Commercial Real Estate and Franchises
Developing your franchise real estate is a critical piece of franchise operations. In your search for real estate for your franchise or for your small business, there are two routes that you can take: you can either lease or buy. About 85% of franchises lease commercial real estate, and that is what this article will focus on. So, let’s take care of some definitions.
What is a letter of intent?
A letter of intent is an outline of an agreement between two parties. There is no universal standard format for Letter of Intent (LOI) but there are some standard clauses that you should make sure are covered.
That’s the cornerstone of the negotiation. The first question everyone always asks is how much is the rent. So in most cases, the landlord or the broker will quote you a rent rate and a price per square foot. Let’s work through an example of what that looks like.
If you’re interested in 3,400 square foot space for your franchise restaurant; and the landlord’s representative has told your broker that the rent rate is $25 per square foot. Now, let’s take 3,400 square feet and multiply it by $25 per square foot. That lands us at $85,000 per annual base rent. If you want to figure out your monthly rent rate, you just divide your yearly rent rate ($85,000) by 12.
Of course, you want that rent to be as low as possible but a reasonable rate hovers around 10% of occupancy. So whatever your gross sales are, you want your annual rent rate to stay south of 10% of that number.
The bigger issues surrounding rent is how space will be tendered to you. Meaning, how will the landlord deliver the space. Will it stay as it is or will the landlord be required to fix it up before they turn it over? The condition is covered in what is called a work letter. The work letter is often attached to the LOI as an exhibit and it covers things like your HVAC, water, sewer, and electrical.
#2 The Permitted Use Clause
In a LOI clause, you’re asking the landlord to agree to your specific use of the space. So if you are opening an arcade that serves alcohol, you have to describe it specifically. So you would write something in the LOI like “an arcade selling alcohol for on-premises consumption” to “selling a merchandise and other food items”. You should go on to talk about any other vending machines and other ways and purposes that you will be using the premises.
This is important because while you may be in the clear from a zoning perspective with your municipality, that does not guarantee that your use in specificity is allowed by the landlord or the landlord’s other tenants as bound to him by other lease agreements.
#3 Lease Commencements and Rent Commencements
Those sound like the same thing, right? Doesn’t your first rent payment start on the same day that your lease starts? Not necessarily. They’re actually two very separate things.
Lease Commencement is the day that your lease start. Landlords like to make this day the day that they hand the keys to you, whether or not you have begun construction on the lease space.
Rent Commencement is the day that your rent starts. If you’re like many other people, you want to put that day off until you’re making some money. It can be tricky to get the landlord to agree to delay your rent payments until you’re open and operating but you should absolutely ask for it.
If you buy into a franchise or invest money into a small business, you naturally want to protect that asset. One way to do that is to negotiate an exclusivity clause into the LOI. An exclusivity clause makes it very difficult for the landlord to put a direct competitor in the same shopping property you are in.
Assume that you owned a bagel shop on an end cap in a shopping center. The owner of another bagel shop saw how well you were doing and wanted to open up his second location in the same shopping center maybe two doors down from yours, without an exclusivity clause, they could technically do that. A savvy landlord will initially object to exclusivity clause. For the right rent rate they can include an exclusivity clause. Without this clause if the landlord wanted you out of the center, the landlord could let that second bagel shop join the center.
#5 Personal Guarantee
Many franchises have questions about guarantees. Just to get this out of the way, the following is not legal advice. But typically, a landlord will ask for a guarantee in almost every case unless you’re a big company or a huge conglomerate. A guarantee does exactly what it sounds like. It guarantees the landlord rent payments or reimbursement of assets if you flake out and default on your lease.
The nitty-gritty detail of the guarantee is spelled out in your lease agreement but you can negotiate the terms of the guarantee upfront in your Letter of Intent. You could potentially get the landlord to relax on the length of the guarantee or you could propose a burndown of a guarantee.
How do these items tie into franchising?
Regardless of whether you are a franchisee or small business owner, the items discussed here are important to you. The advantage you have as a franchisee is that your franchisor will be able to provide you with a lot of this language. But don’t fear if you’re not a franchisee because a good broker will have a bank of standard language that they can use to help you as well.
There are a lot of clauses that you could insert into an LOI to construct an all-around good deal for LOI terms yourself. Ultimately, no matter how many professionals you hire, you’re going to be responsible for getting yourself the best deal possible. There’s a wealth of free tools and literature at franchisefrankness.com to help you out.