Buying time: Operators consider futures before remodels, new leases

Buying Time: Faced with imminent lease renegotiations and rising real estate prices, operators stop to reconsider their futures before committing to costly remodeling projects or new lease terms

Angered by greedy landlords and powerless to do anything about property owners’ hunger to double and triple per-square-footage rent rates upon renewal, Nieporent speaks to a quandary that is shaping the unit growth plans of chain operators and independents alike.

His and other operators’ concerns, however, are not without cause. In big and influential restaurant towns nationwide, lease rates in the foodservice industry have been inflating since the beginning of the decade.

The Council of International Restaurant Real Estate Brokers, or CIRB, compiles such figures for various areas throughout the country. For example, in Manhattan, asking rents on a retail per-square-footage average have risen 23 percent since 2002, from $88 to $108, with Fifth Avenue having the highest commercial lease rates in the world, a whopping $1,035 a square foot. Similarly, in Atlanta’s trendy Buckhead section, restaurant space for standalone outlets that once rented for $20 to $25 a square foot in 2000 are going for $42 and up now. The Uptown area of Dallas has similar rates of increase for restaurant rentals, from lease rates of $20 a square foot in 2000 to as much as $50 today.

First-time chef-entrepreneur Gleason Hayes last year closed his Southern-accented seafood shack, Shoreline, near downtown Raleigh, N.C., after his landlord demanded a more sophisticated look, as stipulated in a clause in his lease concerning the fifth year he was in business.

“Yeah, I had one of those signs letting folks know we were just remodeling,” he says. “But the truth of the matter is that I was trying to buy time with the landlord, who is all excited by all the development that is going on here and in Durham with all of the big banks and corporations that are moving here.

“But we really were not getting the traffic, and I was hoping to see if the landlord would amend the lease somehow,” he continues. “The real truth though, is that we never really got the traffic to make the kind of upgrades he wanted.”

While the foodservice industry has long operated on a dependable and largely proven premise that nothing boosts sales better than periodic remodeling, operators are wondering if real estate inflation, in concert with tough lease renewal negotiations, is rendering one of the industry’s most bankable practices obsolete.

Richard Lackey, president of the Lackey Cos. and a founder of the CIRB, says he shares the concerns of Nieporent and others. He agrees that it makes no sense to invest six to seven figures to remodel a restaurant when the lease is within a few years of terminating, nothing has been done to extend the terms, and the lease will likely be renewed with an inevitable spike in rent. But while Lackey agrees that negotiating years before the lease expires is a good way to hold down occupancy costs and gives peace of mind to remodeling projects, he says there are still important questions operators need to consider.

Among the negotiating points operators should explore with their franchisor or landlord is the efficacy of remodeling a store in a location where the rent may go up but the market’s economic vitality is going down.

Lackey says most big chains and independent operators with clout know the importance of insisting on option extensions that can add as much as 10 years to a lease. He notes, however, that this practice is rarely used by New York City landlords, where gross rents, usually including a percent of sales, are in vogue.

Therefore, he says, operators should discuss lease options well before contracts near termination and keep an eye on market trends, traffic patterns, neighborhood renewal projects and other signs of long-term market viability if they intend to remodel.

“No prudent restaurant operator allows his lease to get down to two to four years, because if he has been there a number of years before that and he is doing good business, he will be walking on egg shells,” Lackey says. “On the other side of the coin, if the market is declining, but you want to stay in that neighborhood and still upgrade your facility, I think you should approach your landlord like you are in it together. ‘We’ve been in this marriage for 15 or 20 years, and I need a lower rent if I’m going to survive.’ If the landlord is smart, they’ll work with you.”

With rents inflating faster than the operators’ ability to pass on menu increases, Lackey says that franchisees who are required to remodel but are in bad locations are not out of line if they plead with their franchisors for a break on royalty costs. He argues that even a one- to two-year suspension of royalty payments is not unreasonable until the return on investment from the remodel is recovered by increased sales and traffic.

“There are so many angles, so many ways to work out this dilemma,” he says.

Nowhere are those angles being looked at harder or with a broader mixture of foreboding and optimism than within the franchise community of KFC, the quick-service chicken chain owned by Yum! Brands Inc. All 5,500 domestic KFC units are required to remodel by a June 2008 deadline at a cost estimated to range between $150,000 and $200,000 per unit, sources report.

Company officials, in discussions with Wall Street late last year, said they expected some 200 to 300 stores to close as franchisees, particularly older licensees, balk at the plan or decide to sell or close their stores, which would deprive the brand of net new-unit growth.

One KFC franchisee, however, says, contrary to his franchisor’s prediction that it is older franchisees who might not upgrade, he believes the decision rests more on justifying such expenditures given the certainty of rising rents.

With a few restaurants facing lease terminations beginning in 2012, the franchisee asks: “The major problem to me is will I be able to get my lease extended at a rate I can live with? Why put a couple of hundred thousand dollars into a business in 2008 if your lease terminates in 2012?

“Who wants to spend that kind of money?” he asks.

The KFC franchisee says he is going to do all he can to sell the units with imminent lease termination dates and still commit to upgrading them.

“But I got to get a buyer now,” he says. “I needed a buyer yesterday. It takes a long time to find a buyer, get him qualified and get the company’s approval. If you market the place before you do the remodeling, people are not going to buy the place once they find out about the remodeling plans. So to be fair, you got to do it now.”

Shahid Chaudhry, president of the KFC franchise association in Southern California, where commercial rents can be as outrageous as in Manhattan, says he does not believe that his members will balk at making the necessary face-lifts to conform to new chain standards.

“I don’t see it as a gloomy picture,” Chaudhry says. “If you plan ahead, I think renewing a lease and handling the remodeling standards can be handled pretty well.”

But he concedes that he would not be surprised if a tiny few of the 55 members in his area who operate some 200 stores in the 300-unit market close or sell their stores and use the proceeds to open outside of the region to escape rent escalation.

“Unlike the company, I definitely believe that we are looking at an issue that has more to do with local economics than the age of our franchisees,” he said. “When you look at the fact that minimum wage went up Jan. 1 in California and the cost of real estate, it’s quite expensive to do business here. So I expect that there will be a few franchisees who will say it is more cost-effective to open in another region with the new prototype than stay here and remodel an old one. So I think people will be moving outside of L.A. where they can find a better deal.”

Keith Chambers, president of KFC’s International Franchise Association, agrees.

“I’m an eternal optimist, and I just don’t see that many stores [200 to 300 closures] happening,” Chambers says. “We are talking about $2 million businesses on average. Who walks away from that just because they have a landlord problem? You negotiate. You talk to people. You ask the franchisor for help.”

However, Chambers also says that the mandatory remodeling of units at a time of inflating commercial real estate is a unique intersection of events in his years in the system.

“I’m not disagreeing with the company [that there might be a few closures],” he says. “We are all concerned about it. But I think we are working towards a common goal. We have remodeled nearly 300 stores this year, and several hundred more will be done by the end of this year. This is a renaissance for the brand, and if landlords can’t appreciate that, well, then, it’s their loss.”

Arturs Kalnins, an associate professor at the Center for Hospitality Research at Cornell University’s School of Hotel Administration in Ithaca, N.Y., says few points are as divisive in the franchisor-franchisee relationship as mandatory remodeling, despite the fact that it can make good economic sense.

“Franchisees are often very resentful of the demand for upgrades,” he says, “and the combination of an upgrade soon before the end of the lease is particularly troubling.”

Kalnins—whose expertise is studying franchising and real estate trends in the foodservice industry worldwide—agrees that there is no reason why disputes over remodeling near the end of a lease cannot end amicably and maybe even lucratively.

“Franchisors can usually convince franchisees of new investments most easily by demonstrating increased revenues that will result,” he says. “So if the franchisor upgrades some company stores and clearly shows additional demand and revenues, I find that the franchisees usually will go along.”

But the “double whammy” of remodeling and lease renewal forces franchisees to put on their best thinking caps, Kalnins says.

“The franchisee should absolutely not agree to a major remodel before the lease renewal comes due,” he says. “The unscrupulous landlord clearly has the opportunity to gouge the franchisee who has recently upgraded. In economics this known as the classic ‘hold-up’ problem: Once you have made a nonreversible investment, such as a remodel, whose ongoing value is zero without the cooperation of a partner [landlord], the partner can capture most of the future value of that investment via the lease, but only after the nonreversible investment has been made.

“The solution then is that both the lease and the remodel decision need to be made at the same time,” he continues. “Then, if the landlord is being unreasonable, at least the franchisee can terminate the restaurant without paying for the remodel.”

Kalnins says franchisors should show similar flexibility. “They should allow some delay in the upgrades so that the franchisee can renegotiate the lease first,” he says. “After all, it is in their interests, too, to keep the restaurant viable.”

Nieporent of the Myriad Restaurant Group argues that from his perspective, operators who want to appeal to their landlords’ empathy when it comes to remodeling close to a lease termination do so at their own peril.

While his world of business competition and operations is far less dependent on mass marketing or brand dominance, Nieporent points out that what he shares with big-brand franchisees is one blinding truism.

“Landlords don’t give a damn about their tenants’ problems,” Nieporent says, whether it is a lease or contract negotiation, a negative shift in consumer traffic or higher costs for remodeling projects.

“You would think that if you have been a good tenant over a number of years, made the landlord some money, and brought a certain prestige and experience of success to a location that a landlord would work with you,” he says. “Don’t bet on it.”

Nieporent suggests that one way to make landlords more empathetic to an operator’s business is to treat them like partners.

“There are some good landlords out there who value a long-term tenant with name recognition and may even say to themselves that [they would] rather have them here than not,” he says. “I look at our company, and we have a pretty good record and experience, and I think I’ve reached a point with some of them where I can say, ‘We are going to remodel, and I’d rather get a couple of months free than going with a brand new entity.’”

Susan Kezios, president of the American Franchisee Association, a franchisee rights advocacy group often at odds with the policies and mandates of franchisors, argues that franchisees are particularly vulnerable to losing money when they are required to remodel stores in bad locations.

She argues that one reason some brands fear in coming years a hemorrhaging of older franchisees who opt to retire is that many of their units are in locales where the market dynamics have turned sour and the franchisee knows it doesn’t make any sense to remodel.

“It’s no fault of the franchisee that the market turned, yet, in so many cases, they are being asked to throw money into a situation that can’t be reversed,” she says. “This is a big problem in the industry.”