As retail leasing continues to evolve, real estate investment trust (REIT) landlords, retail tenants and the business / advisory teams on both sides will want to ensure that REIT issues are surfaced and negotiated before the lease is signed, averting unpleasant surprises and renegotiations down the road. With proper planning, the vast majority of REIT issues arising in retail leases can be effectively managed.

Excerpted from the Summer 2018 issue of the International Council of Shopping Centers (ICSC) Newsletter, Goulston & Storrs Tax Counsel Jonathan Stein addresses some of the key REIT issues for retail leasing professionals.

REIT Issues for Retail Leasing Professionals
When a shopping center or other mixed-use development that contains retail is owned by a real estate investment trust (REIT), special care must be taken in negotiating tenant leases that are REIT-compliant. These REIT rules can be frustratingly at odds with common commercial practice at times, but with proper planning and structuring, REIT landlords and their retail tenants can often agree to terms that are both REIT-compliant and commercial.

Income Considerations
REITs, like partnerships or LLCs, generally avoid income tax liability at the entity level. Unlike partnerships or LLCs, however, a REIT must meet certain tests to maintain its tax-favored status. In the retail leasing context, the compliance focus is on whether a REIT landlord could have “disqualified” rent under the lease. Such disqualified rent would prevent the REIT from meeting its income test requirements. Although there are many reasons that rent could be non-qualifying for a REIT, most issues in the marketplace today have to do with tenant services or percentage rent formulas with unusual terms. Under the special tax rules for REITs, impermissible tenant services can transform otherwise good REIT rental income into non-qualifying income, with extremely serious consequences for the REIT’s tax-favored status.

“Good” Rents
“Good” rents include: (1) amounts paid for use or occupancy of real property, (2) charges for services customarily furnished in connection with the rent of real property and (3) rent attributable to personal property leased in connection with a lease of real property, provided that the rent attributable to the personal property does not exceed certain limits. A service is customary if, in the geographic market in which the property is located, tenants in a similar class of building are customarily provided with the same service. Many everyday payments that flow from the tenant to the landlord are considered rent under these rules, even when such payments are not strictly for the use of space. For example, reimbursements for real property taxes and common area maintenance, interest on unpaid rent, and additional amounts received by a landlord from a tenant in the event of a sublease or assignment may all generally be treated as qualifying rent for REIT purposes. In addition, items that the IRS has ruled are customary services for retail tenants include the provision of electricity, elevator services and trash removal; property security; administrative support for merchants’ associations; and common area repair and maintenance. Finally, for rent to be qualifying income for the REIT, it cannot be contingent upon income or profits of any person (including subtenants) from the property.

Percentage Rent
Although rent contingent on profits is not qualifying, rents based on a percentage of the tenant’s gross sales are permitted from a REIT perspective. The interaction of these two rules can sometimes generate confusion based upon how “gross sales” are defined in the lease. In some cases, unusual or excessive exclusions from the “gross sales” definition in the lease could make it unclear whether the percentage rent under the lease is more properly characterized as rent based upon profits, not gross sales, of the tenant.

Impermissible Tenant Service Income (ITSI)
Although today friction between tenants and REIT landlords from unusual exclusions from gross sales may occasionally arise, the real issues in most retail leases involving REITs have to do with impermissible tenant services income or ITSI. Under the rules for good rents described above, a REIT cannot furnish non-customary services in excess of a de minimis threshold of 1 percent of all amounts received from the premises. ITSI can pose unique problems for REIT compliance for two reasons: (1) non-customary tenant services do not have to be separately charged for (i.e., they can just be included in the rent) and therefore can be difficult for compliance professionals to identify and (2) income from such services can taint otherwise “good” rental income, jeopardizing the REIT’s tax-favored status.

Taxable REIT Subsidiary (TRS)
Because ITSI can be difficult to catch in the context of a retail lease, most REIT landlords will include a “savings” provision in a retail lease. Such a provision will typically provide the REIT with the ability to adjust any rents under the lease to bring these payments into compliance with the various rules described in this article. In addition, REIT landlords will want the right to review any sublease and assignment to ensure that it is not based on profits of the subtenant or assignee.

This article is reprinted with permission from ICSC © (2019).