I recently had the opportunity to lead a session about restaurant leasing at a commercial leasing conference in Washing ton. Apparently, as a result of that work, I was invited to speak at a conference in New York City. That conference was entirely about negotiating restaurant leases.
I admit to wondering, when I first started gathering my thoughts for these sessions, what I would talk about and why restaurants merited their own session – let alone their own conference! After not much time, though, I started to remember that restaurants – although they often exist in a mixed retail environment or as an adjunct to an office facility – really do bring with them a panoply of issues which need special consideration.
This is the first of a series of three articles on restaurant leasing. In this article, I will discuss the identity and attributes of the tenant and the operator of the restaurant, as well as how the lease document can contemplate changes to these during the term.
Who is the Tenant?
Restaurant tenants, like most other retail tenants, come in a variety of sizes. The difference with restaurants is that many large restaurant chains exist to franchise their locations, so the day-to-day occupant will not be the party the landlord is contracting with. Alternatively, the large restaurant chain may have its operator sign the lease but build in a right to require an assignment of the lease to the chain. At the opposite end of the spectrum is the owner/proprietor who has a vision for his or her own restaurant – a vision which sometimes conflicts with the day-to-day realities of a retail environment.
At either end of the spectrum, the tenant named on the lease is often not the day-to-day directing mind of the operation.
One of the interesting linguistic differences between American and Canadian lawyers in this area is that Canadians talk about “covenant,” as in, “what is the covenant that the landlord is getting?” Americans are confused by this, since they correctly see the lease as chock full of covenants and are not quite sure which one is being referred to. By “covenant” in this case, though, we Canadians are really asking what is the net worth of the tenant? At the end of the day, no matter how it is phrased, the key question is, where is the money that is going to pay to construct the restaurant and, once that is done, where is the money that is going to pay the rent? Whether the chain or the operator is on the covenant is a key question for the landlord.
Apocryphally, I have been told by leasing people that it is usually the third restaurant which is successful. They mean the third restaurant in that location. The first may succeed if it is a national chain which has deep enough pockets to sustain months – possibly even a year or two – of losses before its business takes off but, for independent restaurateurs, their dream is often overtaken by their lack of cash flow before their business starts to run in the black.
This means that a sophisticated restaurant tenant (or at least one with a sophisticated lawyer!) will pay extra attention to the assignment provisions of the lease, to make sure that there is an “exit strategy” that will enable the tenant to leave if the cash starts to run out. Landlords are not fond of thinking of lease assignment provisions as an “exit strategy” but, in this case, it is both necessary and meaningful for both parties to focus on what will happen if or when the restaurateur decides to sell the restaurant – regardless of the reasons for doing so. There are, in fact, certain restaurateurs who have been quite successful in creating a restaurant operation, with their name attached to it, and then selling it once the restaurant experiences its initial success. For these restaurateurs, obtaining flexible assignment provisions is integral to their business strategy and their landlords need to know that this is part and parcel of what they are bargaining for.
What would a restaurant tenant want to focus on in this area? Its starting requirement will be that the landlord has to act reasonably in deciding whether or not to give its consent to an assignment request, so it will want to negotiate to eliminate or reduce any period of time during which the landlord can unreasonably withhold its consent.
Secondly, it will want to assess the landlord’s list of what constitutes a reasonable ground for refusing consent. If the landlord requires a tenant with a strong financial covenant but accepted the original tenant with no covenant, there is an argument that the landlord is trying to better its position on an assignment. On the other hand, a landlord that is dealing with a restaurateur like the one referred to above, who starts up restaurants and then sells them when they are doing well, may well accept a shell company with no covenant from the original tenant but knows it is bargaining with a sophisticated and experienced restaurateur with a track record of success. In those circumstances, it may be fair for the landlord to require a stronger financial covenant from the assignee than from the original tenant.
What about the requirement many landlords have that the tenant has to have a successful history of operating businesses similar to that being operated in the premises? This would preclude, for instance, an assignee that is composed of one or more parties who have worked in the industry for a number of years but who have not previously owned their own restaurant. The original tenant may want to seek some flexibility to accommodate this possibility.
A right to change the use may be requested by the tenant in the initial lease negotiations. If the tenant can only assign or sublet for another restaurant use, it will have limited its exit strategy (especially where it seems that any restaurant use will fail in the space). Many landlords, though, will resist this in their efforts to control tenant mix. This could be one of the main points of contention in the offer negotiations.
Lastly, a landlord may want to protect itself by seeking an indemnity from the principals behind the corporate tenant. The tenant may be prepared to agree to this, especially if the tenant is a shell corporation with no assets, but the indemnifiers will want to understand thoroughly what their obligations are, if and when those obligations will diminish or fall away, and what will happen to that indemnity obligation if the lease is assigned. Landlords will rarely reopen an in demnity at the time of an assignment, so the time to clarify all of this is at the time the lease is being negotiated.
The other possibility – especially with national chains – is that they may want to keep the lease in their name but have fairly unlimited rights to sublet the premises to a franchisee which will operate a restaurant under their banner.
For landlords, this is generally understood when initiating ensure that they get what they are bargaining for. Especially for strong national tenants who will not agree to cede much control to the landlord, it is important for the landlords to ensure that they are somehow protected. A requirement that the premises be operated in a first class manner and to the same standards as the tenant applies to the rest of its franchisees is a good starting point.
The landlord would always want to be advised of who is actually occupying the premises, regardless of whether or not it has the right to consent to the franchisee. As well, the landlord would normally want to receive a copy of the franchise agreement and any sublease so that it can be fully conversant with the particulars of the relationship. Realistically, most landlords do not read these but file them away. Nonetheless, they will want to refer to them if a problem arises.
From the franchisor tenant’s point of view, the landlord’s standard form of lease may require that the tenant give to the landlord any money which the tenant receives in connection with the assignment or subletting of the premises. This is really there to ensure that the tenant cannot collect “key money,” or a value attributable to a below-market rent – money which the landlord sees itself as being entitled to, as it made the original investment in the real estate. Regard - less of what position any party wishes to take on that issue, in a franchise situation, a franchisor tenant wants to be very sure that its landlord understands that franchise fees belong to the franchisor tenant and not to its landlord.
Conclusion (for Part 1)
Having reviewed issues relating to the initial and future identity of the tenant and restaurant operator, in future issues I will look at operational matters such as specific issues that arise from the restaurant use, liquor licences, patios and other restaurant issues.