The three primary areas buyers focus in on in doing their analysis to determine if the restaurant, bar or club opportunity it the right one for them is as follows: a. Price Valuation, b. Location Overview and c. Lease Terms. In the most recent article I discussed Price Valuation and Location Overview and in this edition and the next edition I will discuss the major components of Lease Terms. In this edition I will cover the following topics: a. term of lease, b. rent, c. yearly rent increases and d. additional occupancy expenses. In the next edition I will discuss the following topics: e. the guarantor, f. use clause, g. assignment and subletting and h. options.
The Major Components of the Lease
- Term – Term is the length of the lease in number of years. It is recommended that the operator obtains minimally a five year term, which is called the base term and a five year option which is discussed below, so the tenant has enough time to get a return of his investment and return on his investment. Some landlords do not grant options in which case it is recommended that the operator obtain a ten year or longer lease term. The advantage of having a shorter base term with options is that the tenant is only personally liable for the base term and if the business is not successful the tenant will not exercise the option and will minimize his personal liability. Generally the more that is invested in the business by the tenant the longer the lease term the tenant requires in order to be able to recoup his investment and obtain a reasonable profit on the money the tenant has invested in the business
- Rent – Rent is the monthly payment the tenant is required to pay to the landlord for the tenants right to occupy the space. Most rent amounts are determined by the amount of square feet the tenant occupies times the market rent per square foot for the space. For example if the operator occupies a 2,000 square foot space and the market rent is $2 per square foot the monthly rent will be $4,000(2,000 sq ft x $2 sq ft = $4,000 per month).
- Determining the Market Rent. If the operator is negotiating a new lease or renewing an existing lease the best way to determine the market rent is to talk to several reputable commercial real estate brokers who specialize in retail restaurant, bar or night club leases in the area of the proposed business. It is also a good idea to talk to real estate appraisers that have access to commercial rents in the area as well as checking out reputable commercial real estate websites such as loopnet.com to see what is currently for rent in the same area. Rents in large metropolitan areas will vary dramatically depending upon which specific site the business is located. For example in San Francisco monthly market rents will vary between $1.50 square foot to $10.00 square foot. Another method for determining market rent is to drive the area of the proposed location and look at for lease signs and call the brokers of these sites and ask them what is the asking rent for these spaces. The operator can than take an average of the rents he has surveyed and use this survey as a basis for negotiating the base rent with the landlord. Additionally the operator can call existing restaurant, bar and night club owners in the area of the operators proposed site and ask them how much rent they are paying. In most cases the owners will not give you this information as they feel this is proprietary information and in many cases the owners may have older leases with substantially below current market rents. If the operator is negotiating a new lease and has a good prior track record the operator can sometimes negotiate a below market rent as the landlord feel s his risk factor has been reduced based on the operators past success. If the operator is renewing a lease he/she should capitalize on the operators past success as a tenant in terms of paying their rent on time, keeping the premises well maintained and being a asset to the building as a tool in negotiating a favorable lease.
- The Landlord Perspective on Rent. Although the landlord wants their tenant to be successful they are very concerned with obtaining the maximum market rent for the space leased as this determines the value of their building. For example if a tenant is paying $60,000 a year rent and the formula for determining the value of the landlord’s building using a capitalization method and a 6 cap rate, the value of the landlord’s building is $100,000 ( $60,000 annual rent / .06 cap rate = $100,000). If however the market rent for this space is $75,000 per year and using the same valuation formula above the building is worth $125,000 ( $75,000 annual rent / .06 cap rate = $125,000). So the higher the rent the more valuable the building,
- Yearly Rent Increases – Yearly rent increases should be tied to either pre-negotiated fixed yearly rent increases on the Consumer Price Index (CPI). A consumer price index (CPI) is an index number measuring the average price of consumer goods and services purchased. The average CPI in the San Francisco-Oakland-San Jose area in the past several years has been approximately 3% a year. When the CPI is used it is common to have a minimum yearly increase, also called a floor and a maximum yearly increase, also called a ceiling. When floors and ceilings are used with CPI rents floors usually are in the range of 2 to 4% a year and CPI ceilings are in the range of 5 to 7% a year.
- Flat Rent – Although rents are usually adjusted yearly on the anniversary date from the commencement date of the lease, in some cases, if the operator has a strong track record or the rental market is weak and it is a lessees market, the operator can negotiate a flat rent. A flat rent means that the rent is fixed at a certain level for a given number of years . For example there is a ten year lease and the rent for the first five years is $2,000 per month and the rent for second five year period is $2,500 per month. If there are additional rent expenses required with a flat rent such as property taxes, fire insurance and common area maintenance expenses usually the landlord will pass through to the tenant the yearly increases for these expenses as he does not want to be out of pocket for these costs
- Fixed Rent – This means the rent is fixed either at a stated fixed dollar amount or at a yearly fixed percentage. An example of a stated fixed amount dollar rent is as follows: in a five year base term lease the monthly rent is stated as follows: year 1 – $2,000, year 2 – $2,100, year 3 – $2,200, year 4 – $2,300 and year 5 – $2,400. An example of a stated fixed percentage rent is as follows: there will be a yearly 3% increase of the base rent as follows: year 1 – $2,000, year 2 – $2,060, year 3 – $2,121.80, year 4 – $2,185.45 and year 5 – $2,251.02
- Percentage Rent – If the landlord insists on a percentage rent the operator should cap the percentage to 5 to 6% of yearly sales. In exchange for a percentage rent the operator should negotiate a below market minimum rent and have the landlord make a monetary contribution to any remodeling the operator plans to do without having this landlord contribution amortized as additional rent. The rational for percentage rent is that since the landlord is making a monetary contribution to the tenant the landlord is in effect becoming a minority partner so to speak with the tenant and is entitled to a percentage of sales based upon his investment. Percentage rent usually kicks in at a determined natural break point which is as follows: if the base rent is $60,000 per year and the percentage rent is 6% of gross sales and the natural break point is $1 million per year of sales, the operator does not pay percentage rent until he does at least $1 million sales a year. This is determined as follows: take the annual minimum rent of $60,000 and divide this by the percentage rent which is as follows: $60,000 minimum rent / .06% percentage rent = $1,000,000 natural break point of yearly sales. This means that if the operator does $1.5 million sales in a given year his rent will be as follow: $1.5 million sales times .06% percentage rent = $90,000 rent.
- Sliding Scale Percentage Rent – In some cases if the landlord is making a large landlord contribution toward the tenants remodeling a sliding scale percentage rent formula may be negotiated. With this method the landlords rent is calculated using different percentages at different sales levels. An example of a sliding scale percentage rent formula is as follows: on the first million dollars of sales the operator does in a given year the landlord will get 6% of yearly sales, and on any sales the operator does in the same given year between $1,000,001-$1,500,000 the landlord will get 7% of yearly sales and on any sales the operator does in the same given year above $1,500,001 sales the landlord will get 8% of yearly sales. In the above mentioned example if the tenant does $2 million in sales the tenants rent formula would be as follows: the percentage rent formula on the first $1 million of sales is $1,000,000 x .06% = $60,000 + the percentage rent formula on sales between $1,000,001 and $1,500,000 of sales is $500,000 x .07% = $35,000 + the percentage formula on sales between $1,500,001 and $2,000,000 of sales is $500,000 x .08% = $40,000. The total rent owed to the landlord would then be $60,000 + $35,000 + $40,000 = $135,000 for that given year.
- Additional Occupancy Expenses – In addition to base rent the tenant may be charged what is called triple net expenses (NNN) which means that in addition to the base rent the tenant will be charged monthly for real estate taxes, fire insurance on the building and common area maintenance costs (CAM costs). CAM expenses can include landscaping expenses, security expenses, common area utility expenses and building maintenance costs. These expenses are determined by a predetermined formula which is spelled out in the lease. The formula is usually tied to a pro rata share of the total building NNN costs based on the percentage of space the given rentable space has relative to the total rentable space for the building. For example if the given rentable space is one third of the entire rentable space of the building the NNN expenses would be equal to one third of the yearly real estate taxes, one third of the yearly building fire insurance expense and one third of the yearly CAM charges. Specifically if the buildings yearly real estate taxes were $24,000, the yearly fire insurance expense was $12,000 and the yearly CAM charge was $6,000 the total buildings yearly NNN expenses would be $42,000. The tenant for the given rentable space would then be responsible for paying one third of the $42,000 NNN expenses on a monthly basis as follows: $42,000 x .333% = $14,000 or $1,166.67 per month ($14,000 per year / 12 months = $1,166.67 monthly NNN expense). This NNN rent is paid monthly in addition to the base rent and the tenant is usually billed monthly by the landlord with the invoice breaking down the various components of the NNN expense. In the above example if the tenant is occupying 100% of the building the tenant would then be responsible for paying 100% of the $42,000 NNN expense or $3,500 per month NNN expense ($42,000 yearly NNN expense / 12 months = $3,5000 monthly
There are some cases where the tenants additional occupancy expenses may be limited to only a single net lease (N) where the tenant only pays real estate taxes or a double net lease (NN) where the tenant only pays real estate taxes and the fire insurance on the building.