Developers activating properties: restaurants and tenant allowances

There is an article in Washingtonian ("Developers are giving DC restaurants crazy deals they can't resist, but should they") about how restauranteurs are being offered great deals by developers aiming to lease space in their buildings.  The article makes the point that even with a year of free rent, maybe the location doesn't make sense.

That should be obvious.

Slides from a presentation by LWLP--Live Work Learn Play, a real estate consulting and development firm based in Toronto.

For all the talk of placemaking, one has to remember that the goals of the property owner may not jibe with the tenant.

The property owner aims to "activate" its property and make it exciting, to help lease up commercial and/or residential space.

That's done with funky retail and restaurants.  Activation is more important to the developer than the success of the tenant--although there is no question that the developer wants the tenant to be successful. From the article:

After all, a hip eatery might be one of the reasons someone buys a condo in an up-and-coming area or might be among the amenities that help justify a law firm’s high rent. It might even be the catalyst a developer needs to make its neighborhood the next 14th Street corridor.

But with so many shiny new buildings popping up, landlords are getting more aggressive, offering restaurateurs such perks as heavily discounted initial rent or occasionally even a free restaurant build-out. Developer PRP Real Estate Investment Management is dropping about $10 million to bring the celebrity sushi spot Nobu to its West End condo building.

Isabella says these sweetheart deals have helped him expand, at times without other investors. They’re part of the reason he opened a trio of eateries—Yona, Pepita, and Kapnos Taverna—in Ballston.

Usually, the developer aims to do this with the proprietor of a business paying for the privilege of being in their development. Only in extreme circumstances or for particularly high profile firms would the developer be willing to provide a whole lot of incentives, in terms of free rent, reduced rent (typically this is offered), and build out allowances.

For ultimate success of the business, the proprietor needs to have a great business plan and concept and the ability to execute, whether or not they get significant "TI", tenant improvements ("Basic Tenant Improvements for Commercial Real Estate," Real Estate Optimizer; "Restaurant Build-out Allowances: Lease Negotiation and Restaurant Real Estate," Restaurant Voice), the long term rent needs to be reasonable, etc.

And the location needs to be good.  From the Washingtonian article:

But the bargains don’t work out for everyone. “Getting these great deals is like enabling a drug addict—then the restaurateur almost can’t say no,” says restaurant real-estate broker John Asadoorian. “They may have overlooked a lot of the concerns they had, because a lot of the risk was taken out of the equation.”

Specifically, many of these deals happen in areas with low density and foot traffic. (Think Ivy City, a once-industrial neighborhood in Northeast DC.) No matter what the rent, operating can be awfully expensive while you wait for the surrounding area to arrive.

Even if the financial toll is lessened, the risk to reputation remains. Jeff Black, who owns Pearl Dive Oyster Palace and Black’s Bar & Kitchen, among others, says he had one offer to open a Silver Spring spot with three years of no rent. He passed: “I’ll have three great years, and I’ll have two years of sucking wind and trying to Band-Aid it together, and then I’ll have to close the store, and that reflects poorly on me and my brand.”

As far as being an early entrant into a "new district," depending on the location and the period of time required for success, I'd ask for many years of free rent, or a rental agreement based on a percentage of revenue, with rents escalating only as revenues increase, so that the developer continues to share the risk for the entire period that the district remains emerging.

Plus, rents still need to be in the ballpark of industry metrics. Generally retailers shouldn't be paying more than 4% to 10% of gross revenue in rent, and restaurants no more than 15%. If the numbers are higher than that, and extraordinary revenues/s.f. aren't expected, walk away.

For example, an inexperienced group ("Food co-op to save New Haven's crisis?," Yale Herald; Elm City Market Food Co-op - A Model for Downtowns") creating a food cooperative in New Haven Connecticut agreed to big rent increases as sales increased, despite the reality that supermarket profit margins are less than 5% of gross sales (which is why supermarkets typically pay lower than market rent). As sales increased, rents increased, but profits didn't--especially as a growing business finds that expenses tend to increase extranormally with growth.

They failed ("Elm City Market auctioned off," Yale Daily News). Similarly, a lot of Cosi's problems have come from the fact that they are paying upwards of 25% of gross revenue on rent for locations in central business districts ("What Happened at Cosi?," Restaurant Finance Monitor). From the article:

“We estimate that on average the rest of Cosi's portfolio has rents of around 15% of sales,” said Brenner. “But for the worst performing stores with bad leases and too low sales, rents in some instances are greater than 25% of sales, making it virtually impossible for those stores to be profitable.”

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-- Small Restaurant/Food Service Self-Assessment
-- Retail Business Check up survey