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Restaurant Leasing Food for Thought - Key Issues for Landlords and Tenants to Consider

Jun 02, 2016

 

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By: Craig T. WatrousCraig_Watrous.jpg

 

In commercial real estate leasing, restaurants present a unique and particularly complex array of issues for landlords and tenants to consider. Due to the nature of restaurant operations, a restaurant’s use of commercial space often requires expensive tenant build-outs, city and local permits, special use considerations, ADA compliance, heavy traffic, specialized systems, and new equipment. There are often enormous upfront costs which have to be spent to get the space up and ready for the restaurant to open. The result is a game of risk and cost shifting between the landlord and the tenant. For landlords, restaurant leases can be very lucrative and also very risky. For tenants, the terms of the lease can shave away the razor thin profit margins that make or break the business. For these reasons restaurant leases are often heavily negotiated, complex documents that shouldn’t be taken lightly. This article attempts to summarize some of the key issues that both landlords and tenants should consider when negotiating their restaurant leases. Rather than take sides, we’ve tried to highlight areas in the restaurant lease that both the property owner and the restaurateur should consider. Of course the list isn’t exhaustive but hopefully it provides food for thought.

 

The Liquor License

            Many restaurants not only want a liquor license but depend on it for their revenue stream and to bring in traffic to the restaurant. The main question that needs to be addressed is can a liquor license be obtained for the premises? If the restaurant’s success depends on getting a liquor license for the premises, then the lease should be contingent upon the issuance of that license. This benefits both the tenant and the landlord. The last thing a landlord wants is to have a tenant who is doomed for failure. Similarly liquor sales often mean increased traffic to the premises which may directly benefit the landlord’s other tenants, potentially increasing the value of the real estate. Some factors to consider if the lease is contingent upon the tenant getting a liquor license:

  • Will rent be charged during the contingency period?
  • How long does the tenant have to secure the liquor license?
  • If real estate brokers are involved are the brokers’ fees also made contingent upon the issuance of the liquor license?
  • Can the tenant start renovations to the premises prior to issuance of the liquor license?  Who pays/removes these renovations if the license is not approved?
  • Will the tenant pay the landlord something (even if it’s not rent), while the property is withdrawn from the market pending approval of the liquor license?

 

The Certificate of Occupancy

            For properties that have been used in the past as a restaurant this is less of a concern. For new builds or properties that haven’t held restaurants before, the certificate of occupancy may not be a sure thing.  Some things to verify/discuss:

  • What does local zoning allow?
  • Is it economically feasible to convert the space into a restaurant? The parking, traffic, and access are just as important as the physical space.
  • Are there any existing building or ADA violations that need to be remedied? Who will pay for these?
  • Is the building up to date on code requirements?
  • Who will deal with these issues? Timing? Costs?

 

The Restaurant’s Equipment – Title and Sales Tax Issues

            If the tenant is bringing its own equipment then the lease should expressly spell out what items are considered fixtures and which are not. Does the space already have restaurant equipment in it that the tenant will be permitted to use? If so, then the parties need to consider the related title and tax issues. 

  • If the equipment is sold to the tenant by the landlord then sales tax will likely apply.
  • If the equipment is leased to the tenant in connection with the rent then a discussion with an accountant should take place to see if special allocations should be applied to avoid unexpected tax liability. 
  • If the tenant is going to be using equipment from a past tenant, then the tenant should make sure that the title to the equipment isn’t held by a third party (think equipment lease), who may demand the equipment be returned. 

 

HVAC

            The HVAC equipment for restaurants is significantly more robust than what’s needed for a typical commercial property. The tenant should have a qualified contractor review the space to inspect the condition, quality, and number of HVAC units and determine if they will be adequate for the restaurant’s needs. 

  • If the tenant needs to install additional HVAC equipment decisions need to be made regarding the location, installation, and type of equipment required by the lease. 
  • Does the landlord want to require that a particular contractor install the HVAC equipment?
  • The parties should also determine who is responsible for the HVAC maintenance, the schedule for that maintenance, who owns the HVAC units that the tenant installs, and who is responsible for replacing them if they die during the lease.

 

Hot Water

            Often overlooked, some restaurants need specialized hot water heating units. The following factors should be considered:

  • Does the space have them?
  • If not, who will pay for them?
  • Who will install them?
  • Landlords need to keep in mind that restaurant tenants will use a lot of (hot) water.  They may want the premises to be separately metered if they aren’t already.

 

Fire Systems and Sprinklers

            Restaurants need special fire and sprinkler systems.

  • Are the existing systems up to code? 
  • Who will pay for these costs?
  • Do they meet the tenant’s and landlord’s insurance requirements? 
  • Is the fire code’s occupancy limit for the premises enough for the restaurant to meet it table top needs?

 

 Electrical Systems

            Restaurants are generally large consumers of electricity.  The tenant needs to be sure that the electrical systems at the premises will meet its needs. The landlord needs to make sure that the tenant is responsible for its fair share of its electrical use.  

  • If more electrical supply is needed then the parties need to determine who will pay for the upgrades and what/whose contractors will be used.  
  • The tenant (and landlord), may want to go directly through the utility company.
  • If the premises are part of a multi-tenant building, then the parties should ensure that the tenant’s sub metering will measure just its use of electricity or that its pro-rata allocation is appropriate.


Gas Lines

            The parties need to confirm that the gas services to the premises is adequate for the restaurant’s needs. If more gas lines are required, allocation of the costs needs to be established. As stated above, if the gas isn’t separately metered then the lease should spell out how the tenant’s gas usage will be appropriately allocated to the tenant.

 

Exhaust Systems

            If the premises are stand alone, then this is an easier issue to deal with. If the premises are part of a larger building then the issue can become significantly more complex.

  • Installation, repair and replacement of exhaust systems can be very pricey.  Who will pay these costs?
  • If there are already systems in place, are they up to code? 
  • Does the landlord want to require that the tenant maintain a service contract with a specific company?
  • The landlord will most likely want any new exhaust systems to remain with/part of the premises after the lease expires.

 

Sewer Lines and Grease Traps

            Both the common sewer lines and the lines leading from the tenant’s space need to be assessed.          

  • The size and condition of the sewer lines should be reviewed by a qualified contractor.  If they aren’t in good shape or aren’t big enough, the landlord and tenant will need to negotiate who will do/pay for the work. 
  • The same investigation should take place with the premises’ grease trap.
  • If the premises are part of a larger development with other restaurants, does the landlord want to require that the tenant use a particular grease disposal company?

 

Miscellaneous Systems in the Premises

            The tenant and landlord should closely assess the suitability of the remaining systems servicing the premises:

  • What’s there?
  • What’s their condition?
  • Who is responsible for their repair/replacement? 
  • What new systems are needed?
  • Will installation of the new systems affect the building’s common areas?
  • Who will pay, own and maintain them?

 

Bathrooms and Other Access Issues

            The ADA has to be considered. Because a restaurant is a “place of public accommodation” it’s subject to the ADA’s access requirements.  Bathrooms always come up because they’re expensive and often not up to code. Another main item to be reviewed is the entrance to the restaurant.  For older buildings this can be an issue. An allocation of ADA responsibilities needs to be made in the lease. 

  • Are the premises warranted to be in compliance at the start of the lease?
  • Is the tenant responsible for maintaining the premises in compliance with the ADA during the lease?
  • Are indemnification provisions included?
  • Who is responsible for lawsuits?
  • If portions of the premises need to be modified, who will pay?

 

The Signs

            Restaurants need signage. Similarly, landlords want to ensure that the tenant is able to draw patrons while protecting the appearance of the property. If the premises are part of a larger building there may be some restrictions on sign placement, size and style. If the premises are older the tenant may want to install new signs.            

  • Location, size, type, style and related restrictions need to be hashed out in the lease. 
  • Can the tenant use temporary signs?
  • The landlord may want to put in specific restrictions on temporary signs, storefront window signs, sidewalk signs, etc.
  • Generally, the landlord is going to want prior written approval rights over all signage or changes to existing signs. 
  • If the tenant is a franchisee the tenant may have specific franchise signage requirements.

 

Term of the Lease and Renewals

            Restaurant leases often have longer terms than other commercial leases. For landlords, because so much cost is put into the space prior to the lease, a longer term helps to recapture some of the upfront costs. For tenants its always location, location, location. If that location works, the tenant will want a longer term and lease extensions to lock it in. Of course, when things are going well both parties will want the lease to continue, but considerations should be put in place regarding not only the initial term but also renewals and extensions. While the tenant may want automatic extensions, the landlord should consider putting in provisions that protect it from getting locked into a long term relationship with a problematic tenant. If the tenant has had defaults in the past, the landlord may want discretion over future renewals.

 

Security Deposit and Personal Guaranty

            It’s well known that restaurants regularly fail. Keep in mind, most restaurant equipment is leased, so when a business goes south often a landlord’s best hope of recovery is to go after the tenant’s security deposit. Thought needs to be put into how much deposit is reasonable while still working within the restaurant’s initial operating capital needs. Does the landlord want to require a personal guaranty from one or all of the restaurant’s principals?       

 

Parking

            The parking can make or break a restaurant. However, it’s not just the parking for the restaurant’s patrons that needs to be considered but also parking for the restaurant’s employees. For property owners, if other tenants use a development’s parking facilities, they need to be careful that the restaurant doesn’t monopolize the lot.

  • How much parking is available?
  • Does the restaurant want/need reserved space?
  • Does the landlord want to require that the restaurant’s employees park off site?
  • Security issues: are their parking attendants, lights, guards?
  • Will the restaurant require a valet service?
  • If part of a larger development, can/will the tenant be charged for parking garage use?
  • Parking lots are expensive to maintain and replace. Maintenance and repair issues  should be carefully laid out in the lease?

 

Ambiguities in leases lead to great lawsuits.  A standard, off-the-shelf form, likely won’t address the particular needs and concerns of the restaurateur and property owner. It’s worthwhile for both parties to spend extra time upfront negotiating lease terms and putting the details in writing. We hope this article has been helpful.

 

(Mallon Lonnquist Morris & Watrous, PLLC, is a business, employment, real estate, and litigation law firm. Craig T. Watrous is a Colorado real estate attorney and partner at MLMW, based in Denver, Colorado. Craig regularly represents clients on both sides of restaurant leases. Craig can be reached at cwatrous@mlmw-law.com and (303) 722-2165.)

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