CHAPTER
7

Negotiating Your Lease

In This Chapter

• Why leasing is best for beginners
• Tips on working with real estate brokers
• Benefits of taking over an existing restaurant
• The basic terms of commercial leases
• How to negotiate a smart lease

Your monthly rent will be your most stable overhead cost, a reliable cost that can help maximize profit. Most commercial leases are for 10 years, with two 5-year renewal options. Locking in a rent that isn’t more than 6 to 7 percent of sales is essential for financial success.

In Chapter 5, you learned the equation to use to see if you can make a good profit in a space. Now we’ll help you negotiate a good lease by teaching you about commercial lease strategy points and tips on negotiating with your prospective landlord.

Should You Lease or Buy?

We don’t recommend buying to first-time restaurateurs. Buying a building, and investing in real estate in general, is a completely different endeavor than starting a restaurant. Buying takes such a significant financial and managerial commitment that it distorts the equation for a beginning restaurateur.

Think about it—an investment in a building is huge. Let’s say the building costs one million dollars, and the capital investment in your restaurant is $300,000. The investment angle doesn’t hold up. If you have that much doubt about your restaurant’s prospects to back up a $300,000 investment with a million-dollar real estate deal, maybe you should re-evaluate your plan to open a restaurant.

An exception would be if you already have significant experience investing in real estate, or if you’re a restaurant veteran who has good financial backing. In that case, buying a building can be a great asset to back up the volatile nature of the restaurant business over the long term.

Working with Real Estate Brokers

Work with experienced professionals who specialize in commercial real estate, know the landscape, and have worked with restaurateurs. Your sister-in-law or her cousin just became a realtor? Sorry, but you don’t have time to help her make her first commission. You’re looking to make a long-term financial commitment, and you need a seasoned professional. Don’t let your goal be sidetracked by helping newbies who need a break. It may sound cold, but this is business and you’ve got a lot at stake.

POTENTIAL PITFALL

Don’t let a real estate agent rush you or push you into a property that doesn’t work with your business model. The agent’s goal is to close the deal quickly. Take enough time to make an informed business decision.

Okay, you’ve found a commercial real estate broker who has been in the business a long time, and knows the territory, players, and history. Give them a profile of what you’re looking for and the business terms you can live with. Remember, your broker is really just a facilitator. And remember who’s paying your experienced real estate broker’s commission—the property owner. Your broker’s interest is in making the deal and getting his or her commission. You need to be your own advocate and make sure you don’t compromise to the point where it knocks your business model off course. You’ve got to watch your own back. That means read, analyze, and understand the entire lease. There’s no such thing as a “standard” lease.

The Ins and Outs of Commercial Leases

There are two basic designations of property: residential and commercial. Most of us are familiar with residential leases for apartments and houses. Commercial leases are a little more detailed. They have additional charges you don’t see in residential leases, the triple net (NNN) charges you learned about in Chapter 6.

Commercial rent is based on dollar-per-square footage annually, and NNN is based on a percentage of that. It’s usually between 5 to 10 percent of the rent. For example, if rent is $50 a square foot, NNN might range from $5 to $15 per square foot per year. Costs vary depending on whether you’re a tenant in a free-standing building or one of a dozen tenants in a strip mall. In the latter case, your portion of NNN would be calculated by dividing your restaurant’s square footage by the property’s square footage.

Calculating NNN Charges

Terms to Know

Triple net indicates that the monthly rent includes property tax, insurance, and common area maintenance (CAM). Tenants pay for the upkeep of shared areas. This can include parking lots, walkways, utilities, security, and property management.

Usually these charges are estimated annually, and that figure is divided over 12 months and added to each rent payment. At the end of the year, the estimate is compared to the real expenses. You could be given a credit or a bill. When you look at restaurant spaces, ask the landlord what happens if repairs are suddenly needed. Will the landlord cover them or expect the tenants to come up with the cash? Once you become a tenant, avoid maintenance surprises by staying apprised of what’s going on in the building and any repairs that are needed or are underway. The landlord should always be responsible for roofing expenses; it’s his building, and if the roof’s leaking you can’t operate and pay rent.

SMART MOVE

To make sure NNN charges won’t surge, examine the property. Ask the landlord for his maintenance operating budget and capital budget forecast. Ask to see the records of the most recent three years of charges.

Unscrupulous landlords have been known to increase CAM fees to help cover vacancy costs by suddenly adding fees to rent.

There are legitimate ways NNN can increase. Property taxes are passed along to the tenant (you). That means if your renovations add and build value to the building, the town or city will place a higher tax on the property. (Check with your local economic development bureau and other public-private partnerships devoted to increasing business in your town to see if there are any tax abatements.)

That said, as much as restaurateurs have to mind their pennies and be frugal, the truth is accelerated CAM or property taxes rarely make or break a restaurant. The equation for success is to stack up as many positive fixed decisions as you can, such as signing a lease for rent equal to 6 to 7 percent of your sales. It’s one of the biggest numbers you’ll live with for years, so negotiate well.

These days, rental increases should be in the 2 to 3 percent range annually. That means by the end of five years, you’ll have to bump your prices 10 percent to meet this rent increase. In the past, during times of inflation, landlords could increase rents sharply. Some leases state that increases will be tied to the consumer price index (CPI). Check to see that the proposed increases in your rent are in line with your local CPI, which can be found on the Bureau of Labor Statistics website.

Protect yourself from an open-ended lease. A lease is a way of putting bookends on the deal. Don’t sign anything for which someone can suddenly change the numbers.

Negotiating Points

As you negotiate, keep notes on everything the landlord agrees to, and make sure these points make their way into the lease in writing.

Following is a list of additional points to try to get on the lease. We’ll discuss them in more detail later.

Lease Negotiation Points Checklist:

• ❏ Include rent abatement during the build-out and permit process.
• ❏ Contingency in the event zoning use changes prevent opening a restaurant or getting a liquor license.
• ❏ Exclusive use: ask the landlord not to lease to the same type of restaurant as your raw vegan place.
• ❏ Assignment: Your right to transfer the lease to a new tenant is a valuable asset you might want to sell 10 years from now.

Your lease should not include the term “in sole and absolute discretion of the landlord.” You want the word and spirit of “reasonable” included.

Sometimes you can negotiate with your landlord to let you start off paying a lower rent, such as 6 percent of your sales, with the promise it will rise to 7 percent when the restaurant exceeds minimum sales. It’s a way to incentivize him; it makes him want your restaurant to do well.

Try to negotiate a two- to three-month abatement in paying rent to cover the time you’re making investments and improvements to the property. Use your limited capital decorating budget on things that express your concept. Don’t start renovating bathrooms. Instead, paint, resurface, and redecorate. Use what you have. It can take an experienced eye to see the diamond in the rough and how color, texture, and consignment store lighting can transform a space. Even people who have a good eye, who’ve picked up a lot of knowledge about restaurant interiors over the years, rely on interior decorators to express their restaurant’s concept.

SMART MOVE

An unrented space is a landlord’s greatest expense. Landlords are motivated to give deals to tenants who show the ability to commit to a 10-year lease and create a thriving business.

Other Incentive

In addition, you should try to get the landlord to include a Tenant Improvement Allowance (TIA). TIA is the funding a landlord may or may not provide a restaurant to spend on the renovation or development of the space. You can also ask for a Furniture Fixture and Equipment (FFE) allowance, which refers to money a landlord might provide to help with furniture, light fixtures, and equipment.

Key money is what a restaurateur pays either the departing tenant or the landlord to take over the space and an FFE.

Don’t buy equipment you don’t need. Only buy equipment if it’s a good deal, is in good shape, and will work to express your restaurant’s concept. For instance, the fancy new ice machine the departing tenant installed produces the ice spheres and pebbles that will help define your bar program. Ask the departing restaurateur or the landlord for a written schedule of what’s included in the key money. That schedule will be attached to the lease. You don’t want to assume you have the ice machine and then sit down to sign the lease and discover the machine was leased.

DEFINITION

Key money is an amount of money a departing tenant or the landlord will request from an incoming tenant in return for the furniture, fixtures, and equipment they are leaving behind. Make sure to confirm in writing who owns what before you pay anyone. A Uniform Commercial Code (UCC) search will help disclose any filed liens. Many states have online UCC lien searches.

Jody recently paid key money for the first time. He paid it because the guy selling the restaurant had a kitchen set up with good equipment that worked perfectly for Jody’s restaurant concept. He wanted the space and equipment, and the key money sweetened the deal for the departing restaurateur.

Restaurant leases are long, because restaurateurs often need a lot of time and money to earn a profitable return on their investment. The classic idea is it takes four to five years to create a solid business, and then you make money for five to six years. After that, you decide whether to renew your lease or sell it. Your lease is a tangible asset, and a lease with five or more years on it can be sold. Remember most commercial leases state that options to extend the lease become void if the tenant stops paying or falls behind on rent. It’s worth negotiating a clause to restore the option upon payment of the arrears.

To check on the condition of the equipment, refer to the tags that note when they were serviced recently. Kitchen service providers will come in and make sure ovens are calibrated, and give you an inexpensive consult on the condition and outlook of the equipment.

Run specs by your local health department. Often they’ll want to look at your menu and know how you’ll be cooking items. They want to know how your restaurant will control fire and grease. If your health inspector decides you need to extend your exhaust hood 6 inches around the cooking line, and expand the exhaust hookup, that’s an expensive proposition. It could throw off your capital budget.

New Construction

New construction is often delivered in what’s called vanilla box or warm lit shell.

DEFINITION

Vanilla box is a term that usually indicates the landlord will bring basic utility services and plumbing access to the space and cap them. He’ll finish the ceiling and cover the walls in sheetrock. This is also sometimes called “warm lit shell.”

Make sure the space has adequate gas and electric power. A strained electric service will cause issues. Imagine if all the lights in your restaurant were to dim every time the soda gun compressor kicked on. Gas power usually isn’t an issue unless there’s been an extreme change in use of the space, such as it was built to be a card shop and now it’s a restaurant. To determine whether the system will deliver the high heat a restaurant stove needs, track down the spec cut sheets for your equipment online, or go through your kitchen equipment sales and repair service. It can be expensive to upgrade a gas line to a restaurant.

In some areas such as Aspen, where natural gas isn’t available, kitchens are fueled with propane. That makes high-heat cooking a challenge. Jody learned that the hard way when he started a restaurant there. No one told him you can’t get as high a heat with propane as with natural gas. When the chef started testing recipes, they didn’t turn out right.

If he’d known about the propane problem, Jody would have built the stove to compensate, but now, after the fact, retrofitting the stove was costly and pushed the restaurant off schedule. And the food never was as good as he had originally planned.

You never know what unexpected disasters can befall a restaurant space. There was a well-known sushi restaurant in a gorgeous mountain resort, which moved into a historic house that had been renovated by digging space for a new kitchen beneath the building. Here in this land of open, screenless windows, bugless nights, and cool mountain air, came an unexpected problem. The renovated restaurant smelled intensely of fish, and that wasn’t a good thing. The owners had to install an expensive ventilation system to fix this unforeseen problem.

Before signing a lease, verify that the infrastructure can support your restaurant’s needs.

Infrastructure Checklist:

• ❏ Gas
• ❏ Electricity
• ❏ Plumbing
• ❏ Ventilation

Everything on this checklist has the potential to cost several thousands of dollars to bring up to code. Discuss any concerns with your local building, health, and fire departments.

Existing Space

A beginning restaurateur is wise to find a space in which someone else has invested in restaurant infrastructure. When restaurants go out of business, the improvements are often retained and secured by the landlord. Listen to word on the street about restaurants that are not doing so well. Look for restaurants that are going out of business in your desired location. And then bide your time.

As a restaurateur goes out of business for financial reasons, he falls behind on rent. He can’t afford to pay it. During his first wave of denial, he’ll try to sell the restaurant for what he invested in it—but it isn’t worth that much. In the second wave of denial, the restaurateur tries to sell his furniture. But it has little value. At this point, it’s just a bunch of used furniture.

The value in the restaurant space lies in the infrastructure—the kitchen hood, grease trap, stove, and walk-in refrigerator or freezer. If you can get these without having to invest your own money, you’ll be in better shape. Buying brand-new grease traps and hood vents doesn’t bring a return on investment. Depreciating equipment on taxes is done over a protracted period. You need to ride it a long time to get your investment back.

The savvy potential restaurateur looking for a restaurant space waits it out while the first owner gasps his final breath and the landlord takes back the space. The landlord will probably throw in the tables and chairs with the deal, and with some creativity you can repaint, reuse, and upcycle what’s left behind.

DEFINITION

When you upcycle, you take a particular item and refresh its look. For example, you can take a worn-out chair and repaint the wood, then add new upholstery to create a piece that can be used in your restaurant for years to come.

Once you find the space within your desired location, a space that has the bones that are compatible with your concept and that’s either closing or has closed, you’ll have to give your landlord two months’ security deposit to secure the place. Make sure your accounts are in order. There’s no quicker way to tank a real estate deal than to hand over a security deposit that’s no good.

Rent Abatement

If you’re renovating the space, try to negotiate a period of free rent or a rent abatement period during the amount of time estimated to perform the renovations. Landlords are usually agreeable to this because the time is being used to add value to their building. Typically, all permanently installed items such as stoves and walk-in refrigerators remain the property of the building owner unless otherwise specified in the lease.

In the lease, these terms are called lease commencement and rent commencement. What Jody usually does is tell the landlord to give him 90 days or until the day the restaurant opens, whichever comes first. If the restaurant opens sooner than 90 days, he starts paying rent opening day. Don’t try to take advantage of the landlord. By having your concept complete, you start preparing your new restaurant before you sign on the dotted line. During the due diligence period, in which you’ve tied up the space with a deposit (which is almost always refundable), you can explore the details. From the moment the 30-day due diligence period begins, your team needs to get busy.

Once you sign the lease, you’ve got to finish renovations and open the restaurant by the time the first rent check is due. A budget can be ruined before the restaurant’s doors open if construction issues cause delays.

Few landlords are willing to include a contingency clause that allows you to cancel the lease if you can’t open for business or have delays. The only case for making headway with a landlord on canceling a lease is a situation such as you aren’t able to get a liquor license due to certain conditions relating to zoning or change of use. However, it’s part of the real estate broker’s job to vet that. In that case, you should be able to walk away from the lease. Rent abatement is the proper way to deal with the time required to get your restaurant up and running.

Exclusive use—a clause in the lease stating that the landlord will exclude or limit competing restaurants in the same complex—is a tough bargain. It isn’t easy to get landlords to agree to exclusive use unless you have brand recognition. For example, Dunkin’ Donuts can require a landlord not to lease to another coffee shop in the same shopping plaza. If you don’t have the power of a big chain restaurant, don’t worry too much about exclusivity. Your landlord wants to keep his real estate rented and earning income. And it’s to his benefit not to allow direct competitors who would knock current tenants out of business. Your successful restaurant is a benefit to his shopping center.

Assignment—your right to sell or transfer your lease to another—is an important negotiating point. It’s an exit strategy that, depending on the success of your restaurant, could put you in a position to make money or staunch the debt if you close down the business.

Many times, the deal is predicated on the landlord formally accepting the new tenant. He has to grant the assignment to the new tenant. Sometimes, if the landlord thinks the former tenant has a stronger track record, he might ask to hold the former tenant on as a security guaranty.

The landlord might ask for some type of protection if the new tenant doesn’t complete the terms of the lease. Jody prefers a “good guy” guarantee. It states that if he decides to close the business and is unable to assign it to another tenant, he’ll guarantee that from one year to the day he returns the keys, he’ll pay rent. But if the landlord can’t rent the space to anyone else within six months, Jody is done. There’s something seriously wrong with a commercial space that stays vacant longer than six months.

The Least You Need to Know

• Signing a lease that’s 6 to 7 percent of your projected sales is one of the smartest long-term business agreements you can make.
• Leasing an existing restaurant space is recommended for first-time restaurateurs.
• Work with an experienced commercial real estate broker, but do your due diligence.
• Be familiar with the terms and the terminology of commercial leases so you can negotiate on FFE, TIA, and rent abatement.