01 Dec Smart New Lease Models Send Restaurants Back to the Negotiating Table
Restaurants across the country and the world are re-negotiating their leases with landlords. Not only are new clauses being added to incorporate pandemic reality, but completely new models are emerging.
Instead of fixed-price rent based on floor space, some restaurants are demanding variable percentage-of-revenue rent that fluctuates with the profitability of the restaurant.
Making landlords effective investors in the success of your restaurant is better for everyone involved. This is where the old model fails.
Old Lease Models Don’t Make Sense Anymore
Post-Covid, the reality that restaurateurs are facing is that their square footage is now far less an indicator of revenue potential. Where once indoor floor space was a good indication of earning potential, delivery and take-out have become today’s major revenue streams.
As a result, areas reserved for indoor dining, typically 60% of floor space, have become less valuable.
Thanks to the reach of delivery services, the value assigned to location has also been eroded. In fact, venues where large crowds used to gather are likely to experience loss of value, as congested areas are now often the first to be locked down.
Major restaurant chains are even prioritizing off-site dining. Floor space previously intended for hosting patrons needs to be relinquished or repurposed.
Designated outdoor seating space, on the other hand, has gained value. Access to pickup parking, street level windows and drive-through lanes have become prime value adders.
Restaurant income now fluctuates at the mercy of new external factors. Lockdowns and virus variants, as well as supply deficits and labor shortages have made forecasting based on seasonal peaks extremely hard, if not irrelevant. In many cases, paying a fixed rate just doesn’t make sense.
A price per sq foot model doesn’t suit landlords either. Most proprietors lost money during the pandemic. Those who weren’t able to find common ground with their tenants were left with vacant and derelict properties.
This resulted in higher costs, taxes and fines, and made re-renting very hard. Finding a solution that keeps the property occupied is in every landlord’s best interest.
Current Lease Models Take 8-10% of Restaurant Revenue
- Net lease model
Most restaurants had a net lease model until the pandemic. This type of lease is based on a dollar price per square foot plus the ‘Triple Net’, or ‘NNN’, expenses: common area maintenance (CAM), taxes and property insurance. These are usually proportional to the actual costs every month. And, although they are paid to the landlords, they do not profit from them.
- Gross lease model
Restaurants with a gross lease model paid a fixed sq. foot-based rate every month that included rent but also utilities and NNN costs. This improved forecasting by creating a fixed occupancy cost. The downside is that landlords usually increase the initial base price to protect themselves from fluctuations. As a result, operators miss out on reductions in utility or maintenance costs due to lower use, in cases of lock-downs for example.
Whether under a gross or net lease model, the average industry lease costs are typically 5-8% of revenue.
When adding taxes, CAMs and insurances, as well as signage, utilities and designated parking – the total occupancy cost comes to 8-10%. Establishments that have smaller kitchens, no serving staff or no seating, like bakeries or cafes, can afford to pay around 12.5%.
Are Restaurants Getting a Bad Deal?
In comparison to other industries, restaurants are getting a bad deal on rent under the current system. The percent of gross sales that businesses spend on rent varies by industry, location and many other factors. In general however, most stores, offices and educational businesses would expect to pay less than half of what a restaurant does.
For retail businesses, especially in malls or commercial centers and office buildings, rental agreements also define that the landlord takes part in the setup, or build-out, costs. They call this providing a ‘Vanilla Shell’.
But many – especially new – restaurateurs assume that fitting the space to their business is their own responsibility and they don’t think to bring it up as part of new lease negotiations. In addition, restaurant leases frequently neglect complex kitchen requirements such as HVAC, hoods, or fire safety grease traps.
Restaurants are a pillar of every neighborhood. They are usually a cornerstone upon which other businesses flourish. Employees need places to get good food, host clients and hold events.
With such an important impact on the local community, every effort should be made to make it easier for restaurants to survive.
Old Rent Models Get Worse with Time
Pre-pandemic restaurant leases were typically signed for 5 or 10 years. Depending on the neighborhood, rent increases 2-4% every year. The actual property value, however, increases faster than that and landlords want to readjust when a lease is up.
Operators are surprised with 15-50% spikes in rent when the lease is up for renewal. And because most restaurants’ revenue actually declines after 5 years, and typical profit margins are 3-5%. The majority never make it past one lease cycle.
Agreeing on a more realistic way to increase rent will keep more restaurants afloat and stabilize income for landlords.
Turnover Tied Rent Models Emerge
A turnover based model (also called ‘variable lease rate’ or ‘percentage rent’) is a growing trend in the US, and around the world, since the Covid-19 pandemic erupted. In essence, the operator pays a rent that is tied to the restaurant’s revenues.
There are various versions of this model. Some structure it such that every month the higher option between a minimum dollar amount or a percentage of revenues is paid. An alternative is a constant blend of the two.
The reason that the percentage rent model is becoming so popular is that both parties benefit from it. Restaurant owners pay less rent when income is slow, regardless of the reason. In turn, landlords can help prolong the lease life, reducing agent and renovation fees, while also becoming a stakeholder in the success.
When both sides share the risks and the profits, everyone is incentivized for success.
The Fine Print - Important Clauses in Post Pandemic Leases
Re-negotiated restaurant leases now also include some of the following important clauses.
- Percentage reduction, deferrals or rent forgiveness – In addition to setting the base revenue percentage for when business is good, new leases also include a ‘lower percentage’ to be used when turnover or occupancy decrease below a certain level due to external factors like a forced lockdown. In many cases deferrals postpone rent until revenues cross the defined threshold.
- Defining exclusions to ‘revenue’, ‘sales’ and ‘profit’ – New leases meticulously define exclusions. These may be items that make little or no profit, income the restaurant does not actually keep or collect (e.g. tax or tips), or income not related to core services (e.g. branded T-shirts or potted plants for sale).
- Pandemic force majeure discount – New leases are now defining the pandemic as prolonged force majeure and determine a discounted percentage rate as long as the restaurant is legally allowed to be open but the country is still in a ‘pandemic’.
- Landlords participating in build-out costs – The way restaurants use space changed and new leases are requiring landlords to participate in changing the restaurant layout. This also includes building parklets, opening delivery windows or creating outdoor seating.
- Gross sales termination right – If a restaurant is not able to reach a predetermined sales goal by a specific date, typically 2-3 years down the line, they will be able to prematurely terminate the lease. This is beneficial for landlords too, as it reduces the risk of prolonged default.
Re-Negotiating Rent Requires Transparency and Trust
Approaching a landlord to re-negotiate terms in the middle of a lease is a daunting task, but it is crucial for operators to take advantage of the opportunity now.
To achieve a percentage rate lease, restaurants will need to share information they usually keep private. Operators will have to effectively collect data about the business and be transparent about the costs, traffic, revenue and profit margins will be key enablers.
Viewing the discussion not as a confrontation but as a strategic restructuring with a win-win outcome in mind is the best way ahead. It requires building a relationship of trust, and making landlords partners to success.
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