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LANDLORDS & LEASING

by Colin Taylor,
last updated 23/07/2009

Colin Taylor lifts the lid on leases in this personal view of the retail property market

Finding the right premises at the right price is a necessary part of retail franchising, but it's not always the easiest part. For franchisors and franchisees alike, the word is 'Beware' - it's the law of the jungle out there. Even within the last 12 months, poor premises selection and weak lease negotiation has resulted in more than one franchisor going to the wall as the chickens have come home to roost.

If a franchisee has the wrong site, or is paying too much rental, he or she is always going to be hamstrung and unable to make the desired profits. Even worse, there will always be a competitor who has done these things better. No matter how inferior their product might be, if their premises offer them enough advantages they will make more money.

A large part of getting the right premises on the right terms comes down to timing. It is all a matter of supply and demand. When a shopping mall has a waiting list of tenants, the landlord kicks the tenants unmercifully. When there are empty sites, the tenants can kick the landlord but only if they do so before they sign the lease. Once the lease is signed, it's too late to change the terms. In this article, I will outline some of the issues to consider and points on which you should try to negotiate.

Risk Management

First, you should be aware that there are changes in the wind. You may have heard that retail sales are up 6% against last year (excluding motor vehicles). This might make you (and landlords) think that retail generally is on a roll. Wrong!

The fact is that retail sales are being concentrated within fewer outlets as the big get bigger and stronger. The Warehouse grew sales by about $180 million last year to over $1 billion annually. This is equal to creating about 360 average sized speciality stores of $500,000 turnover each. Unless you know the full picture, retail growth statistics can be rubbish. But if you can interpret the statistics correctly you can at least be aware of the trends - if a landlord is asking you to sign for a six-year lease, you had better be clear on where your business and your competitors are going over that time.

Entering a lease agreement is all about risk management. You limit your exposure by taking the appropriate amount of space on terms which you believe the business will be able to afford. Experienced franchisors obviously have the advantage of knowing how their businesses operate in other locations, but still handle each site on an individual basis.

First, you must decide what type of location you need: street front, shopping mall; power centre; or factory-type premises. Then you need to decide the optimum size for your type of business. After that, you need to decide what the proposed business will be able to afford in the way of rent and operating costs. Accept that the considerations of budget may require some degree of compromise, but don't be prepared to compromise on any elements which you consider are vital to the long-term success of the new outlet.

Type Of Premises

Street Front Locations You need to be either a mum & dad niche market operation or be a strong promoter to make this work. Street front stores today are either for servicing local markets or for destination-type stores. Rents will generally be cheap unless the street in question is Queen Street, Lambton Quay or Newmarket.

A note of caution: some landlords at the better locations may want to receive key money at the expiry of your (probably six year) lease before you can take up a renewal. I believe this to be immoral and would avoid it like the plague. You should find out from prospective landlords what their policy on key money is, and make your decision whether to sign or not accordingly.

Shopping Mall Locations Shopping malls generally have better customer numbers than street locations. However, at this time of change there is hardly a mall in New Zealand which is not suffering from loss of customers. Foot traffic through the malls seems to be dropping, perhaps because they are too similar and have too little to enthuse the shopper.

None of these landlords to my knowledge ask for key money; however they will try to foist ratchet clauses on you. These should be avoided if as a tenant you are strong enough to resist.

Power Centres These are 'big box' locations where a number of major retailers group together to market and promote. They have plenty of parking and the rent is generally much cheaper than for shopping centres. Is this where the customers are going?

Factory-type Premises You need to be a destination-type store for this to work, but if you want cheap space and plenty of it this can cost between $5.50-$10.00 per square foot. Provided you can operate within council requirements and, crucially, drag enough people to visit you, this may be what you need. Remember that you will probably spend most of what you save in additional advertising to tell people where you are.

Having decided where, what type of location, how much space, how much rent, rates, operating expenses and the marketing level you can pay - ie, the total cost of occupancy - you then need to be aware that you will never, ever get a better chance of a fair rental deal than before you sign the lease. Conduct all your negotiations fully before you sign.

You are bound to be pushed for a decision long before the detail is complete - often long before the premises are complete. You will be regaled with tales of those famous tenants (who can't be named because of confidentiality) who will be your neighbours, and whose presence will ensure great success for you. Caution: if you really need those famous brands around you, or if you need the shopping mall or power centre to be full on day one when you open for business, then put this as a condition in the lease. Insist on a penalty clause too: ie, no rent to be paid until the occupancy rate is 95% full, or until there are not more than three vacancies. This is very important when dealing with the owners of secondary or minor malls in particular, as their enthusiasm to sell you the space may well exceed the facts.

Who Should Hold The Head Lease In A Franchise System?

Many franchisors - most notably McDonald's - adopt the practice of taking the head lease on sites and then sub-leasing the space to their franchisees.

The argument goes that holding the head lease means that the franchisor has control of the site. If the franchisee does not play the game, then the franchise agreement may be terminated and the errant franchisee evicted from the premises. The outlet can then continue either as a company-owned store or with a new franchisee.

Retail franchisors who adopt this practice also say it ensures that the franchisee does not pull down the signage and try to trade as a stand-alone (not franchised) store. They may additionally cite the strategic importance of the location as a reason for taking the head lease.

Today, I believe that the risks of this approach outweigh the advantages.

a) If the franchisor holds the head lease, then the franchisee guarantees the rent to the franchisor but the franchisor guarantees the rent to the lessor. If the franchisee cannot pay (despite giving personal guarantees), the franchisor will still have to - regardless of the fact that there is no income to pay for it. The money will have to be found from elsewhere in the system, damaging the prospects of other franchisees.

b) The fact that the landlord's income is guaranteed by the franchisor means the landlord is less likely to negotiate in tough times.

c) All those accumulated leasehold liabilities make the franchisor's balance sheet look very sick. In a big system, they show millions of dollars of liabilities to landlords. These days there is very little goodwill or key money value to offset the liabilities of owning the lease.

d) If the franchisor worries that he has insufficient control over the franchisee then this indicates that the franchisor lacks faith in his or her system. If a franchisee wants to go independent, I say good luck to them. Competition is so fierce that there is little room for the independent retailer in NZ today, especially given that their previous franchisor will be keen to re-enter the market in direct competition with the rebel franchisee.

It is perhaps worth noting that the principal reason why McDonald's went down this route is not because of control, but because their fee structure was inadequate. McDonald's sub-lease is a means of raising revenue - and in many cases they bought the properties so they are assets.

Incentives

Some landlords may offer incentives for the franchisor to hold the lease rather than the franchisee because it is more valuable to a landlord's bricks and mortar investment to have it leased to, say, an international chain rather than to an individual.

If landlords do offer incentives to the franchisor because of their perceived value and strength then it can be argued that those benefits should stay with the franchisor rather than being passed to the franchisee. At Stirling Sports we have never done this: although on occasions the benefits offered have been extremely valuable, we have always passed them on to our sub-lessee franchisee. We take the attitude that gaining an advantage for our franchisees is simply doing our job. If we make them and our whole group stronger financially it makes our whole system more profitable.

Length Of Term

Considering the uncertainty within the marketplace for landlords, and what I believe will be dramatic changes in the power base between landlord and tenant, the term of any lease undertaken should be as short as possible. My ideal would be a three year term with two rights of renewal to the tenant, giving a total of nine years if all rights of renewal are taken up. However, you are unlikely to get a landlord to agree to this unless he/she is desperate.

The days of long leases of up to 21 years are long gone. These leases came back to bite everyone after the '87 crash, and the retail world is changing so fast that now it is not in anyone's best interest, landlord or tenant, to be held into long leases. At some locations, month to month tenancies can be advantageous especially where there are lots of sites vacant: in this case the landlord will dearly want to hold on to those tenants they have. Having flexibility to move is the key.

Reviews

Most leases offered are 6 years with 2 x 2 x 2 rent reviews.

Whether you are a franchisor or franchisee, it is important that you negotiate strongly not only your first lease term but also key clauses for future reviews. Consider what will be happening to you and your business at the site when it comes to the end of the term, and try to get the lease to follow the expected path of your business.

Wherever you can negotiate it, rent reviews should be fixed to a known factor - for example, the current rent you are paying with any increase to be based upon the Consumer Price Index. This prevents you being vulnerable to a change of heart or, if your old lessor sells the premises, to a rapacious new landlord.

Caution: watch for ratchet clauses. These say the rent can go up but not down. For example, 'at review dates the rent will increase by not less than 5%' or 'will increase by the CPI rate plus 3%'. Landlords love ratchet clauses because they set a known factor for the increase which makes budgeting easy. However, this is grossly unfair to the lessee because it assumes that at the review date the economic climate is better than at the previous review.

All negotiations should encompass total occupancy costs, including: rates; building insurance; marketing levy; and opex (operating costs) payable to the landlord. What you need to agree is how much total occupancy costs will cost you each week, month and year of the time when you occupy the premises. Once you know the total then you can be fairly sure if you can afford it or not.

By the way, it is not unusual to get concessions, even perhaps extended free-rent periods, cash handouts or help with the shop fitout, from a new landlord eager for your signature. But be aware of that first rent review probably only 2 years after you open your store just when you think that you are getting on your feet. That is when the landlord will catch it all back unless you have built checks and stops in the lease conditions to cap any rent reviews to something you believe you can afford.

With regard to concessions, part of any strategy should be to seek some form of subsidy for the shop fitout from the landlord as you are making his/her building better and more valuable. You should certainly negotiate a rent-free shop fitout period of at least 21 days, and ensure that your workmen have access and can make reasonable noise to get the job finished

Exit Clauses

At sites where the landlord wants you badly, you should be able to negotiate all sorts of exit clauses which allow you to walk away: perhaps if total costs of occupancy become more than a certain percentage of turnover, or if you pay two months rent as a penalty. This is easier said than done obviously, because you will have made a large commitment to your shop fitout and spent considerably on advertising and promoting your business at the site.

In practice, exit clauses are more beneficial in helping bring the landlord to the negotiating table than for really wanting to move. Walking, however, is better than going broke!

For this reason you should minimise any clauses requiring re-instatement of the premises when you leave. You should instruct your store designers to create modular shopfittings so that you can unscrew them from the walls and walk away leaving as little damage to the site as possible. It also enables you to transfer fittings to the next site with the greatest ease.

Percentage Rent Clauses

Many shopping centre leases have percentage rent clauses. Percentage rent says that if the set percentage for your type of industry is, say, 5% of your sales value, and if that 5% is more than the basic rent for the premises, then you start paying percentage rent: ie, 5% of sales instead of the basic rent. It is a way of landlords getting an extra piece of the action when times are good and your business is growing.

Unfortunately, it doesn't work both ways - it goes up for the landlord when sales are good but doesn't come down for the tenant when sales drop off. It is something to be very careful about - prior to signing! If yours is a niche or speciality retail business and you have entered a lease under special rent concessions because of your industry's low margins, you need to be watchful at first and future reviews to ensure that you don't have market rent foisted on you. Aim for special concessions to apply throughout the term of the lease.

Non-Trading Radius Clauses

If you intend to open additional stores in shopping malls then non-trading radius clauses become of vital importance. The non-trading radius clause means that no matter what happens to the fortunes of your shopping mall, you cannot go to perhaps a better site within that radius (usually 3-5kms) while tied into these lease conditions. Fight to avoid this clause. It is like allocating franchise territories: once given away or sold, it often can't be regained without substantial cost.

And There's More

Some other quick points. In shopping malls you need a clause in the lease which prohibits the landlord from creating kiosks in the space in front of your store which might prevent customers from seeing your displays.

The lease should be specific by name for all the expense items in the lease outgoings, to list those items which are tenant responsibility so that names of expense items cannot be changed to circumvent the intent of the lease.

If you are dealing with leasing consultants or real estate agents, their livelihood is by way of sales commission and they can be over-eager to get the deal done. Keep accurate records of what is agreed, because some will promise the world knowing that management will later deny the deal that you thought had been agreed.

You and the landlord should both meet your own legal costs, this keeps both parties on the straight and narrow and hopefully ensures that litigation and legal costs are kept to a minimum.

Checklist

If you are in retail you have to have premises, so leases are a necessary evil. Having read the above, you should create your own ready-to-go checklist from items noted here and from other matters you have experienced yourself. Thereafter, never sign a lease unless you have checked the details against your checklist.

Life is a compromise - the above could be called a 'tenant's wish list'. You are unlikely ever to get everything your own way, but having a clear intention and good knowledge of what is and isn't acceptable to you should ensure that you get the best possible compromise.

Life is about risk management - leases are risks, so manage them.

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