Retail

The Franchisee Lease

Landlords can benefit but they also need to be wary of details.

The year 2015 saw more than 795,000 franchise outlets throughout the U.S., according to the Franchise Business Economic Outlook 2016. That number is expected to increase by 1.7 percent this year, adding approximately 13,500 new units across 10 business lines.

While retail and restaurant franchises are likely to lease space in shopping centers, a growing number of franchises in business, personal, and educational services are also locating in other types of commercial centers and small office parks. Thus, landlords of multi-tenant properties are increasingly likely to encounter franchisees as potential tenants. 

Having a franchisee-tenant can prove a very lucrative and beneficial arrangement. However, it does come with a unique set of risks, many of which are addressed below. With one in 12 businesses in the United States now being a franchise, landlords should familiarize themselves with ways to minimize the risks and effectively navigate the pre-approval and franchisee-lease negotiation process.

Landlord Benefits

Probably the most significant benefit of having retail and restaurant franchisee-tenants is that they bring a familiar trade name, other franchise locations, and as a result, an existing customer base to a property. Nationally recognized tenants also draw other potential tenants with an interest in occupying space in the same center. Sometimes they are even willing to pay increased rentals, if the perceived draw of the franchise is large enough.

In addition, there are several other benefits to leasing to a franchise tenant.

Qualification of Tenant. Prior to granting approval to purchase a franchise, a franchisor generally reviews the franchisee's experience, finances, and other pertinent factors to determine whether the franchisee will be able to maintain a successful business. Because failure of a franchisee's business is a direct reflection on the brand, and patrons' perception thereof, a franchisor has a particularly strong interest in the franchisee's success. As such, by the time the franchisee approaches the landlord, the franchisor has often undertaken extensive due diligence and pre-qualified the franchisee.

Franchisee Investment. While each franchisee runs its own business, there are fees, regulations, and standards imposed by the franchisor. Upon taking possession of a leased premises, a franchisee will likely have invested significant sums of money that an independent startup tenant would not, such as a franchise fee, legal fees for the franchise agreement, and accountants' fees for the preparation of budgets and projection reports for review by the franchisor. The franchisee will then invest additional funds in building out the premises and purchasing inventory, equipment, and signage, all in accordance with the franchisor's requirements. Thus, a franchisee-tenant is often more invested in the success of the location than a corporate or independent tenants.

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Franchisor Cure. Finally, most franchisors have the right to cure lease defaults, step into the franchisee's shoes as tenant, or find a replacement franchisee. It is costly for a franchisor to de-brand a location. Especially if a location is successful but a franchisee is otherwise in default of its obligations under its lease, franchisors will often exercise this right.

This is advantageous in that the landlord does not have to expend money on eviction proceedings or enforce the provisions of the lease or guaranty. Also, there is no time between tenancies, so the landlord does not lose rental income and the continuous operation of the business maintains foot traffic at the landlord's center.

Before Negotiating

Managing timing is crucial in franchisee lease negotiations. A landlord will not want to remove a property from the market, undertake due diligence to approve a tenant or guarantor, and pay lawyers to negotiate and draft a lease agreement before a franchisor fully approves the franchisee and its chosen location. 

However, prior to issuing approvals, a franchisor may require a fully executed lease. So, ideally, a landlord should delay incurring the bulk of the costs associated with the lease until the only outstanding contingency to the tenant obtaining a franchise agreement is the franchisor's approval of the lease.

Loan Document Compliance. In negotiating any lease, but particularly a franchisee lease that may be subject to certain franchisor requirements, a landlord should look back at any applicable loan documents, such as deed of trust or mortgage, loan agreement, and security agreement, to ensure that the lease and the franchisor rider do not conflict with the landlord's obligations as borrower. Specific areas of concern are casualty provisions, such as who retains insurance proceeds and whether there is an obligation to rebuild after a casualty; any conflict with a franchisor requirement in which the landlord waives its interest or subordinates its rights to place a lien on the franchisee-tenant's bank accounts, furniture, fixtures, or equipment after a lease default; and whether the lender has the right to review and approve any assignments or amendments of the lease.

The Franchisor Lease Rider. Too often, extensive negotiations, drafts, and redrafts of a franchisee lease are completed, the lease is ready to be executed, and only then does the franchisor lease rider or addendum first surface. Upon review, a landlord will sometimes find those provisions conflict with the fully negotiated and agreed upon lease provisions. Some franchisors are more flexible in the negotiation of their riders, while others' riders are not negotiable. Thus, a landlord should review and attempt to resolve any unacceptable provisions in advance of engaging in the lease drafting or review process.

Franchisor Rider Provisions

Franchisor's Consent. When a franchisor requires that the landlord and franchisee-tenant obtain franchisor's prior consent to any lease modification or amendment, it is in the landlord's best interest to add that only material modifications or amendments require consent and that consent may not be unreasonably withheld, conditioned, or delayed by the franchisor. To avoid unnecessary delays, a landlord may propose a time period within which the franchisor must either provide consent or notice of denial, and if no response is provided within that time frame, the franchisor is deemed to have consented.

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Default Notices and Cure Periods. Commonly, franchisors require copies of default notices. They also may require additional time beyond the cure or grace period provided to the franchisee before a default becomes actionable. A landlord may agree to the extended cure period, provided the franchisor serves notice that it will cure the default prior to the expiration of the franchisee-tenant's grace period.

A landlord should not be prohibited from taking action against the tenant for an extended period of time if at the end of that period the default will nonetheless remain uncured. Additionally, if a rider provides a franchisor the right to take over the lease after a default, the landlord should include a provision that requires the franchisor to cure all monetary and non-monetary defaults as a condition to landlord's approval of the lease assumption.

De-Identification. Franchisor lease riders often include the franchisor's right, to enter and “de-brand” or “de-identify” the leased premises, particularly if the franchisee has vacated, been evicted, or the lease has ended. In connection with this move, a landlord should attempt to negotiate a time limit during which the franchisor has the right to enter the premises after the tenant's occupancy ceases. After that time period, the landlord will either receive rent from the franchisor or have the right to remove and dispose of all branded items, at the franchisee-tenant's expense, without any liability to franchisor. In addition, the franchisor must indemnify landlord for any and all activities performed on the premises by the franchisor, and after de-branding, the franchisor shall restore the premises to the condition required in the franchisee's lease.

Alternative Franchisee. In the event that a franchisor rider includes the franchisor's right to assign the lease to an alternative franchisee, a landlord should add the right for it to receive and review the proposed replacement franchisee's financial statements and approve or disapprove within its reasonable discretion. If a franchisor is not amenable to a reasonable discretion standard, the landlord can attempt to negotiate that any assignee must have the same or better net worth than the initial franchisee-tenant, or the franchisor must provide some form of a corporate guaranty.

Finally, a landlord should require that a written assignment and assumption agreement be executed by the initial franchisee-tenant or the franchisor (as assignor), as may be applicable, and by the replacement franchisee (as assignee), so that all parties understand their respective obligations.

Landlord Pitfalls

Signage and Exterior Prototype. A landlord should have the right to review the franchisee-tenant's signage requirements and exterior prototype to ensure that, especially in a multi-tenant property, they are consistent with the general aesthetic of the center. Landlords should also negotiate a pre-approval condition to any renovations or material interior alterations.

Length of Term. A landlord should either review the proposed tenant's franchise agreement, and/or include representations in the lease that the franchise agreement expires either at the same time or after the term of the lease. Landlords should also review or seek franchisee representations as to any termination rights of either the franchisor or the franchisee under the franchise agreement.

Use Provision. Because a franchise concept tends to evolve over time, franchisors direct their franchisees to seek flexibility in their leases regarding signage, interior design, trade name, and most importantly, the use provisions. For example, if a restaurant franchise alters or adds menu items, or a clothing franchise adds shoes to its inventory, the franchisor wants to ensure that all franchisees can comply with the new franchise protocol.

A landlord should not be overly restrictive in this regard, but should include language that it would have to be a global change imposed upon all franchisees of the brand, or at least within the region where the premises is located, and importantly, must be subject to all exclusive provisions in the leases of the other tenants in the center.

Guaranty. There is a common misconception that a franchisee-tenant is directly related or backed by its franchisor, or that the landlord will be receiving a franchisor guaranty. The confusion can be bolstered when, as often is the case, a letter of intent is accompanied by information and statistics regarding the franchise, as opposed to the actual franchisee-tenant entity. Assuming the franchisee is a newly formed entity having no value or assets other than its franchise rights, a landlord should request and review the financial statements of the principals of the entity and obtain a personal guaranty, which provides the landlord with a reasonable level of comfort.

There are many benefits to having a franchisee-tenant; however, landlords and their lawyers should keep an eye out for these threshold issues.

 

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Jessica T. Zolotorofe

Jessica T. Zolotorofe is an associate with the Firm of Ansell, Grimm & Aaron, based in Woodland Park, N.J., specializing in commercial real estate transactions. Contact her at jtz@ansellgrimm.com.

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