RESTAURANT LEASES 1.0: HOW MUCH RENT IS TOO MUCH RENT?
One quick thing to know is that unless your lease is a gross lease or a percentage lease (I’ll discuss these in a future blog), then it is probably a Net Lease, which means the tenant pays base rent plus net expenses the landlord incurs. You’ve probably heard the term “triple net lease.” This is most always listed as “NNN,” which stands for…triple net. If a lease is a triple net lease, then tenants should always be considering occupancy costs, which is the base rent + NNNs.
OK, here is the short and very generalized answer to how much rent is too much. Over 8 or 9% of the restaurant operator’s gross sales is too much. There are a handful of embedded assumptions in this statement, so let’s unpack them…
When I work with restaurant clients and leasing—whether it’s a client who has a lease in place, a restaurant buyer getting an assignment of the seller’s current lease, or an operator negotiating a new lease— I always always calculate the restaurant gross sales needed to support the occupancy costs.
This way clients know immediately if the occupancy costs are too high in order for them to achieve and maintain profitability. If an operator is already locked into a lease and seems to be operating successfully, but can’t seem to achieve profitability, there is generally one or a combination of reasons for this:
- Cost of goods (COGs) are too high
- Labor costs are too high
- Occupancy costs are too high
Two of these costs are mostly variable costs, meaning they increase and decrease with sales. However, occupancy costs are fixed, which means that the operator pays the same monthly amount in occupancy costs whether or not the business is busy. (This is true unless they have a percentage lease, but again, that is the topic for another episode).
The sweeping solution to all three of these problems is to raise prices, but every operator knows this solution is risky, as it can cause a backlash with customers. Most of the time the solutions are more nuanced. Operational or menu costing analysis may be necessary to fix the variable costs. But there is no fixing a fixed cost. Once leases have been negotiated and the restaurant operator has taken occupancy, there is generally no way to alter those expenses. (Covid rent reductions have been the very rare case of landlords working with tenants on rent reduction). So it is very important to get occupancy costs right out of the gate.
Here are a few more points about the term occupancy costs. When it comes to commercial leases, rent is only part of the equation when considering the cost to occupy a premise. Landlords typically pass through their costs to own and maintain the real property through to the tenants via CAM or NNN fees.
CAM fees stand for “common area maintenance” fees and can include expenses such as landscaping, security, parking lot maintenance and lighting, scheduled maintenance, management fees, etc
Triple net (NNN) fees are costs that the landlord incurs and passes on to the tenant or tenants. They include property tax, insurance, and common area maintenance.
**You’ll notice one of the nets in the NNN (triple net) lease includes CAM. But these terms can mean different things depending on the lease and the landlord. One of the most popular commercial lease templates produced by AIR (pronounced A – I – R, not the word “air”) uses the term CAM in place of NNN.
There are leases that are single net (one landlord expense) or double net (two landlord expenses), but they are less common.
Here are some terms to be familiar with:
Net Lease: a lease that charges NNN fees
Gross Lease: a lease that charges base rent and no other fees and expenses
Percentage Lease: a common lease for restaurants. It ties the rent to the gross annual sales of the restaurant. I’ll talk about percentage leases in another episode.
So, if a restaurateur has a net lease where they pay base rent plus additional monthly fees (NNN costs), those expenses together are referred to as “occupancy costs.” The occupancy cost for a restaurateur is a very important number to know because if the occupancy cost is a percentage of gross sales that are too high, then the restaurant owner will have difficulty achieving profitability.
For many, many years in the restaurant industry, the margin for occupancy costs was a percentage of gross sales between 6-8%. But in my region, the San Francisco Bay Area, those days are long gone. Because the industry is so established in San Francisco, there are tried and true margins for success in the restaurant industry. Now these will vary depending on the concept. For instance, the margins for a fine dining restaurant are different from those for a fast-food restaurant. For our purposes today, I’m going to be referring to margins for a full-service, casual, single unit restaurant.
One of the first things I do when I work with clients and leasing is to build an excel worksheet that clearly explains the gross sales needed to support the occupancy costs year after year.
Here is what I include in the spreadsheet:
- The square footage of the restaurant (this number is always approximate, and I’ll talk more about this in a bit)
- The rents and NNNs (I list both the annual and monthly expenses for these)
- Annual base rent increases
- Percentage of occupancy costs: I assess multiple factors to determine whether occupancy costs are 7, 8, or 9% of gross sales. The occupancy costs factor include location. I’m referring to a full-service, casual restaurant in a vibrant downtown core with bustling retail and lots of foot traffic vs an area with lots of vacancies and few complimentary businesses. We also take into account the condition of the premises.
Once I have that information, I build a table that lists the base term of the lease. If it’s an existing lease or lease assignment, I’ll also list the remaining term by year to account for increases. It is a very rare lease that does not charge an annual increase in rent—sometimes it is tied to the CPI (Consumer Price Index), but most of the time it is a percentage increase like 3% over the previous year.
I populate the spreadsheet with all of the occupancy costs laid out year over year including monthly rent, monthly NNN, annual rent, annual NNN total annual occupancy costs, and % of occupancy costs. Then in the last column I include the annual gross sales required to support the annual occupancy costs.
Here is an example:
You’ll notice the square footage of the restaurant is listed as well as the rent per square foot. For restaurant operators, this can be an important number, as it is one of the few rent metrics that they’ll be familiar with. But for landlords (and this is clearly stated in nearly every lease I’ve ever read) the square footage of the premises listed on the lease is for reference only. And the rent, not to price per square footage prevails.
There are many considerations why this is the case. First, how is the square footage determined? Is it measured from interior wall to interior wall, exterior wall to exterior wall of from the presumed middle of the wall? Also, what is it like outside? Is there patio seating, common areas, or dedicated parking spaces?
If you’d like to know more on the topic of square footage, there are a lot of articles dedicated to it that you can find with a quick web search. But, as the point of my topic today, the price per square foot is nearly inconsequential. What really matters are the annual gross sales need to support the annual occupancy costs. Once restaurant operators are equipped with this information, they are in a much better position to negotiate or renegotiate lease terms with landlord.
Ryn Longmaid is a restaurant broker and consultant at Santa Rosa Business & Commercial in the San Francisco NorthBay and the host and founder of the Facebook Live Series, Deep Dish: discussions on the business of restaurants for restaurateurs, restaurant buyers and sellers and the restaurant curious.
As well as being a licensed real estate broker, Ryn is a CBB with the California Association of Business Brokers (CABB), a CBI with the IBBA and she holds an MBA in Sustainable Business Management. In addition to being a proficient business broker, Ryn has over 20 years’ experience in the restaurant, hospitality, and food industries. She has served as the executive chef for Amy’s Kitchen, personal chef to actor Don Johnson, and she founded and operated a successful and longstanding restaurant. She has also held teaching posts in restaurant management at the Art Institute-San Francisco and The Culinary Institute of America-Greystone.