The Importance of Retail Leasing in Franchising

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1 The Importance of Retail Leasing in Franchising For franchises operated from a fixed location such as a shop or office (rather than a mobile vehicle-based franchise), the lease agreement and conditions are critical to the success of the business. Lease agreements are binding contracts that can be as extensive, detailed and complicated as a franchise agreement, and involve many terms and conditions which obligate the tenant. Like a franchise agreement, the lease will be for a certain term, and usually include an option to renew at the end of the term. For a new (or greenfield) franchise, a lease should (as a general rule) coincide with the franchise term. In other words, the start and end date of the first term of the franchise should be the same as the start and end date of the term of the lease. This ensures franchisees have the maximum time under their franchise to use the leased premises. Like the franchise term, the term of the lease should also be long enough to allow for the franchisee to recover their business establishment costs from the normal operation of the business during the initial term. If the establishment costs are high and the lease is short, the business may not recover its initial outlays for set-up during the initial term. Many leases will provide a tenant with an option to renew, however the terms and conditions associated with the renewal offer particularly the rent to be charged may not be as attractive as those in the initial term and potentially cost the business more in a second or subsequent term. For this reason, it is particularly important to recover the establishment costs of the business during the initial term of the lease. If, at the end of the term a renewal of the lease is not offered, or only offered on such terms as to be commercially unviable (such as at an unsustainably high rent), the tenant must consider either closing down their business or moving to different premises altogether. In either case, the tenant will also need to comply with their franchise agreement by either closing or relocating (in accordance with the terms and conditions outlined in their franchise agreement). Similarly, buyers of existing franchised businesses should satisfy themselves that the going concern they are buying has enough time left on the lease to recover their purchase costs, and are aware of the potential for the rent to change. 1

2 Additionally, buyers of existing franchises will generally need to be approved by the franchisor and equally by the landlord under the terms and conditions of the lease. Like a franchisor, a landlord must agree to the lease being assigned to a new business operator, but may not be unreasonable in withholding their consent. The management and renewal of a lease is an important function for any business owner. Failure to exercise an option to renew a lease may result in a catastrophic loss of value if the business is forced to close or relocate. Most leases which include an option to renew will require the landlord to notify the tenant in writing up to six months in advance with the renewal offer, and provide the tenant a timeframe to respond with their intention to renew the lease. If the tenant does not respond to the renewal offer in the time provided, the landlord may then require the tenant to leave, or continue on a short-term month-to-month rental (subject to market demand for space in the landlord s premises) at the end of the tenancy. Of course prior to entering or renewing any lease agreement, a tenant should obtain independent legal, accounting and business advice in the same way that they should seek advice prior to entering a franchise agreement. In both cases, they should seek out advisers with franchising expertise and a comprehensive knowledge of the leasing regulations that apply in the respective state or territory. (Unlike the Franchising Code of Conduct which is a national set of regulations which govern franchising, leasing regulations are determined at state or territory level with different regulations. While the information presented here is intended to be relatively generic, a potential tenant should be aware that variations in state leasing regulations do exist, and should always seek professional advice prior to signing a lease agreement in any State or Territory.) Irrespective of state leasing jurisdiction, franchisees of fixed-location businesses may operate from a site by two principal methods: 1. They lease the site from the landlord themselves; 2. The franchisor leases the site from the landlord and provides arrangements for the franchisee to use the site. Franchisee leases direct from the Landlord Where the franchisee leases the site directly from the landlord, the franchisee has greater control over the lease but may also be disadvantaged by being 2

3 unable to negotiate better rent or terms as a result of inexperience or lack of overall market presence. The franchisor may also not consent to the franchise under a direct lease arrangement if it has concerns about maintaining the uniformity and integrity of the franchise system and the brand. Alternatively, the franchisor may consent to the franchise only if the franchisee and the landlord agree to an assignment of the lease to the franchisor in the event that the franchisee ceases to be a franchisee, or for breaches of the lease. If there is an assignment agreement in place between the franchisee, landlord and franchisor, it is common this additional agreement will be at the cost of the franchisee in addition to their costs for the lease agreement. The Franchisor leases the site A common leasing arrangement is for the franchisor to lease the site from the landlord, and then to sublease the site to the franchisee or otherwise provide the franchisee with a license to occupy the site. By leasing the site, the franchisor may be able to use their prior experience and market presence to achieve a more competitive outcome. The franchisee may be offered a sub-lease for the site, whereby the franchisor then becomes the franchisee s landlord. This gives the franchisor more control over the site and the performance of the lease, and the franchisee pays the rent to the franchisor who in turn pays the landlord. Under a license to occupy, the franchisor has the greatest control over the site and the franchisee may have fewer rights than under a formal lease agreement. A potential downside to the franchisee may occur if the franchisor breaches their agreement with the landlord, and the franchisee is forced to vacate the site for no fault of their own. Whether the franchisor subleases to the franchisee, or offers a license to occupy the site, the franchisee must be provided either with a copy of the lease, or a copy of the right to occupy document within a month of it being signed, or details of the conditions of occupation within a month of the commencement of occupation. Irrespective of who leases the site, the franchisee should obtain professional advice about the lease, sublease or right to occupy agreement. Additionally, the franchisee should be aware that rent may need to be paid on the site even if the business ceases to operate. This obligation may continue 3

4 for months or even years afterwards, and is a risk that should be factored into the overall assessment of the franchise offer. The Leasing Process Prior to entering into a lease (and subject to the State or Territory where the lease is to be granted), a landlord may be required (depending on the State) to provide a tenant with a disclosure statement similar to the requirement for a franchisor to provide a potential franchisee with a disclosure document. The purpose of a disclosure statement is to provide a tenant with information to make a sound commercial decision, and must be provided with a copy of the lease or agreement to lease at least seven days before an agreement can be made. There may also be a requirement for a potential tenant to provide a disclosure statement about themselves to the landlord, or for a buyer of an existing business to provide a disclosure statement to both the landlord and the existing operator. After identifying a suitable site and conducting initial research into its market potential, a potential lessee may enter verbal negotiations with a landlord resulting in a letter of offer which outlines the basic terms and conditions of a proposed lease. This is not a lease itself and does not commit the parties to enter into a lease. If the letter of offer is accepted or results in further negotiations with an acceptable outcome, then the next step is to commence disclosure and issue an agreement to lease, or the lease itself. (An agreement to lease may be used where the premises cannot be properly described such as in a new centre development or redevelopment of an existing centre but is a binding agreement to enter a lease agreement at a later date). At this point the tenant should seek professional advice before signing either a lease agreement or an agreement to lease. Rent The rent may be one of the single greatest costs of running a fixed-location business. In committing to a lease agreement, a tenant agrees to pay the rent for the duration of the lease or until such time as the lease is assigned to another tenant or terminated by the landlord even if the business operated from the site ceases to trade. The obligation to continue to pay rent on an abandoned site can severely compound the cost of a business failure. 4

5 Base rent the minimum rent charged for the space occupied - is usually expressed as a dollar rate per square metre. Smaller sites may often pay a higher rate per square meter than much larger tenants in the same building or centre. Turnover rent is where the rent to be paid is calculated as a percentage of a tenant s total sales turnover, in a similar fashion to the calculation of royalties for some franchise systems. Base rent and turnover rent may be used together where base rent applies up to a certain level of turnover, after which turnover rent may then apply. Leases which include provisions for turnover rents will also include obligations for the tenant to provide sales turnover information to the landlord on a periodic basis. There may also be provisions for the sales turnover to be audited once a year, at the end of the lease, or at other times agreed between the parties. The frequency and method of payment of the rent will also be spelt out in the lease agreement. Changes to the Rent Changes to the rent payable on a tenancy also known as a rent review - will be determined by the formula set out in the lease agreement, and may range from very simple to very complex formulas. Rent reviews should not be conducted more than once a year after the first year of the lease. Simple formulas for rent changes may include an agreement to increase the rent by a set dollar amount per year, or by a set percentage per year. In these two scenarios, the variable (either the amount or the percentage) is known in advance. In another simple formula, the rent may increase by a variable with an amount unknown at the time of entering the lease. A common variable of this nature is the Consumer Price Index (CPI) which is a measure of the quarterly change in the cost of a basket of goods and services which typically account for a high level of metropolitan household expenditure, and which is compiled by the Australian Bureau of Statistics (ABS). In some cases, the formula may involve two of these variables together (eg. CPI plus X percent, or X percent or $Y, whichever is the greater, etc). If an external variable, such as CPI, is a negative value, then the rent review may result in an overall decrease in rent to be paid, however it is more common for rents to go up than to go down. 5

6 Another formula may involve averaging the base rent and turnover rent paid for the previous period, and setting this as the new base rent for the next period. In this scenario, only one variable (base rent) is known at the outset of the lease, as turnover rent paid will be determined by the turnover during the period. The market rent review formula considers what rent would be reasonably paid for the premises if it were offered to the open market, rather than continuing under the current tenancy. The landlord and tenant may agree on the new market rent between them, or may choose to appoint a specialist valuer to make a determination and to receive submissions from both parties. In boom times, market rent reviews may result in potentially substantial increases. In poor economic times, market rent reviews may result in smaller, or potentially even negative increases. Outgoings In addition to the payment of rent, tenants may also be required to contribute toward the landlord s operating costs of the building or centre in which the tenancy is located. Such operating costs might include cleaning and maintenance of common areas, lifts and elevators, air conditioning, lighting, local authority rates and centre management costs. Outgoings are generally calculated in proportion to the total lettable area of the building or centre occupied by the tenant. If outgoings are to be charged, a landlord should supply an annual estimate of these, and provide a financial statement of outgoings paid every year or accounting period. Outgoings may also include advertising and promotions organised by the landlord or centre management to attract customers to the centre or building, or these costs may be covered by a separate levy applied to the tenants. Additional Key Factors in a Lease In addition to rent, outgoings and the term of the lease (discussed in some detail at the beginning of this article), there are a number of other key factors in considering a lease. Like a franchise agreement, lease agreements will vary from one location to another; however there are some general factors which are common to most types of lease agreements. These are outlined as follows: 6

7 Permitted Use and Exclusivity Landlords may restrict the number or type of businesses in their premises, and may do this through clauses in the lease agreement dealing with permitted use and exclusivity. A use of the site permitted under the lease (eg. coffee shop) does not necessarily guarantee exclusivity by business or product type. There may well be one or more other coffee shops allowed elsewhere in the centre or building, and other businesses which primarily sell another product (eg. doughnuts) may also be permitted to sell coffee. Permitted uses and exclusive or non-exclusive offers provide landlords flexibility to maximise the market appeal and potential of their property. Tenants may have little opportunity to negotiate concessions in this regard, but should at the very outset determine that the permitted use clause will allow them to operate the kind of business intended for the site, and should check that the goods and services to be provided by the franchise are consistent with the permitted use provisions. Trading Hours The tenant in a retail shopping centre will be required under the terms of the lease to open for trade during core trading hours set by the landlord, which must fit within the allowable trading hours of the State or Territory and region in which the business is to be operated. Failure to operate the business during the core trading hours may result in a breach of the lease agreement. (A breach of a lease agreement may also result in a breach of a franchise agreement, thus compounding the consequences of failing to operate in accordance with the lease). Common Areas Common areas of a retail centre may be intended for use by the public, tenants or both. Common areas include walkways, escalators, elevators and stairs, restrooms, carparks, gardens, food courts and entertainment areas. It may be essential for a potential tenant to assess the suitability of the common areas of the site to be leased to ensure they are of a standard in keeping with that of the intended business, and adequate for the customers of the business to access its premises. 7

8 Bond or Guarantee Under the terms of a lease, the tenant may be required to provide a personal or bank guarantee (or both) or a security bond. A personal guarantee means that the guarantor will be liable for any outstanding rent even if the lease is in the name of a company, trust or partnership. Additionally, an amount equal to several months rent (determined between the tenant and the landlord) may be required to be lodged in a bank account for the benefit of the landlord if the tenant fails to pay rent or make good the site after the end of their occupation. Relocation and Demolition A lease may give the landlord the authority to relocate the tenant to another site within the same building or centre. If relocation is required usually as a result of a tenancy mix review or refurbishment or construction works the landlord is required to provide a reasonable period of notice and details of the proposed and comparable alternative site. Where relocation is required, the tenant may accept the relocation offer or provide notice of their intention to terminate the lease. If the relocation offer is accepted, the tenant is generally entitled to receive payment for the reasonable cost of the relocation. Similarly, if the lease includes a demolition provision and the landlord requires the tenancy to be demolished, the landlord must give a minimum period of notice according to the relevant State or Territory legislation, and generally permit the tenant to terminate the agreement sooner if they desire. The landlord is also liable to pay reasonable compensation for loss or damage to the tenant. Fit out and Services The lease can be expected to require shop fitouts and signage to be installed in a manner and to a standard acceptable to the landlord, and for the tenant to pay for the connection of services such as electricity and water. The lease may also specify a requirement to update or refurbish fitouts and signage on a periodic basis to maintain an overall image for the building or centre. 8

9 There are many other factors to consider in a lease agreement, and these should be considered in conjunction with the relevant State or Territory retail leasing regulations. Negotiating a Lease Where a franchisor holds a head lease and sublets to or grants a right to occupy to a franchisee, negotiation of the terms and conditions of the lease will be done by the franchisor direct with the landlord. Where the lease is to be held by the franchisee, the franchisee may wish to engage the services of an experienced tenant advocate to negotiate the lease on their behalf. A tenant advocate can be expected to have a greater understanding of market conditions and capacity to negotiate concessions otherwise unavailable to an inexperienced lessee. Lease negotiations may focus heavily on issues of term, rent and rent review formulas, outgoings, location, floor size, permitted use, contribution to fit-out costs and other incentives such as rent-free periods, and other conditions. Conclusion It is important to obtain independent advice from qualified and experienced professionals in relation to both the franchise agreement and lease. By understanding the rights and obligations of a lease in advance, a potential franchisee is in a better position to make an informed decision about a franchise business offer. 9