Don’t go it alone during lease negotiations, experts say
Long before this Captain D’s location went up, the lease team outlined success.
Leases, like a franchise disclosure document, are something too few people spend enough time on and never really read until they have a problem.
But as a chief determining factor in a businesses’ success, the lease shouldn’t get the brush off and requires some thoughtful, detailed investigation. Beyond the big rent number, there are lots of potential pain points for operators. And if they’re having issues at the market level because of a bad lease, the franchise system is weakened, too.
“It’s surprising, the lease is often an afterthought, it’s all about location or sales or positioning, yet the lease is a potential time bomb waiting to go off if it’s not addressed,” said Jim Haslem. Haslem, a real estate consultant and CEO of CS Advisors, a financial and real estate consulting firm, is one of the people operators call when the lease goes sour and the location is at risk. He said clients could save a lot of time and money (including his fees) if they just take care to negotiate a lease that works for them in the first place.
That, he says, starts long before a real estate opportunity pops up.
“It’s critically important for any concept—even a one off—to create a pro forma for each location. You take your P&L based on your cost structure and you create a model. Then within that model, you run what I call the best case, the base case and the worst-case scenarios,” said Haslem. “Then plug in the rents that you think you can afford based on a percentage of sales and your base rent as a percentage of sales.”
He’s quick to point out rent is the main point of negotiation, but operators need to figure out their total occupancy costs. If they get a rosy rent number but are stuck with overwhelming common area maintenance costs (CAMs), it’s functionally the same as paying too much in rent. And things such as continuous operations clauses can compound the damages of a failed location.
Laying out performance scenarios provides a rational occupancy budget, said Haslem. With that in hand, operators can plug in locations to determine what works, but also what to negotiate in occupancy costs and identify other factors that can be tackled early.
CPR’s Josh Sevick
“Usually, the letter of intent is given to the attorney after it’s signed, and the attorney is supposed to draft the document. They’re not binding, but if you don’t have the important terms in the LOI, it’s difficult to get it in the lease,” said Haslem.
A balanced approach is needed get a strong LOI without negotiations breaking down. Haslem suggested getting key issues into the LOI and giving the drafting attorney—which all franchisees should invest in—a list of items to address in the lease. Then, he advised evidence-based negotiations. Bringing that pro forma, the occupancy budget and an actual or projected P&L gives the negotiations legitimacy. If a business can’t function on elevated market rents, it will be plain to see. This may not sway a landlord to ease demands without other leverage, such as a desirable brand, but it will at least be based in fact.
Sale-leasebacks add complications
The trend toward sale-leasebacks continues, especially for sophisticated operators with the capacity to do their own development. But beyond the nuts and bolts of a typical lease, the practice adds some quirks to lease negotiations, according to Gary Chou, senior vice president and consultant at brokerage firm Matthews.
“In the context of a sale-leaseback, it’s oftentimes that the seller knows they’re giving up control of the real estate. One important lease negotiating point is right of first offers or right of first refusal because when they sell, the original owner might be in a position where they want to buy it back,” said Chou.
For the operator who buys land to get control over curb cuts, signage and laying out the parcel to ensure that isn’t undone by the next owner, there’s an especially strong reason to do so. And if the operator’s buying spree or growth spurt is over, getting that real estate back is a wise use of excess capital, empowering another sale-leaseback or to secure debt down the road.
The sale-leaseback also changes what the typical operator wants across the lease, even the big rent numbers.
“If I were an operator trying to do a sale-leaseback, I would be more interested in having a higher starting rent but lower increases,” said Chou. “They want to create value today.”
He said ticking rent up by 10 percent would mean a higher purchase price and more capital returned to the operator for their next project or to pay down debt.
CPR Cell Phone Repair works well in 600- to 800-square-foot spaces, meaning the brand’s franchisees can save on occupancy costs.
Brands help limit confusion
To help with the many confusing issues and tricky language that goes into lease negotiation, many brands help out with real estate advising.
Captain D’s, a Nashville-based seafood concept with 522 locations, works closely with franchisees through the LOI phase, even requiring an addendum to the LOI to get things started right.
“We actually sit down with our franchisees and go through the hot buttons with them. We’ll go though the LOI, they may use their own or we have one that we can share. We like to go through that line by line so they fully understand what we’re asking for and why,” said Phil Russo, VP of real estate for Captain D’s.
To avoid undue oversight on franchise business, however, nothing is required except a standardized addendum.
“A lease addendum is required for every lease. We want to make sure that if the franchisee wants to leave that site, that they could turn it over to us, so we make sure there’s a provision like that,” said Russo.
Another provision is approval for seafood use. It sounds obvious, but Russo said some operators signed leases before ensuring another brand hadn’t negotiated a non-compete clause for the retail center. He also noted free rent periods have been a hot topic in leases lately, given extreme construction delays in many of the strongest growth markets.
“We like to see enough free rent period. We really don’t want to see franchisees commit to a site or pay rent on a site until the due diligence is completed on a purchase or the restaurant is built out on a lease,” said Russo.
He also advises franchisees to push for a lease that parallels the 20-year franchise agreement to avoid unnecessary challenges during the term. A great restaurant could become a bad business if rent doubles at the 10-year mark.
At CPR Cell Phone Repair, the ownership group saw a big need for help when it came to lease negotiation after it bought the brand in 2013. The concept, as the name suggests, repairs cell phones and other electronics at its more than 550 locations.
“We were struggling with locations,” said CEO Josh Sevick. “Nobody really knew why they were doing what they were doing. It wasn’t driven by data or information. People had good ideas, but we really had to look at what was happening.”
Occupancy costs emerged immediately as a major stressor for many locations across the system. Some of the spaces were just too big. The brand can work well out of 600 to 800 square feet, but many operators (confident, sophisticated ones especially) chose the sexy, high-traffic areas in a typical 1,600- to 1,800-square-foot box. That drove rents sky high.
“People had signed on right before we bought the company with leases that were double what we would have done,” said Sevick. “It was very obvious through our first couple benchmarking surveys we had people all over the place as far as best practices.”
Aiming for a smaller box in more ideal locations for the brand was the easy part. Namely, CPR wants to be near the A-plus location, but not in it. Rent in the 10 percent range was fine with the brand’s nearly 70 percent margins, “but 20 percent doesn’t cut it,” said Sevick.
So the franchisor designed a best practices guide with a detailed walkthrough of the lease negotiation process, watchwords and issues to push hard for. Sevick also said they began pushing franchisees to get a real estate attorney, a real one.
“We stress that our franchisees engage a real estate attorney, not just the family attorney but a real estate attorney,” he said. That’s meant helping franchisees understand the value of the representation. And it’s easy math when saving a few thousand dollars a month on the overall occupancy cost.
“When you look at the $3,000 a month, for three years, that’s a crazy amount of money, so spending a thousand or two up front makes sense. We just had to hammer that home,” said Sevick. “It might hurt a little now but you want to make sure you’re in a good position, it’s one of the most important factors.”