As a commercial real estate and business broker specializing exclusively in restaurant businesses for sale and restaurant real estate for sale or lease, many times I am asked by both tenants and landlords to negotiate a lease in each respective party's interest in the process of finding a restaurant site location. One issue which consistently arises is build-out allowances. The landlord typically desires to contribute as little as possible, while the tenant desires as much as possible. In my opinion, there is a way for each to win, should a developer budget a much higher allowance than competitive developers.
In the following example, I am making an assumption that a 5,000-square-foot restaurant tenant is looking at space in a new shopping center. The prospective tenant is of marginal to moderate strength and has one successful existing location. The tenant does not have the borrowing power or track record to go to the bank. The total "turn-key" for the restaurant is $400,000, of which $200,000 is permanent improvements, including plumbing, electric, HVAC, hood system, walk-ins, etc. The other $200,000 is removable equipment and start-up expenses, including soft costs. The standard tenant upfitting allowance is $10 per square foot or $50,000. The base rent is $10 per square foot. The cash available to the tenant, including the value of leased equipment, is $250,000. The tenant needs $150,000 in build-out allowance.
Should the landlord approve a build-out allowance for $30 per square foot for restaurant tenants, this could work to everyone's advantage.
By offering $30 p.s.f. the landlord first of all provides an advantage over competitive locations, and therefore should be able to obtain greater rent. Should the extra $20 p.s.f. in upfitting be amortized over a 10-year term at 11 percent annual interest, the effective cost to the tenant would be $100,000 at 11 percent or $16,530 per year in payments This effectively adds $3.31 p.s.f. to base rent. The landlord could conceivably obtain $14 per square foot in base rent because of the competitive advantage, and because of the additional upfitting contribution. By arranging permanent financing in advance, the cash flow position to the landlord is also improved, because the amortization period is greater than 10 years on the permanent loan. The tenant has a real win by being able to open a second location much sooner than the tenant's borrowing ability would dictate. A $14 p.s.f. lease capitalized at 10 percent creates a value to the landlord of $700,000; ($14 times 5,000 square feet or $70,000 in base rent per year divided by .10). Had the landlord only provided the standard $10 p.s.f. upfitting and received a rent of $10 p.s.f., the effective value created would be only $500,000 ($10 times 5,000 square feet or $50,000 in base rent per year divided by .10). The result is that the landlord has created as much as $200,000 in additional value of the shopping center for an investment of $100,000 in additional upfitting money. Not a bad return for the landlord!
The downside risk for the landlord is, of course, in the event of the tenant going out of business. In my opinion, should the tenant default on the lease, the landlord is not in a very high-risk situation. First of all, the shopping center may have already been sold at a higher price because of the resulting cap rate. Should the landlord still own the center, the likelihood of finding a new tenant is great, because of all the restaurant permanent improvements that are in place, including the tenant work. Restaurant prospects traditionally look at "conversion" opportunities extremely positively. In fact, the reality is, should the tenant's sales and profits be a disappointment, the tenant will probably sell his business assets at a distressed price and assign the lease. Even if the tenant defaults, stops paying rent, and vacates the space, the landlord can take steps in advance to have a UCC filing in a second lien position on public record to prevent the removal of any equipment. The first lien holder (for example, the leasing company) would have an advantage in leaving the equipment in place until a new tenant is found, who will pay off or assume the equipment lease. The landlord can still lease the vacant space if need be at $12 p.s.f. and break even on the investment. In summary, the tenant wins by being able to open a new location more quickly than the banks would normally allow. The tenant also wins by keeping a more attractive debt-to-equity ratio. The tenant can certainly understand paying a higher lease rate because of the extra upfitting allowance, and should be willing to offer the landlord a lien position on the improvements and equipment. The landlord wins by creating higher value in the selling price of the shopping center, by being able to offer a real competitive advantage over other locations, and by more quickly leasing space. The rewards are great for both tenant and landlord.