Quick-service restaurant leases are predicated upon the restaurant doing a certain amount of volume and revenue. Unfortunately, no one could have anticipated the current scenario of having to operate while under social distancing and occupancy restrictions. Further, quick-service restaurants are also becoming increasingly dependent on third-party delivery services, which further encroach on profitability. Currently, numerous states are experiencing surges in COVID-19 cases, which indicates that these types of restrictions will not be lifted in the near term and such restrictions may even be increased as states consider pausing or rolling back their re-opening plans.
Even if this type of scenario had been contemplated, from a legal standpoint, many restaurant owners had been operating under the misguided notion that in the event of a pandemic, it would be deemed a force majeure event and they would not have to pay rent. If they were still required to pay rent under their force majeure provision, they then believed that any rent obligations would be covered through their business interruption policies. The quick-service industry has learned that in most cases, the force majeure provisions do not excuse a tenant from paying rent and business interruption policies exclude claims arising out of a virus.
Formulating Short- and Long-Term Solutions
In response to social distancing and occupancy restrictions, quick service restaurants will be able to manage certain primary expenses such as labor and food costs. However, one ongoing expense that will remain fixed is lease payments (except in cases of a percentage rent lease). Therefore, restaurant owners are going to have to develop a game plan to navigate the phases of re-opening while also navigating their rent obligation.
An effective rent negotiation strategy includes:
- Opening the lines of communication with your landlord;
- Crafting a short-term solution that takes into account both the restaurant’s and landlord’s immediate concerns; and
- Developing a long-term solution that addresses if, when and how the landlord will eventually be made whole or otherwise compensated for any rent deferral or rent forgiveness.
The silver lining is that because of the widespread nature of the pandemic, landlords are generally incentivized to work with restaurants to get through this period. This will be a challenging environment for landlords to find replacement tenants, so having restaurants go out of business or having to evict tenants is not an ideal scenario for any of the concerned parties. Having open spaces in shopping centers or properties turns a relatively short-term problem into a potentially longer one for the landlords as it may take them considerable time to find a replacement tenant, and the increased availability of commercial space may find landlords agreeing to decreased rents in order to sign replacement tenants. Therefore, landlords should be open to working out a solution with their current restaurant tenants.
Effectively Communicating with Landlords
When developing a strategy to deal with landlords, restaurants need to be mindful of the ecosystem that they are a part of. The foundation of the ecosystem is the customers who patronize the restaurant. Their dollars are used by the restaurants to pay their landlords, who in turn use those dollars to pay their lenders. Social distancing, occupancy restrictions and the public’s general health concerns related to the coronavirus result in customers not patronizing restaurants at the same pre-COVID levels, which in turn creates a stress on the entire ecosystem. Restaurants no longer have the customer revenues to pay rent, resulting in the landlords potentially not having sufficient funds to pay their lenders.
The key to reaching a solution starts with opening the line of communication. Simply ignoring landlords or otherwise not engaging is simply increasing the chances that the landlord will eventually pursue eviction proceedings. Restaurant owners need to view the landlord as a partner that is ultimately also impacted as part of the ecosystem and needs to be kept updated as to how the restaurant is performing. While a landlord may know that a restaurant is limited to curbside, drive through, delivery and outdoor dining, it does not know the exact impact it has on restaurant sales. A landlord can incorrectly assume that a restaurant is still generating enough revenue to pay its rent if the restaurant is not communicating. If restaurants are able to effectively communicate the specifics of what they are facing, it will be easier to convince the landlord to work out a solution that addresses the individual restaurant’s challenges during the re-opening.
Any strategy has to take into account the landlord’s perspective and concerns. They are not at the top of the ecosystem, as they generally will have to make their mortgage payments to their lender. In addition, they have monthly expenses related to the maintenance and upkeep of the property, as well as obligations to pay real estate taxes and insurance. Finally, in certain cases, a landlord may also have to answer to investors and shareholders. As an example of crafting a solution that takes into the account the landlord’s concerns, when the pandemic began, certain tenants were able to negotiate continuing to pay CAM and other additional rent for a few months to cover some of the landlord’s carrying costs to maintain the property.
Understanding Rent Deferral
While a landlord may agree to short-term allowances to enable a restaurant to survive the pandemic, a contentious issue will be whether such allowances are provided as rent deferral or rent forgiveness. If it is merely a deferral, then landlords will expect to receive the deferred rent at some future point, whether it be in a lump sum payment or amortized over a certain period during the lease.
An effective rent deferral plan should be a win-win. The tenant is given breathing room to operate while it is experiencing repressed revenues, but the landlord is paid back the deferred rent once the tenant’s revenues normalize. For this to work, the restaurant has to be able to pay the deferred rent in a manner that does not jeopardize its ability to operate. For example, if the restaurant had to pay the deferred rent in a lump sum payment or over a short-term period, that could result in the tenant not being able to pay the increased rent payments and sustain its operations. Therefore, it is crucial when negotiating deferred rent that the repayment terms are realistic and will not strain your cash flow to the point where your ability to operate is at risk.
Considering Rent Forgiveness
Negotiation with a landlord may also result in conditional rent forgiveness. For example, rent forgiveness may be conditioned upon a lease extension. From the restaurant’s perspective, the ideal scenario is that if it receives a few months of rent forgiveness, it also agrees to a corresponding lease extension. In this scenario, if the restaurant received three months of rent forgiveness, it agrees to extend the lease for an additional three months so that the landlord eventually receives the anticipated monies under the lease.
However, landlords may condition rent forgiveness on more considerable lease extensions. There is a growing concern that the commercial real estate market could implode as a result of this crisis and if a tenant does not exercise its renewal option rights, the landlord could have to agree to renegotiate with the tenant for a lower rent in order to keep them in the space. To avoid this, landlords may require a tenant to agree to an early renewal in consideration of receiving rent forgiveness. In this situation, restaurants must evaluate whether the landlord’s extension request merits the short-term rent forgiveness that they are being offered.
Ultimately, this pandemic has presented unique challenges for quick service restaurants to navigate. However, because of the sweeping, widespread nature of the pandemic, it has also created an environment in which landlords are motivated to work with their tenants to help them survive the crisis. By effectively communicating to landlords the specifics of how the pandemic is impacting the restaurant, working on a solution that addresses both parties’ short-term issues and negotiating a win-win solution for deferred rent or rent forgiveness, quick service restaurants should be able to effectively navigate this crisis.
Adam Siegelheim, a shareholder with the law firm of Stark & Stark (www.stark-stark.com) in Princeton New Jersey, is a member of the firm’s Franchise and Business & Corporate groups. His practice includes the representation of restaurant franchise companies, as well as representing multi-unit restaurant operators.