July 7, 2011

Key Lease Issues for New Restaurant Tenants

Arnold & Porter Advisory

By Ken Neale

Restaurant leases raise unique issues for the restaurant operator. Many new restaurants operate on tight budgets and cannot afford surprises that will delay the opening or increase costs. Restaurant tenants also need breathing room to allow the restaurant to get off the ground and stabilize operations.

In reviewing a restaurant lease, the tenant should carefully consider the following key issues:

  • Zoning and Permits. Check zoning for the property to make sure it permits restaurant use. Also, check on the availability of necessary permits and make sure you understand the time frame for obtaining such permits. In California, the process for obtaining or transferring a liquor license has been substantially delayed due to budget cutbacks affecting the Department of Alcoholic Beverage Control. Consider tying the rent commencement date under the lease to the receipt of necessary permits. If you are seeking an assignment of a liquor license, make sure you understand the nature of that license and its limitations. Not all liquor licenses are equal.

  • Code Compliance; Property Condition. Carefully inspect the premises to determine its condition and any work necessary to bring it up to code, including the Americans With Disabilities Act ("ADA"). ADA requirements can be substantial for restaurants because they are "public accommodations." Hire a professional, such as an architect, to assist in the inspection process. Make sure you have a clear understanding of what needs to be done to the premises and who to be is responsible for any work or upgrades. Make sure the lease clearly allocates responsibility for maintaining building systems going forward.

  • Free Rent; Percentage Rent. Consider structuring rent so that it is reduced or free early on during the lease term as the restaurant ramps up operations. In addition, if the lease calls for percentage rent, you should negotiate appropriate carve-outs, including gift certificates (until used), employee discounts, taxes (of all types) and sales of fixtures.

  • Use. A more general use clause is preferable to a specific use clause (e.g., restaurant vs. Mexican restaurant). You may wish to change the theme of the restaurant which can be more difficult if the use is limited to a particular food type. Also, for a restaurant located in a shopping center or food court, consider whether the landlord will agree to an exclusive use for your particular type of restaurant.

  • Term; Early Termination Right. A new restaurant can be a risky venture. It's best to obtain as much flexibility as possible, either by having a short lease term with several options to extend, or by negotiating an early termination right at a reasonable cost.

  • Options to Renew. Options to renew the lease should have clear mechanisms for determining rent for the renewal terms as efficiently as possible, particularly if rent is based on fair market rental value. Generally, we recommend baseball arbitration whereby each party simultaneously submits to the arbitrator its determination of the fair market rental value of the premises and the arbitrator chooses which of the two proposals is closest to what it believes to be the fair market rental value of the premises. This approach encourages both sides to be reasonable.

  • Security Deposit and Guaranties. Many landlords will require a significant security deposit or a personal guaranty from the principals of the tenant, particularly for new restaurants. Although, as a new venture, you may wish to preserve as much cash as possible during the early months of operation, it may be better in the long run to negotiate a higher security deposit as an alternative to providing a personal guaranty.

  • Assignment and Sublease. You should negotiate the right to assign the lease without landlord's consent upon the sale of the restaurant. Also, the issuance of equity in the tenant to raise additional funds should not constitute an assignment requiring the landlord's consent.

  • Parking. Parking is important to most restaurants. If parking spaces are provided in the lease, make sure to understand the terms of the parking and landlord's obligations to maintain and police the parking area so that you may have the full benefit of your parking rights.

  • Self-Help Rights. If the landlord is responsible for repairing certain building components, such as the roof or the HVAC system, you should negotiate the right to use self-help in the event that landlord is not performing its obligations in a timely manner. If the landlord does not reimburse you for repair costs, you should have the right to deduct the cost from rent due under the lease.

  • Utilities. Many restaurants are located in buildings where utilities are shared. You should make sure that the sharing is fair, particularly if no separate meter is provided; or you should have the right to install a separate meter.

  • Hidden Costs. In addition to base rent and percentage rent, many leases include obligations to pay such items as real property taxes, landlord's insurance, operating expenses or common area maintenance, advertising fees, utilities, and repairs. Make sure you understand these obligations and negotiate them as appropriate.

  • Outside Areas. Negotiate the right to use sidewalk and other outside areas. (Sidewalk use may require a separate permit, however.) Consider negotiating the right to use common areas for special events on a limited basis, such as Sunday brunch.

While the foregoing are some of the most important issues to consider in negotiating a restaurant lease, there are many other issues of equal or lessor significance. A restaurant lease is an important document, and the restaurant owner should hire competent legal counsel to review and negotiate it.

If you have questions about any of the issues raised in this article, contact Kenneth A. Neale at 415.677.6322 or your usual Howard Rice attorney.

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