Negotiating a Letter of Intent
Reducing Start-up Costs
Lowering Monthly Rent
Protecting Working Capital
FGP agent introduction call to landlord’s agent to get acquainted, discuss our brand use in the center and confirm our fees as a courtesy to agent and landlord to proceed. Introduce next step of the pre-letter of intent (LOI) discussion. Then, if all parties are in agreement, we will be submitting an LOI.
Email standard pre-LOI invitation and copy all parties in attendance, including the Franchisee. Once the landlord’s agent confirms a day and time, email all parties a confirmation with the conference dial-in number.
Pre-LOI conference call objective, call format and script.
This conference call is intended to provide an honest and transparent opportunity for a Franchisee to listen to agent-to-agent communication on a first-hand basis. This conference call protects a Franchisee from being left out of the LOI negotiating process. This will provide a Franchisee the information necessary to make more informed decisions on how to negotiate the financial terms with the landlord. Being included in this telephone call also allows the Franchisee the opportunity to listen to the experience and conversation that exists between the landlord’s listing agent and their own leasing agent. It also removes any second guessing that might occur if the agents are speaking among themselves. There are many potential gaps of misunderstanding as well as financial opportunities that could be overlooked in the translation of the conversations.
Additionally, as the Franchisee’s leasing agent is asking questions of the landlord’s listing agent, the Franchisee can listen to the eagerness of the landlord’s agent to lease the property. Having this insight offers the Franchisee a more informed and confident ability to collaborate with their leasing agent with regard to the financial terms of the proposed LOI. If they are not invited to participate in this phone call, they would simply be taking the word of their leasing agent. Leasing agents have a wide range of experience and inexperience. So, this heightens the importance of a first-time Franchisee to be given a transparent opportunity to participate in this conference call. When a Franchisee is asked to participate in this pre-LOI conference call, they are certain to remove any doubts regarding the landlord’s position within the negotiating process. Whether the Franchisee had any experience or not, by the end of this phone call they would understand the range of a smart offer and aggressive offer or a misinformed, overly aggressive offer.
Upon completion of the conference call, which will last approximately 30 minutes, the leasing agent and Franchisee will remain on the telephone to discuss the various financial opportunities that may exist to reduce start-up costs and monthly rental rates, in addition to other soft concessions that reduce the legal risks and ongoing costs. A location that was perceived to be a number-one hero location may become a zero location in the matter of a 30-minute phone call. The landlord’s listing agent may convey an inflexible attitude regarding the overall financial terms of the location. At the same time, a second or third location may become the number-one location because the start-up costs could be reduced substantially in addition to very low and competitive monthly rental rates. The combination of these two financial contributions might offset the location quality of your initial first and most desired choice.
To maximize the financial opportunities that may exist, it is essential that all parties included on the phone call are invited to collaborate on the “emotional and factual” elements that they heard throughout the conference call. Everybody on the call may hear the same thing, but it may also mean something different, depending how you heard the information, either emotionally or factually.
B) Call Format and Outline
Once the conference call is activated, it’s important that the call not begin until all parties are present. The Franchisee’s leasing agent will host the entire call, beginning with introductions of participants, thanking each member for their attendance, asking permission to offer an outline for the call (if this is more comfortable) or present an outline asking for acknowledgment before conversations begin.
“Bill, would you allow me to suggest an outline for today’s call?” Bill’s reply, “Absolutely.” “Thank you. What I would like to do first and foremost is to get to know the personality and desires of your landlord. Then I would like to ask you various questions regarding the financial terms and condition of the property. If we are all satisfied with the outcome of these questions, we will prepare a letter of intent and submit to you within 24 hours. And I will be asking our Franchisee, in addition to our senior project manager, at the end of this telephone call if either of them have any clarifications, questions or major concerns. I would also like to give you the opportunity to ask any questions about our brand, Franchisee or our processes. Is this outline something you would be comfortable with? Great, let us proceed.”
“Bill, would you be so kind as to introduce us to the landlord’s legal name and their background in terms of number of properties they own, types of properties and how long it takes them to reply to an LOI offer, and the real time to draft a landlord lease? The reason I ask you this question is that we have had many bad experiences with landlords taking 2 to 3 weeks to respond to LOIs, and as much as 2 to 4 weeks to simply draft a lease. Then, when we receive it, 100% of the leases are filled with mistakes. It is critical that we ask for the name of the professional individual who will be the primary contact in the event the landlord provides a landlord lease. We want their name, where their office is located and whether they are an inside employee or a third-party, outsourced legal professional. This will greatly affect whether the lease is negotiated over a period of 8-12 weeks.”
“Can you please offer the square footage, unit number and whether it is an exact measurement or the measurements are on file at the city? Is there an as-built in the landlord’s office or on file at the city? The reason we ask this question is because an architect is helpless with regard to drafting a technical document for a Franchisee to prevent general contractor cost estimates and opinions being provided at 20 to 30 percent above the actual costs. Do you believe the square footage is accurately measured?”
“How long has the space been vacant, who is the prior tenant, and how long do you anticipate the space being vacant?” This polite question puts the landlord’s agent on notice and communicates to our Franchisee how eager the landlord might be and how much leverage they might have.
“How much build-out time is the landlord offering tenants?” If the agent responds with, “any amount of time less than four months,” it is critical that we explain that we do not want our Franchisee paying rent prior to the opening of the business. In order for the landlord’s agent to understand our position, we must explain to them that a floor plan schematic may take two weeks, rough drawings another two weeks to get floor plans, lighting, mechanical, electrical and plumbing to get accurate cost estimates in a timely fashion. When we submit our plans for a construction permit, it is common to take 2 to 4 weeks. And that’s in the event there are no delays at the city, changes in regulations or corrections sent back to our Franchisee, their architect or general contractor to revise the plans. Once a construction permit is finally issued, it may take the GC 4 to 8 weeks to frame, sheet rock, roll and trim the paint. By the time you install fixtures, furniture, equipment, signage and other installations, the entire process can take 4 complete months, and that’s if everything goes perfectly and there are no city or weather delays or delays by professional service providers. It is important that our Franchisee has a minimum of five months or the earlier of the business opening. Is this something your landlord is amenable to?
“Can you speak to the bathrooms? How many bathrooms are there? What type of bathrooms are they, and are they up to ADA code?” In almost all situations, a smart landlord’s agent will respond with “I do not know” because they do not want to be liable for misrepresenting the condition of the bathrooms or any changes in past current regulation at the city. If it’s an older space, and the previous tenant did not have to have ADA compliance, when a new tenant moves in, usually a city will then, at that time, require the new tenant to invest the capital to bring it up to code.
“Can you also tell us if there are sprinkler heads, and, if so, are these two up to code? Older buildings will allow tenants to operate. However, new tenants will be required to invest the capital to bring these up to code in almost all cases. Even if the city might approve, the fire department, upon inspection, will then withhold their approval, which denies a certificate of occupancy. It’s important that the architect is prolific at reading the city code and can project whether fire sprinklers will need to be installed. There’s a wide range of costs, and this must be a landlord capital improvement in the negotiating process. These combined landlord obligations must be discussed openly. We must also explain to the landlord listing agent that we are not suggesting that the landlord invest this money as a requirement to the LOI, so as to waste capital in other aspects of the needed deal structure. However, in the event our Franchisee is unable to obtain any licenses or certificate of occupancy, the landlord will have to step in and pay these costs directly or through reimbursement.
Heartbeat of Conference Call
The heartbeat of the pre-LOI conference call represents the most important aspects of reducing start-up costs and monthly rental rates to protect long-term Franchisee profitability. At the center of all landlord negotiations is the financial relationship between the landlord’s investment of their own capital and property improvements, which are permanent to the long-term rentability of the space within the location, the asking monthly rental rate and the tenant improvement allowance that a Franchisee may request to further reduce start-up costs. A landlord will strive to maximize their return on capital without reducing their vacancy rate, putting the tenants out of business and filling their property, thus increasing occupancy rates with tenants who complement the property and offer a unique shopping experience and environment for the local community of customers. The landlord’s success is in their unique ability to engage and improve the emotional connection, attracting customers to their property. Human beings will be forever attracted to emotional and stimulating shopping experiences and environments, whether they are brick and mortar or online. The landscape will continue to change but will, most likely, always exist.
There is a winning formula that a Franchisee must understand prior to a pre-LOI conference call and when collaborating with their agent in building strategies while negotiating an LOI. There is a winner and a loser when negotiating with the landlord. The Franchisee’s goal is to disguise their financial goals, while making the landlord feel they have WON at the negotiations. There is a balance that must ultimately be achieved so that the landlord feels it was a win-win outcome, which makes them willing to continue to negotiate and proceed.
Ironically, the formula for winning FIRST begins with understanding the advantages of the space you are negotiating. If there are aspects that are positive, the goal is not to “improve” those and not to reveal these attributes, yet improve the other financial categories of the negotiation.
For example, if your rent was the lowest and most positive attribute of the space, you would build on all other aspects to reduce start-up costs, free rent, build-out time and potential tenant improvement dollars, etc. If you can’t drive down the rent because it already fits your pre-calculated budget nicely and is below market rates, the landlord will resist, and you will lose your opportunity to capture capital in other places. If you revealed to the landlord’s agent any eagerness or positive attributes that make the space perfect, the psychology used and needed to your advantage no longer exists.
The second key component is to predetermine if you wish to reduce your start-up costs, emphasize the reduction of your monthly rent or find the balance of the two of these characteristics. There is one school of thought: that since you have secured the capital and business loan for the tenant improvement allowance, you would build out your entire space with your own capital and drive other aspects of the financial terms starting with your monthly rental rate. The opposite side of this thinking is to utilize the capital of the landlord to protect your start-up capital, to have this available to you as working capital in order to reduce the risk of running out of money. There is nothing worse for a small business owner than to say in the ninth month of business, “If I had $15,000 more in working capital and six months, I know I could make it,” while their friends and family politely look the other way.
Some landlords will offer tenant improvement allowance interest free, upfront and reimbursed upon completion of build-out to offer you, as the tenant, this working capital protection and keep you longer as a tenant. Franchisees often make the mistake of overemphasizing the fact that they are paying the landlord back this money through an increased amount of monthly rent amortized over the term of the lease. However, what is more important to understand is that, if your monthly rental rate remains within your low to high previously budgeted goals, and this includes the small increase of monthly rent, then you have WON at the negotiations with the landlord. In the event the landlord offers tenant improvement dollars and asks that you pay them back a small monthly amount amortized over the term of the lease, and this amount causes your monthly rent to exceed the high side of your budget, then you have lost at the negotiations with the landlord. It is important to always negotiate the asking rental rate with a rainbow offer, meaning that you discount the asking rental rate 30 to 40 percent depending on the current occupancy rate of the shopping center.
While I do believe that the best negotiation is no negotiation, seldom are tenants in a position with time and capital to utilize these types of negotiating tactics. Wall Street is in a financial position to utilize ultimatums as their highest and best form of negotiation. Their strategy is to make everything fast, simple and solicited, meaning that they would rather present a letter of intent to the tenant that is one page and avoid the other protective qualities and financial opportunities that are deserving to a tenant, and would receive if they were allowed to present a more comprehensive LOI, such as Starbucks’ 25-page letter of intent. Up to 60 percent of all properties are tied back to Wall Street, either through mortgage or landlord ownership. They have no incentive to put tenants into profitable leases, thus increasing the importance of ensuring that leases are negotiated to protect sustainability.
Danger – beware of the biggest financial risk when negotiating with this type of landlord. When a landlord’s listing agent forces their LOI on the Franchisee, it is a highly sophisticated and lethal form of landlord negotiation strategy. Although these types of landlord’s listing agents represent a very small 10% percent of landlord negotiators, they are clearly the “fox protecting the hen.” Regardless of how accommodating it seems to a first-time Franchisee, a listing agent would politely send over an offer, it will omit 90% of the financial savings opportunities and, through avoidance tactics, expose a Franchisee to other much-needed protective lease requests that should be negotiated and finalized prior to a landlord lease. Should this occur, it elevates the strategic importance of how to reply, because so many elements are missing intentionally when the landlord sends us the LOI.
transfer the landlord’s terms on to the Franchisee’s comprehensive LOI.
insert Franchisee’s comprehensive LOI terms into the landlord’s term sheet. Because landlords who utilize these tactics are generally “take it or leave it ultimatum” types (“We’re in a hurry, we have other interests,” etc.) will request to not convert their PDF to a Word document.
This allows you to not reveal your willingness with regard to what you will pay on a monthly basis until further financial benefits can be offered and assessed as the LOI is presented, and the counter-negotiations are offered. It also offers you a one-time opportunity to see how the landlord replies to this “rainbow offer.” (Rainbow is a symbol of a large arc in the sky, representing a low to high rental rate). If the landlord comes down to your offer, while still agreeing to offer tenant improvement dollars, you win! This is because you strategically and courageously called their bluff and knew that they were more eager than they led you to believe they were. If they meet you halfway, and offer you the tenant improvement dollars, you win! You can even meet them halfway to your lowball offer and sometimes still win. However, it is a very risky move because, if you try to pull them down to your lowball offer, they will take tenant improvement dollars away, and it’s very difficult to request it back unless you go back to their midpoint offer, which then can cost two or three more weeks in counter-negotiations and waiting. But if you would have started it halfway, they would have countered you in the middle of their asking rate, and you would have left money on the table. If they reduce the rent only 10 percent off of their asking rate, but offer you the tenant improvement dollars, and the small amount added each month puts you at the asking rent, you may still win, providing it stays within your low to high monthly rent goals.
If the landlord comes back firm and won’t budge except to demonstrate a small degree of flexibility, there are generally multiple and sometimes good reasons. If they come back at their asking market rent and still offer you tenant improvement dollars, but they add a small amount to your monthly rent, which exceeds the high side of your monthly rental goals, you have lost the negotiations. However, you might still have the desire to accept the tenant improvement dollars because it saves you so much of your start-up budget and protects working capital, which is a premium in itself, and you should not be so shortsighted as to overlook this value. I don’t mind losing in the negotiation if there are genuine reasons, such as only one vacancy in the property, it is only been on the market for 30 days, several tenants are demonstrating interest, it’s my number-one location, it is new construction with a higher mortgage on the property, and, lastly, it is only $200 to $500 more on my monthly rent.
Interestingly enough, in almost all cases, the additional rent that a tenant would pay calculated over the term of the lease can sometimes be a better decision than paying more in start-up costs at another location that you were considering. In the scope of broader and better decision-making, it is actually less expensive and saves more capital to pay more rent. You certainly might still accept the tenant improvement dollars because they still offer you an opportunity to protect your working capital that you would otherwise spend out of your own proceeds. There’s a tremendous premium to protect working capital throughout this negotiation process, since it is a known fact that small businesses fail because of too little available working capital.
Condition of Property
Condition of property is a baseline starting point for a tenant and landlord to agree upon without any ambiguity or disagreement with regard to the definition utilized throughout the negotiating process.
Condition of Property Definitions
Cold Dark Shell
When looking in the front window, there is simply dirt, pebbles or a concrete slab, there may or may not be metal studs representing the framing of each side of the walls, there is a roof without any mechanical duct work or insulation, and there is no noticeable lighting or even sprinkler heads coming from the roof. There are exposed pipes in what is known as a dirt cutout, which will represent the potential for a bathroom. There will be no mechanical or electrical wiring throughout the building and, in some cases, no heating or air-conditioning unit on the roof. It is simply a front window, back brick wall with a door that opens to the outside.
Depending on which region of the country the Franchisee will be operating, the quality of the materials, the square footage of the space, the HVAC tonnage and amount of plumbing, electrical and mechanical will create the wide range of landlord capital improvement costs to bring the space up to a white box, vanilla-shell condition. The most common sales tactic of the landlord is to train their listing agents to present in their LOI the term “tenant improvement allowance” instead of the term “landlord capital improvements.” And inexperienced Franchisees and Franchisee agents could easily misinterpret that this is a financial opportunity that the landlord is presenting when, in fact, the term “tenant improvement” is a misrepresentation that lures an inexperienced tenant who desires the space.
In almost all cases, the money the landlord is offering is less than 50 percent of the true cost to bring the property up to a complete vanilla-shell white box. There are three distinct methods (see Exhibit A) on how to negotiate with the listing agent to get the landlord to use their own capital to make the space rentable and in compliance with all regulations. If you were a landlord, you would keep your capital in an escrow account and train listing agents to transfer these costs to inexperienced, eager or overconfident franchisees. The method that is used to negotiate with the listing agent depends on the quality of the location and how much the Franchisee desires the space. If the Franchisees can remain indifferent because they have other options, this leverage can increase what the landlord is willing to invest to bring the property up to a vanilla-shell white box.
Vanilla Shell (white box)
This is the most common delivery condition that landlords will offer a potential tenant. When looking in the front window, there will typically be a flat concrete slab, both walls primed with sheet rock ready for paint, a drop ceiling with standard lights in working condition, mechanical, electrical and plumbing installed with duct work, sprinkler heads and heating and air-conditioning on the roof. The negotiating process compared to a cold dark shell is easier for all parties to understand when negotiating the lease. The financial options relating to the asking monthly rental rates, along with the tenant improvement allowance request, allow everybody to understand the math more concisely.
Gray Warm Shell
This is typically an interior space that is defined somewhere between a cold dark shell and a vanilla shell. This gray area can add a high degree of confusion between all parties. When a Franchisee is looking in the window, there may be any combination of elements existing. When negotiating this type of LOI, it is important to identify the items and costs that the landlord would have to invest to bring the property to a vanilla shell, or a Franchisee would have to negotiate the landlord capital improvement dollars and ask the landlord to perform the work to bring the property up to a vanilla-shell white box, accept the capital improvement allowance from the landlord and perform the general contracting to bring it to a white box, or to request the landlord to get their own cost estimate from their general contractor and present to you as a potential tenant so that you can add this to your LOI request. If the landlord stonewalls a potential tenant to say, “This is the amount of capital improvement dollars I’m going to offer you” and using the term “tenant improvement dollars,” they will usually request a tenant to go get their own cost estimates knowing they are highly experienced in landlord-related general contractor work.
The first-time Franchisee has day-to-day experience in sourcing 4 local general contractors, interviewing them for key elements to save money and time and requiring general contractors to submit, on a standard cost estimate form, which are all different from each contractor, leaving a Franchisee with inaccurate, confusing and uncomparable cost estimates and opinions. It can take up to 3 to 4 weeks of lost time and frustration for a Franchisee to try to secure these cost estimates. When the landlord already knows give or take 10% of the actual cost to get their property to a vanilla shell, these types of negotiations become long and protracted because the listing agent is not a general contractor, the Franchisee’s agent is not a general contractor, and the Franchisee is not a general contractor.
2nd Generation/Vanilla Shell
This has a very light amount of previous tenant materials remaining. When looking in the window, there is some form of flooring, carpet, tile etc., that can easily be removed. The walls are generally painted, plumbing sinks exposed, maybe one or two small offices or reception area in the middle or any unique or peculiar elements of trade fixtures that were left behind by the previous tenant. The interior structure is a traditional vanilla shell. However, in this case, it would be a light demolition job to restore it back to its original, clean, vanilla-shell condition capping off plumbing and electrical, replacing ceiling lights that might be old and restoring white walls primed for a new fresh coat of paint. This type of interior space is uniquely different from a brand-new vanilla-shell white box in that it has not had a previous tenant. The method of negotiating this type of space can sometimes save a tenant substantial amounts of capital because some of the existing interior can be used to reduce start-up costs. However, it’s important to ensure that the landlord be held accountable to bring it back to its fresh, brightest and newest condition.
2nd Generation Conversion/Renovations or Restorations
This type of space can provide exciting start-up savings opportunities if there is a careful assessment to the interior space on a walk-through checklist format. If a Franchisee is in a hurry, it is easy to lose potential savings opportunities.
For example, the space was a previous restaurant or ice cream store with all of the expensive grease traps and hoods and plumbing with additional bathrooms. A new restaurateur can completely demolish the property through effective negotiations and restore the interior space back to a white box, while still having the opportunity to save the important elements needed for their new restaurant build-out. In a retail service business, a former day spa or medical office that had a $200,000 interior build-out fully up to code can provide a wonderful opportunity to determine what percentage of the exact amount of materials and layout can be saved through proper floor planning and space configuration.
The theme to this type of negotiation is to carefully identify which areas of the interior space are usable and which areas must be demolished. It can be somewhat misleading because when you demolish 30 percent of the existing space, you will find that the flooring, ceilings, lighting and sprinkler heads required by code seem to be disrupted, surprising you due to the fact that you did not save the amount of money you thought you would save. The negotiating method is intensified by a more detailed site survey and walkthrough, and then spending the time to cut and paste a floor plan so that you can estimate the amount of demolition costs, the required tenant improvement allowance and who would be best served to perform this work—the landlord to save time and money or the tenant because they can save time or money.
At this point within the pre-LOI conference call, the Franchisee’s agent will be scanning the interior pictures by video and on a Google drive. This allows a Franchisee’s senior negotiator to ensure that the landlord’s listing agent does not misclassify or define the space to try to confuse or take advantage of the Franchisee’s potential savings opportunities.
When an LOI is being prepared strategically and written on behalf of a Franchisee on any one of the above types and conditions of space, there is a shortlist of approaches to distinguish the difference between what was discussed earlier as:
landlord’s obligations at their cost to ensure the bathrooms, fire and all interior and exterior ADA are up to code and compliance;
a starting point of a verbally “mutually agreed” condition of property without any ambiguity or misunderstanding;
landlord delivery within our expectations of exactly how the space will be delivered to our Franchisee in the items included at the landlord’s cost to ensure that this happens; and, lastly,
tenant improvement allowance that we would request ABOVE what the landlord would already be including within the asking rental rate.
Task list – short form:
A list of items written within the letter of intent that is somewhat short in nature, but bullet points the items that we want the landlord to perform with their “labor and cost” with a delivery date to our Franchisee. Then we will request additional tenant improvement dollars above the landlord’s delivery task list. When it is a simple negotiation process because there are not many tasks for the landlord to complete, we will estimate the dollar cost to this list, and, if we don’t think it’s enough, we will negotiate in other areas, such as free rent, lower asking rent and the opportunities for additional tenant improvement dollars.
Task list – long form:
A long, detailed list written as an Exhibit A mentioned within the LOI but added to the back of the LOI because the list is longer, more detailed and expensive, and yet highly unique to the pre-existing space that is currently in place. The principles of negotiation are the same, yet there are too many items to insert into the LOI, and most likely it is best to get a couple of general contractors to give a cost estimate so that we can reduce the tenant improvement allowance request and focus on other areas of the LOI, such as more build-out, free rent, lower asking rates, etc.
Landlord work letter (Exhibit A):
Attached to the back of the LOI as a specific document provided by the Franchisor that outlines in detail all aspects of what the Franchisor would like to see included in a standard vanilla shell. Sometimes a Franchisor will add small additions, such as sinks, high ceilings or low ceilings, a bathroom in the middle of the space and one bathroom in the back of the space that can highly affect trenching and plumbing costs. Soundproofing, unique electrical equipment, grease traps, hoods, mechanical, electrical, plumbing, lighting, duct work and HVAC tonnage can all represent unique and different vanilla-shell definitions that will be requested as an Exhibit A as needed, that will be referenced within the landlord delivery section of the LOI, and to be delivered at the landlord’s sole cost and expense by a certain delivery date, including penalty credits of free rent for any delays.
White Box Plus
In some cases, when we are negotiating a vanilla-shell delivery by landlord at their cost, we will try to add $5,000, $10,000 or $15,000 worth of enhancements that the landlord will consider as tenant costs. However, we try to negotiate these white-box plus items if we think we will not get a tenant improvement allowance to meet our own needs of negotiation. It is important to be specific in these requests, to limit them so that it just does not draw too much attention, and yet when the general contractors begin the work, the landlord knows that it was well defined and they are responsible for this work and cost. If we try to negotiate structural elements (e.g., major interior build-outs) it throws up an immediate red flag that the tenant should be paying for these costs within their budgeted build-out and start-up expenses.
Turnkey build-out request with a specifications construction and design document. It is rare that a new emerging, or even a mature franchise company, would have invested in this type of document. They are usually complete sets of documents regardless of the size and configuration of the space that would include each and every cost for the landlord to deliver the keys to the tenant by performing the entire job as well as paying for its cost. It is very common that regional and national corporate chains negotiate in this manner because, if they invest in this document one time, a senior negotiator can add a $200,000 document and focus on free rent, and ask rental rates that could be agreed upon and include the landlord performing and paying for this job. These kinds of turnkey build-out negotiations typically require perfect documents and, in the absence of a Franchisee, is better off requesting a vanilla shell and maximizing the tenant improvement dollar request to remove misunderstandings and ambiguity of tenant improvement dollars in contract disputes throughout the build-out.
Tenant improvement dollars represent a huge impact of opportunity to reduce start-up costs and yet protect low monthly rental rates that are budgeted within previously calculated business plans. This is an area of the negotiation that directly ties back to the asking rental rate, and landlords consider this to be the material heartbeat and bottom line to their negotiations. It is important to understand your “competition” in depth anytime you’re negotiating in a real estate transaction. However, commercial real estate is a highly complex subject to learn and understand with regard to landlord financial models, forecasting models and return on investment strategies.
A simple way to reduce this complexity is to first understand that, contrary to popular belief, the landlord pays the listing agent a negotiated and agreed commission amount that they negotiate between themselves prior to the listing agent acquiring the contract to lease spaces. Usually the landlord will pay the listing agent 5, 6, 7 or 8% of the aggregate base rent total of the lease. This is a non-recurring expense for the landlord as a marketing and selling cost of a lease expense of the financial models.
Landlords will also agree with landlord listing agents that, if the Franchisee is not represented and negotiates their own lease thinking they will save more money, the landlord’s listing agent can retain the entire commission amount. The reason the listing agent will keep the entire commission is that they know that when an eager Franchisee who is inexperienced, or an overconfident Franchisee who is also inexperienced, calls to negotiate their own lease, they know how much more money they will save because a Franchisee may only negotiate one or two leases in their life, and the listing agent has negotiated up to 500 and knows all of the psychological and financial strategies to out-negotiate a Franchisee and save the landlord much more money than if the Franchisee had been professionally represented by a senior negotiator. In this event, the landlord’s listing agent will cooperate and share their commission with the agent representing the Franchisee, exactly like residential real estate.
When a Franchisee is represented by a high-quality senior leasing negotiator who can save them in all aspects of financial and legal risks up to $20, 50, 100 or 200K, the split commission with the listing agent is irrelevant. For every one dollar in commission, a Franchisee might save $5, 10 or 20 in savings.
Moving onto the next aspect of tenant improvement dollar negotiations, it is important to isolate the asking rent and what this includes from the landlord. A large majority of leasing agents will never even think to ask this question. Landlords receive a windfall of free money, and Franchisees lose this financial opportunity. By isolating this singular question at the right time during the pre-LOI conference call, a Franchisee can pick up capital that they would never have known about. This is not always the case when a landlord is adamant about delivering the space “as is” and willing to walk away at all costs. Once these facts are known, then the negotiation must shift to all parties understanding that, until the landlord and tenant agree on a base rate and tenant improvement allowance that protects the landlord’s financial return on investment, there will be no final letter of intent signed by both parties. This is not a harsh outlook by the landlord; it relates to their own sustainability of a large mortgage and high risk of bankruptcy.
Since we, as senior negotiators, inclusively, are now up-to-speed, and confident Franchisees know this, we can then strategically calculate another way to win at the negotiations. This starts with what two elements will allow a landlord to increase the tenant improvement allowance in accordance with their projected business models: banking covenants regarding use of lines of credit, and whether it is a rural, medium, metro or major metro landlord. The first element is the aggregate term of the lease, as a landlord is willing to invest more capital with a 7- to 10-year term. They are willing to invest modest amounts of capital at five years, but, as the term of the aggregate lease increases for the landlord, they can also increase their tenant improvement allowance. This is not always the case, by any means, but, generally, it is our goal to calculate the aggregate lease.
For example, if the total lease is $700,000, we will bundle up a combined offer to save up to $200,000 or 30 percent of the aggregate. On the other hand, the landlord is trying to reduce their out-of-pocket cash and soft concessions down to less than 10 percent, if it all possible. If it is a highly desired location, it’s the only vacancy, and it is of interest to several tenants. Needless to say, the landlords know the premium and will hold firm. If there are many vacancies in a space that has been sitting vacant for 3 to 4 months, and we project another 2 to 4 months of lost rent, then we increase our concession requests. There is a fine line where a smart offer starts and ends, and aggressive offer starts and ends, and a ridiculous offer starts and blows up. Together, we will try to make sure our starting offer begins on the end of the aggressive line. If we are too aggressive, the strategy will backfire, and the landlord will not counter the LOI, which is an immediate power shift leveraging the landlord. Now, when we call the landlord, they know we are eager, and they are in control as our prices go up.
The second and most important element to a landlord when we are negotiating a very aggressive LOI on behalf of our Franchisee is that they will suggest that their counter offer be based on the strength of the financial statement of our Franchisee with regard to assets-liabilities=net worth. Seldom have I seen landlords surprisingly check credit scores or call references regarding past history. In large major metro markets where there is diversity and elevated levels of mistrust, almost 100 percent of landlords will submit applications filled out to include bank statements and amounts within those statements.
These are the two dominant factors that affect a landlord’s willingness to find that striking balance between the asking rental rate in addition to an amount that they are willing to offer in tenant improvement allowance. If we request a higher amount, let’s say, $50,000 to $100,000, to amortize over seven years, using $70,000 as an example, it would be $10,000 or approximately $833 per month added to the base rent each month, interest-free. However, if the lease aligns with the length of the franchise agreement, and/or the bank loan term (say, 10 years), this would calculate to $70,000 divided by 10 years, amounting to $7,000 a year and/or $583 a month added to the base rent. This means that the longer the term, the lower the monthly base rent, and the shorter the lease term, the higher the monthly base rent.
Free rent is usually a discussion point that is inserted later into the call once all of the major financial terms have been tentatively discussed and heard by all parties. It catches the landlord’s listing agent a little by surprise because they have already made a light commitment to five months of build-out, and now we are coming back and asking for a range of 2 to 4 months of free rent from grand opening forward, or possibly a concession of 1 month of free rent annually for the term of the lease. They have tentatively agreed on landlord delivery costs and the possibility of additional tenant improvement costs, and then we ask for more soft money.
These are real net dollars and additional savings to protect working capital, breakeven and profitability. It is the norm for landlords to avoid negotiating build-out separate from free rent. They use the term “commencement dates.” The lease commences on the date it is signed, and the rent commences at the expiration of a fixed build-out period. We tread lightly so as to not affect what we believe are other strong financial savings opportunities within the LOI. However, we do probe the soft concessions because, if we need to come back, and our Franchisee has soft financials, we will either reduce the tenant improvement dollars or hold firm on the tenant improvement dollars but give the amount back in exchange for rent reduction. If we ask for $50,000 in tenant improvement allowance, are financially light (defined as different personal net worth ranges unique to the landlord’s definition). Sometimes, it is best to hold firm for the tenant improvement amount but tell them you’ll accept this money in the equivalent rent abatement discounts below the already agreed asking rent levels throughout the term of the lease. Some landlords are afraid to put their capital into a lighter personal statement of net worth, but will take a risk to amortize this amount monthly by reducing the rent below the already agreed amounts.
There are some effective strategies with regard to protecting the first two years of rent, asking for lower base rental amounts to protect cash flow, breakeven and profitability, which is easy for a landlord to understand. Offering a fixed-rate term throughout the lease at a lower starting point can trigger too many responses that would not be in our favor, including going back to market rate very quickly or adding a 4% annual increase or CPI, whichever is greater, to the monthly rate if we offer too low of an amount over a fixed term. It is generally more cautious to offer a lower rainbow offer the first year, up to a 30-40% range, unless all parties agree that this is too aggressive based on what was heard from the listing agent on the call. There may only be one vacancy and three tenants interested in this vacancy. We typically will increase the rent 3% per year fixed, knowing we can offer 2% annual increases. However, 90% of the time the landlords will counter back to 4%, and then we have to settle for 3%.
When you calculate a 10% percent increase annually, there are too little savings on an annual basis to cause disruption in the other areas of financial negotiation. If you negotiate a lower monthly rate, and they agree, you have essentially wiped out any increases because you factored them into your initial rent offer schedule. That’s why we start very low and give them the 3% increases. If we want to be ultra-aggressive, we can give them a 10% increase to the base rent beginning in the first month of the sixth year. This delays the rental increases or will be very low to start in the sixth year of the term. Our best strategy is the weighted average offering the landlord their asking rent at the “midpoint” term of the lease. This is a little aggressive because they want their asking rent today, to start in the first month of the lease. In some cases, when we have felt it was appropriate, we have given them their starting asking rent in the last year of the term, which can be rather insulting to the landlord. And there is a risk that it will shut down the negotiations or, at a minimum, force us to call them, power-shifting, in their favor, the price back up to its original amount.
Common area maintenance (CAM), also known as an NNN triple net lease, is when a landlord requires their tenants to pay their fair share by square footage of the property taxes and insurance. The CAM costs are simply the operating costs that the landlord deems necessary to maintain their property interior, exterior roofs, landscaping, parking lots and additions. Each landlord is rather close in the way that they utilize these additional costs, and tenants will typically pay on a monthly basis. A landlord will then calculate these costs and rebate, and, in some cases, increase 3-5% per year or CPI, whichever is greater for them, and whichever is less for the tenant (in our point of view). Generally, a fixed percentage amount is a better method to these costs.
During the pre-LOI conference call, it is important to ask the landlord’s listing agent what is generally included and excluded in these CAM costs. Ninety-percent of the time, the landlord’s listing agent is 60% accurate on their details. They will typically reply “the landscaping, parking lot, roofing, snowplow, etc.,” but they will not know if it includes water or trash. So, we leave it outstanding and to be determined (TBD) and stated within the final lease on a contractual basis. The listing agent can generally find out and put this question to rest. There’s generally no negotiation when it comes to CAM fees and property taxes and insurance as they are all paid by the pass-throughs within the prorata share of a tenant’s square footage. Interestingly enough, with an office, medical, flex and industrial spaces, these are gross leases, and the tenant simply pays an amount that includes these CAM fees, property taxes and insurance, and utilities (lights, water, gas, and electric) can be included. Occasionally, you will hear the term “modified lease,” and this is a combination of all variables and unique to the specific landlord’s property. This particular element of the LOI is not a “hill to win” in the battle (in our point of view), simply because 1% is such a small annual amount that, when calculated, does not have enough bargaining value. It is more important that, in the lease review, there is a line-item understanding of these costs and that you will receive an annual statement from the landlord.
Option periods are extremely important to protect your sustainability in possession of the property through the life of your franchise agreement. Landlords have the desire, at the end of the lease term, to negotiate an open market rate. Our preference is to control the first year of the new term to ensure that the base rent does not exceed 2, 3 or 4% of the previous year. We also believe that this individual option should be transferable in the event you sell your business. However, landlords will often want the right to renegotiate a new term with a new tenant at the then-current market rates. They will typically limit the option periods to you as a tenant. Two option periods are generally the limit, and most landlords only offer one option.
HVAC is a contentious piece of the negotiation in almost 100% of the leases negotiated. It doesn’t have to be; it is just that the listing agent generally doesn’t know the age and condition, the landlord can’t find the records, and so neither party really has a leg to stand on. However, our strategies relate fairly and specifically to the age and condition of the HVAC. Strategy number one is to write at the end of HVAC section that our suggested wording is contingent upon a landlord’s inspection at their cost, and HVAC records, if available. If they disagree to send an HVAC inspector over to their building at their cost, it is critical that the tenant pay for the cost of the inspection. If the HVAC is 1 to 10 years old, we request that the landlord put it into great working condition at their cost and give us a working condition warranty for a year, if we can get it. We then agree to keep a quarterly maintenance contract, which includes parts, repair and service. In the event the HVAC becomes inoperable for any reason, 50% of landlords in America will believe it is the tenant’s cost to replace because the landlord had no control over the tenant maintenance, and 50% of landlords will pay the cost of replacement should the HVAC become inoperable. It is rare, if ever, to change a landlord’s mind on this deep-seated philosophy.
If the HVAC is 10 to 20 years of age, we require the landlord to invest in its working condition, and we request a one-year working condition and warranty in exchange for our tenant’s quarterly maintenance contract at their cost for parts, repair and service. However, because of the age of the system, we will offer to pay up to $300-$500 depending on what number we choose to pay for parts, service and repair on a per occurrence or total annual amount, whichever we prefer. We didn’t ask for the landlord to pay any cost above this baseline number. In the event the landlord is unwilling to replace the unit at their cost, we will pick a point at which if the HVAC becomes inoperable within the first 2-4 years of our lease term, the landlord will pay for its replacement cost. If it becomes inoperable after this point of time, the cost is split 50-50. HVACs are not as expensive, and there is a wide range of types. We have had general contractors tell us that the average cost of the equipment and labor to install can average $1,500 per ton. Usually, there is 1 ton per 350 ft.² If it is an ice cream store, and you were at the beach or in the middle of a hot state, you might request 1 ton per 250 ft.²
It is also important to note that with an HVAC system that is 10 to 20 years of age, we will insert an annual amount that our tenant is willing to pay for parts, repair and service, and then ask the landlord to pay any portion above this amount. In the event the HVAC is 20-30 years of age, there’s a likelihood that the risks of it needing to be replaced throughout your term will occur. Sometimes a landlord will just simply put a new HVAC up because they know the cost of maintenance could be more expensive than simply installing a new HVAC. The breakdown in negotiating HVAC language is usually unfounded on the poor experience based on the suggested language by the leasing agents. Because of this lack of experience and limited records, the tenant has a tendency to overreact, and for all of the right reasons.
Soft Areas to Touch on within the Pre-Letter of Intent
The following items represent very important subject matter that relates to the overall LOI in relation to non-financial, time related and lease-protective characteristics. The drafted language within the LOI is written in specific detail and clarifies our position.
The simplest way to communicate a permit contingency is that, in the event the tenant cannot secure the proper licensing or permits to conduct a business, the lease will terminate with the landlord returning all deposits within 7-14 days. A savvy landlord will strike out this entire paragraph as their position is that the Franchisee should be communicating with the city planning office and their Franchisor to make sure their unique business “use” will be approved at the city licensing department. A landlord is not willing to execute a lease only to lose 4-8 weeks with a Franchisee taking their time to then learn that the city will not issue a use-permit signature to the Franchisee. Our position is to wait until we reach third base on the financial negotiations and then expedite the process if we believe we are going to be going to leases. It is a waste of time to conduct this activity too early, and yet best practice as a Franchisee is that you should have a sense of security they will be approved prior to lease execution. This is a deal-breaker paragraph within our LOI simply because we do not want to have a Franchisee obligated in the lease and not be able to conduct business in the site.
Landlords will always request that they be given an opportunity to assist in the process since they have an established relationship with their shopping center at the city planning office. If they strike the entire paragraph, we will counter with providing the landlord time limitations of 30-60 days from the LOI signature date or extended this time to four weeks past the lease signing date. In some cases, even an extension from the time that has elapsed, and a tenant still has not secured a “use” permit.
Exclusive language within an LOI must be crafted to prevent future competitors that may be directly or indirectly coming into your shopping center or property. In many cases, there are existing tenants who will already have well-defined, exclusive lease clauses prohibiting the use of your type of business. Their attorneys will either write broad paragraphs to include every type of business that would resemble yours, or very narrow specific paragraphs that ensure they will not have anybody competing with them in the shopping center.
For example, tutoring, education, testing, SAT testing and counseling, if written properly, can prevent your type of use from coming into a shopping center. For quality purposes, it is important to have the Franchisor who is protecting their Franchisees submit to their Franchisee the best “exclusive clause” they have used throughout the United States. Typically, we have serviced other Franchisees within the franchise system, which allows us to have the pre-written exclusive clauses available to insert into the LOI. It is important to simply read these so that nothing is overlooked.
“Use” definition in the letter is important for the landlord and the city to understand. What products or services your business will be providing will allow the landlord to determine if your unique use will be approved within their shopping center classification. When you were filling out the use application of the city, it is important that you are transparent and consistent with this use wording within the application. If you submit use wording within your city application, you are approved, and if the city later learns that you had misrepresented your use your lease, there is the possibility of becoming terminated with fines.
The term of the lease and what role it plays within the financial strategy is extremely important. It is also important to understand that an independent business has a different perception to a landlord than a franchise business. Independent businesses are, in fact, a “dream in a briefcase” type of start-up business. Landlords are less willing to engage in longer-term leases and offer aggressive concession programs. The business owner is also generally lacking confidence because their business is not proven and tested to be profitable. Unfortunately, the combination of the owner and landlord’s attitudes toward their own best interests limit the leases 1, 2 or 3 years. These types of leases are generally at market rates, and landlords offer very little, if any, build-out or free rent, tenants are requested to take properties “as is,” and the landlords generally do not invest in tenant improvement dollars.
Conversely, a franchise-formatted business generally has a track record of previous locations, which offer landlords the confidence to enter into longer-term leases to allow a more commercially negotiated financial outcome that is in the best interest of a long-term profitable enterprise for both the Franchisee and the landlord. Most franchise agreements are 10 years, and most SBA or conventional business loans are 10 years. The term of the lease can be used as the most valuable negotiating tool to drive down the start-up costs and monthly rental rates in order to secure the profitability and long-term sustainability of the business. A short-term lease is just the opposite; it is generally more expensive and will increase the out-of-pocket costs of the business owner. It is also to be noted that, when a short-term lease is at risk of expiring, short cycles the landlord has further control to continue to increase the rent with the new market rates. Additionally, in the event a tenant wants to sell their business, there is little to no equity in their lease contract with a new potential buyer of their business. This affects the valuation of the business and puts a buyer at risk that they will not be able to secure profitable lease terms, may have to relocate the business, or the landlord may hold up the sale through hostaging, not allowing the business to be sold unless the buyer agrees to a higher rental rate. Buyers of businesses want security within previously negotiated rental schedule term leases and transferable option periods.
The term lease can be used as a control point to negotiate higher tenant improvement dollars and lower base rent starting points and increases throughout the term of the rent schedule. The most confident, and some would argue the smartest, is a 10-year term because it offers the tenant and landlord the strongest position for success. The landlord will perceive the most confidence in the Franchisee and will offer the most aggressive concessions with this term of lease. In some well-written and negotiated letters of intent, a Franchisee can substantially reduce their start-up costs by requesting extremely high tenant improvement dollars and very aggressive, low monthly basis rental rates. This, alone, can sometimes provide the capital relief necessary to reduce start-up costs and monthly rental rates to ensure that the business is secure in the long term. Again, this type of lease is suitable for a more confident Franchisee who wants to maximize every aspect of financial opportunity from their landlord and to protect their business.
The next term strategy is the 5-7-year term decision point. It is important on the pre-LOI call that a Franchisee is put in a position to hear what savings opportunities would exist from a 5-7-10-year term. When this question is not asked, a Franchisee will lose critical savings opportunities that could have a major impact on the start-up costs and monthly rental rates.
Landlords are fully aware their Franchisee will be advised by other attorneys to file a Sub-S or LLC corporation to enter their franchise agreements and execute their location leases. Landlords will accept these shell corporations without a balance sheet or ongoing operating history under the condition that the tenant will “personally” sign for the lease. Landlords will not permit a shell corporation with no operating history to be signed by the Franchisee as the president of their corporation. Of course, it never hurts to ask because there may be that one landlord who might agree, as an exception to the rule. However, it is extremely rare that this would ever happen.
There are situations in which a Franchisee has another existing business that is incorporated with the legal name, which has a balance sheet of assets and liabilities and cash availability, a two or three-year profit and loss statement showing the history of the business, and even two years of corporate tax returns that give the landlord a legal reason to believe the facts. A landlord will strongly consider this corporation as the tenant on the LOI, as well as the guarantor signing as the president of that corporation. The landlord is betting that that corporation will not go bankrupt just to terminate their obligations to the new lease. They also will consider this because the owner has a track record that they can substantiate from the financial information offered by the tenant. Going into business the first time is a risk that all Franchisees accept prior to purchasing the franchise and putting up their own capital or securing a business loan, and the franchise agreement generally has a personal signature. With some exceptions, the banking documents require personal signatures and continuous guarantees, and, as you are probably already aware, banks require collateralizing some primary and secondary assets.
The personal guarantee is recognized by the landlord as their only opportunity within a commercial agreement with a tenant to financially protect themselves. Most Franchisees are not quite sure what a personal guarantee includes or excludes and how this relates to their own signature on the lease. Most likely, you have already spoken with your franchise attorney or your banker, or you have had other financial experiences that require a personal guarantee. If you try to manipulate or try to get a corporate signature within the LOI stage, be prepared to deliver the financial information they request.
Landlords become very suspicious when a new shell corporation and a new Franchisee is trying to sidestep any liability of their obligations when they’re considering investing their own capital in tenant improvement dollars and capital improvement dollars for the unique attributes of your property. The personal guarantee is best addressed during the lease contract review. Sometimes, depending on the landlord, you and your attorney can present options to reduce guarantees, providing you are in good standing as a tenant, a successful operator, in compliance with all aspects of your lease contract, and you have a history of timely payments. In other words, you have built trust because you have been accountable and have been current on each of your obligations throughout the early periods of your lease. Very few landlords will negotiate personal guarantees based on their own attorney’s advice. If you were a landlord, I’m rather certain you would do the same.
During the lease contract “legal review” process, the landlord has previously agreed to the financial terms of their relationship with the Franchisee, which means they’ve overcome hurdles and are further invested in securing you as a tenant, which would seem to imply that they would be lenient on the other contractual provisions. However, landlords are either small risk-averse owner/operators, regional landlords with refined operating systems or large, rigid, inflexible, institutional, Wall Street REITs who have all experienced corporate chain bankruptcies that can be used as legal tactics to protect corporations, been talked into by salespeople to allow signatures on newly formed shell corporations in the past, and almost all have been on the receiving side of tenants abandoning their properties in the middle of the night and on weekends. Without personal guarantees to hold tenants accountable to their obligations, landlords would incur rapid tenant turnover and put the shopping center profitability at risk.
Through no fault of a Franchisee, there are many economic cycles and poor business operators that put landlords with very large investments with banking requirements and personal guarantees at risk. It is easy to see why, under these circumstances, getting out of a personal guarantee is virtually impossible when signing a landlord lease contract unless you can convince them that your corporate signature as an officer is backed up by another active corporation that you own with strong ongoing financial statements. The strategy to determine if the landlord is flexible at all with personal guarantees will generally occur when your attorney and the landlord’s attorney, who understand the meanings of personal guarantees, are having communication both verbally and in writing.
The landlord’s attorney does not want to be the individual who causes the lease to fall out, with the amount of work the landlord has done to secure a potential tenant. Your attorney is simply gracefully trying to suggest options to protect you and gets the landlord comfortable. It is the landlord’s property, and they set the rules for personal guarantees. The bst a Franchisee can do is to design a “legal review protocol” that would give them the highest potential of getting lucky or be offered any gracious personal guarantee provisions from a landlord. Approaching a personal guarantee termination, expiration or limitation includes well-designed, pre-planned and strategic options that will be previously discussed with your attorney and presented in a way that does not send a message that you are a risky investment looking to escape your obligations. The first step in the process is to learn how to think from the landlord’s perspective and then use this thinking to your advantage.
For example, the strength of your tenant’s financial statement will be correlated to the landlord’s willingness to invest in your business through capital improvements and tenant improvement allowance. If you have provided the landlord the financial statements, and they are considered very “strong” (through their own private interpretations), this might convey to one landlord to remain extremely firm on the personal guarantee, and another landlord might be open to “flexible options” providing the future rent is protected for a landlord and/or until they can secure another tenant.
On the other hand, if the landlord considers a Franchisee’s financial statements to be “light” (again, through their own private interpretation), limited in assets and cash on hand, but they were still willing to proceed on the professional biography as well as their interest in your unique “use” in their property, this might change their attitude toward the personal guarantee. One landlord might have already limited their investment in tenant improvement allowance and other concessions throughout the LOI negotiations, and already knows they are taking a high risk on the Franchisee with a “light” financial statement. There’s always a mutual professional courtesy with respect to the tenant’s privacy, that no specific discussions related to the net worth will generally occur, as all parties have mutually come to this point together. “It is what it is.”
In some ways, the landlord has already safeguarded themselves financially, and in the back of their mind, they’re thinking, “Well, if they go out of business, they’re not going to have the money to pay any future rent, and most likely they’ll be in default two or three months of the back rent. If they panic, are inexperienced or get poor legal advice, they may leave in the middle of the night, or a landlord might have to evict them in accordance with state eviction laws by sending them a series of written three-day pay or quit, 30-day pay or quit or other landlord-related notices, in addition to the ones are required by law. The landlord has most likely experienced tenants who have closed their business before and/or has had to evict them because they could not become current on the rent. The most important aspect of the landlord is to be able to terminate the lease legally as this has the most value to their future ability to lease the space and begin cash flowing again. They are, in some cases, financially set back if any bankruptcy or legal proceeding would prevent them from leasing their space in addition to the cost of legal fees should they have any through the process.
Note: A commercial lease, unlike residential apartment leases, are required to be standard, state-approved contracts. And, while some states do provide suggested landlord lease contracts, the commercial lease is a contract that is negotiated by both parties, and, for the most part, these terms will hold up in any legal proceeding because both parties agreed to the terms unless state laws regarding landlord and tenant eviction would come into play in favor of protecting the landlord or tenant.
Some states are very tenant-friendly. It is difficult to predict a landlord’s philosophy regarding personal guarantees with a Franchisee who has a “light” financial statement. Some landlords are entering the lease with an attitude of “What do I have to lose? Hold firm on the personal guarantee, and, if they close, I probably won’t get anything anyway because they don’t have much.” Another landlord might say, “I have a standard and firm policy and will not compromise the personal guarantee,” even more so because the landlords think they are doing the Franchisee a favor, offering financial concessions and allowing them to rent their space, thinking that they’ll go out of business in three years. The landlord may be thinking, “Regardless of whether I know you’ll be able to pay me, I do not want to give up any of my rights that I might have available to me in my personal guarantee.”
It is my hope that you now have a better psychological understanding of what landlords are thinking from strictly a business point of view when they lease their space to a wide range of Franchisees with different professional and entrepreneurial experiences, financial strengths and credit scores.
Landlord Breakeven Point
Keep in mind that a landlord who offers five months of build-out and multiple months of free rent invest in landlord capital improvements to bring their property up to rentable condition and code, offer a tenant investment capital known as tenant improvement dollars, pay their attorneys to finalize a lease contract and pay their contracted listing agent their commission. A landlord will incur an investment and/or replacement cost to bring in a new tenant into the space that could represent a low of nine months to a high of two years just to break even on their financial investment. On principle alone, what landlord would agree to enter a lease without a personal guarantee from a start-up tenant with a newly formed corporation and without an operating history? It is rather bold to think or request that the landlord would relieve a tenant prior to earning their capital back and before reaching a minimum breakeven point on the transaction. The strategy below is a graceful approach to respect the landlord and show that you are understanding their thoughts and calculations, including their risks of taking on a new tenant who may or may not succeed in their business. If there is any “slow pay” prior to a landlord breaking even, they are at even a greater chance of losing more capital before they break even.
The personal guarantee terminates at the end of the second year providing the tenant is in full compliance of the lease and rental payments. The personal guarantee will convert to a month-to-month obligation. A landlord will, in almost all cases, disagree, and it will become a deal-breaker, but it may be a fair “starting point” for attorneys to openly discuss any ideas that could favor the mutual interest of both parties. The landlord will most likely put a redline, striking out this revision, which would be expected. However, their response will certainly reveal their position and how they view the transaction in terms of their risk and investment that they are making in the tenant and will not even break even for up to 2 years. Their overall policies that are in place with other tenants require covenants of banking institutions.
The “comment letter” conference call meeting (which is not utilized by all attorneys and Franchisees) is a platform by which the protocol of open and transparent dialogue with this issue gives both you and your attorney a unique opportunity to probe conversationally around the subject. It is critical to use the right words and tonality within this conversation, and time them at the right point, either through soft, open-ended questions tied to a statement the attorney might mention, or this subject can be brought up in the pre-written “concern section” of a comment letter when the timing is right within the formatted outline of the call. This is where Franchisees, when left out of attorney discussions, have no real insight as to whether this item is being represented in the best light on their behalf and whether it is being discussed conversationally at all, which results in an inability to explore the opportunity of a win-win personal guarantee agreement. Inviting all parties to participate inclusively in open conversations allows more trust to form, likeability to grow and flexibility to be entertained by both parties.
If they fully strike out and are unwilling to compromise, I might then strategically look closer at the “default clause” within the lease, and any “accelerated payment clause” that might be in the lease. These lease clauses will all relate to termination in some fashion. Because the landlord was definitive in striking out the personal guarantee request, maybe there is another way to write in language that would invalidate the personal guarantee and supersede because both parties have agreed.
For example, in the default section, cross out any sentences that would conflict with a new offer that would suggest that the personal guarantee will fully terminate at any time beyond two years with a 90-day notice in the event the tenant personally guarantees the back rent due and 4 months of future rent. It might be an odd place to read this second bite at the apple; however, when they read this offer, it is a slight improvement and compromising position to offer a personal guarantee that limits the back rent and a small portion of future rent. Most likely, you will be in default intentionally at this point in the process anyway, so including this in the default section may not be that unusual. You are interfacing with a default strategy that guarantees the landlord some financial compensation in exchange for terminating the lease and releasing a personal guarantee. If your financials are light, they might see value in this short windfall of future capital and believe that you could pay it even though you’re going out of business and you’re willing to personally guarantee this past due amount and 4 months of future base rent. They already have your security deposit on hand, so they can apply this money to past due amounts. If you have a high net worth, most likely the landlord will try to increase the amount to 6 months, 9 months or one year of future rent. Regardless of whether you have a light financial statement or a strong one, they have invested substantial amounts of tenant improvement dollars, and the landlord has still not recovered their initial outlay of capital from a breakeven point in a short period of two years’ time. If they are smart, they will request that the unused portion of the tenant improvement allowance and lease commissions be paid to their listing agent/split with Franchisee agent and added to the settlement amount in order for the landlord to consider officially “terminating” the lease.
It is fairly easy, from a business point of view, to understand why a landlord may be thinking that, with the Franchisee who has a light financial statement, if they get to keep the security deposit as back rent due, +1 to 4 months for future rent plus unused amortized tenant improvement and paid commissions might still be a stretch for the tenant to pay. After all, if the tenant is going out of business because they can’t pay the rent, how would they be able to pay a settlement total as mentioned? This puts the business decision-making of the landlord in a very awkward position. If the landlord settles with the tenant, will they ever really ever get paid? Will the state laws allow the landlord to attach any collateral at that time in this new separate agreement with a stipulation of judgment that, in the event they miss a payment, they have a stipulation of judgment on file at the courthouse to secure payment through the collateral.
This is the end point that is difficult to think through, but, with the advice of an attorney at that point in time, it is nice to have a previously and mutually agreed understanding and help parties to exit the relationship. For a Franchisee who has a high net worth, there is a double-edged sword because you have more to lose, and the landlord has more to gain. This is usually an opportunity for the landlord to stand firm on their personal guarantees because at least they get a feeling of relief that the file that has the lease has a strong financial statement. For this Franchisee, sometimes there are more options to consider. For example, you can try limiting the personal guarantee with a letter of credit at the bank in the amount of one year of future rent, unused amortized tenant improvement dollars and previously paid listing commissions.
Another option is what is called a “good guy clause,” which allows both parties to agree that you can pick any point during the lease with an appropriate notice to cancel of 60-90 days, with an agreement to pay 3, 6, 9 or 12 months of future rent at that time to protect the downtime and vacancy for the landlord. Early termination, or kick-out clauses, are where the landlord grants the tenant a one-time right to cancel the lease at 24, 30, 36 or 48 months with a 60-day notice, requiring the tenant to pay the landlord back for the unused amortized portion of the tenant improvement allowance and any other costs the landlord may have incurred, including leasing commissions of the tenant.
Lastly, some landlords will accept 3, 6 or 9 months of a deposit as a remedy to offer termination, and include paying back the landlord for costs they have not yet heard back.
The goal with signage, when negotiating an LOI, is to maximize all opportunities, without limitation, to utilize signage that meets the Franchisor’s criteria of colors, logos, etc. There’s also a need to maximize signage on the monument, pylon and facial signs on the top of your location space. There can also be additional opportunities, if negotiated, to put signs on the side and back of the buildings, trailer signs out on the front and some communities, banner and window signage as approved by the city for limited periods of time. Leasing agents will always defer to the city’s approval, yet this is an excuse to sidestep and get acknowledgements from the landlord on what they will approve first and foremost. It is a given that the city, county or state will have signage regulations that will override the landlord. However, when negotiating signage with the landlord, we want to acquire yes, providing the city will approve.
Letter of intent preparation and approval:
Once a well-written LOI is prepared on your Franchisee’s behalf, it is important that the Franchisee read, in minute detail, every word of the proposal and not assume that the leasing agent has included all of the new ideas that you might have thought about since the pre-LOI conference call. There may be new additions that you would like to insert into the LOI that have been on your mind or that have triggered a new thought when reading the LOI. A leasing agent will not go forward until they have an email approval in writing as a quality assurance step to ensure your interests are presented in the manner you wish them to be presented.
Psychology is the most important factor when negotiating an LOI and yet the least understood by commercial leasing agents and first-time Franchisees. It is most common that the emotional personality traits of being too eager or, conversely, too over-aggressive, will cause your leasing agent to overreact contacting the leasing agent by telephone or email asking when will we receive a reply from your landlord. This is the most dangerous approach and will cost a Franchisee the most amount of capital, because a savvy landlord’s listing agent will take this opportunity to see what their landlord most likely will not do before they even present the LOI to the landlord. Your leasing agent would be in a position that is unfavorable to you because they would have to reply to the listing agent and report this new information to you. The best practice is to realize that your patience will pay off with the most money for you. As difficult as it is to do, if you ask your agent to communicate with the leasing agent before they communicate their reply, it will have a major impact on how they counter the financial terms of your proposal. Slowing down to speed up, with the best strategy, will save you the most capital in your start-up costs in your monthly rent.
The average time for a landlord to respond to LOIs varies widely. However, our experience has shown that it can be as short as three days to as long as four weeks. Many landlords are, not surprisingly, very wealthy and frequently travel the world, or their properties are retirement vehicles with owners in the retirement years, and they travel quite a bit. For many of the large landlords that or institutional, large publicly traded companies, university owned, pension trust, and REITs meet either once or twice a month by committee and may review up to 100 LOIs in one meeting with 50 agents on the large conference line.
The main reason that we ask, in the early part of the pre-LOI conference call, how long does it take for the landlord to reply to LOIs and draft landlord leases is to discover this so that we can, without being eager, not waste a phone call or second-guess the landlord’s interest in our Franchisee as a tenant. These are perfectly timed inquiries, depending on the type of landlord. The eighth work day is a good time to ask for an update by email only to the listing agent in a vague, indifferent manner. One word demonstrating emotionality will increase the landlord’s agent’s confidence to not give us what we want, in totality. Once we receive the landlord’s counter to our LOI proposal, we can relax and begin to function smoothly back and forth with our counter LOI proposals without being perceived as eager, overconfident or desperate.
Letter of Intent Execution:
There is no perfect rule of thumb other than the tenant executing the LOI, and, through email exchanges, a non-binding letter of intent is consummated. There is genuine goodwill at this point in the process, that the landlord has accepted all of our terms that we mutually agreed upon and is prepared to forward landlord leases to us as the leasing agent. There are some cases in which the landlord has elevated a small degree of uncertainty in our minds, and, even though most of the time they are unfounded, we will ask for the landlord to sign the LOI just for mental peace of mind. However, very often, landlords need to sign the LOI but are not available or out of state, and, while some have notaries, it simply slows the process down. Sometimes, the effort to get a landlord signature can cause a 1-2 week delay, and this is riskier, in some cases, than the cost of capital and slowing the process down to open the business.
Landlord Lease Contract:
It is important to note that the importance of the pre-LOI conference call was to intentionally determine how much time would be lost for a Franchisee in the legal review process. In addition to long delays from landlords to prepare leases, Franchisees will often unknowingly make an additional mistake by selecting the franchise attorney who reviewed their franchise agreement and/or a local attorney they have used in the past, or a friend of the family, under the agreement that they would get their side of the review done faster and cheaper. Combining these two issues has caused Franchisees to lose, on average, 5-12 weeks of precious time to open their businesses. Through no fault of their own, the landlord’s listing agent fully disclosed that it could be 2-3 weeks for a busy landlord to prepare a lease that incorporates all the elements of the LOI. And this is only a tentative promise one should plan for delays. The Franchisee, by the time the LOI is executed, is usually too excited and has already made commitments that make it too late, or they are too tired and they will virtually sign anything that is put in front of them.
Both of these situations can put a Franchisee at grave risk for the lowest quality lease review by the most contentious redlined battles of attorneys who do not know each other and will not pick up the phone to talk to each other until they get deeper into their exchanges of redlines within their contract to realize they have become contentious at polarized positions. The lease is at risk of being killed! Meanwhile, the Franchisee could never have predicted that the good intentions of one attorney, combined with a distant, busy, third-party attorney for the landlord, is uncompromising and overreaching. This then upsets the Franchisee’s friend or referred local attorney since this attorney is a complete outsider to understanding the Franchisor addendums, SBA and banking subordination agreements, has maybe only read less than 10 commercial leases in their entire career, and is not tied to the overall ideas of the legal process, which includes steps of open and honest transparency including the Franchisee, simply will not exist.
All of this results in putting too much emphasis on smaller items, and too little emphasis and strategy on the most important items. If the lease is read too fast, it is a low-quality review, and if it takes a week to two weeks to review, this is too long. It is always best to consider making the decision on a lease review protocol that will give you the best and highest potential of the highest quality review, turnaround time without hurry, a fixed price with some additional cost contingencies that are options and to the benefit of the Franchisee, and with a practitioner who understands franchising, banking, landlords and Franchisees, all as integral components to collaborate and finalize the lease. A Franchisee is tempted to take financial shortcuts because they believe it will save them money, but our experience shows that it is just the opposite.