Before Covid, landlords had the upper hand in restaurant lease negotiations. Now they’ll settle for tenants who can make the monthly rent.
The balance has shifted. Advantage: tenant. Now landlords are reducing rents to entice survivors to sign on.
Angelina Branca’s relationship with her landlord was rocky even before the coronavirus. They had disputes over HVAC, plumbing, water bills, and city taxes. But Branca and her husband John had spent around $280,000 transforming a former shoe store into Saté Kampar, their 50-seat Malaysian restaurant in Philadelphia’s Passyunk neighborhood, so in February the Brancas had their lawyer contact the property manager about their June 1 lease renewal.
The Brancas faced a scheduled 15 percent rent hike on their $2,760 monthly rent, and their landlord refused to reduce it or make adjustments because of Covid-19, which closed the restaurant on May 17. Branca estimated they would need another $7,000 in monthly revenue to meet the increase—easy enough under normal circumstances, unlikely at reduced occupancy with no end in sight. The couple vacated the space on May 31 to avoid being locked into another five-year term at a higher rent.
“We worked so hard to try to make use of what we invested,” said Angelina. “We feel like we were being pushed out.”
Before Covid, landlords had the upper hand in lease negotiations. Restaurant owners aim for lease rates of 6 to 10 percent of their gross revenue, but they often end up paying more and cutting into increasingly narrow profit margins.
The virus changed all that. “Landlords started out as pitbulls, and they’ve turned into poodles,” said David Helbraun, founding partner at Helbraun Levey, a New York law firm that’s currently renegotiating restaurant leases for 200 clients. Restaurants used to be a relative bright spot for landlords, compared to other retail businesses, but, according to the National Restaurant Association, and investment bank UBS forecasts that at least 20 percent of restaurants will shutter by the end of the year. Landlords can’t afford to be hardline with the survivors.
“This is worse than 2008, certainly. Retail looked bleak before Covid-19. Now it’s a complete mystery about how deep the bottom will go and when it will turn around,” said Barbara Denham, a senior economist at Moody’s Analytics REIS.
“Restaurants are our neediest category.”
Rent rates are softening, but it’s a volatile landscape. Landlords who took on a lot of debt to acquire their properties often can’t amend leases, even in the face of prolonged vacancies, because the lenders that hold their mortgages won’t agree, according to Peter Braus, managing principal of real estate firm, Lee & Associates. And some might prefer the relative security of renting to multi-unit operators and chains, pushing independents out of the market.
“If you have a solid operation, you should be able to negotiate something, but it’s just so complicated because there are so many variables,” said Mark Stone, president of the restaurant consulting firm Infoclear Management LLC. “There’s no clear road map.”
Promise in percentage leases
Percentage leases look like a promising solution, with tenants either paying a percent of gross revenue or a lower base rate than a standard lease, plus a percentage. It’s not a new concept, and it can backfire if a restaurant does well. “If a restaurant crushes it, the landlord gets extra rent,” says Chris Maling, principal of retail capital markets for Avision Young, an international real estate investment trust.
For now, percentage leases are a temporary fix, designed to limit what a restaurant pays until its business returns to pre-pandemic levels: the goal is to phase out the percentage as business improves.
“They’re never going to make up the business they lost, ever. To expect those tenants to repay for that rent in the future is unrealistic.”
Lee & Associates, which has residential, office and retail clients, owns 40 buildings in New York City and brokers leases in many more. “Restaurants are our neediest category,” said Braus. “They’re never going to make up the business they lost, ever. To expect those tenants to repay for that rent in the future is unrealistic.”
So far, Lee & Associates has been able to work out deals to keep their hospitality tenants in place. Percentage leases aren’t a panacea, though. “I’m only going to do it with tenants that have systems in place that I trust—a restaurant with 40 locations. I’m not going to do it with a mom-and-pop,” said Braus.
One size doesn’t fit all
In the wake of the pandemic, insurance companies have refused to pay business interruption insurance, which would normally pay for rent during restaurant closures, and the federal government’s Paycheck Protection Program doesn’t come close to making up for lost revenue, at 60 percent of funds earmarked for payroll and 40 percent for rent.
“If I paid landlords with PPP money, I couldn’t restart my business,” said Birch Coffee co-owner Jeremy Lyman, who’s negotiating leases with more than a dozen New York City landlords. Lyman says that business is always slow in January and February, and having been shut down during traditionally strong months, “PPP money has to be applied to catching up” on invoices and expenses.
“Deferments wouldn’t work based on the numbers we were doing pre-Covid, even in a super successful store.”
Some of Lyman’s landlords waived April rent and began to offer two-to-four month rent deferments, “but deferments wouldn’t work based on the numbers we were doing pre-Covid, even in a super successful store,” he said, noting that an average Birch Coffee shop grosses more than $100,000 per month.
Lyman proposed a percentage rentt schedule to his landlords: depending on the building, he would pay 10 to 20 percent of his revenue, with no base rate, until he returns to 80 percent of his pre-Covid business. None of his landlords have refused the offer outright, but no one is finalizing deals until they better understand Birch’s sales trajectory.
How far will retail fall?
For all its struggles in the last few years, the restaurant industry “was saving retail,” said Denham. As clothing and furniture companies closed, restaurants “were expanding at a healthy rate.”
Three years ago chef-owner Dan Wu opened Atomic Ramen in The Barn in Lexington, Kentucky, as part of a national food-hall boom. At the time, 155 food halls operated in the United States, according to the National Retail Federation; developer Cushman & Wakefield predicted that number would rise to 300 by the end of the year. The Barn closed permanently in late May.
Though his landlord waived a few months’ rent, Wu and his six fellow operators didn’t see a path forward without foot traffic or outdoor dining; they collectively broke their leases and walked away with no penalty.
“Even if you found me the perfect piece of real estate, I don’t know if I’d open a restaurant right now. It’s too much investment and risk in a time that’s so uncertain.”
Before Wu had packed up his equipment, friends in real estate started asking him to open a new Atomic Ramen in their buildings. “Everybody wants me to come back, and for a little while, I held onto that idea,” said Wu. “Even if you found me the perfect piece of real estate, I don’t know if I’d open a restaurant right now. It’s too much investment and risk in a time that’s so uncertain.”
The overall retail vacancy rate is predicted to rise from 4.6 to 5.5 percent by the end of the year, representing a 19 percent spike in vacancies since January, according to Robin Tranthom, a consultant at Costar, a commercial real estate analytics firm. He predicts that they’ll continue to climb through the end of 2021, and as a result, CoStar forecasts that retail rents will fall by 13 percent.
Weak tenant positions
Stone says that tenants like the Brancas, who invested heavily in their restaurant’s build-out, are in a weaker position to negotiate; they increased the value of their space, and their landlords can charge higher rent to future tenants.
Their landlord, Damon Costantini, said that the couple paid far below market value for Saté Kampar. “I’ve had multiple other restaurateurs reach out to me, as well as other retail stores on the avenue looking to upsize,” he said. “I believe another restaurateur will recognize the value of the location and the space. And further, will appreciate it.” Costantini has already shown the space to nearly a dozen prospective tenants.
Most independent restaurant owners personally guarantee their leases, which means that landlords can come after their personal assets—savings, homes, and cars—if they stop paying rent before their lease expires, according to Jasmine Moy, a New York-based hospitality attorney. The only exception is New York City, where leases contain a “good guy” clause that allows tenants to break these leases with proper advance notice; the city also recently passed amendment 1932-a, releasing commercial tenants from liability if they vacate before September 30 of this year.
Moy expects landlord lawsuits over the amendment, though, putting restaurant owners in legal limbo.
Hope for independents
As dire as the climate seems, some mom-and-pops will hold on. As soon as Mohammed Diallo saw the coronavirus decimate business in China, he reached out to his landlord to talk about revenue projections and a survival plan. He and his brother Rahim opened Ginjan Café in East Harlem in August 2019 and had a rent hike scheduled for July 2020. Instead, their landlord extended an abatement and stalled the increase for two months, during which time they’ll pay a percentage of revenue on top of the original base rate, up to the amount of the new rent.
The Diallo brothers immigrated from Guinea to the United States in the late 90s and started a ginger beverage company with $1,000 in capital, while holding down full-time jobs. But they’re also graduates of New York’s Hot Bread Kitchen incubator program, which gave the Diallos resources to scale their ginger juice business more quickly.
“Mom-and-pops that have been operating for a long time deserve a break, but it’s out of their control,” said Mohammed. “I feel like people who don’t look to grow and evolve always end up suffering.”
Opportunity and uncertainty
If UBS’s closure prediction holds, though, some 132,000 restaurants won’t survive the crisis. That glut of vacant spaces represents both the devastation of local economies and, on the flip side, real opportunity for restaurant owners via lower rent, fully built-out spaces, inexpensive kitchen equipment, and new, favorable lease terms.
While Maling doesn’t think percentage leases will outlive the coronavirus, he says that future leases will include clauses protecting tenants from pandemics and government-mandated shut-downs. In the next few years, Stone expects landlords to pay for more tenant improvements and provide more up-front free rent.
“There’s no way I’m ever going into another property where I’m upgrading it.”
Fast-food and fast-casual chains are poised to bounce back faster than most casual and fine-dining restaurants, because their businesses were healthier in the first place, and saw less decline, as little as 21 percent for fast-food businesses, compared to 84.7 percent for fine-dining establishments. Chains like Sweetgreens and El Pollo Loco are scooping up open real estate for new locations.
The return to restaurant ownership will be slower for Angelina Branca, who’s currently working out of a donated kitchen to make meals for hospital workers. She hopes eventually too open a new restaurant, possibly in Philadelphia’s Center City—a neighborhood where rents once seemed unattainable. She’d like some outdoor space and a landlord who’ll help pay for improvements.
“There’s no way I’m ever going into another property where I’m upgrading it,” said Branca. “If landlords want my restaurant, they need to put in their share.”