12 Ways to Cut Risks of Adding Incubator Tenants to Your Shopping Center

To fill empty space and bring pizzazz to a shopping center, more and more owners are adding “incubator tenants” to their tenant mix. An incubator tenant is a small business—often a new mom-and-pop outfit—with a unique retail niche. For instance, the tenant may have a cute and “different” gimmick, such as selling only items with hearts. Or it may add local flavor to the center by selling the work of craftspeople from the area. The shopping center “incubates” the business by creating a favorable leasing situation. The goal is to help the business not only survive but grow from a small outfit into a successful enterprise in the center. These types of tenants can also help spur business at centers that aren't performing well.

Although incubator tenants can bring variety to a center filled with the same lineup of retailers as every other center, renting space to an incubator tenant can be risky. An incubator tenant's principals often have little or no retail experience. So while some incubator tenants become successful permanent tenants, others crash and burn.

To help you avoid getting burned too, CLLI, with the help of Samuel B. Garber, assistant general counsel of General Growth Properties, Inc., and Evelyn S. Leonard, vice president and general counsel of Levin Management Corporation, has put together the following checklist of 12 tips to use when you negotiate with an incubator tenant. There's also Model Lease Language for some of these tips: CLLI0062

Get Tenant's Business Plan

Starting a business is time-consuming and a big financial risk. So the incubator tenant needs to have a well-developed and thought-out retail concept, as well as a business plan to implement the concept, says Garber. Require a prospective incubator tenant to give you its business plan, he advises. Then you can determine if the incubator tenant's retail concept is viable and worth pursuing at your center.

Among other information, a business plan should describe the tenant, its principals, its product or service, the market for that product or service, its management team, and its budget, says Garber. If the incubator tenant doesn't know how to prepare a business plan, or its business plan is inadequate, you can provide guidance, he says. Also, make sure you get the principals' current financial statements, adds Leonard.

Practical Pointer: You may also have to provide guidance to the incubator tenant on how it can get financing, if it's not already familiar with financing procedures, notes Garber.

Agree to Short Initial Term

If you decide to rent space to an incubator tenant, then initially give it the right to stay in your center for only a short time—say, one or two years, says Garber. After all, many incubator tenants have either never rented before (because they've worked out of their homes or had other careers) or have rented only a small store in a less desirable location. Although the incubator tenant will need some time to get its business up and running, you'll want to treat your initial relationship with it as a trial period, he says.

Use License Agreement or Short-Form Lease

You should use either a license agreement or short-form lease (see box on p. 3), says Garber. If the tenant works out, you can sign a full-blown lease with the tenant as you would with your other tenants. You can begin negotiating that full-blown lease for a longer term (say, five years) between three and five months after the license agreement or short-form lease starts, says Leonard. By that time, you should have seen enough of the tenant to know if its business is strong enough to last in your center.

Practical Pointer: The model language provided in this article is intended for a lease, but it can be easily modified for a license agreement.

Put Tenant in Small, Hard-to-Rent Space

It's better to give incubator tenants a smaller space—for instance, under 1,000 square feet, says Garber. Then, if the incubator tenant's business fails, the failure will be less noticeable and disruptive to your center.

Incubator tenants probably won't need anything bigger, since they usually sell small items. But if an incubator tenant will sell bigger items—such as furniture—you may decide to give it a bigger space, Garber notes.

You also can put incubator tenants in your hard-to-lease vacant spaces, adds Leonard. You shouldn't get much flak from incubator tenants on this point because they typically can't afford bigger or more desirable spaces, anyway, she notes.

Make Tenant Pay for Improvements

Since the incubator tenant will get its own financing, make it pay for all improvements to the space (for example, carpeting and painting), says Garber. If you pay for improvements and the tenant doesn't work out, you've wasted the money. And making the tenant pay forces it to be realistic about the work it wants done to the space.

Incubator tenants rarely object to paying for improvements, he says.

Get Right to Relocate Tenant

It's a good idea to get the right to move—or “relocate”—an incubator tenant to another, similarly sized space in the center, if necessary, says Leonard. This flexibility is helpful if a bigger tenant in the center wants to expand or if a desirable new tenant wants the incubator tenant's space, she notes.

Make the lease's relocation right enforceable on short—say, 30 days'—notice, says Garber. This is a reasonable amount of time to let the incubator tenant pack up its store.

You'll also need to adjust the tenant's rent payments based on the square footage of the relocation space, says Leonard. And expect to pay some of the tenant's expenses if it performs the move and provides estimates of its costs—or to pay all of the moving expenses if you perform the move, she notes. But try to avoid reimbursing the incubator tenant for the cost of any improvements that it made in the original space, she adds.

Model Lease Language

Landlord shall have the continuing right, throughout the Lease Term, to recover possession of the Premises to relocate Tenant to alternative premises in the Shopping Center containing approximately the same square footage as the Premises. In the event Landlord elects to exercise this right to relocate Tenant, it shall do so by giving Tenant [insert #, e.g., thirty (30)] days' notice prior to the date on which Tenant will be required to vacate the Premises and take occupancy of the alternate premises, as of which date Tenant covenants and agrees that it shall surrender and deliver up vacant possession of the Premises. Minimum Rent and Additional Rent shall be adjusted proportionately as of the aforesaid date to reflect the square footage of floor area of the alternate premises as compared to the square footage of floor area of the Premises. Landlord shall reimburse Tenant for [insert amt., e.g., one-third (1/3)] of Tenant's direct and reasonable out-of-pocket expenses incurred to move and reinstall Tenant's fixtures, equipment, and inventory; provided, however, Tenant shall submit for Landlord's prior approval written estimates of the aforementioned expenses and Landlord shall have the option, in lieu of approval of Tenant's estimates, to perform the relocation at Landlord's expense.

While incubator tenants will generally accept a relocation provision, you probably won't want to use that provision if possible, notes Leonard. Moving an incubator tenant during its initial term could hurt the tenant's fragile business—and also hurt you in the end. If you've put the incubator tenant in a space that has been empty for a while, you're less likely to need to relocate it, she notes. But still include a relocation right in the lease, just in case you ever need to move the incubator tenant, says Garber.

Charge Lower Rent

An incubator tenant often can't afford the market rent paid by other center tenants. So try the following rent structure:

Discounted minimum rent. Charge the incubator tenant a discounted minimum rent. There's no set formula for this discount, says Leonard. Set a reasonable rent based on the tenant's estimated initial gross sales. This rent could be as low as half of your center's per square foot market rent.

Percentage rent. Even though the tenant probably won't generate much percentage rent, it's still a good idea to put a percentage rent clause in the lease, says Garber. Since the incubator tenant is getting a break by paying a discounted minimum rent, there's no reason you shouldn't get a piece of the pie if its business takes off. Also, requiring the incubator tenant to report gross sales helps you keep tabs on how its business is doing, he adds.

Full share of CAM and other costs. Charge the tenant for its pro rata share of common area maintenance (CAM) charges, real estate taxes, and promotional charges, says Garber. It's important to show the incubator tenant early on what it's like to be a tenant in a shopping center, he explains.

Practical Pointer: If the incubator tenant's business flourishes at your center and you decide to sign a longer-term lease with it, bump up the tenant's minimum rent to market rent, says Leonard.

Get a Security Deposit

You may be tempted to waive the security deposit requirement, but don't. Collect at least two or three months' rent from the incubator tenant, suggests Leonard. An incubator tenant usually has fewer assets than your other tenants. If the tenant defaults under the lease or doesn't pay its rent, the security deposit gives you protection.

Also, require the incubator tenant to restore the security deposit to its original amount if you must use the security deposit to cure—that is, fix—a default, says Leonard.

Model Lease Language

Tenant shall, as a condition precedent to its rights hereunder, deposit with Landlord, for Landlord's general account, the sum of $[insert amt.] as security for the performance of each and every term and condition of this Lease on Tenant's part to be performed hereunder (hereinafter “Security Deposit”). Landlord may use, apply on Tenant's behalf, or retain (without liability for interest) during the duration of this Lease the whole or any part of the Security Deposit to the extent required for the payment of any Rent which may be unpaid, or for any sum which Landlord may expend to cure any default of Tenant, whereupon Tenant shall promptly restore the Security Deposit to its original amount. Tenant's failure to restore the Security Deposit to its original amount shall constitute a default under this Lease. Provided that Tenant has complied with all the terms and conditions of this Lease, the Security Deposit (less any amount applied as provided above) shall be returned to Tenant, without interest, after the Expiration Date and after surrender of possession of the Premises to Landlord in accordance with the terms and conditions of this Lease.

Strictly Limit Permitted Use

Make sure the use clause in the incubator tenant's lease is very specific. Spell out the items the tenant can sell, says Leonard. An incubator tenant works best when it's filling a new niche in the center. Don't let it stray from its specific use, she warns.

Model Lease Language

Tenant shall use the Premises for the display and retail sale of [insert merchandise] and for no other purpose.

Set Hours and Manner of Business Operations

Require the incubator tenant to be open and continuously operate during the center's business hours, says Leonard. An incubator tenant won't bring much to your center if its space is dark when the rest of your tenants are open. You'll also want the incubator tenant to operate in a high class and respectable manner.

Incubator tenants may balk at these requirements, but don't compromise, says Leonard. It's important that an incubator tenant learn to function like a shopping center tenant rather than struggle later when it's a permanent tenant.

Model Lease Language

Tenant agrees to open and continuously operate its business in the Premises, which continuous operation shall at all times be under the Trade Name set forth in Clause [insert #] hereof. Tenant shall keep the Premises open for business during all business hours of the Shopping Center and shall conduct its business in a high class and reputable manner and in accordance with the Shopping Center Rules and Regulations set forth in Exhibit [insert #] attached hereto.

Bar Assignments and Sublets

Bar the incubator tenant from assigning its lease or license agreement or subletting its space, says Leonard. After all, you agreed to give this particular incubator tenant a special deal (including discounted minimum rent) that you wouldn't have negotiated with other tenants. A third party shouldn't get the advantages of that deal by taking over the lease (or license agreement) or space, she says. To strengthen this bar, make any change in the incubator tenant's ownership or control count as an assignment, Leonard adds.

Model Lease Language

Tenant shall not assign, mortgage, or pledge this Lease, or enter into any sublease, concession, occupancy agreement, or license of the Premises. Any change whatsoever in ownership or the control of Tenant shall be deemed an assignment and default under this Lease.

Get Personal or Corporate Guaranties

Since the incubator tenant may not have many assets, it's smart to get guaranties signed by the incubator tenant's principals, says Garber. This gives you greater assurance that the rent will be paid and the incubator tenant's lease obligations will be performed. And if a principal is married, require the principal's spouse to sign the guaranty, too, he says. Otherwise, the principal may try to transfer his assets to the spouse so that you can't reach them, he warns. Alternatively, if the incubator tenant is owned by a parent company, have the incubator tenant get its parent company to sign the guaranty, advises Garber.

CLLI Sources

Samuel B. Garber, Esq.: Asst. Gen. Counsel, General Growth Properties Inc., 110 N. Wacker Dr., Chicago, IL 60606; 312-960-5000, Sam.Garber@generalgrowth.com.

Evelyn S. Leonard, Esq.: Vice President-Gen. Counsel, Levin Management Corp., 893 Highway 22 West, N. Plainfield, NJ 07060; (908) 668-8000; eleonard@levinmgt.com.

Sidebar

Should You Use License Agreement or Short-Form Lease?

Leasing experts differ over whether you should sign a license agreement or a lease with an incubator tenant. A license agreement gives the incubator tenant (technically, the “licensee”) the right to use your space for a specific purpose. But unlike a lease, a license agreement doesn't create a landlord-tenant relationship between you and the incubator tenant. That means that neither you nor the incubator tenant gets all the protections offered by your state's landlord-tenant law and that would have been available if you had both signed a lease, says Evelyn S. Leonard, vice president and general counsel of Levin Management Corporation.

Pros of license agreement. Incubator tenants' businesses often fail relatively quickly. If this happens, you want them out of your center as fast as possible. The license agreement benefits you by giving you the flexibility you need to get rid of the incubator licensee that isn't working out, says Samuel B. Garber, assistant general counsel of General Growth Properties, Inc. Because there's no landlord-tenant relationship, you don't have to go through an eviction proceeding—which might require at least 30 days' notice—to get rid of a licensee. Instead, you simply tell the licensee that you're terminating the agreement and that it must leave the space immediately.

Plus, there's a benefit even a licensee can appreciate: A license agreement is less costly to draft and negotiate than a lease. So both you and the licensee can save money on legal fees, Garber points out.

Pros of short-term lease. Why consider a lease instead? Because a license agreement doesn't always do what it's supposed to do. An incubator tenant that signed a license agreement may not go quietly if you try to throw it out of the space, says Leonard. It may claim that the license agreement was really a lease and that it's entitled to full landlord-tenant protections. Courts often rule that “if it walks like a lease and talks like a lease, it's really a lease,” she says. Then the licensee gets all of the rights of a tenant, plus you'll have to go though an eviction proceeding. Worse yet, in some states, you may be barred from using any expedited eviction proceedings if you've signed a license agreement instead of a lease and the licensee refuses to leave its space, says Leonard. She generally uses a short-form lease that includes owner protections, rather than risk having a license agreement backfire.