How do Lease Terms Impact the Business?
If you’re buying a business, what should you look for in the lease? Well, that depends. Let’s examine some of the issues.
The most obvious one is the rental rate. If the business you’re buying leases its location from an unrelated party – usually the case when the business is located in a mall, strip shopping center, industrial park, central business district, multi-tenant office building and similar real estate – the business’ financials should clearly show the amount of rent and related fees paid by the business in any given year. The business’ financial performance reflects these expenses and you might be able to assume that the future financial performance of the business will be similar if the rent does not change appreciably.
Some of the Issues
That said, most commercial leases include an escalation clause that describes the periodic increase in rent. In addition, many retail leases, especially in shopping centers, include a percentage rent clause which means that the “minimum” rent is just that: minimum. If you are a savant in business and the one you buy is wildly successful, you are likely to end up paying more than the minimum rent. More on that in a moment.
The next aspect to examine is to determine if the lease is transferable. Many landlords and property management firms do not allow a tenant to transfer the lease to a successor tenant, at least without the written approval of the landlord and the landlord will very likely charge a transfer fee and possibly alter the lease terms.
Another issue is the lease term. How much time is left on the lease term? Is there an option to renew? Is the rental rate for any renewal period described in the lease? If so, do you think the business you’re buying can absorb that increase?
There are many other aspects of an existing lease that will impact the profitability of the business, all of which should be reflected in the business’ financial statements, but these three are most likely to be impacted by a transfer of the business to new owners and any modifications are likely to impact the business’ profitability. So, let’s look at each more closely.
- Rental Rate – First, you must determine if the existing lease has an escalation clause, a provision that allows “builds in” a rental increase at certain dates, usually every year, or upon certain events, such as extending the lease for another term. If such a clause exists, it must be factored into your projections to see how it will impact the profitability of the business after you buy it.
- Is the lease transferable and, if so, at what cost? Most leases are not transferable without the express written consent of the landlord. In our experience, it would be unlikely that a landlord would not approve a lease transfer if the transferee (the business buyer) was at least as credit-worthy and reliable as the transferor (the business seller). If the lease is not transferable, your contract to purchase the business must be contingent on your ability to enter into a new lease with the landlord at terms that are acceptable to you.
- Remaining Term – This is a big one. How much time is left on the existing lease. This depends on a number of factors but the most important is the type of business you’re buying and the ease with which it can be re-located. You want to make sure that you have enough time to get a return on your investment. As an example, in a previous post, we referenced the pending transfer of a child care business in which the value of the real estate was low because the rental income was below market. But to increase the value of the real estate, the rent charged to the business would have to increase to a level that would not give the buyer even a modest return on its investment in the business within any reasonable period of time.
Minimum Rent vs Percentage Rent
I mentioned minimum rent above. Minimum Rent is generally paired with Percentage Rent. This is a common situation in malls and some shopping centers but mostly impacts retail businesses. Professional landlords and property management firms are generally run by smart people (Mom and Pops are completely different story) and will likely have some idea as to what revenue a particular business can generate in their property. Their object for their own revenue is twofold: they want a minimum rent that reflects what they believe the business can support and still stay in business. But, if the business does spectacularly well, the landlord feels, not unjustifiably, that the business’ success is in no small part due to the amount of traffic the landlord drove to the property. As such, the landlord will probably want a share of the “excess revenue”. (If you want more information on how this is computed – as well as other tips for addressing the lease that should be considered in your due diligence period – we put together a Due Diligence Lease Check List and you can download it for free here.)
There are multiple other lease terms and conditions that must be factored into your analysis of the business as a target to purchase. More of them are addressed in the Check List available above. As with anything else, the key is planning. If you’re a buyer, do you need to own the real estate? It’s unlikely. If you are a business owner and your business owns the real estate, when it comes time to sell – and it will – you are likely to find a much smaller pool of buyers which would generally translate into a much longer sale cycle. If you’d like to learn more about strategies on how to avoid these problems, leave a comment below.