As a shopping center investor, a common obstacle you might face when going to sell a shopping center is that last irksome vacancy. You want to obtain full occupancy to be able to sell the center at the highest price possible. Maybe you have given yourself a deadline, you want the center sold before the end of the year or before cap rates start to rise. A possible solution to this issue would be to guarantee that rental income by signing a master lease on the vacant space.

A master lease is used when the seller of the shopping center guarantees the rental income of any current and potential vacancies in the shopping center. The master lease creates a sublease for each space in the center and the seller has the right to sub-lease any vacant spaces. When guaranteeing only a portion of the property, the seller is not responsible for rent on other units. Depending on the current occupancy and potential turnover in the next year or two, the seller may pay the buyer rent on one currently vacant space, space that becomes vacant soon after closing, or pay the difference between actual rents and market rates. The seller should take the vacancy factor into account when deciding how much of the property to guarantee. It may not be necessary for the seller to guarantee more than 95% to achieve the desired outcome of the master lease.

The purpose of a master lease is to support a higher purchase offer as the pro-forma cap rate is applied to the subsidized NOI. Guaranteeing the entire center or a portion of the property increases the price of the property for sale because it increases NOI. As long as the seller has strong credit, the master lease should bolster a lender’s underwriting of the property for the sale (although the seller’s credit won’t matter if the amount of the full lease is set aside in an escrow account). The buyer will most likely get better financing terms due to the higher occupancy of the center.

The term of a master lease typically begins on the closing date and ends either on a negotiated date (usually 1-2 years from the closing date) or once a new tenant has signed the lease contract. Often, the total amount of rent due from the seller is held back from the purchase price at closing and placed in escrow with the title company in order to fund the rent payment under the master lease. The balance of the funds in escrow may be returned to the seller once the new tenant’s rent commences.

In most cases, the seller does not actually take possession of the leased premises and would not have responsibility for maintenance, repairs, or insurance. The master lease usually gives the lease-up responsibility to the seller who must seek out tenants for the master leased space. The agreement will likely detail minimum leasing terms required by the buyer and could require the seller to present the new owner with a lease proposal. These details may be negotiated during the buyer’s due diligence period and be attached to the sales contract as an amendment. The buyer will be obligated to enter into a lease that satisfies the agreed leasing terms set forth in the master lease.

The master lease strategy, when structured with buyer and seller protections, can offer benefits to both parties and reduce many hurdles to the successful sale of a shopping center. The seller guarantees the rental income to obtain a higher purchase price. The buyer agrees to pay the higher price because they are essentially buying a stabilized center and don’t have the responsibility of leasing up the final vacancy. The seller has the opportunity to dispose of the asset before the market enters into a higher cap-rate environment. The buyer has the benefit of better financing terms due to the higher occupancy/rental income, and they are able to purchase the “stabilized” asset sooner, while interest rates are still very attractive.

If your retail center is in a submarket with high average vacancies for comparable shopping centers, you may not want to sign a master lease. If the seller guarantees 95% of a center with 80% occupancy, but the average occupancy in the submarket is 90%, the seller may be locked into the full term of the master lease and won’t easily achieve early release by lease-up or buyers will not give credit to the lease in their offers. If your center is in a submarket with low average occupancy, the master lease may not be a good strategy for you.

The buyer and seller will have to negotiate many issues when considering a master lease. They will determine the term of the lease, how the seller will pay rent, if the funds will be held in escrow and how the excess funds will be dispersed if a tenant is found. The lease must give explicit responsibility to one party to handle the leasing and the lease-up costs. The lease-up responsibilities are typically given to the seller, but the buyer may provide some guidelines. It is up to the buyer and seller to determine what the tenant approval process will look like and how involved the new owner can be. The seller could be somewhat limited when negotiating with a tenant because the tenant may negotiate a lower lease rate than the seller guaranteed. If that happens, the seller may have to pay the difference in the rate.

According to Levenfeld Pearlstein, LLC (a law firm), “master leases create all of the rights, remedies and defenses afforded tenants under local landlord/tenant laws.” There is always the risk that the master tenant could declare bankruptcy and stop paying rent. In the event of a default, the new owner would be required to begin eviction proceedings to gain possession of the leased premises and they could sue the seller for the acceleration of the rent owed.

It is important to document the master lease carefully to understand how the transaction will be taxed. The seller’s rental subsidy can be viewed as an adjustment to the purchase price, which would reduce capital gains, or it can be treated as rental payments, which are deductible for income tax purposes and taxed at marginal rates. For a buyer, master lease rents could be viewed as ordinary rental income or as a refund of purchase price. Buyers and sellers should be well educated about the tax implications of a master lease transaction.

The master lease has been popular with multi-tenant retail developers who are looking to exit a project before achieving 100% occupancy. The master lease strategy has grown in popularity and may be used by owners of shopping centers to achieve the highest possible price for their assets. A master lease may be a good strategy if you are hoping to exit your commercial real estate now while cap rates are low and your property has a strong cash flow. If you want to sell your property at 100% occupancy but you are still waiting for the last space to be filled, marketing the shopping center as stabilized with the implementation of a partial master lease may direct attention to your property and bring you offers early so that you can sell sooner and at the highest value possible.

Sources
“The Value of a Master Lease.” Levenfeld Pearlstein, LLC, 22 Oct. 2018, www.lplegal.com/content/value-master-lease.
DeRienzo, David. “Using a Master Lease to Sell a Retail Asset.” All Things Commercial Real Estate, 7 Feb. 2018, www.derienzocre.com/blog/2018/2/7/using-a-master-lease-to-sell-a-retail-asset.