Creativity Lends to Delicious Restaurant Deals in Tough Market

As the economy sputtered in 2007 and crashed and burned in late 2008, so went the restaurant leasing market in many parts of the country. In stark contrast to the frenzied, debt-fueled restaurant development during the mid-2000s, the end of the decade was marked by unprecedented industry contraction in many cities, which continues today. Noteworthy restaurant closures and casualties dot the American restaurant landscape, and  larger-scale restaurant openings in many markets are a rare occasion.  This trend should continue in a number of markets for the foreseeable future, as economic challenges make restaurant development prohibitively risky, especially under traditional leasing models.

Creative deal structuring is the key to restaurant development in this challenging market. Many of the country’s better restaurants opened since the recession are supported by transactional structures that made their creation worthwhile for both the property owner and the restaurateur. In almost every market, better restaurateurs want to develop new stores; they are just smart enough not to do unreasonable deals in this unpredictable market.

A “better restaurateur” is an operator with a meaningful track record of financial success operating one or more restaurants in a given food segment (e.g., quick service, fast casual, casual dining, or fine dining), particularly within the past three years. An “unreasonable deal” is a restaurant opportunity that presents an unacceptable risk of failure, which, for various reasons, is the case with a fair portion of conventional restaurant leasing opportunities in most markets right now.
 
The basic financial components of a conventional lease are base rent, care and maintenance charges, and often a tenant improvement allowance. If total occupancy cost is projected to exceed a certain percentage of gross sales from the restaurant (restaurateurs generally need to keep occupancy cost at less than 10 percent of all sales), a better restaurateur will usually pass on the offer. Combine a high projected occupancy cost with personal guarantees and no tenant improvement allowance, and you have a deal only the most cavalier restaurateur would dare accept under today’s conditions.
 
A deal cannot be one-sided.  Better restaurateurs know this, as do better property owners.  If either side loses, neither party wins; property owners realize that failure comes with a high cost, and it is prudent to offer a transactional structure that lends to mutual success.

The following three transactional structures are simply food for thought–general structures that have succeeded (to date) in various restaurants, around the country, that were born during the recession. Each structure has its variables and risks, and every restaurant transaction must be approached with the appropriate level of care and customization. 

Structure:  Sweetheart Lease

Description:  Restaurateur leases property with generous terms from landlord.
 
Characteristics:

• Landlord provides significant tenant improvement allowance (sometimes funding the complete build out or conversion cost of an existing restaurant).
• Reasonable base rent and/or percentage-only rent.
• CAM charges are subject to reasonable caps.
• Tenant typically does not provide guarantees; if guarantees are provided, liability under the guarantee is subject to a cap.

Suited for: Property owner struggling to find better restaurateur tenant in a new space; property owner seeking to replace a failed restaurant in an existing space with a quality tenant.

Structure:  Management Agreement

Description:Restaurateur manages restaurant for a fee under contract with property owner, who also owns the restaurant. 

Characteristics:

• Property owner funds build-out or conversion of restaurant which manager operates on owner’s behalf.
• Owner pays all operating expenses, and manager receives fee in exchange for management service, which is typically a base fee versus a percentage of gross sales.
• If restaurateur is developing a new concept for the owner, it may also receive a development fee.  Profit-based incentives in the management agreement provide incentive for restaurateur to maximize profitability of restaurant.

Best for:  Property owner with a need for food and beverage service unable to interest a better restaurateur in a sweetheart lease; owner of space with a failed restaurant looking for a modest conversion; certain hotel or resort owners or owners of properties where food and beverage is a loss leader.

Structure:  Partnership

Description: Property owner and restaurateur form a partnership to handle restaurant operations at owner’s property.

Characteristics:

• Single-purpose entity is formed with landlord and restaurateur as owners (equity positions depend on strength/capital investment by restaurateur, amount of capital needed for investment, and the need for third-party investors).
• Restaurateur will sometimes invest capital, but equity is typically earned through services rendered.
• Landlord provides most, if not all, of financing for build-out or conversion (sometimes through a private offering to individual investors; sometimes restaurateur contributes).
• Restaurateur develops concept and operates restaurant and receives compensation “off the top,” typically a monthly fee versus a percentage of gross sales, in addition to equity distributions.
• Equity distributions to restaurateur (and sometimes landlord) are often subject to a distribution preference to capital investors who receive a larger percentage of profits until their capital investment in the restaurant is returned.  After this payback, profits are typically distributed pro rata in accordance with ownership interest in the entity.
• Landlord will typically command a reasonable rent from the operating entity.

Best for: Transactions with experienced and savvy landlords and restaurateurs with the proper disposition to work through the challenges of partnerships, especially in an uncertain market.

Hopefully, property owners and better restaurateurs will continue to creatively connect to keep fresh and exciting offerings coming to a hungry audience. 

Riley Lagesen is a partner at Davis Wright Tremaine LLP and leads its national Restaurant Industry Practice Group firmwide.