How to Negotiate a Restaurant Lease Agreement

Before the first hand is dealt in any lease negotiation, smart operators bring to the table an attorney to help navigate the legal fine points.

Still, you need to educate yourself on these matters when you ante up to cut a deal for one of your biggest cost centers. If you are playing to win, you want to know what's at stake beyond simply the amount of money you have to fork over to the landlord on the first of each month.

The terms and conditions related to your usable space; covenants, conditions and restrictions; and the ability to assign and sublease your space can be the difference between a great hand and unnecessary losses. A little technical understanding of the language of a typical restaurant lease may help you better understand not only what cards you have available to play, but how best to deploy them to your advantage.

I know, I know, even using the poker metaphor, leases are boring as hell. On the other hand, that's just the way you want to keep it. In my experience, when contracts become exciting, that's often a bad sign. In the game of poker and leases, sweating is not a good sign. Am I giving you a knot in the middle of your stomach? Good. This is no time to doze.

In this article, we'll help you become familiar with a few terms that recur throughout the process, understand why certain options presented are the best (and why), and help you develop a strategy for determining whether you want to be dealt in or sit at another table.

Ante Up

Every hand of poker begins when the players indicate whether they're in the game. In other words, if you want cards, you need to ante up, ladies and gents. The leasing process is initiated most often by a leasing agent or broker, with a letter of intent called a "LOI." It sets forth the general terms of the proposed deal, to see whether the interested parties are close enough to warrant extensive negotiations.

While a letter of intent is customary, it is by no means mandatory or prerequisite to the execution of a lease. Some parties insist that the lease follow the letter of intent verbatim (because the deal may have changed during the intervening period, I have some clients who will agree to refer to them as the guides they are intended to be, but simply will refuse to sign them). In addition, to ensure that a court does not determine that the deal has been spelled out in sufficiently clear detail to form a binding agreement, care should be taken to include language that states that the letter of intent is an expression of interest and that neither the proposed landlord nor the proposed tenant intends to be bound by the document. (While letters of intent vary from area to area as much as from lawyer to lawyer, an example that includes the type of language suggested has been included in "Generic Letter of Intent" below).

Your Two Pocket Cards (The Cards That Only You Can See)

1. What you want. You're in the game, but before you decide to send or review a letter of intent with the idea that signing a lease will follow, you need to seriously consider what it is that you want to end up with at the end of the day. The landlord will come to the table with his stack of chips, including revenue expectations, knowledge of market rental rates, required concessions and, under some circumstances, the historical use of and rent paid for the premises. You are at a distinct disadvantage if you do not come prepared equally as well, if not better. As soon as you sit at the table, you have to communicate that you understand the rules and you've come prepared to play and win.

2. What you're willing to do to get what you want. Before settling in your chair, you also need to consider what factors are most important to you. There are many factors, and their importance will vary from situation to situation. Among the matters you should consider are location, rent (base, percentage and additional), expansion rights, competing businesses (and the ability to extract a covenant from the landlord that a rival will not be allowed to compete with you in the center), tenant improvement allowances (how much the landlord will contribute to getting your restaurant ready to serve its first meal or beverage), renewal terms (also called extended or option terms -- the right to stay at that location on pre-agreed terms) and timing. Opening a restaurant in January may prove far less desirable than opening it on November 1, just before the annual seasonal holidays. You may want to negotiate for "dark periods" where the restaurant doesn't have to open if not ready by an agreed date.

The Flop, the Turn and the River (The Five Cards That the Landlord Can See, Too)

As stated, the landlord will come to the negotiating table with its own set of expectations, experience and skills. Among them, you should expect to see:

Common-area maintenance ('CAM') charges. CAM charges are additional rent, payable on a per-square-foot basis, based on the tenant's share of the rentable area (see "Rentable vs. Usable Space: What You Really Get" on Page 30). CAM charges can add a significant load to the base monthly rent expense. At 50 cents per square foot per month for premises consisting of 2,000 square feet, that load, even without factoring annual increases, is $60,000 during the first five years of the term. To avoid surprises, a savvy tenant will negotiate an annual cap on increases such as 106 percent of the amount of the previous year's CAM charges.

An unanticipated and preventable increase of 15 percent in CAM charges can wreak havoc on an otherwise well-conceived and tightly controlled annual operating budget. A cap of 6 percent is reasonable (try for 4 percent; accept 8 percent if you have to; 6 percent is fair). Landlords will resist any such cap with all their might. Be persistent. The primary reason that landlords resist CAM limits, particularly those caused by real estate tax increases that often occur following a sale of the property, is because their inability to recover that revenue affects their net operating income ("NOI"). NOI is the income that the property generates less the recurring operating expenses (with no consideration given to income taxes or debt interest) and a predetermined vacancy rate (usually something like 5 percent).

When the property is sold, the NOI is divided by a market-driven capitalization rate ("CAP RATE") such as 6 percent to determine the price of the property. If a property has an annual NOI of $1.2 million and that sum is divided by 6 percent, the value of the property would be $20 million. In other words, you'd have to put $20 million in the bank at an interest rate of 6 percent to get the same return (NOI) that the property produces. A lower NOI or a higher CAP RATE yield the same result: a lower price for the property. If you demonstrate that you understand the landlord's concerns about CAM caps, you're in a far better position to get him or her to recognize why a CAM cap is necessary to ensure the continued profitable operation of your soon-to-open business.

Covenants, conditions and restrictions. RS&G editor Barry K. Shuster and I covered this important subject in depth in the July 2006 issue (see "Understanding Your Properties Covenants, Conditions and Restrictions"). As we explained (but in much greater detail):