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Determining Rent & Other Lease Terms

Posted by restrealty on June 30, 2015
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What is the Correct Formula to Determine How Much Rent To Pay and Other Helpful Lease Points

Occupancy costs are becoming one of the most challenging costs that restaurant, bar and club operators face today with rents escalating far in excess of cost of living increases in high demand areas such as in the San Francisco Bay Area and in many desirable retail locations in Southern California .

There are two major components to rent which include base rent plus any additional occupancy costs referred to as net expenses. A lease can be a gross lease with no net costs however a large number of leases include net expenses. The traditional net expenses are real estate taxes, property insurance and common area maintenance expenses (referred to as “CAM expenses”). CAM expenses usually come in to play with the following situations: a. rental space is in a freestanding building, or b. rental space is part of a shopping center, office building or other type of commercial building. When there are net expenses involved they are usually determined based on the size of the subject space compared to the building as a whole. For example if the subject space represents five percent (5%) of the total building then the subject space will pay five percent (5%) of the total net expenses. However if the rental space is in a free standing building the tenant typically pays one hundred percent (100%) of the net expenses. There can also be a variation on net expense when there is a single net (N) expense as follows: a. the tenant only pays real estate taxes, b. the tenant only pays property insurance and/or c. the tenant only pays CAM expenses. There can be a double net (NN) expense lease where the tenant pays two of the net expenses or a triple net (NNN) expense lease where the tenant pays all three of the net expenses. It is important in negotiating net expenses that you negotiate putting a cap on these expenses otherwise you’ll experience excess increases above normal cost of living expenses in many cases.

If you are developing a business from scratch I would suggest that you prepare three income and expense proformas (projections) – an aggressive projection, a conservative projection and low projection before negotiating the premises lease. I would use the low projection as the basis to determine how much rent you can pay and if the proposed total rent (base rent + net expenses) comes in at an approximately six percent (6%) of projected sales then you can realistically consider the rent proposal at hand. Another method for getting the landlord to consider a lower minimum rent is to offer him a percentage lease so once you hit a certain sales level (natural break point) where you’ll make a good profit you’ll be able to share some of that profit with the landlord in the form of percentage rent.

If you are purchasing an existing business that is profitable you have a track record of past earnings to determine if the rent paid is reasonable compared to the sales level.

Make sure that you have plenty of lease term (number of years on lease) to amortize your investment and control your destiny. You should have a minimum base term of five (5) to ten (10) years and one (1) to two (2) five (5) year options. Your rent should be spelled out in terms of yearly increases for a minimum of ten (10) years so you will not get yourself in a situation where a fair market rent adjustment to your lease prohibits you from continuing to stay in business at the subject space as you can’t afford to pay the fair market rent.

Most landlords want rent increases adjusted yearly on the anniversary date of the lease. They usually tie these increases to the Consumer Price Index (CPI) which in recent years has been approximately three percent (3%) yearly. If possible try to negotiate a flat rent for as many years as possible which means the rent stays at the same level for several years. Alternatively have the rent adjust at staggered yearly increases such as every three or five years.

Once lease costs approach ten percent or more of the business sales there is a strong chance that the business will not break even and potentially will lose money. Unfortunately in high growth areas in California frequently the business is paying ten percent (10%) or more rent and the operators are working hard and making little or no money or in fact they’re losing a lot of money because among other things their rent is too high. Many businesses I deal with go out of business because their rent is too high.

There are some circumstances where a business can afford to pay ten percent (10%) or more occupancy costs as follows: a) high volume alcohol businesses where their cost of goods (pouring costs) are low and their profit margins are significantly higher than most food and beverage businesses or b) a restaurant is doing extremely high sales volumes and due to economies of scale their operating costs are lower and their profit margins are higher. I would only recommend purchasing these type of businesses with these high rent costs if the business has had a seasoned history of earnings for at least five (5) years.

Many landlords especially landlords that own several commercial properties are motivated to maximize their rents as the value of their building is determined by capitalizing the net operating income of their building. Most landlords want to keep the value of their buildings high for either refinance purposes or sale purposes for the present or the future.

If you want to be conservative in calculating your rent expense try to keep your total rent including net expenses to be no more than six percent (6%) of sales. One of the common problems that many food and beverage operators are having today is that they cannot pass off their increased food, labor and other operating expenses to the customer which are rising far in excess over the cost of living. The average consumer’s discretionary income is not keeping up with the escalating expenses that restaurant, bar and club operators are experiencing and consequently operators cannot offset all of these expenses in menu price increases as they will price themselves out of business if they try to do so. Alternatively customers will frequent operations where they have stronger price value choices such as chain operations that do higher sales volumes and have lower costs due to their strong purchasing power.

If you would like further detailed information regarding rents and leases please purchase Restaurant Dealmaker which is available on amazon.com and has chapters dedicated to many of the subjects indicated above.