Pick Up Stix, a San Clemente,CA based chain of fast casual Asian restaurants, has shuttered 26 stores in Northern California, Nevada, and Arizona as of January 15, 2008. Apparently there was no notice given to the local employees, according to the buzz on Elk Grove, CA based Elk Grove Online (requires registration).

Higher Sales Volume and Costs Justify Higher Rent for a Freestanding Drive-Thru As Opposed to a Strip Center Endcap or Inline Shop Space–But How Much Higher?

From Lyle in Illinois

Q :We are looking to open our first fast food franchise location. We have found a location which is an ex-fast food location with existing drive through and the building size also fits what we need.
The location is in anchored strip mall with a grocery store and a few other brands. Asking price for the inline strip shops is $24-$25 psf (NNN) per year, but the freestanding building landlord is asking about $50 psf for the 2,400 SF building. My questions are:
1. Does this make sense?
2. What can we do to bring the rent down?
3. How can we estimate sales from the demographics or traffic count?
4. Any other ideas?

A: This is a great question,Lyle, and involves some time and basic math. Let’s get into it.

Let’s assume for now that the landlord is firm, and we’re working to determine sustainable occupancy cost for your fast food franchise. Here are some factors:

1. Replacement Cost for a Fast Food Drive-Thru

2,400 SF of building will need about 24,000 SF of land to self-park and meet code which is probably about 1 space for every 3 seats. You didn’t say if it was a hard corner (on the intersection, no setback), so let’s assume it’s an outparcel in the center, and for a small piece we will give the land a value of $14 psf, or about $336,000.

The construction cost for strip mall with a basic interior finish runs about $125 psf (I’m guessing again, it’s more in California, what isn’t ) , and as we have a very small building we’ll say $200 psf, or about $480,000 to reach the same level as a strip mall buildout. BUT, I’m going to add $100 psf Lyle, because you probably have a 400 amp panel, floor drains, lots of plumbing and wiring, fixtures, etc. That’s another $240,000 and that includes permits and fees. So far…

Land: $336,000
Building: $$480,000
Extra Restaurant Improvements: $240,00
Total Estimate Drive Thru Building Replacement Cost: $1,050,000+/-

Landlord ROI= 10%=$105,000 per annum= $43.75 psf. So, we’re close, Lyle, depending on the condition and age. We’re on the edge but not off the radar from the cost approach.

2. Calculating Break Even Rent with the Market Approach

I’d like to see you pay no more than 10% of gross sales in rent for a freestanding drive-thru in the suburbs. Your retail shopping center lease form probably calls for percentage rent of 6%-7% of gross as we discussed this <a href=”http://localcenters.com/retailing/featured-5/”> article on estimating sustainable rent</a>, but while we talked about in our article about how to estimate sustainable rents, 12% for a sit down restaurant, your margins are thinner and a10% rent factor on stabilized volume is where you need to be.

$50sf rent x 2,400 SF= $120,000 annual rent/.10= $1,200,000 annual sales volume. That’s $100,000 per month, $25,000 per week and $500 psf in sales volume.

Here’s where your franchisor needs to help you. That’s a lot of volume for a Starbucks, low for McDonald’s, about right for a Church’s, on the low side for Chick-Fil-A and the list goes on BUT, other than Starbucks those stores are about double the size of yours.

I don’t like it, Lyle, this is why we fix a rent point first and work backwards. What 2,400 SF operation could do that volume? Why did the past tenant leave? I’m feeling like the deal-killing attorney here

I think your question is answered, if my estimate from 2,000 miles away without knowing your specifics are even close to being accurate, I think you need to meet with the landlord, tell him it’s a great location and he’s the greatest guy in the mid-west, but the numbers don’t fly, and could he help you understand how you can make money here??

I am visualizing a B to B+ location, not on a hard corner, dark store, and am estimating volume at $750,000 a year. Sounds like a $33 deal to me. Let us know how you deal works out, Lyle! ~LC

From Dennis in Keene, NH

Q: We have financing and are looking to make profit managing a 6-10 store strip mall. How can we get help in finding anchor stores for our project? thank you…

A. Dennis, if any of us had the definitive answer there would be no one to compete against us, right?

It’s a great question, and I will try to make the response somewhat specific to you and your vicinity. First, you used the word “anchor,” and we typically don’t have anchor tenants in strip malls. An anchor is a larger tenant like a grocery store, a discount box store, or a deparment store that activates the gravity model of a critical mass of on site shoppers. We don’t achieve that critical mass in strip malls, and as such we have to cater to the convenience tenants who are often essential services, not luxury or discretionary-based shopping goods.

In your case, your town is about 25,000 which is a small market but viable. In addition, I see arterials meeting in Keene from every direction, so your trade area is expanded, and that’s always a good thing!

Tenants come to you usually in one of five ways:

• Sign call
• Broker
• Referral
• Walk and Talk
• Direct Marketing

Signing: Brokers may tell you of their intense marketing plans, and if they do it that’s great. The fact remains that your prospects are usually not obvious, and about 65% will initially inquire from a leasing sign on site. That sign should look good, and the biggest line on it should be the contact phone number. And I mean BIG.

Broker/Agent: It’s unlikely there are any large firms in the vicinity like CBRE or Grubb and Ellis, so if you go with a listing leasing agent, and in your case as you’re not experienced I would, you will have to select an experienced commercial agent, not a house broker. They not only need to know WHO to talk to, but HOW to talk to them.

Referral: You seemed like a nice, talkative guy in your email, and as long as you’ve been in your particular business, I’ll bet you’ve met most people in Keene! Pick out some key local business people, get a good looking plan and duplicate it, and show it to them. Ask them if they have any ideas of someone who could benefit from that location. They will talk it up, I promise. Be sure to “remember them” with a nice bottle of wine or even a check if they have an idea that works out for you.

Walk and Talk: The difference between Referral and Walk and Talk is that you pick the prospects and go talk to them. If you’re not a salesman this can be intimidating, but once you make your third call you’ll get in the rhythm and will probably enjoy it.

One of the most exciting things about strip mall leasing is that everyone loves to talk about shopping and retailers. Even after 30 years in the business and owning a number of strip malls, I still “cold call” because there is an exponential progression of local knowledge to be gained by doing so. Don’t assume that the person you call on must say yes; but expect many to be your referrers to real prospects!

Direct Marketing: It used to be mailing to a prospect list, but we use email now. It’s effective if you think out the right prospect categories, and you can find most business emails on the internet. While we’re very careful about spamming the general public, most businesses are pleased that you thought of them, and they like to know about new projects too.

Hope this helps, Dennis. We will be publishing several articles in much more detail about each of these methods soon. Thanks for writing, and good luck being a developer!

John

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From Kathy in Athens, GA

Q: I have been approved for [xx] franchise, and have found a strip mall in a good location. The landlord is not moving on the rent. How do I know how much rent I can pay?

A. Kathy, I’m deleting the franchise name and will send you a complete percentage rent table, and I will explain how to use it. For this discussion, I found a short version of a percentage rent table here.

Here are some steps to take which aren’t a substitute for a sophisticated income model (which this franchisor doesn’t typically use), but will give you an estimate that’s fairly close to the maximum sustainable rent you can pay.

1. Shop around in comparable locations. Yours is a common use so you won’t be able to get in to some places as the use will be taken, but ask the leasing agents and even the shop owners what they are paying. You should be able to determine if your landlord’s rent is in the right range.

a. Don’t forget to ask the triple net rents, or CAM. They can vary widely between centers, especially if the property has been reassessed upon a sale. Here in California the CAM can increase dramatically after a sale is closed, from the property tax increase.

2. Look at the percentage rent tables; in your case the typical percentage rent is 7%. Although most strip mall leases do not require percentage rent clauses or the landlord often will waive them, we should understand what they mean. Let’s say the minimum base rent is $24.00 or $2.00 per square foot per month. Divide the annual base rent by the stipulated percentage rent figure, and we arrive at $343.00($24/.07). Remember, we’re discussing square footage, not absolute rents. Multiply your space square footage, let’s assume 1,2000 s.f., by $343.00 and our product is $411,600. When you have a percentage rent clause, that figure of $411,600 is known as the “break point.” If your annual sales are above that figure, you will pay the greater of 7% of your gross sales, or the minimum base rent of $24.00 psf. So, if you did $40,000 per month, or $480,000 per year, your adjusted rent would be (7% x$480,000)= $33,600, whereas as if you did less than your breakpoint of $411,600, your rent would be $28,800.

The significance of hitting a break point is that your rent has dropped to a highly favorable( read low) percentage of gross sales. In the past two decades CPI increases (which our legal contributor Dave Durrett does not recommend) or fixed annual increases have all but replaced percentage rents in strip mall leases, but the calculation is significant for calculating commercially reasonable rent levels for each category of business.

3. Take the table percentage and double it. In your case, that means you can pay around 14% of your sales volume in base rent and sustain operations. This is a very rough estimate, but sometimes close enough for a go/no-go decision.

4. Divide the quoted minimum base rent ($24) by the doubled percentage figure (14%) and we arrive at $171. Multiply by the square footage of 1,200 and we arrive at the lowest volume needed to keep the base rent at 14% of gross sales, or $205,200 annual sales volume. If your sales volumes are at that level or better you should be fine (in your business; rent levels differ for each category) but with volumes below that figure you might have trouble breaking even as your rent would exceed 14% of your sales.

5. Divide and Conquer. $205,000/ 12 months = $17,083/4 weeks = $4,271 per week volume to pay the bills.

Can you do that, Kathy? Looking at a recent aerial photo, your location in Athens doesn’t appear to be in the newest growth area, but if it’s stable I think you can do those volumes with that franchise.

Capsule Notes-Estimating Maximum Base Rent Payable

 

• Ascertain average vicinity rent levels
• Find the appropriate percentage rent factor
• Double that factor
• Divide the annual base rent by the doubled factor
• Reduce to monthly or weekly as needed
• Your decision is now can you produce the minimum sales volumes to sustain operations?

The conundrum with taxation and real estate is that the demand for much of US commercial property is inversely proportional to the reduction of tax rates.

As such, Fair Tax advocates such as Ron Paul would not do our industry many favors over the mid term. Over 50% of all income producing properties purchased in the US are wrapped in an IRS 1031 Deferred Exchange agreement, wherein the purchaser elects to defer the payment of capital gain income taxes until the property, or its successor, is sold.

One may argue that the buyers of such property would have more after-tax capital in the event of a substitution of a national consumption tax for the current income tax, and thus more liquidity to purchase income producing properties. There is no argument there, however if there were not tax advantages for many income producing properties, and especially smaller properties like our strip malls, one could arguably postulate that those investors would demand a higher return rate (Cap Rate) than the 7% or so we are seeing today.

The worst possible scenario would be raising taxes and eliminating capital gains. Currently a 1031 exchange is predicated on a holding period equal to the capital gain qualification period. With higher taxes and virtually no tax incentives, cap rates could easily become double digit once again as we experienced in the late 70s and early 80s. With a chasm-like positive leverage gap created between the cap rate and the current mortgage loan constants, one of the two would have to normalize over time. I’d bet on the mortgage bankers, and you really don’t want to be on the wrong side of that bet.

The most significant Congressional act of my career was Tax Reform Act 1986. Prior to that reform, there were so many loopholes and incentives for purchasing investor real estate that there were actually promoters guaranteeing negative cash flow to unsophisticated investors. TRA 1986 jettisoned most of these tax advantages and shortly thereafter real estate was once again valued on…..cash flow! And that is as it should be.

Ron Paul is not a contender, but we’re still on the sidelines as buyers until we get a little clarity of what the new administration and the Congress might bring us in 2009.

Using the CPI Can Cause Major Problems in Collecting Those Rent Increases!

By Legal Contributor David Durrett, Esquire–Cohen Durrett, LLP

Many commercial lease structures include rent adjustment provisions that rely on changes in the Consumer Price Index (”CPI”) which is assumed to reflect the cost of living increases, if any. Unfortunately, landlords do not appreciate that the U.S. Department of Labor, Bureau of Labor Statistics publishes many indices and does not publish every index every month. Also, the base year for comparison, the year on which the rental increases is to be based, has been changed for some indices. The calculation of the rent increase can be done for the single year just completed or for the period of time back to the original date of the lease.

Ironically, the negotiation of a CPI clause often results in a tenant’s desire for a ceiling (e.g., not to exceed five percent per year) and a landlord’s desire for a floor (e.g., not to be less than two percent per year). In essence, each party desires some certainty concerning the rent adjustment.

Because of the risk of using a CPI provision, landlords may be better served by simply increasing the rent by a fixed percentage each year.

Aside from often not clearly indicating the appropriate index, landlords often forget to enforce the CPI clause and to make the required calculations. If a landlord should fail to make the calculation and advise the tenant of a rent increase, then the landlord may be surprised to learn about Section 2076 of California’s Code of Civil Procedure.

Section 2076 requires a person receiving money, at the time the money is received, to object if the money tendered is insufficient. If no objection is made, then the person receiving the money is considered to have waived any right to additional payment. Based upon this statute, the California Supreme Court held in the case of Julian v. Gold, 214 Cal. 74 (1931), that

a landlord cannot demand payment of rent for past months if he has already accepted partial payment for those months without objection

. A similar result occurred in Bettleheim v. Hagstrom Food Stores, 249 P.2d 301 (1952), where a landlord was entitled to an increase in percentage rent from two percent (2%) to four percent (4%), but who continued to accept two percent (2%) by mistake. The appellate court held that the landlord lost its right to demand the additional two percent (2%).

Too often landlords contact attorneys after they have forgotten to send the tenant a notice of an increase based on the CPI adjustment. Section 2076 poses a problem as to the rent already collected. Landlords would probably be better served by using a rent schedule that shows fixed percentage bumps that require no future calculations by either party over the course of time. Of course, this still does not relieve the landlord of comparing the check with the rent schedule. The underlying theory for such a schedule is to keep it simple. If landlords feel that complexity makes the provision better, then attorneys will profit in resolving the complexity.

Attorney David Durrett has practiced as a shopping center lease specialist for over 25 years in Northern California. David has represented Fortune 500 clients and sole practitioners. He can be reached durrettatcohendurrett.com, or at (916) 927-8797. Neither Cohen Durrett nor Mr. Durrett are offering legal advice with this article, and any legal questions pertaining to this content should be directed toward your legal counsel.