditor of the transaction is the national retailer, the developer's lender may be willing to accept a new lease, but if the lease payments, particularly over time, rely on rent stream from the additional subtenants, the developer's lender may not be willing to accept the risk of being landlord to less creditworthy subtenants.

Assignment and subletting clauses raise many of the same issues concerning the permanence of the ground lessee to the transaction and what happens if the ground lessee's interest should change hands. The right of the developer to assign the ground lessee's interest in the ground lease to the guarantor, as long as the guarantee remains in effect, it is generally acceptable to the ground lessor. Such an event, however, does not have the same economic effect on the ground lessor as when the ground lessor's interest merges with the ground lessee's in the event of a default by the ground lessee; but it does assure that the entity whose credit was instrumental in the lease being signed remains directly obligated to the ground lessor.

In agreeing to unlimited subletting, the ground lessor's principal concern is whether the guarantee remains in place. Because the guarantee may be limited to the initial term of the sublease of the guarantor's affiliate or, may remain in effect only so long as the affiliate's sublease is in place, the ground lessor could find itself, in the event the guarantee terminates, with subtenants that are considerably less creditworthy than the guarantor's affiliate with no guarantee. For this reason, where the ground lessee has sublet to multiple tenants, the ground lessor frequently requires some level of approval to protect against the eventuality that the ground lessor may end up as the direct landlord of such multiple tenants. Approval often takes aim at credit concerns, and the desire of the ground lessor to make certain that such subleases are triple net leases.

The practice of national retail chains to use preferred developers to locate and turnkey retail stores can increase the number of site opportunities that retailers can explore at one time and thus may result in more store openings. This method of operation, however, is not without risk to the retailer where its longer term interests may outweigh the number of retail openings it can count on its balance sheet for any given fiscal year. It also makes the business and legal arrangements more difficult because it introduces parties to the transaction, especially in leasehold transactions, where the perspectives are different and where lenders with distinct interests may play a pivotal role.

The risks ground lessors take when there is a single key guarantee by the "anchor" chain are multiplied when the developer sublets to additional retailers whose term may be extended beyond the initial term of the "anchor" retailer or of the "anchor's" guarantee. Weighing these risks make the lease negotiations more difficult, but not insurmountable.