by Simon Lord
last updated 14/12/2011
- getting the right place at the right price
by Simon Lord
last updated 14/12/2011
I recently conducted an interview with an award-winning franchisee who found himself priced out of his central Auckland location by rising rents. In that case, with the help of his franchisor he eventually relocated to another site where his considerable talents have built a thriving new business. Not so lucky, however, was a food & beverage franchisee who emailed us recently to tell us about her own experience. She and her husband had taken up an opportunity with a well-known franchise, with their business sited in a large mall. Despite taking expert advice from banking and financial advisors, the business failed.
While there were a number of other contributing factors (such as the rise in the minimum wage and the increase in paid holiday entitlement from three to four weeks per year), there were also site-specific issues. First, an extra storey was added to the mall, almost doubling the number of competitors. Second, a new car park was built at the opposite end of the mall, decreasing foot traffic by the franchisee’s location. Finally, while the initial rent had worked out at 14% of sales, it rose over time to more than 25% – the killer blow. ‘The franchise and occupancy agreements did not allow any out, the franchisor was unable to get our rent reviewed and, even if the Consumer Price Index went negative, there was still a rent increase,’ the email reported.
Property Is Second-Highest Cost
According to Peter Scott, founder of commercial property advisors Parallel Directions Ltd, ‘Property is usually the second-highest cost (after staff) of any retail business, so when that cost gets out of control it can have serious – often terminal – consequences. Lease negotiation is a specialist area and it is easy even for franchisors to get caught out by ratchet clauses (whereby the rent payable by a tenant can remain static or increase at review, but not fall) or property changes. The new car park which damaged the franchisee’s business would not have been a whim – it would have been in the mall owner’s plan for a long time, but the franchisor may not have been aware of, or may not have considered, the impact it would have on this particular location.’
Peter Scott has been in the commercial property sector for over 25 years and describes Parallel Directions as a ‘tenant advocate’. He says there are three stages at which good negotiation can make a significant difference to the viability of any tenancy: at the beginning, when the lease terms and conditions are negotiated; during the tenancy, if problems arise; and at the expiry of the lease term, when lease renewal, reinstatement (‘make-good’) or other claims will need to be considered by the landlord and tenant.
‘Of these, the initial negotiation is the time you can make the most impact. What you put into a lease is critical and, while it is difficult to get a big mall operator like Westfield to change their basic terms, it is sometimes possible depending on the nature of the business and its importance to the mix of tenants. One possible option is to have a fixed base rental plus a turnover lease, where an additional amount is calculated depending on what goes through the till. However, ratchet clauses as mentioned in the examples above are quite common.
Peter says that the rent review is actually one of the most misunderstood areas in lease negotiation. ‘For example, how will the landlord and tenant agree on the level of rental at review time?’ he asks. ‘The initial lease negotiation needs to deal with this. Most people have heard of a ratchet clause, but how many really understand what it means or how to deal with it? These clauses are quite common so it helps to know, or to take good advice from someone who knows. What tenants have to recognise is that landlords are not driven by what is fair; they are driven by what they can achieve in the market. After all, that is how their business works.
‘The frequency of rent reviews is not standard; landlords may choose to review annually, every two years, every three years… It’s important to understand that if you signed up to a six-year lease term in 2011, if there is a rent review every two years then the landlord will only have two opportunities to increase their return between now and 2017. Generally, at each rent review the landlord will try to push the rent up as often as possible because by the time the next review comes around, the rent is likely to be below the then-current market value. If the review is only three-yearly, they might say ‘right, I think an increase of 5% per year is fair’ and the tenant will suddenly see their rent increase by 15%. That’s going to hurt, especially if you hadn’t planned for an increase.
‘But if the tenant franchisee and the franchisor have someone such as a tenant advocate on their side, it may be possible to negotiate a much better deal, both initially and when review time comes around. Since the GFC, it has become more of a tenants’ market, and a skilful negotiator may be able to achieve an improvement in the rental and the lease terms and conditions.
Another area that Peter advises franchisees and franchisors to look at is the total occupancy cost of any space. ‘In addition to net rental costs, most leases require the franchisee to pay towards the cost of operating the mall or building. This is usually based on the size of the franchisee’s premises. We looked at that recently for a franchise taking on retail space at the foot of an office building. The budget included items such as lift maintenance and other items related to the tower – they just weren’t relevant to our client’s premises on the ground floor. We were able to have these items removed and so saved our clients lots over the term of their lease.
‘We also measure what space the tenant actually uses – it’s surprising how easily that can be over-stated. There’s a famous 1980s example of a building in Auckland that was leased out as nine storeys which was, in fact, only eight storeys! What a windfall for the client when this was discovered and the Courts ruled in their favour.’
Where The Franchisor Is The Landlord
In some cases, franchisors will take the head lease on a site and then sub-lease it to the franchisee. This can be attractive to the franchisor as it secures a key site, but Peter warns that it can result in added complications. ‘Franchisors are always keen to help franchisees succeed, but when they have their ‘landlord’ hat on, they need to have a different agenda. It’s important that they separate their relationship as franchisor from that as sub-lessor in order to protect their investment. If the franchisee does a moonlight flit, the franchisor still has responsibilities for rent, for operating hours and for make-good when the tenant franchisee moves out. They don’t transfer that responsibility to the franchisee.
‘Franchise New Zealand recently reported the case of a gym franchisor who was left with a rent bill and empty premises after the franchisee absconded. It appears that the franchisee had been in breach of their obligations from early on; a landlord would be tough on that and give a tenant just a few days to comply or would impose penalties. Most tenants would do the right thing at that point, but if they have a franchisee/franchisor relationship with their landlord it can get more complicated.’
The Three Critical Factors
Craig Watson believes that the role of franchisor or master licensee for a franchise comes with great responsibilities, ‘Not only in providing a potentially profitable franchise system but also in making sure the property fundamentals are right.’ Craig has seen both sides of the property equation, having worked in senior management roles at Westfield and as Head of Leasing for AMP before becoming the master franchisee for Donut King in New Zealand.
‘In my view, site selection is where a lot of franchises go wrong. I used to see it all the time as a landlord when the franchisor would be desperate to get into a centre because they had a franchisee ready to go and they would end up choosing from whatever was available. Sometimes they would end up with the wrong location for that particular business or paying too much in rent to be sustainable.’
Craig suggests that, for the long-term value of the franchise, franchisors need to be vigilant. ‘I know it sounds simple but site selection and lease negotiation requires knowledge, research and the ability to negotiate with major property companies expertly trained in commercial negotiation. This intimidates most people.
‘Franchisors and master franchisees need to ensure they negotiate the right location, in the right centre, at the right price. This goes hand in hand with having a successful retail system and a great franchisee, of course,’ he says. ‘Get all three of these factors right and it will go a long way to ensuring a successful retail business.’
Top five costly lease clauses for franchises
Melissa Pocock is an Australian lawyer who has recently become a lecturer at Griffith University, where she is completing her PhD. She recently published a list of The Top Five Costly Lease Clauses for Franchisees, which are summarised below. Read the full list.
1. Rent reviews
Typically, rent does not decrease between years. So, it will be an increasing cost for your franchise business for the life of the lease.
Work out a realistic budget / business plan and check that you can afford the rent (particularly after it is reviewed upwards a series of times).
You should also check whether there is a clause providing for ‘turnover rent’ to be paid once your sales reach a certain level.
Additional operating costs that a landlord incurs as a result of operating a shopping centre are often passed on to tenants. This is often a significant cost and, like rent, generally must be paid monthly.
What types of outgoings must a tenant pay and how are they calculated and apportioned between tenants? Check the lease to ensure that this calculation and apportionment is fair.
Check what circumstances allow the landlord to relocate your tenancy and what the procedures are when this occurs. Is there financial assistance for relocating? Is there a discount on rent and outgoings during any relocation periods? Can you object to the new premises? Is there an adjustment of the rent downwards if the new position is not as desirable as your current position?
If there is no relocation provision, check whether there are discounts or compensation available for disruptions in the operation of the centre.
The lease will often require you to obtain certain insurances. The most common of these are plate glass and public liability insurance. If you do not obtain the required insurances, you will be in breach of lease. There may be additional insurances, however, that are relevant for your business. Seek advice as to what insurances are appropriate for your circumstances.
5. Centre hours
Often a shopping centre will have core trading hours and tenants will be required to be open during those hours. You should check that the opening hours fit your franchise business model and whether you will be penalised if you are not open during the core trading hours.
Most importantly of all, understand what you are getting yourself into. Pay for good advice – it will serve you well in the future.
This article first appeared in Franchise New Zealand magazine Volume 20 Issue 3 September 2011
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