How independent restaurants are managing the increasing costs of leases
By Nancy Wood
It’s not late-breaking news that commercial real estate costs are on the rise, but it sure seems like rocketing rents are increasingly forcing independent restaurants and mom-and-pop places out of business.
It’s happening across the country – restaurateurs are struggling with the perfect storm of increased competition, labor shortages, growing labor costs and declining profit margins. Given all those challenges, when the landlord decides to raise the rent, too, it can tip the scales and put a restaurant out of business.
A Good Market
Since the 2008-2009 recession, the market has been trending up, and even though some economic indicators point toward a peak in post-recession growth, research reflects that the property market is still healthy. And that means landlords can charge more rent, especially when there’s higher demand for space.
In fact, 2018 was the ninth consecutive year for commercial property rent and valuation increases in the U.S. according to J.P Morgan’s “2019 Commercial Real Estate Outlook.”
Georgia’s economic landscape is strong, too – particularly in metro Atlanta. Commercial real estate firm CRBE’s “2019 Retail Outlook Report” lists Atlanta among the cities with the highest ‘Net Asking Rent Growth’ over the next five years.
“Whether you’re a law firm or a restaurant, the cost of real estate in general is more than it was 10 years ago, and certainly 20 years ago,” says Steve Simon, a partner in Fifth Group Restaurants. Simon, who entered the Atlanta restaurant scene 26 years ago, recalls seeing rents that were $6/square foot.
“Now, we have rents that are $70/square foot, depending on what part of town you’re in,” he says. Even though some hot parts of the metro area are edging toward a rumored $100/square foot, Simon thinks there is greater rate consistency in different parts of town now. But, as he puts it, “It’s all expensive.”
That sentiment is reflected in the number of recent high-profile restaurants closing their doors in part due to increasing rent, including Miso Izakaya, 4th and Swift, and 5 Seasons Brewing in Atlanta. Both Feed Fried Chicken and Such and Hugh Acheson’s restaurant Achie closed in 2018 at the The Battery at SunTrust Park as well.
Rent prices have skyrocketed in intown Atlanta, especially along the in-progress Atlanta BeltLine, but it’s also affecting restaurants in Macon and Columbus, Athens and Savannah, especially as the national trend of returning to downtown has made space more desirable – and more expensive to operate in. So how can locally grown restaurant groups with multiple concepts and small, independent restaurants alike survive and thrive?
Making the Numbers Add Up
With notoriously low profit margins and increasing labor costs, restaurant owners and operators have to consider strategic ways to mitigate rising real estate costs. Georgia restaurateurs have learned – some the hard way – that making sure all the boxes are checked for a particular concept doesn’t necessarily spell success.
Finding the right space is much more involved for restaurants than just a cost per square foot number. Success is based on many other factors – starting with location. Is it urban or suburban? High density or low? Is there easy access? Ample parking? Is there high traffic during operating hours? Is the space in a new development or is it second or third generation? Does the size and layout work with your concept? What is the total occupancy based on your configuration?
All of those puzzle pieces have to fit to keep costs down – and once that’s figured out, what about your landlord? Considerations that can affect what a landlord might charge, like keeping up with inflation and operating expenses, or increasing revenue and the property’s value, are all part of the process. And don’t forget the old adage “what the market will bear” – that can play a role as well.
“There are a lot of people who are in a position to lease or loan to a restaurant who don’t fully understand the variables and the intangibles that will contribute to someone’s success,” says Ryan Turner, co-founder and partner of Unsukay, the parent company for Atlanta restaurants Muss & Turner’s, Eleanor’s and Local Three.
“Anyone can create a good-looking business plan and pro forma and numbers that look great.” But he’s found over his 14-year career in the industry that “landlords and investors alike need to have the financial literacy to better understand how to make those numbers happen.”
Wide-held industry models estimate basing a property lease on five to eight percent of anticipated revenues, depending on the type of restaurant. “We look at total occupancy,” says Turner, “rent, property taxes and common area maintenance charges.” And while he targets six percent or lower to start, their operations generally end up at eight percent.
Fifth Group Restaurants – with multiple concepts including South City Kitchen, Ecco, laTavola, Lure, Alma Cocina and el Taco, tries to keep occupancy costs to six or seven percent maximum. But Simon points out the need to be cautious on revenue projections. For he and his partners, one key to addressing higher lease rates is looking for sites where there is still demand and where the concept will make sense architecturally.
“We definitely try to match a new or existing concept to the neighborhood and to the building,” he says. “So whether it’s the bottom of a high rise or a stand-alone building, we want the environment and the approach to be desirable.”
For concepts that are built on a franchise model with locations across the state, high rent rates can stall growth. “The real estate market has a big impact on our business,” says Shawn Hooks, who with two partners runs Southeastern Interstate Group as area representatives for Firehouse Subs.
“The higher the rent, the lower the margins, so that can be a deciding factor whether we grow or not,” she says. “Quite often, it is.”
Hooks’ group supports 193 restaurants in most of North and South Carolina, east Tennessee and in Georgia, from McDonough north through metro Atlanta to the Georgia state line and Augusta. While the smaller towns and outlying areas are generally charging rates in the low $20s/square foot in strip centers, Hooks says, “We see rent rates all the way into the $40s and in some areas, even the $50s, but we won’t go above $35.”
High rent areas generally don’t provide all the characteristics Firehouse Subs needs to succeed, like visibility, access and parking. “Ultimately, we end up moving to a different area because it’s just too high a cost to take a risk,” says Hooks. “That has really forced us to build in the suburbs.”
Negotiating the Best Lease to Keep Costs Down
Learning the ins and outs of negotiating a favorable lease for any type of restaurant concept takes experience – and expert advice. Typical restaurant leases are negotiated for varying lengths of time, and negotiating any lease can impact the cost of doing business, whether it’s a new space or an existing one.
As Hooks puts it: “Rent is a big deal to us. We work hard to get the leases where we need them, including escalators,” she says, referring to a clause that states rent can increase by a specified amount each period. Sometimes this include a cap on the increases or requirements to lower the rent in the future. “When our options come up, we always try and contain those to small escalators or small bumps every year.”
Hooks and her franchisees typically negotiate five-year leases with five-year options and use local real estate brokers who have experience with the brand and its requirements. “We’ve got a pretty proven track record, and we know we’re in it for at least 10 years.”
Unsukay’s partners have a history of signing 10-year leases, and Turner prefers negotiating directly with the landlord company’s owners or CEOs. “At this point in our careers, a 10-year time frame is something we’re comfortable with,” he says. “For the most part, we’ve had a lot of success with landlords who have been willing to treat us like partners.”
For him, it’s an opportunity to talk through the deal, hear their side and “explain why we would ask for something or a dollar amount. You can generally get a better deal.”
Those relationships with brokers and landlords can make a big difference to the bottom line. “I have landlords who put more value on our longevity, and it’s not worth trying to replace us,” says Fifth Group’s Simon, “and some say take it or leave it.”
Regardless, he says, “I don’t think we’ve signed anything in the last five to seven years that we don’t have at least 15 years of terms – whether that’s in a 10-year base with a five-year option or a 15 year. We’re often trying to tie a place up for 20-25 years when we sign our initial lease – with extensions.” What’s consistent, he says, “is that every landlord wants more rent.”
Taking Advantage of Next-Gen Spaces
Another way many restaurateurs deal with the rising cost of real estate is to focus on second- or third-generation spaces. These are spaces that have had a prior restaurant occupy the space – vs. a brand new development – so it usually already has a built-out kitchen that comes with equipment, proper ventilation and water and sewer tap fees (a huge up-front cost when moving into a new space). Meanwhile, new locations, buildings and developments typically charge higher rents because developers have to pay for their own loans, so leasing a second- or third-generation space can definitely make a difference.
“We’ll let someone else realize the depreciation due to the natural attrition in our industry,” says Turner, “specifically the fact that our market is oversaturated with restaurants. We’re not compelled to create something brand new and pay for it.”
Although Unsukay’s first Muss & Turner location was a new build, the partners have had a lot of success with Local Three, which was the former Joel restaurant in a Buckhead office building. Because they were creating an amenity in a Class A building that was desperately needed, Turner says, “We were able to negotiate a better rent deal because we weren’t the primary generator of revenue.”
For Firehouse Subs locations, Hooks says that while they look at both new and next generation sites, “We really like existing strip centers because our cost of entry is lower – and you’ve got components like a bathroom and firewalls – that you’re not going to have to reinvest in.”
Another plus can be the offer of tenant improvement (TI) dollars. This is the amount a landlord is willing to spend so that the tenant can retrofit or renovate the restaurant space. It’s usually as a per-square-foot or total dollar sum.
Realistically, those dollars are ultimately paid back in rent, and the rent may be lower if tenants don’t take those dollars, but, says Turner, “It is a convenient method of funding for restaurateurs that you don’t need to get from an investor or a bank.”
Fixed Cost Challenges Create Innovation
Negotiating smart leases, looking into upcoming areas for opportunities or renovating existing spaces for more efficiency can all affect the bottom line where real estate is concerned. But the demise in retail traffic, the increase in meal delivery services and changing consumer attitudes are now part of the formula as well.
For concepts like Firehouse Subs, the increase in off-premise dining sent them back to the drawing board. “With the sharp rise in real estate costs and the change in our consumer to eat at home, we’re redesigning our restaurants,” says Hooks.
The ‘restaurant of the future’ will shrink the brand’s typical footprint from 1,800-2,000 square feet to a range of 1,500-1,700 square feet. Hooks says they are also looking for more real estate situations that can be configured with drive-thru windows.
Leasing smaller spaces can work for certain concepts as well – like the current explosion in food halls and stalls. New concepts or brand extensions can benefit from a lower cost of entry to the marketplace, but more established independent brands are even looking at licensing agreements.
For example, Fifth Group Restaurants has licensed three of their concepts in areas outside of their traditional business footprint with two concepts at the airport, Ecco and el Taco, and one in Alpharetta at Avalon, South City Kitchen. Simon says Alpharetta “was a long way for us. We ended up with a licensing agreement because we couldn’t do a shared kitchen with the hotel there,” he explains. Although he admits it’s not as profitable as people think, “As a brand extension, it’s been a good thing for us. And we’ve put a lot more energy into it to make sure they maintain our standards.”
Even buying vs. leasing is a consideration. Although only a small percentage of restaurateurs own their properties, there are some financing and tax benefits. “A bank is more amenable to lend toward real property than to a lease with improvements for a restaurant,” says Simon, whose group owns just one of its properties. “Plus, the term of the financing gets much longer if you own property, and sometimes it makes it easier from a cash flow standpoint.”
In the franchise arena, Hooks says in some cases, franchisees do end up buying their property. “It’s not uncommon,” she says. “But you have to have the financial wherewithal to be able to do it. You’re investing a lot of money into a location, so that’s an asset you get to keep versus paying a landlord.”
For any restaurateur, finding the right space at the right price for the right concept is the name of the game. A high comfort level and confidence in the location, the population, a low financial threshold of entry and “the demand for what we’re doing” are all part of Unsukay’s approach, says Turner. But he adds another important ingredient: The people.
“The better we get on a day-to-day basis from the consistency of the food to the connection level to our guests, things will take care of themselves.”