10 ways to manage the 10-year lease
Let’s face it—the restaurant business has always been fraught with risk. Fickle customers, unpredictable food trends, changing lifestyles, stormy economic cycles, and relentless competition are just a few culprits.
And now come the latest disrupters—delivery, order apps, over-development, the rise of the independents, and, of course, millennials. At November’s Restaurant Finance and Development Conference in Las Vegas, there was a lot of talk about staying flexible and nimble during these tumultuous times.
But how does one stay flexible and nimble when it comes time to sign a 10-year lease? Restaurants are never going viral and will always depend on brick and mortar locations for their business. So, with all this risk and uncertainty, how can an operator still feel OK about signing a 10-year lease? Here are 10 ways to mitigate the risk.
1. Consider retail trends when picking your real estate. There’s always been an unspoken love affair between retail and restaurants. That’s why restaurants have always gravitated toward small-town main streets and mall outlots. But this is a time of great upheaval in the retail industry, and while it is impossible to predict the future of brick and mortar retail stores, it’s probably a safe bet that in years to come there will be less of them. “A” real estate will most likely remain “A” real estate, but look out for the “B” and “C” locations. Don’t get tricked into declining real estate locations by low rents or large tenant allowances. Look at your potential site and imagine what it would be like if Amazon deliveries increased by a hundred times.
2. Structure your rent to protect your downside. Let your landlord share in the risk by negotiating a lower base rent with a higher percentage rent. That way if things go well, the landlord still gets their rent, but if your business struggles, your rent will be less of a factor.
I know a lot of operators who balk at percentage rent because it feels like they are giving away part of their profits. Hint: You are giving them away anyway in the form of base rent. Also, be sure to have a cap on your CAM, or common area maintenance, costs. If vacancies increase your landlord may try to put an unfair portion of the shopping center costs on you.
3. Borrow from your landlord, not from a bank. The great thing about tenant allowances are that they make the landlord your partner for success. If the business is a success your landlord gets the investment back through the rent. If your location fails, the landlord may add this to their damage claim, but it still beats owing money to the bank. And don’t feel too badly for your landlord—remember they get to keep the improvements.
4. Negotiate a kick-out. Make a reasonable request to be able to terminate the lease after the third, fourth or fifth lease year if your sales don’t hit some minimal threshold. Of course it’s painful to walk away from your investment, but it’s better than losing money for another five to seven years. Your landlord may request a mutual termination right that might be OK, but be careful of where you set the threshold.
5. Negotiate a flexible use clause. Try not to get pegged into too narrow or specific of a use clause. You need as much flexibility as possible to change out your concept or your menu if things aren’t going well. I’ve seen leases where the landlord wants to attach the menu and require that they get approval over any changes. Look out for this! Given changes in trends, preferences and nutritional science, you need the freedom to make radical changes to your offerings.
6. Ask for a co-tenancy provision. Whether you are leasing space in a regional mall or a small strip center, consider how important the current tenants are to the success of your business. If you like the location because of the presence of an anchor tenant or because of the overall quality of the tenants, protect yourself with specific language that allows you to terminate the lease if these tenancies change.
7. Avoid operating covenants. Try to avoid covenants that require you to remain open and operating for the term of the lease. In drastic situations where you are losing more money than you pay in rent, it is advantageous to simply close the unit. An operating covenant in your lease would allow the landlord to force you to stay open. Witness the latest court order obtained by Simon Properties that prevented Starbucks from closing its Teavana stores.
8. Negotiate liberal assignment and sublet clauses. When all else fails, you may want to put your location on the market and get someone to take it over. Restrictive assignment and sublet clauses in your lease will give the landlord too much say in who you sell to. Of course, the landlord is going to want to control their real estate, but try to avoid giving them an absolute right of approval. And at the very least, make sure that if you are a franchisee, you can assign to your franchisor, and if it is a corporate location, you can assign to a franchisee.
9. Negotiate the remedy provisions. Look out for draconian remedy provisions. Landlord form leases were not drafted with your best interests in mind. Make sure the landlord has to mitigate their damages, and if they get to accelerate the rent on default, make sure that you get to offset the rent by fair market rental value of their real estate. Also, look out for language that allows them to cut off utilities if you are in default.
10. Limit personal guarantees. If you have to sign a personal guarantee, try to limit its scope. Try to have it burn off after a set number of years, or limit it to a specific dollar amount or a specific length of term.
You are in an inherently risky business. If you are a multi-unit operator, sooner or later you will have to grapple with a unit that is failing. Make the upfront effort to protect yourself against the downside. Sooner or later you will be glad you did, or sorry you didn’t.
Stephen Cohen is an attorney specializing in retail and restaurant clients, with a concentration on real estate, development, finance, workouts and strategic planning. He is licensed to practice law in Minnesota, New York and New Jersey. Reach him at firstname.lastname@example.org.