Restaurant Lease Pitfalls to Avoid
When it comes to leasing restaurant space, most restauranteurs are keenly focused on where the business will operate. Afterall, there are three rules to retail, right? Location, location, location. This article examines what to look out for in between finding the perfect restaurant property and what happens before opening your doors. So the question is, what are the restaurant lease pitfalls to avoid?
Letter of Intent
The biggest mistake I see tenants make is what is not included in the negotiation prior to the lease being drawn up. The letter of intent is constructed typically by the listing agent, using the landlord’s template, and no tenant-favorable clauses will be volunteered by any self-respecting landlord. The perfect example of this is a renewal right, which is often agreed to by a landlord, but usually only after the tenant remembers to ask for it.
By default we are much better at critiquing and focusing on the words on the page, and we really require a letter of intent checklist to remember the items that are silent at the LOI stage.
It is always better to find out what is a yes or no at the very beginning of the negotiation.
Tenant Improvement Allowance
Restaurant build outs are far more expensive than conventional lessees of space (most office space users essentially inherit second generation space and re-use offices constructed by previous occupants).
The dining area is expensive and so is the kitchen. The amount of the allowance (or the actual budget of the construction) is often worth more than a full year’s worth of rent – so the stakes are high.
I see too many tenant improvement allowance clauses that are poorly written. The most common culprits are:
- It does not cover the full amount required – this means you must be very diligent in determining what your exact costs are and figure out how you are going to finance the balance of the funds required.
- Construction savings are not captured by the tenant. This is a common practice of landlords – the LOI stages an exact amount for the TI allowance. Then in the lease, it says it is “up to” the stated amount. Therefore if you have a $30,000 tenant allowance and only spend $25,000, then the landlord only reimburses the $25,000. The extra $5,000 should be applied as a rental credit, as it was factored in to your monthly payments. In this case the landlord is just stealing $5,000 by inserting those two innocent looking words in the lease.
- The amount gets scaled back between the LOI stage and the lease. For example, if the negotiated rental rate is $25 per square foot and the allowance is $40,000, but then the allowance is scaled back to $30,000 by the lease stage, then the rental rate should also be reduced. You are paying back the allowance (a loan), and this was factored into your $25 rental rate. So if the landlord decreases the allowance, you should also get relief on the rental rate.
For a complete guide on how to handle the TI allowance, click here.
In my experience, 75% of commercial leases have personal guarantees. In some cases, the landlord will also attempt to put the spouse of the business owner as a guarantor as well.
I always advise to completely remove the guarantee, but sometimes that will be a deal-breaker for the landlord. So here are the concessions that you can play around with:
- Increasing the deposit (in many cases increasing it from 2 months to 6 months can get the job done) – I would recommend that those extra months of deposit be applied to rent within the first year so the funds get put to use and do not just sit in the landlord’s bank account.
- Reducing incentives like free rent and the tenant improvement allowance.
- Increasing the rental rate either throughout the term or for a probationary period.
The personal guarantee should always have an expiry date on it that is sooner than the expiry of the lease. At some stage you should have earned enough goodwill and made the landlord “whole”. If you sign a lease for 5 years, pay rent for four years and default on the lease, the landlord is still better off than not having leased the space to you. With a favorable personal guarantee clause that had an expiry that was on the first or second anniversary of the lease, you would not be personally liable for that last year of rent in this case. Follow up reading: How to Modify a Personal Guarantee.
Operating Cost Gross Up
In the case of a unit that is part of a larger complex (malls, shopping centers, office properties), look for the number 95% in the operating cost clause.
There likely is some confusing language that states that the landlord has the right to gross up the operating costs as if the building is 100% if it is only 95% occupied.
What this means is that if the property is 100% occupied and a tenant who has 5% of the property vacates, then that tenant’s share of operating costs gets spread among the remaining 95% of tenants.
This is found in about 15% of leases. Most landlords absorb the 5% and this is how it should be done. This clause is simply a landlord trick to save 5%.
Are you confident that if the landlord replaces the roof, HVAC units or resurfaces the parking lot that you will not receive a big bill? Most leases are silent on these capital costs, which should be amortized over their useful lives (if a roof is going to last 15 years, that cost should be spread out over 15 years).
Being silent on the treatment of these costs allows the landlord to treat them as they should be, or to try to charge them in one year (which has been the source of many a lawsuit).
Be sure that your lease specifically lists examples of capital costs (HVAC, roof, and parking lots are the main ones), and that those costs will be amortized over their useful lives, in accordance with generally accepted accounting principles.
Assignment & Subletting
Getting out of lease can be just as important as getting in. In the case of assignment of a lease, that is typically when you are ready to sell your restaurant. Some clauses can be so onerous that it makes it incredibly difficult to assign your lease to the buyer of your business, which can thwart the sale of business. An example of this is that the purchaser must have a net worth at least equal to yours. What if you have a high net worth and it is unrealistic? The net worth requirement should only have to be enough to satisfy the requirements of the lease. Some landlords also want to participate in the upside of the sale, having a commission built in for them on the sale price.
On the subletting side, most sublet approvals have many conditions attached such as not being able to sublet if:
The prospect is another tenant in the complex
The rent is higher than what you are paying
The rent is lower than what you are paying
The landlord has available space for lease
The landlord has negotiated with the prospect in the past six months
Many leases do not have any of these restrictions. If you have all of these restrictions it effectively negates your sublet right entirely.
More on assignment vs subletting here.
While a future tenant could re-use much of your leasehold improvements, there likely will be enough changes that a landlord would want the liberty to have you restore and demolish your space so the next tenant can start from scratch. The problem is that this is typically a $5 - $10 per square foot cost (and some landlords will send you an invoice for this and not necessary follow through with the work).
When you are at the negotiation stage and have leverage, it is wise to ensure that your LOI specifically states that you will not have the obligation to restore the premises at the expiry of the lease and the landlord will accept the premises in an as-is condition at that time.
Jeff Howell has 20 years experience in commercial leasing and is one of the founders of Lease Ref, an online commercial lease review service for small business owners, including restauranteurs.