5 Things Real Estate Developers Should Know About Leasing to Restaurants

Over the years we’ve helped many restaurants and landlords work with each other and have
seen ugliness on both sides. We’re often baffled at the lack of empathy each side can have for
one another. For instance, Landlords have a mortgage to pay. When tenants seek rent abatement because they’re not profitable or they are starting to circle the drain, the landlord must pick up the slack, coming out of pocket to pay the bank while they wait for the restaurant to pull it together. Restaurants often view landlords as Darth Vader, always pressuring them to pay rent on time (sheesh!) regardless of business volume or seasonal success. When a landlord escalates through the legal means afforded by a well-written lease, restaurant tenants only harden their dislike/distrust/distaste for them. Restaurateurs work long hours to produce and sell food products, often unable to let the business out of their sight for even a measly three-day staycation at a nearby hotel without the business veering off course for lack of supervision. Landlords often blame a restaurant’s financial issues on the operator, labeling them as ignorant, lazy, or for selling a product that no one wants. While both sides may have a point or two, it is usually the business structure, and relationship, that dooms restaurant tenants, not curmudgeonly, unyielding landlords, or dimwitted, lazy restaurant operators. Below are some critical points that landlords should consider when dealing with restaurant tenants:
1. Chains offer stability but potentially downgrade the experience. Over the last 10 or so years, the term “food hall” has been thrown around as something different than a mall “food court”. The difference is usually that mall companies or developers want the security of engaging proven fast-food chains that know who they are and have established systems and a following. Food halls are curating a food experience blended with some brand-enhancing retail experiences. National chains can pollute the eclectic vibe of the food hall. One Subway in a sea of independent food kiosks (serving bao buns, or food-truck-style limited menus) can purge the “cool” right out of the property, killing the draw. Food hall tenants or property developers attempting to put forward a great food and retail destination property don’t get to tap into the predictable operating performance of the national chains and instead get to suffer “amateur hour”. Landlords should look for tenants that have established a reputation in the local community and have a track record of success. Just because a food vendor’s concept fills a niche or seems cool, doesn’t mean they know how to operate a business. Whether a kiosk in a food hall, an end cap in a strip mall, or a freestanding box, landlords must balance the operating sophistication of a national chain with the impact it will have on the overall guest experience. The whole is greater than the sum of its parts.

2. Independent restaurateurs (vs. single unit chains or conglomerate brands) are often new at this. For food halls, to assemble a profitable experience or to generate “restaurant-hopping” energy for their patrons, landlords need to pack as many food vendors under the roof as possible. These “kiosks” or “bays” are typically between 180 and 450 square feet…barely enough to cook raw food to order, let alone to prepare the ingredients or store raw inventory. Successful vendors will come from a larger concept with surplus kitchen space available to them as a commissary…where they can receive bulk inventory, make sauces, and marinate meats. Without this space, landlords should provide a shared kitchen with segregated ambient and refrigerated bulk storage and prep space (with equipment) available. Regardless of whether the aspiring tenant will rent a kiosk or their own full-sized space, they should be able to explain how they will manage their Prime Costs – Cost of Goods (inventory) and Labor. These are the two critical costs in a restaurant so make sure they can describe their systems for delivering labor discipline (labor templates, scheduling protocols, and wage ranges) and COGS management (order guides with pars, line diagrams, line check system, and production calling system).

3. Restaurants need enough space. While restaurants may represent an amenity for your property…and “prize” to attract other tenants, the size of a restaurant is an important factor in determining their success. For food hall kiosks, as mentioned above, if the tenant tells you they can store and produce everything in the small space you’re providing, they are, without a doubt, going to miss out on the power of purchasing in bulk. Their sales in that unit will have to cover the labor required to convert raw ingredients into ready-to-eat items. For a free-standing restaurant or strip mall unit, when a restaurant is too small, they suffer the same issue and often don’t throw off enough cash to afford adequate management. If their menu is too big and their space is too small, their inventory will sit longer, eroding quality. Service will stink, food will not be great, management will be stressed, and eventually the business will struggle to reconcile the high effort for low profit…and fail. Chain restaurants don’t usually suffer this fate as they just won’t bother with your space if it isn’t right for their concept. Independents, however, don’t know any better. Do yourself and your tenants a favor and don’t rent small spaces …at least not without the right balance between space, menu complexity, operating discipline, and management. For shotgun, end cap, or free-standing spaces, the sweet spot is between 2,500sf and 6,000sf. Outside of those boundaries and you’d better be in an area with enough population density to keep them busy.

4. First time independent restaurateurs are dangerous to themselves…and ultimately you, the landlord. These folks with cool concepts serving cool food that no one else has in the area are often unclear about what rent they can afford. Landlords, in an effort to maximize their investments, will take advantage of this to try to charge the highest rent possible along the demand curve, without considering the financial benefits of a long-term relationship. Because these newbie tenants are often risk takers and don’t know what they’re looking at, they’ll say yes just about any lease terms. A common structure is a “rent above break point” where the landlord demands a competitive base rent per square foot and then they want to share in the upside if the tenant scores it big by switching to a percentage-of-sales rent above break point. This is actually a GREAT way to protect your tenant and your investment because when they do better, you do better…but landlords often forget about the part where they have an obligation to help that tenant “do better”. This means charging lower base rent, reducing the break point, and getting into the percentage-of-sales rent game earlier. Also, landlords can easily demand 7% or 8% or even 9% of net sales… but should they? 6% is enough! That extra 1%, 2%, or 3% going to the tenant will help them survive and hopefully thrive. While you may score a justifiable base lease rate, what happens next? Requests for rent abatement, a revolving door, empty space, etc. Pigs get fat, hogs get slaughtered. To boot, many property developers (especially food hall developers) are in business to flip properties within a 5ish-year horizon. What makes the property valuable is the guest experience through smart tenant curation and occupancy/lease-up. A property developer that can tout a fully, or nearly full, property with long term tenants who are happy will be able to sell that property faster and for a greater multiple of invested capital than one that isn’t full and provides a janky guest experience.

5. Restaurants need Tenant Improvement (TI) funding support. “I’ll give you a cold, dark shell… you fit it out on your nickel. We’re in a great part of town and this space is in high demand… take it or leave it.” If you’re leasing to a Nail Salon, the fit out for it is minimal…and the tenant gets to take everything with them if they fold…leaving you with a shell not far from the one you initially leased. Offering Tenant Improvement funds to normal retail tenants should not be the same as what you’d offer a restaurant to convert your space. To install a restaurant, it generally requires an expensive hood system, enhanced gas and power applications, more powerful HVAC, floor drains, grease traps, and expensive service-area treatments (like ship lap ceilings, custom millwork bars, and picture windows), let alone any landscaping, drive through windows with menu boards, and prominent signage. Second generation restaurant space is in high demand because the new restaurant tenant gets to benefit from the failure of the first. And why did the first one fail? Because their buildout costs were monumentally higher than the that of a 2nd-genner! When you’re stingy with the TI money, you can practically guarantee that the first occupant will struggle unnecessarily and will have a greater chance of failing than your subsequent tenants. 2nd-genners may stay alive longer but not because their concepts are better…but because they don’t have the same debt to service. That first tenant may have had a winner, and they believed in it enough to go all in on building it out. There is a good chance that the first tenant would have generated more rent (and percentage rent over break point) for you had you offered solid TI money…. specifically, because that first tenant was more vested in their concept…they risked much more! If you’re a landlord, you should value those risk takers by offering qualifying TI money up to $100/sf to help your tenants weather the early battle for market-share. Let’s face it, Subway isn’t going to enhance your overall experience. This strategy will pay dividends for much longer than the savings you’ll achieve by not offering it.

Overall, landlord/tenant relationships need not be antagonistic or win/lose. When landlords who lease to restaurants understand how fragile restaurants can be in their formative years if not supported, they can enact win/win strategies that take both businesses to higher heights than when they don’t. Landlords should be active participants in their restaurants’ successes –not by being quick to offer free rent, but by vetting their tenant candidates more carefully, protecting tenants from themselves, deploying graduated rent strategies, and providing adequate TI support. If a property developer and landlord could name one enemy, it’d be vacant spaces. Prioritizing positive, mutually beneficial relationships with your tenants, is a vacancy killer.

Ray Camillo – Founder & CEO, Blue Orbit Restaurant Consulting