LEASE RESISTANCE

JON SPRINGER

It's a sign of today's increasingly blurred retail landscape that supermarkets no longer need to look across town to find a local competitor. Chances are good there's one or more in their own shopping center.

Roche Bros. Markets discovered this recently when a KaBloom florist opened in the in-line space alongside the retailer's new store in Mashpee, Mass. Although the fast-growing floral chain's store hasn't hurt sales too badly, Roche Bros. depends on floral as a strong driver of profits and store image, and Rick Roche, the company's chief executive officer, admitted he'd be more comfortable if KaBloom would vavoom. At least to a different space in the center.

"We kind of got caught off guard. We didn't see it coming until the landlord told us it was moving in next to us," Roche told SN. "Fortunately, we were open far enough ahead of them that it didn't affect us too much, but in future leases we'll be sure to ask that they be far across the parking lot from us."

Historically, supermarkets have sought and received covenants in their leases protecting them from competitors encroaching on their business, either by restricting the size or physical location of competitors, restricting the types and amounts of goods they sell or prohibiting certain retail uses altogether.

Originally designed to prevent a landlord from leasing space in the same center to a competing supermarket, more recently these clauses have been put to the test by neighboring drug stores and dollar stores adding food to their traditional offerings.

While those conflicts are increasingly being hashed out in court, supermarkets in the meantime are seeking broader competitive protection in lease renewals and new-store builds, sources said. Reflecting changes in the merchandise mix of the supermarket, these may seek to exclude or restrict potential co-tenants ranging from coffee shops to florists to banks to quick-service restaurants. But this, landlords said, can threaten the mix of a shopping center, reducing a project's appeal to shoppers, its profits and, ultimately, the incentive to build at all. Additional exclusive-use negotiation adds another layer of complexity to an already cumbersome process of site selection, permitting and lease negotiations, too, and this can be a contributing factor in rising real estate costs.

Protection at a Price

While some argue that cross-channel competition for commodity food items and center-store staples has led to supermarkets relying on other items to drive sales and profits, others say supermarkets have created their own competitors by expanding the variety of goods and services they offer. Doug Wiele, principal of El Dorado Hills, Calif.-based shopping center developer Foothill Partners, said supermarkets today tend to overestimate their competition and underestimate the value of the mix in a shopping center.

"The question isn't how supermarket protective-use covenants are weathering changes. It seems to me that supermarket protective-use covenants are the catalyst for change," Wiele told SN. "They're seeking ever more broad protection. The question should not be how are they surviving, but how are they squashing everyone else."

Supermarkets, for their part, argue that generating the largest share of a project's visitors should afford them certain preferences.

"When you're making a commitment of 20 or 25 years in a shopping center, the mix of tenants is important," Harvey Gutman, senior vice president, retail development, for Pathmark Stores, Carteret, N.J., told SN. "Protective-use clauses are one way to make sure there is an appropriate mix."

Wiele said he worries that supermarkets' desire to control who can and cannot be their neighbors ultimately will interfere with the economic model of the shopping center. As anchor tenants drawing the most frequent visits, supermarkets traditionally tend to pay less rent relative to their space than the co-tenants, whose rents earn a living for developers.

"When I got started in this business, grocery stores didn't have banks and Chinese takeout and florists inside the stores. Now they have all of that and would prefer that none of those uses inside the store are anywhere outside the store," Wiele said. "To the extent that the reach of the grocery store widens, and their control over merchandising lines expands, the opportunity to lease space around them diminishes, and the incentive to make grocery store deals goes away.

"If an anchor tenant no longer draws traffic to adjacent stores, then the traditional model of the grocery-anchored shopping center gets restructured," he continued. "The grocer may have to pay their own way, or something else has to give. There's no incentive to give them a sweetheart deal if there's no economic benefit on the backside of it."

Small-shop tenants still have a strong desire to locate in grocery-anchored centers, Wiele acknowledged. "But it's become difficult, for instance, to put a Panera Bread in the same shopping center as a grocery store, because a grocer thinks Panera is a baker and doesn't want that competition. That didn't used to be the case."

Jodie McLean, president and chief investment officer of Edens & Avant, a Columbia, S.C.-based shopping center owner and manager, said managing the merchandising mix of a shopping center while tenants increasingly fuss over uses has become a top priority in recent years. "This is something that our company spends a lot of time focused on right now. We're trying to find creative solutions."

Edens & Avant views itself as a partner to its anchor tenants, McLean said, arguing that whatever benefits one ideally should benefit them both. That requires the developer to understand the needs of each supermarket company and combine this understanding with local demographics and other factors to create a compelling plan for a shopping center.

"We want to lay out a vision for the center which is the right mix for the marketplace. We understand that all grocers don't have the same approach. For example, Kroger is going to a larger format, with a lot of goods and services, and Publix has a different format. It's incumbent upon us to understand how important floral, deli and coffee are to each retailer and put together a merchandise mix that makes the most sense."

McLean said a common conflict is when a supermarket with an in-store fresh coffee department asks the landlord to prohibit renting in-line space to a coffee store. Often, she said, they do so at the risk of costing business over the long run.

"The first approach of the food guy is going to be: I have a Starbucks inside, and I want all of the food inside," McLean explained. "But if your Starbucks customers only come in 2.75 times a week and a Starbucks out here [in in-line shop space] generates 3.7 trips, you can have your Starbucks inside but realize you're also going to generate some business from 75% of the [in-line] trips. It will have a positive impact."

How successful a store can be at receiving the exclusives it asks for often depends on a landlord's options.

"When I was looking for sites, I had a whole list of marching orders that said who can and who can't be a co-tenant," a former real estate manager for a supermarket company, who asked not to be identified, told SN. "In some cases I'd get away with it, and in others the developer told me to take a hike, I'll call your competitor.

"It depends on who has the upper hand. If a landlord or developer has the upper hand, the supermarket isn't about to demand anything," the source said. "But if everyone else is already in the market and the landlord has one shot at getting a supermarket, you can more easily get what you want."

Even then, negotiating exclusives can be an ornery process. Wiele of Foothill Partners said he spent an entire year negotiating a protective-use covenant with Kroger for a store in Northern California.

"We got to where we needed to be, but it took a long time getting there," he said. "It came down to arguing over what is a grocery store and what isn't. Is Costco a grocery store? Is Trader Joe's a grocery store? Does a retailer like Trader Joe's take away sales from a grocer, or because of its regional draw and limited merchandise selection, does it actually bring sales to the grocer?

"I don't think there's a single supermarket operator who would admit that Trader Joe's brings sales to them, but I think some market researchers would suggest that's exactly what's happening," Wiele said.

Sources stopped short of saying exclusive clauses can directly affect the cost of supermarket rents, though they said it can be one of many factors. "There are a lot of factors that impact rents, but I wouldn't say a grocer could buy exclusive uses from us," McLean said. "That's not the approach we would take."

A supermarket executive who asked not to be identified told SN that exclusives tend to be hotly negotiated. "There's a lot of 'You give me this clause, I'll pay more in the option period for rent.' There's trade-offs made with monetary implications," the source said. "That is not an insignificant consideration."

Lease Language Under Scrutiny

One reason new leases are the source of so much controversy is because the long-term leases they're replacing have proved inadequate to deal with changes in the retail landscape since the time they were written, sources said. Much of the controversy in older leases relates to trends toward discount, drug and dollar stores adding grocery departments.

"In the old days, leases were pretty vague, and there weren't many restrictions beyond pharmacies," one source told SN. "Today, you have Kmart stores with pantry departments, dollar stores adding food and some Target discount stores with as many as 90 doors of refrigerated goods. If I'm a grocery store, I don't want Target competing with me in my own center, but these old leases often don't have language that addresses this specifically."

This language is increasingly being scrutinized in court, but because of the high cost of litigation, compromises are often negotiated out of court. "It may be something as specific as you can't have 16 linear feet of shelf space for snacks, but 12," the source said. "This is why leases today are less vague than they were five years ago, and a lot less vague than they were 20 years ago."

Another supermarket executive who asked not to be identified agreed: "Many of the restrictions on older leases were not worded clearly enough. For example, it could prohibit selling food for at-home consumption, but what about pet food? So you have to make sure to include that."

When food-drug combination stores rose to prominence in the 1980s and '90s, in-line drug stores fled to larger corner outparcels. Landlords often filled the former drug store spaces with dollar stores, only to see that tenant tangle with their anchors as they added grocery products.

"I want for a dollar store to recognize they are obligated under the lease not to violate the exclusive-use provisions of the grocer, and we try to tackle that up front," said McLean. "But what we've learned is, even if today [selling groceries] is not the premise of a dollar store, things can change.

"What's happened is that dollar stores entered your center under one strategic business plan and evolved into a use that competes with grocers," she added. "We have to get people to recognize that even as they evolve as retailers, these exclusive uses will not be permitted in those stores."

Stewart Tanz, CEO of Pan Pacific Retail Properties, a Vista, Calif.-based neighborhood shopping center owner, told SN that in most cases dollar stores will comply with lease language limiting the space -- typically 5% to 15% of floor space -- they can devote to groceries. "Although dollar stores have tried to move into [supermarket] territory, we haven't seen much impact," Tanz said. "As long as dollar stores can live with the requirements, I think the synergies they bring together with supermarkets can be a positive."

Developers are also taking steps to design centers with competitive sensitivities in mind.

Wade Williams, a former Smith's Food & Drug real estate executive and who now works for Salt Lake City developer The Boyer Cos., told SN his company designs certain projects into "districts," in part to separate tenants who otherwise would balk at locating together. He also said he sees a trend toward some supermarkets preferring to locate with other large retailers in power centers, where many tenants have very restrictive leases.

At the other end, Rick Domanski, senior client manager of MapInfo, a Dublin, Calif.-based site selection specialist, also cites a trend toward building shopping centers with larger anchor spaces and fewer small shops, with developers increasingly driving pads to one or two specific retailers. He also sees potential for mall-based shops testing co-tenancies with supermarkets in larger community centers.

Williams said supermarkets can be too aggressive, noting that past attempts to compete with video stores and dry cleaners ultimately failed, and that a desire to banish competitors from centers can often result in them relocating -- across the street.

"As hard as we try, we will never be able to reduce our understandings fully to paper," McLean said. "But at the end of the day it comes down to agreeing that it's a partnership between landlord and tenant, and that we both have an aligned interest in creating the most sales possible."

Won't You Be My Neighbor?

With competitors in so many disguises, are there any good neighbors left?

"For developers, the field from which they can pick co-tenants is getting narrower and narrower," Rick Domanski, senior client manager of MapInfo, a Dublin, Calif.-based site selection specialist, told SN.

But some uses can provide valuable traffic for supermarkets. In general, they seek retailers who draw a similar demographic but for different products. "We like things that can generate traffic and complement one another," said Rick Roche, Roche Bros. Markets' chief executive officer, Wellesley Hills, Mass.

One supermarket executive was quick to mention apparel retailer Kohl's, which unlike some large department and discount stores tends not to rely heavily on health and beauty departments or snack foods in addition to its main offerings. "Lowe's is a great co-anchor, since they are less contractor-oriented than Home Depot, tend to draw more women, and there's very little spillover in product categories," the source added.

Jodi McLean, president and chief investment officer, Edens & Avant, Columbia, S.C., said a coffee store such as Starbucks tends to work well with grocery stores, despite their occasional protests. Food uses that don't generate too much traffic, such as an ice-cream store, tend to do well, as do small businesses such as drop-off dry cleaning, gift stores and -- when they can afford the rent -- municipal uses such as motor vehicle departments or post offices. "We like any municipal-type business that generates continued shopping patterns," she said. Book stores that can generate trips during different dayparts also tend to benefit their supermarket neighbor.