Considerations for Taking Over a Closed Restaurant
As a result of the COVID-19 pandemic and the subsequent shelter-in-place order implemented in California, thousands of restaurants have closed and many will continue to stay closed after the shelter-in-place order is lifted.
The California Restaurant Association (CRA) recently estimated that between 20 to 30% of all restaurants in the state that were closed during the shelter-in-place period may not reopen once the shelter-in-place order has been lifted. There are approximately 80,000 eating and drinking businesses in California which means potentially over 20,000 of these eating and drinking businesses may not reopen. This situation extends to many other states and countries in the world for that matter.
This will result in thousands of fully built out restaurants that were in operation prior to the COVID-19 crisis not reopening which will present opportunities for many new restaurant operators.
For brokers, a couple of scenarios could occur for a restaurant that closed during the COVID-19 crisis where the former tenant most likely does not plan to reopen the business.
Scenario 1: Closed Restaurant is Currently Listed with a Broker
The tenant makes an arrangement with the landlord to give the tenant the right to sell his business at a reduced quick sale price. In exchange for the landlord giving the tenant free or greatly reduced rent during the sales period, the tenant saves the landlord having to pay a lease commission to lease up the closed space. Additionally, the landlord has a chance to obtain a new tenant with better operational experience and a stronger financial background.
In this scenario the broker would oversee the transaction through an escrow so the buyer gets title free and clear and the broker will facilitate transferring the ABC license, if applicable.
The value of the business would be adjusted accordingly based on the following: the value of the business will be based on the past two years performance discounted by a material amount based on the terms and conditions of a new lease and based on the projected new sales and profits with the new post COVID-19 operating requirements. This amount could vary from a 25% to 50% discount off the pre-pandemic sales price.
Scenario 2: Closed Restaurant is NOT Listed with a Broker
In this situation, the broker would approach the restaurant tenant, if possible, to determine if he wants to sell his business based upon either the tenant re-opening the restaurant or trying to sell the restaurant closed on a quick sale price basis.
If the broker can make contact with the tenant and the tenant can negotiate no rent or reduced rent during the sales period, the incentive for the landlord, similar to the scenario above, is saving to have to pay a lease commission as well as obtaining a new tenant who is stronger operationally and financially. In this case, the restaurant tenant would enter into a listing agreement with the broker to market and sell the business at a quick sale price. The value of the business would be based on the valuation formula indicated in Scenario 1 above.
If the broker cannot contact the restaurant owner, the broker should approach the landlord to determine how to contact the restaurant owner. If the landlord says the restaurant tenant gave him back the keys and the landlord now has possession of the space, the broker should try to negotiate a lease commission listing with the landlord. In this case, the new tenant could pay little or no key money to the landlord. If there is key money involved, there is no formula to determine the key money and any negotiations will be on a case by case basis.
For a new tenant, there are a number of advantages and disadvantages to consider when taking over a closed restaurant.
Advantages for a Tenant Taking Over a Closed Restaurant:
- The tenant has the use of hundreds of thousands of built out equipment and leasehold improvements at no cost to the tenant, in many cases. Keep in mind, the tenant is responsible for maintaining the equipment and premises and replacing the equipment if necessary, in the future.
- The tenant does not have to spend the long lead time and cost in getting permits and approvals from the city to build out the space.
- The ability to open in a premiere location and acquire physical assets at a good price.
Disadvantages for a Tenant Taking Over a Closed Restaurant:
- The tenant has to hire and train employees versus buying a restaurant with trained employees already in place.
- There is a higher risk that the startup business will not be successful versus purchasing a successful restaurant with a history of strong sales and profits.
An experienced restaurant broker understands the following:
- Negotiating a good premises lease that favors the tenant. This is discussed in detail in the Lease Requirements from the Tenant's Perspective" section.
Familiarization with the major aspects of the physical plant, which include:
- Health department requirements
- American Disability Act (ADA) requirements
- Signage requirements
- Zoning and use requirements to assure that any limitations regarding days and hours of operation won’t be detrimental to the business
- Fire department requirements
- Assuring the space and its equipment meets all planning and building department code requirements and the equipment and leasehold improvements are in good working condition.
- Additionally, for an interim period of time immediately after COVID-19, there is a strong chance that additional safety requirements will be required such as: reducing occupancy requirements to meet distancing criteria, the use of gloves and masks by employees and/or customers, use of disposable serving pieces as well as some possible temperature taking standards.
- An analysis of the location to assure that it is located in a well built out area and not prone to additional head on competition and not vulnerable to a condemnation/eminent domain proceeding. An experienced restaurant broker can study the subject location to determine that it is not prone to any sound complaint issues from neighbors in the building and in adjacent properties.
Besides the above prerequisites that need to be evaluated, there are also a number of additional requirements that need to be considered to insure success.
The landlord's requirements for a new tenant for a vacated fully equipped restaurant.
The proposed new tenant must meet the following requirements:
- At least three years of restaurant management and/or ownership experience operating a restaurant with a similar concept as the one proposed for the new site.
- Have a solid financial background including having enough cash reserves for any proposed improvements the tenant plans to make plus enough cash for a minimum of six (6) months working capital. Working capital is defined as having cash reserves in the bank to pay at least six (6) months of payroll and food and beverage costs.
- Have a strong credit report.
- Have strong landlord references.
- Have a strong balance sheet with bank statements and security statements to support stated assets.
- In some cases, submission of applicant’s tax returns for the most current years.
Lease requirements from the landlord's perspective.
Most landlords will have the following lease requirements:
- A market base rent plus possible net costs which may include a pro-rata share of the buildings real estate taxes, insurance expenses and common area costs (CAM) if applicable. The CAM expenses include common area utilities, security, parking lot maintenance and other common area maintenance costs.
- Yearly adjustments of the base rent tied to inflation or a fixed percentage increase.
- A strong personal guarantee from one or more of the principals of the business for the length of the lease including options.
- If there are options, the rent in the first year of each option is adjusted to fair market rent and subsequent years adjusted for inflation.
- The term of the lease should be five (5) to ten (10) years with a minimal number of options.
- Lease and any options are not assignable.
- A use clause with very specific criteria.
Lease requirements from the tenant's perspective.
Many prospective tenants will have the following lease requirements:
- A below market base rent and no net expenses. If there have to be net expenses the tenant will want them capped so they can only be raised by the amount of inflation yearly with a cap on the inflated amount. For example, if the yearly inflation rate is five percent (5%) the tenant will want the increases to be capped at two percent (2%). In particular the tenant will want a cap on property taxes because if the building sells for a substantially higher price the tenant’s pro-rata property taxes will go up sky high.
- The rent is fixed for a couple of years before any increases kick in and when increases kick in yearly increases not to exceed two percent per year.
- No personal guarantee and the only guarantor is the business entity set up such as a corporation or limited liability company. If the landlord is adamant that he needs a personal guarantee initially, have the personal guarantee burn off after a few years.
- If there are options the rent in the first year of each period will not go up more than two percent (2%) over the preceding years rent and subsequent yearly increases will not increase two percent (2%).
- The base term will be five (5) years with as many five (5) years options as possible.
- Lease and any options are assignable.
- As broad a use term as possible such as a restaurant serving alcoholic beverages.
- Free rent for the first six (6) months of occupancy and/or landlord contributions of a negotiated amount per square foot towards tenant’s capital improvements to the space.
- The tenant having a first right of refusal to purchase the building.
There are a number of necessary items and specifications one needs to know and evaluate before taking over a closed restaurant. Working with an experienced restaurant broker that understands all the facets of the restaurant transaction can be critical to one’s success or failure.