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Home » News » How Buyers Evaluate a Restaurant, Bar or Club Business to Determine if it’s the Right Opportunity – Part 3

How Buyers Evaluate a Restaurant, Bar or Club Business to Determine if it’s the Right Opportunity – Part 3

This is the last of a three part series where I discuss a continuation of lease terms from the prior issue. This issue will include some of the major elements of the lease which include as follows:

1. The Guarantor, 2. Use Clause, 3. Assignment and Subletting and 4. Options.

  1. The Guarantor . What is a guarantor? – The tenant is financially responsible to perform the terms and conditions of the lease and is the guarantor of the lease. The guarantor personally guarantees that he/she will pay rent on a timely basis and will perform all the terms and conditions of the lease. In smaller transactions and for entry level buyers the individual tenant is normally required to personally guarantee the lease. This means that if the tenants does not meet the terms and conditions of the lease that he/she can be personally removed from the premises through a legal action and the landlord can go after the tenant for any lost rent and other costs he incurs as a result of legally removing the tenant from the premises. Before a tenant is accepted by a landlord the tenant must be operationally and financially qualified and in many cases the landlord requires that the tenant owns a home with equity. The reason for this is that if the tenant fails and the landlord has to take legal action against the tenant the landlord can get a judgment against the tenant. Subsequently the landlord can get a lien secured against the tenants home or other property the tenant owns to force the tenant to legally pay the landlord for all lost damages including loss of rent, attorney’s fees and commission costs for re renting the space, Tenants with a long successful track record can usually negotiate having an entity such as a corporation or limited liability company guarantee the lease. For a landlord to accept an entity other than an individual as a guarantor the entity has to be adequately capitalized to assure the landlord that the entity can meet the financial requirements of the lease.
  2. Use Clause. This is a very important section as it states the allowable use a tenant is allowed to have in a given rentable space. The best restaurant use clause a tenant can get is the one with the broadest language such as “a restaurant serving alcoholic beverages.” This clause gives the tenant the right to have any type of restaurant and serve a full alcohol menu. In most leases that are in a shopping center or in office building where there are multiple restaurant tenants the language in the use clause will be very specific such as “ a café serving breakfast and lunch items excluding submarine sandwiches, deli sandwiches and specialty coffee drinks”. The exclusion of submarine sandwiches, deli sandwiches and specialty coffee drinks is because there is probably already a sub/deli sandwich business and specialty coffee business in the complex. Most landlords of retail spaces where there are multiple food service tenants do not want to have head on competitors. They’ll normally allow only one of each type of food service operation such as Chinese, Thai, Vietnamese, Korean, Mexican, Italian, hamburger franchise, coffee specialty operation, hot dog operation, etc. in the given complex. This is to provide exclusivity to the existing tenants to allow them to have a reasonable market share of the food service customers in the complex. Having diverse food service tenants also attracts more customers to the complex and provides a synergistic effect which is helpful to many of the tenants. If a tenant is having a problem making his operation be financially successful and he needs to change the menu and concept he’ll be limited to only concept and menus that are not already in the complex. Having a broad use clause in the tenants lease also makes it easier to sell the business.
  3. Assignment and Subletting. Having the right to assign the tenants lease or to be able to sublet a tenant’s space is very important as there is a high probability that the tenant will not be successful and will want to minimize his financial exposure to continued lease liability. The key language to look for in the lease which is advantageous for the tenant is “the landlord cannot arbitrarily withheld consent to an assignment.” This language means that if the proposed new tenant is operationally and financially qualified the landlord cannot arbitrarily deny the proposed new tenant the right to have the lease assigned to him/her. When an assignment occurs the two parties in the assignment are the assignor who is the existing tenant and the assignee who is the proposed new tenant. In an assignment agreement it is stated that the assignee assumes all of the rights and obligations of the lease being assigned and this agreement is executed in writing by the assignor, assignee and the landlord. In most assignments the assignor has secondary liability for the remaining term of the base lease. This means that if the assignee’s business fails and the tenant can’t continue to pay rent or meet the other conditions of the lease and the landlord is unable to recoup their financial losses from the assignee the landlord can go after the assignor to be made whole financially. If you are an assignor try to negotiate a release of continued lease liability which becomes effective at the close of escrow. This is hard to do unless the assignee is significantly stronger financially and operationally than the assignor and even in these circumstances the landlord will want the assignor to have continued lease liability for at least one or two years of the remaining base term of the lease being assigned. There can be situations in an assignment whereby the assignee wants to change some of the terms and conditions of the lease and this is called a modification of the lease and requires a modification section in the lease assignment. It is generally understood in a lease assignment that the assignor has secondary liability and the assignee has primary liability. Secondary liability means that the landlord must exhaust the financial resources of the assignee that has primary liability before he comes after the assignors financial resources. This means that if the assignee breaches the lease the landlord has to take legal action to be made whole against the assignee before the landlord takes legal action against the assignor to be made whole. However there are many attorneys that take the position that both the assignor and assignee have primary liability and draw no distinction between primary and secondary liability in an assignment. This is exemplified in some situations where the assignee defaults and the landlord takes legal action against both the assignee and assignor at the same time. It is also generally understood that if there are options in the lease other than the remaining base term that the assignor has no continued liability for the options.
    • Subletting. In this situation the existing tenant is called the sublessor and the new proposed tenant is called the sublessee and the document that is executed between these two parties is called the sublease. A sublease situation requires the written permission of the landlord in most cases as does the lease assignment. Unlike an assignment the sublessor who is the existing tenant still has primary liability to the landlord and the sublessee has secondary liability. This means that if the sublessee fails to pay the rent or meet the other conditions of the lease the sublessor is responsible to the landlord. In many sublease situations the rent is paid directly by the sublessee to the sublessor and the sublessor pays the rent directly to the landlord and frequently there is wording in the sublease agreement that if the sublessee breaches the sublease the sublessor has an expedited method of taking over physical possession of the premises. In some situations if there is a base term of the lease and an option in the future there is wording in the sublease that if the sublessee is in good standing in the base term of the lease he will have the right to exercise the option in which case the sublease will be converted into an assignment of the lease and the sublessee now becomes the assignee and the sublessor becomes the assignor and the primary liability shifts to the new assignee who was formerly the sublessee. In both the assignment and sublease it is important that the existing tenant has a comfort level with the new proposed tenant’s financial and operational history to assure himself that the new proposed tenant will be successful and the existing tenant is not vulnerable to have to bail out the new proposed tenant at its expense.
  4. Option. An option is a legal tenants right to extend their right to occupy the premises for a given period of time. For an option to be enforceable it needs to be in writing and included as part of the lease. In some cases the option is personal to the tenant and the option right cannot be assigned to a proposed new tenant. To make certain that the option is assignable to the new tenant it is best to state in the assignment agreement that the assignee will have the right to exercise the option if he is in good standing with the lease. The option language will usually spell out the number of years of the option period and any changes regarding the terms and conditions of the lease which will occur in the option period. Option periods can vary from as little as one to three years to as long as ten years or more. Most option periods are for five years. Mot options keep the same terms and conditions of the lease other than the rent and the formula for the yearly increase in the rent. If there is not specific language in the option as to what the rent will be there will most likely be one of two formulas stated in the option which have been traditionally used which are both tied to the fair market rent for the premises. Fair market rent means a similar rent to what other restaurants that have recently signed a new lease in the area are paying for rent. One formula that is frequently used is tied to binding arbitration. Binding arbitration is a legal procedure whereby if the landlord and tenant cannot agree on the fair market rent they agree to have the fair market rent determined by the arbitrator whose decision is final and cannot be appealed. An arbitrator is usually a retired judge or an attorney that understands the law and the landlord and tenant who are also represented by counsel each presents their research as to what they feel the fair market rent is and they present their respective findings to the arbitrator in a formal arbitration hearing. After the arbitrator hears both sides presentations he makes a ruling as to what the fair market rent will be. This decision is final and there is no appeal so if the tenant is dissatisfied with the arbitrators decision he has no further obligation to occupy the premises after his lease term expires and then he gives the landlord notice he wishes to vacate and then he can remove his trade fixtures in most cases. Arbitration is expensive and can range between $10,000 to $20,000 and the arbitrators cost is split 50/50 between the landlord and tenant and each party pays their own attorney fees. The other primary method that is used and generally the preferred method to determine the fair market rents is the commercial real estate broker method. The tenant and landlord each choose their own experienced commercial real estate broker that has recently completed comparable retail leases in the area of the proposed tenant’s site. Each broker comes up with a recommended fair market value rent and if the brokers cannot agree on the fair market rent the two brokers agree to choose a third qualified commercial real estate broker which both brokers agree to who then determines the fair market rent. Again with this method as in the arbitration method if the tenant does not agree to the new fair market rent he can then give notice to the landlord and vacate the premises at the expiration of this lease and remove his trade fixtures in most cases. In the option section of the lease there is specific language which spells out what is the minimum and maximum amount of time prior to the expiration date of the lease that the tenant is allowed to give written notice by certified return receipt mail to the landlord regarding his interest in exercising the option. For example, no earlier than 360 days before the expiration date of the lease and no later than 180 days before the expiration of the lease. The reason that there is usually a 180 day maximum time frame to notify the landlord regarding the tenant’s desire to exercise or not exercise the option period is to give the landlord enough time to find another tenant to rent the space should the existing tenant decide not to exercise his option and continue as a tenant. There is usually language in the lease that gives the landlord the right to put up a for lease sign and start showing the space to perspective new tenants so many months before the expiration date of the lease. There are situations where the tenant has the right to have more than one option in the lease. If this is the case the tenant has to be in good standing prior to exercising each subsequent option and the terms and conditions for each subsequent option can be different although they are usually the same. If the tenant has more than one option and does not exercise the previous option in a timely manner he loses the right to exercise subsequent options to the lease. Many landlords do not like options as they work primarily to the benefit of the tenant in terms of tying up the premises. If a landlord is considering selling his property in the near futures and wants to maximize his right to get the highest price for his building and if he wants to have flexibility to sell the building to an owner operator and wants to have the ability to deliver the building without a tenant the landlord will not be receptive to a having an option in the lease.

If you need consultation on any items regarding the lease please call Restaurant Realty Company for further information.