What to do when rent is sky high
Planet Fitness likes to swoop in after big-box retailers leave the landscape.
As many operators know, the real estate market is extremely competitive right now and prices are as high as ever. But as this growth cycle comes to an end, distressed leases are set to become a boon and a bane for business owners.
The average business growth and contraction cycle runs about five years, and the current cycle just passed the six-year mark. Economists, analysts and anyone watching the stock market is already seeing some cracks, but nobody can tell just when this cycle will run out of borrowed time. When time does run out, one of the most damning things will be an unaffordable lease.
“The single most important factor that determined whether a restaurant could survive or not was the rent,” said Jim Haslem, an adviser with Huntley, Mullaney, Spargo & Sullivan that specializes in real estate negotiations.
He said too many operators focus only on selling food, the day-to-day operations and overlook their lease.
“It wasn’t the menu, it wasn’t the location, it wasn’t the folks working in the restaurant in the location, it was the rent,” said Haslem. “If the rent was just a little too high there is a very high risk of failure, more than a 50 percent chance.”
Bringing the success of a business down to a coin flip is obviously bad business, but the arcane world of commercial leases isn’t the first thing even sophisticated operators are familiar with.
So what does a distressed lease look like? It depends on the type of business, but typically when rent as a percentage of sales reaches the double digits, it’s time to take a closer look at the lease.
“There’s a range there. If you’re at 6 percent that’s generally a very healthy percentage; if you’re below 8 percent, you’re probably OK. Once you get 8 percent to 10 percent, you’re giving away a significantly higher percentage of your sales,” said Haslem. “And if you’re over 10 percent, it’s something that you’ll have to negotiate.”
Gary Chou, director of the restaurant division at Matthews Retail Advisors, agreed, saying anything over 10 percent starts eating away at the bottom line.
“When we start seeing 10 percent, we start asking questions,” said Chou. “I’ve seen deals where it’s 20 percent of the sale ratio and there’s no way they’re making money.”
For any operators doing the math, some concepts can absorb higher rents if other margins are good. In fine dining, for example, high-dollar dinners and great beverage margins can absorb higher rent percentages, as can large portfolios.
“I’ve seen brands with 12 to 13 percent rents, where from a normal perspective it would seem pretty challenging. But they have their economies of scale; they have 1,000 locations and the ones over here are doing fine, and these others are not doing great, but it all evens out,” said Haslem.
One metric can illuminate just how much an expensive lease is eating into profits. “If you put the rent in the numerator and the EBITDAR (gross earnings) in the denominator, you then see what percentage of profits go to the landlord in the form of rent,” said Haslem. “I love this metric. You’ll find many, many restaurants are shocked when they’re paying more than 50 percent of their profit to the landlord. What that means is they’re in business to pay rent to the landlord.”
Even in a historically high-priced real estate environment like many operators are working with today, it’s still possible to get a manageable lease.
Business owners can protect themselves from a bad lease by negotiating tough up front. Bringing various rent scenarios to a landlord will show how a high-dollar lease doesn’t make sense. Those scenarios will keep operators from getting caught up in the hype of a great location as well.
One big thing to remember is market rent isn’t necessarily the right rent.
“Market rent doesn’t mean that the restaurant is paying the right rent for that restaurant. A restaurant may need a below-market rent to survive,” said Haslem. “If you’re signing a lease at the top of the market—and I think we’re there—if you lock in that lease for the next 5 to 10 years, 18 months from now you may wish you had not signed that lease because rents will come down.”
Regardless of signing an attractive lease, macroeconomic factors, regional economies and changing tastes can put a restaurant in distress. But it doesn’t have to be a long journey to a failed location.
Once a lease is terminated, it’s back on the market. Savvy business owners can take advantage of those distressed leases. Chris Rondeau, CEO at Planet Fitness, found himself in a great situation when the various big box retailers started shutting down during the recession.
Large real estate spots like the 140 soon-to-be vacant Sports Authority locations are opening up as more and more consumers look to the Internet for retail goods. That means large-footprint concepts can swoop in for especially good deals.
“Pre-2009 when the crash happened, real estate was difficult for us,” said Rondeau, listing the various caveats landlords had. “Health clubs are always kind of looked down upon, they don’t stay in business and they clog the parking lot.”
He said the recession and Internet disruption handed him the keys to some great locations, and had landlords coming to him.
“Today with the ecommerce pressure on retail, people don’t need those big boxes and they’re looking at us to fill the parking lot,” said Rondeau. “It’s a much different conversation with landlords today because we drive traffic on the off days—we’re the perfect scenario for people to come into that plaza.”
Rondeau typically looks for 20,000-square-feet locations, and instead of looking for B or C locations, they can now swoop into the Main and Main spots left vacant by large-footprint retailers. He’s getting a lot more tenant improvement capital and a longer period of free rent to keep the people coming. And because it’s less cash out of pocket, Planet Fitness franchisees are able to grow faster.
“It’s less cash out of pocket so they can do two in a year instead of just one,” said Rondeau.
Extra due diligence
Not all businesses have that kind of luck, and have to be careful about distressed lease situations and what a failed tenant might mean for a new business.
Operators should do extra due diligence, make sure it’s a decent location and not get caught up in perks from landlords. “You get a lot of benefit from site work and infrastructure. There’s a lot of money to be saved if you can find distressed properties,” said Jason Keen, an adviser at Verdad Real Estate.
The trick, of course, is finding those distressed locations.
“Nobody knows who’s not performing,” said Keen. “I think some of it is pride, some of it is just lack of understanding that there is an opportunity. There’s not someone to call to say, ‘Hey, I’ve got this bad restaurant.’”
When it’s time to negotiate...
- The first thing to do is figure out if the location will ever be profitable. “Is this a temporary problem or has it been this way? If it’s never going to be profitable, let’s figure out a long-term solution,” said Jason Keen, an adviser at Verdad Real Estate. If it could be a profitable location, then sometimes all it takes is a meeting with the landlord. “I’ve seen plenty of franchisees go to their landlords and ask for a rent reduction,” said Gary Chou, Matthews Retail Advisors. “That’s the first and foremost approach to getting healthier.”
- Many private landlords and experienced restaurant landlord groups are going to be the easiest to work with. Institutional landlords, REITs, insurance companies and other very large groups can be more stubborn. Skeptical landlords and institutional landlords may still work with a tenant, but it means showing them exactly how both parties are benefiting. That’s what Jim Haslem, with Huntley, Mullaney, Spargo & Sullivan, calls fact-based negotiating.
- Laying out various metrics like rent efficiency and the landlord’s share of the rent shows due diligence in negotiations, not greed. And a good landlord will realize that fact. After all, if the restaurant fails, the landlord also loses their share of the passive investment. But not all landlords will play ball. “We like to negotiate a portfolio of leases because you’re not going to win every negotiation—you’re not,” said Haslem. “But if you win some of them, you may win enough to move the dial.”
- If a location still isn’t going to be profitable and negotiations didn’t push the needle far enough, it’s time to get out of the lease. Simply going dark is the last resort, and will likely open up some legal exposure and make for some bad blood. Talking to a landlord and finding a subtenant is better, but buying out of the lease is a win-win for tenants and most landlords.
- “If someone decides to close and you have a 20-year lease and it’s 10 years in, there’s value to just buying out early,” said Chou. “Sometimes from a landlord perspective if the landlord is pretty decent, it’s a good deal because they can put someone better in.”