By James Mitchell, Cushman & Wakefield
A store you would like to buy is for sale, but the owner wants to keep the real estate. You have no choice but to lease. You will want to structure your lease so that it gives you necessary protections and does not cause you loss of blue sky value plus hassle should you ever decide to sell. Key considerations are: lease term and renewal options, escalator provisions, assignability, and a purchase option. Unless all of these considerations are met to your satisfaction, you should seriously consider walking away from the deal.
Manufacturers prefer a long-term lease. It gives you stability of location, time enough to depreciate improvements, and assurance to a future buyer of location security. The combination of initial lease term and multiple renewal options gives a buyer maximum optionality. An ideal mix is a ten-year initial lease with three, five-year options to renew.
It is critical to track when a lease is up for renewal or scheduled to expire. Alternatively, the initial lease can provide for automatic renewal unless the lessee gives notification of intention to terminate.
A landlord will want an escalator clause. An escalator increases rent over the life of the lease to ensure a landlord’s rent is adjusted for inflation. The key drivers of lease expense increases are frequency of adjustment and how the escalation amount is calculated. Usually the adjustment period is annual, but in some cases, it is every three or five years. Most dealer tenants prefer a preset, fixed escalator. The industry standard escalator is about 2.5% per year.
If the assumed annual escalator is the same, a dealer who leases his or her property should prefer a larger reset rate over a long time period versus a smaller reset rate over a short time period. For example, if a lease agreement stipulates that the rate will reset every five years based on an escalator of equal to five times the annual escalator rate (2.5%), the lease cost will be 12.5% higher (2.5% x 5) at the end of five years. Conversely, if the escalator increases annually at 2.5%, at the end of five years – thanks to the compounding effect – the lease cost will be 13.1% higher.
While most tenants prefer the certainty of a fixed escalator rate, some landlords might prefer a floating rate. The attraction of a floating rate is that neither side is locked in prospectively so neither is unduly benefitted or harmed by unexpected deviations from a fixed escalator. But, the benefit of a floating rate to the dealer tenant is usually nullified in practice. Landlords almost always insist on a floor and a cap around the base lease rate. The range is a 1.0% floor and a 4% cap.
Furthermore, a floating rate can be complicated to calculate. It usually is based on the change in the consumer price index (CPI-U) from the beginning to the end of the escalation period. The idea is simple in principle but complicated in practice. We have seen lease agreements where the sections on calculation of rent escalation run to several pages because of the necessity to specify numerous details such as the actual day when the new rate gets calculated and when the new rate goes into effect. Our experience suggests that the benefit from creating a floating rate scheme is not worth the effort.
If you ever want to sell a store on leased property, it is critical to have a “friendly” assignability clause in your lease. Ideally, you want your landlord to have little or no involvement. A deal will fail if a buyer cannot assume your lease or the negotiation becomes too long and difficult because of landlord involvement. You do not want your landlord to be able to hold your transaction hostage. The easiest and fairest way to deal with this is to have a clause in your lease stipulating that your landlord “cannot unreasonably withhold or delay consent” to your assignment of the lease.
The most important feature of your lease is the purchase option. It is an absolute must. Without a purchase option your blue evaporates almost completely. At the end of your lease term, your landlord will have huge control over your profitability. They can kick you off the property if they want to change the use; they can jack up the rent. No potential buyer of your store would accept exposure to these risks. At some point, you as tenant must gain control over the real estate. The time to be thinking about what happens if you ever would want to sell your dealership is when you are buying and negotiating the lease.
Because the purchase option issue is so important, we will explore it more fully in a subsequent article.
Cushman & Wakefield Dealership Capital Services (DCS) specializes in buy/sell transactions, partner buyouts, equity solutions, debt restructuring and sale-leasebacks. James Mitchell has over 20 years of automotive industry experience. He can be reached at email@example.com or (202) 407-8120.