Consider 11 Factors Before Converting Property to Mixed Use

Owning a mixed-use property—that is, a building with both residential occupants and retail tenants—has its advantages. For example, popular retail tenants benefit from the on-site customer foot traffic. And potential residents may enjoy the easy access to shopping, services, or entertainment. But there is a downside.

As an owner, when you decide to mix any type of business with residences, you will have to deal with the conflicting needs of both sides, says Sacramento real estate attorney Winnifred C. Ward. If you are considering converting your property to mixed use, Ward recommends weighing the following 11 factors before making any final decisions.

1. Operating Cost Allocation

One of the first issues that you should consider when dealing with a mixed-use building is how you'll allocate operating costs between your residential occupants and the retail tenants. Retailers often feel that they are subsidizing residential projects through their operating costs, says Ward. For example, retail tenants may ask for documents to prove that their portion of the operating costs is not being used to pay for carpeting or painting in the residential areas. To avoid conflict, scrutinize what you'll consider a residential expense and a retail expense, and be able to justify your allocation of expenses between the residential and retail portions of your building.

For example, show your retail tenants financial statements confirming that in their janitorial services, they're paying for only the cleaning costs for their space, and not the expensive maid service of the condo owners on the residential floors.

2. Utility and Service Costs

When allocating utility costs, keep in mind that some retail tenants have a disproportionate need for services. Restaurants, for example, will have higher sewer and water costs than residences will, and you might experience some backlash from other building occupants if you try to allocate those costs on a pro-rata basis, says Ward. You might consider using separate meters for each of your tenants so you can accurately determine usage and allocate utility and service costs accordingly.

Also, if you're considering leasing to a restaurant tenant, expect that its garbage pickups will be much more frequent than pickups for residential and nonfood retail tenants. Discuss garbage disposal requirements up front to determine the tenant's needs. If possible, restaurant and other food tenants should have a separate garbage area. During lease negotiations with a tenant that needs frequent garbage pickups, make sure you get the tenant to agree to pay the additional costs necessary to cover the disproportionate use.

You could also let the tenant arrange for its own garbage pickup, says Ward. If the tenant's disposal company will be different from the one that services the residents and other tenants in your building, make sure you require the tenant to get your approval before signing any contracts, and that you fully understand its proposed disposal company's operating policies and procedures. Those procedures should comply with the rules and regulations for the building.

Finally, like our Model Lease Language below, your lease should contain language and a checklist that clearly identify which party is responsible for each utility and service contract and what their responsibilities are under the lease.

Model Lease Language

Landlord and Tenant agree that utility bills and service contracts for the Premises shall be paid by the party designated below. In each instance, the party responsible for payment of a service contract covenants that it will pay the service contract prior to delinquency. The responsibility to pay the service contracts shall include all activation fees, installation fees, maintenance fees and other miscellaneous charges associated with said utility and service contract. Within thirty (30) days of the Lease Commencement Date, Tenant shall provide Landlord with a copy of any requested utility bill and service contract information. [Insert checklist indicating which party has responsibility for: gas, water, electric, inside wiring, sewer/septic tank, HVAC, elevator, security system, pest control, janitorial, maintenance, landscaping, and trash removal.]

3. Noise and Odors

Noise from a retail space on the ground floor can travel up to the residential areas. For example, a restaurant with a nightclub on the bottom level can cause constant thumping and vibration that will disturb your residents. If you first assess the types of residents in your building, you can try to get the nightclub's management to agree not to offer music before or after a time that corresponds with the residents' schedules. Also, to reduce noise problems, require the nightclub to install sound-proofing.

If you're considering leasing to a retail tenant with a business that generates strong odors, you should add provisions in your lease to deal with the problem. For example, if the retail space has a kitchen that generates food odors, or an area designated for smoking, make sure that your lease requires the installation of grease traps for the kitchen and provides adequate ventilation to pull smoke away from the building.

It's also a good idea to add a waiver provision to the residential leases or purchase agreements, in which the residents acknowledge and agree to waive any claims arising from the noise, odors, excess lights, or vibrations produced by the ground-floor retail tenants.

Model Lease Language

Noise and Odors. Tenant shall not allow any noxious or objectionable odors, fumes, or noises to emanate or escape from its leased space. Prior to use of any further installation of fixtures, Tenant shall pay for the cost of a study commissioned by Landlord to assure the sufficiency of the insulation of the exterior walls and ceiling of its leased space and for the cost of any recommended remediation to prevent the emanation of any odors, fumes, or noises from the its leased space.

4. Access

Do you want to force residents to go through your retail space to enter their homes, or do you want to create a separate entrance? The latter is preferable from a liability standpoint. For example, if the lease states that the retail tenant will indemnify you—that is, hold you harmless—for any incidents that take place in the common areas, a court could rule that only the retail tenants and their guests will be considered for indemnification purposes. But if you allow residents to pass through the retail area, it may be unclear who is covered under the provision and could land you in the middle of a long court battle.

Also, allowing residents to have access to retail space in a mixed-use building makes it difficult for you to determine common-area costs. If you allow residents to roam freely, your retail tenants can argue that they alone should not have to pay the quoted amount, because they share the space with residents.

5. Parking

A mix of retail tenants and residents will naturally present parking problems, as you'll have only so much space. Adequate parking for your retail tenant's customers will affect the tenant's income and ability to pay rent to you. But you also have to consider parking spaces for your residents, especially if their unit was purchased or leased with designated parking.

To satisfy everyone's needs and alleviate any conflict, consider using built-in barriers to section off separate parking for retail tenant customers and for residents. Make sure you display signage that clearly explains the parking designations, and that all of your tenants and residents understand the parking rules and regulations.

Model Lease Language

Tenant acknowledges and agrees that Landlord shall not be responsible for the enforcement of any parking rules or regulations in connection with reserved parking spaces contained in this Lease and/or in the Building Rules.

6. Signage

Be sure that your retail tenant's signage is compatible with your building. For example, you don't want to lease to a tenant that literally believes in “gorilla marketing” and will put up a 50-foot replica of King Kong to attract customers in front of a low-key and conservative residential building.

Ask to see your retail tenant's proposed signage before agreeing to lease to it, and if you do reach an agreement, add a clause in your lease that requires the tenant to get your final approval on all signage.

Model Lease Language

Signage. Tenant hereby covenants and agrees that: (i) the size, dimensions, material, content, design, construction, location, and method of installation of the Signage shall be as depicted in Exhibit [insert #], attached hereto. Any changes or additions to such exhibit shall require Landlord's prior written consent; (ii) Tenant shall be responsible for ensuring that the Signage is in compliance with all applicable codes, ordinances, statutes, rules, and regulations; (iii) Tenant, at its sole cost and expense, shall obtain and comply with all consents, approvals, and permits necessary from all governmental authorities and landmark commissions; (iv) Tenant, at its sole cost and expense, shall insure the Signage as part of its property and shall carry liability and property damage insurance with respect to the Signage; and (v) Tenant, at its sole cost and expense, shall clean and maintain all Signage on a regular basis so as to ensure that the Signage retains an attractive appearance at all times.

7. Tenant Reputation and Image

You should put considerable thought into the type of retail tenant that you decide to take on. Unlike residents, retail tenants are highly visible and can decrease property value if their logo or image is associated with a negative message.

For example, you may think that a restaurant tenant with scantily clad waitresses is a good concept that will generate lots of foot traffic. But from a marketing standpoint, that may not necessarily be the type of image that you want your building to be associated with.

8. Hours of Operation

A retail tenant that you lease to could have hours of operation that fall outside of the normal 8 a.m. to 8 p.m. schedule. This means you will have to consider additional utility charges, special access, and a host of other expenses. You should get every retail tenant to agree to maximum hours of operation. If a tenant's hours go beyond the normal work day, determine up front who will be responsible for the additional costs to keep the building running after hours.

Also, if a retail tenant will be staying open after hours, you will need to figure out how to provide its customers access to the store without compromising the safety of your residents. For example, if you have a restaurant and a bar downstairs, your foot-traffic plan should give full access to the retail space, but no access to the residential portion of the building. One way to do this is to lock all of the interior doors that allow access to the retail tenant's space, and require all patrons to enter from the street.

Model Lease Language

Hours of Operation. Tenant shall operate its leased space from [insert starting day, e.g., Monday] through [insert ending day, e.g., Sunday], [insert #, e.g., 52] weeks a year only between the hours of [insert time of opening] and [insert time of closing].

9. Deliveries

Your retail tenants will more than likely get lots of large deliveries. And in the case of a restaurant or a grocery store, the deliveries could contain perishable items, such as seafood, meat, or fruits and vegetables. Before you agree to lease to a retail tenant, ask about its delivery needs and ensure that it has a plan that eliminates any responsibility for delivery problems on your end.

Also, because you don't want deliveries coming through your building's residential lobby, make sure that each retail tenant understands that it must receive all deliveries through the back door of its space. In addition, to avoid any liability issues, make it clear that your building's employees are forbidden to accept any retail tenant shipments and that all retail tenant deliveries should take place during business hours.

Model Lease Language

Deliveries. Deliveries shall be made through the rear entrance or service entrance of the building. If items are too large to fit through the building's rear entrance or service entrance, contractor shall request and get the owner's prior permission to deliver through the front entrance.

10. Security

Retail tenants will probably create the need for extra security. For instance, an after-hours nightclub would need extra security to control automobile and foot-traffic flow, monitor patrons, and handle any safety issues during evening hours. You should require the retail tenant to pay extra for the additional security and, if the tenant chooses to hire its own security company, ensure that the company it uses is reputable.

Model Lease Language

Security. Tenant shall ensure that all security employees have a minimum of [insert #] hours of security training prior to being assigned to the property. Training will include, but not be limited to, the use of security equipment, powers of arrest, emergency procedures, use of force, completing incident reports, patrol techniques, first aid, and CPR, as well as familiarization with the Building's Code of Conduct.

11. Percentage Rent

Collecting rent from a retail tenant is different from collecting rent from residents. Instead of getting a flat monthly fee, retail tenants usually pay a minimum monthly amount plus a percentage rent based on a certain percentage of their monthly sales.

Calculating percentage rent requires a lot of effort on your part. You will need an accountant to collect gross sales reports from the retail tenant—which is not always easy—and to calculate what the tenant owes you.

Because this is such a difficult process, be selective about whom you decide to charge percentage rent. Before you make the decision, you should consider:

• The tenant's recent sales history and anticipated sales volume;

• The tenant's commitment to advertising; and

• Whether the tenant has the financial strength to pay for its merchandise and rent.

Editor's Note: If you are adding residential units to a commercial property, be aware that renting to residents poses challenges that are different from renting to commercial tenants. Among other matters, you must comply with federal and local housing laws, such as the Fair Housing Act, when advertising for and screening applicants and managing the residential property.

• Fair Housing Act: 42 USC §3601 et seq.

Insider Source

Winnifred C. Ward, Esq.: Partner, Downey Brand LLP, 555 Capitol Mall, 10th Fl., Sacramento, CA 95814; (916) 444-1000; wward@downeybrand.com.