Restaurant leases – what you need to know

Business

There is a lot of capital required to run a restaurant, and one of the main costs associated with operations is your physical space. However, before signing any lease, whether long term or short term, do your homework, know your options, and most importantly read the fine print.

Before you rent a restaurant space or renew a lease

It is no secret that ADA lawsuits are on the rise. It is estimated that 99% of businesses in California have at least one ADA violation currently. The largest percent of ADA lawsuits are filed in California.
 
The ADA obligates anyone who “owns, leases (or leases to), or operates” a “place of public accommodation” to make sure that place or premises complies with ADA guidelines. California law now requires Landlords and Tenants to negotiate responsibility in the lease. If it is a “gross” lease, the landlord will probably be responsible for the structure and building, however, if there are issues that are solely within the tenant’s control (such as placement of furniture, allowing service animals, etc), the tenant would be responsible. Nevertheless, if the lease does not clearly allocate responsibility, problems will arise.

Possible areas of concern:

  • Lack of public bathrooms – ADA bathrooms require a certain amount of stalls per seats and all must be ADA compliant. If all you have is a one-seater, is there enough room to add more bathrooms?
  • Lack of outside ventilation – Restaurant kitchens produce a lot of smoke, grease and odors. Therefore, ventilation is necessary, not only to keep the dining room free of smoke but to keep the kitchen a healthy work environment. Finding outdoor ventilation can be a problem in older downtown buildings.
  • No Garbage pickup – Restaurants produce a lot of garbage. Is there a place for a dumpster nearby? Or can you share with other local businesses?

If there are areas of concern, negotiate up front as to what the landlord will cover, don’t think that it can be worked out later. If you are negotiating a renewal, be aware that any time you undertake improvements to the space you are required under California law to allocate a certain percentage of the improvements to ADA access and compliance. The amount you must allocate varies but it is important to check the current law before you begin any improvements.
 
Further, if the space has been vacant, you can gently remind the landlord that you should not have to pay for renovations and repairs that you can’t take with you at the end of the lease. For example, if you have to update electrical or plumbing systems, they are going to stay with the building. If a landlord refuses, then it may be a sign to look elsewhere for a restaurant location.

Ask the neighbors about the landlord and the location

The location will be your second home, so it is best that you know who your neighbors are and the neighborhood you are moving into before you lease. Ask other tenants in the building about their experience in the neighborhood and with the landlord.

Understanding types of restaurant leases

It is becoming increasing common that retail space rent is calculated based on a formula, rather than a fixed sum. The formula is the sum of (i) the “base rent” and, (ii) the “additional rent”.  In such formula based leases, the base rent is stated as a multiple of the square footage of the leased property and a fixed, annual cost (e.g., 1,000 square feet x $60.00 = $60,000, or $5,000 per month).  The tenant will usually also be responsible for additional rent, such as its share of property taxes and a proportionate share of common expenses in a shopping center.  In certain situations the landlord may include a percentage of the tenant’s gross revenue as additional rent.  Alternatively, the landlord may include a percentage of gross revenue as all of the rent, if the amount rises above a certain threshold.
 
The inclusion of a percentage of gross revenue in rent is negotiable, as are all of the lease terms discussed in this article; however, in certain real estate markets, especially where the landlord has more leverage than the tenant, the landlord may not be willing to negotiate, or will limit what is negotiable.  When negotiating the terms of a lease, or at least finalizing the lease document itself, a tenant should seek the assistance of competent, experienced counsel.
 
Percentage rent is typically determined as a percentage of sales above a breakpoint.

Breakpoints

Breakpoints fall in one of two categories: (1) natural or (2) artificial (also known as fixed).  While the two have a similar effect, i.e., obligating the tenant to pay a percentage of gross revenue above a certain threshold, they reach the same conclusion by different routes. 

Natural breakpoints

The natural breakpoint is a byproduct of two separately negotiated terms: the base rent and the percentage of gross revenue owed as rent.  The natural breakpoint is calculated by dividing the base rent by the established, agreed-upon percentage of gross revenue due once the natural breakpoint is passed, and then the negotiated percentage of revenue above the natural breakpoint will be due as rent.  For example, if the base rent is $1,000,000, and the agreed-upon percentage is 5%, then $2,000,000 in gross revenue is the natural breakpoint, as 1,000,000 ÷ 5% = 2,000,000.  Thus, the tenant would be obligated to pay 5% of gross revenue to the extent that gross revenues are greater than $2,000,000.

Artificial Breakpoints

The artificial breakpoint is a predetermined dollar amount agreed-upon by the parties.  Once the gross revenue of the tenant surpasses that predetermined dollar amount, the tenant will owe an agreed percentage of sales to the landlord as additional rent.  For example, if the artificial breakpoint is $1,000,000, and the agreed-upon percentage is 5%, the tenant would be obligated to pay 5% of gross revenue once gross revenue surpasses $1,000,000.  Thus, if the tenant’s gross revenue is $1,500,000, in addition to the base rent owed, the tenant would pay 5% of $500,000 ($25,000) as additional rent.
 
During the negotiation of the base rent, be mindful of the various scenarios where you may owe a steep amount. Also be mindful that as your business grows and succeeds the revenues that you thought were impossible are now the reality and your rent will be much higher than those around you.

Exclusions

Gross revenue is typically calculated as the gross receipts collected in the tenant’s general accounts, and thus certain revenue or income will be excluded.  For restaurants, typical examples of excepted items may include returned or exchanged items, unused gift certificates, taxes paid by customers (though this sometimes only applies if the taxes are separately collected as a tax, i.e., not included in the listed price of an item), sales of furniture or other equipment and fixtures, and sales from coin-operated devices, such as vending machines. 
 
California courts have held that tips (not service charges) paid directly to the employees, rather than to the restaurant, and do not constitute gross revenue in the context of determining a restaurant’s gross revenue for purposes of determining rent. However, service charges are considered gross revenue of the restaurant. Therefore, it will be important to evaluate your business model before signing any lease.

Frequency of payment and record-keeping

When a lease includes a percentage of the tenant’s gross revenue as a portion of the rent owed to the landlord, the lease will typically require payments of gross revenue above the breakpoint made on a semi-regular basis (e.g., monthly, quarterly, annually); however, the lease could require a monthly payment, instead.  To ensure that the proper percentage rent payments are made, the lease will include requirements regarding the tenant’s record-keeping.  Specifically, the lease will require the tenant to keep good and correct records and provide a statement, typically certified by an officer or duly authorized representative of the tenant, to the landlord on a basis consistent with the frequency of percentage rent payments providing the relevant information needed to calculate the percentage rent owed, such as the sales for the previous reporting period, the sales from the previous year and/or sales exceeding the breakpoint.  Other examples of statements that might be required, though typically on a less-frequent basis, are statements prepared by a certified public accountant or audited financial statements.  Even if the lease does not require audited financial statements, it will likely require that, in the event an audited financial statement is prepared for another reason, a copy must be provided to the landlord.

​This report was reviewed for legal accuracy and updated in 2016 by Berliner Cohen.