Franchises and the importance of retail leasing

With overall annual rates of retail sales growth plunging from nine percent in mid 2004 to 2.5 percent currently, joining them have been WC Penfold, Lindcraft, Lawrence Mansours, Can Can, Kernels , Juice Station, NrGize, Collins Bookstores , Danoz, Wayne Cooper, The Muses and Gaslight, all striking difficulties recently.

It is crunch time for retailers and mall owners. Booming sales growth has masked excessive property costs, but with occupancy costs at an all time high and a softening retail outlook, sick times are ahead for ill prepared retailers. Retail expert Stephen Spring looks at the background and offers these tips.

Every working day, I interact with numerous retailers in differing locations and circumstances.

They are independents, franchisees, chain store owners, directors and franchisors. In my speaking engagements, I’m privileged to talk with retailers in many diverse retail sectors; normally enthusiastic, passionate and energetic about their colleagues, their industry, their food or merchandise and peak selling seasons.

Sadly, in recent months I’ve noticed a quiet uneasiness in many retailers that seems more pervasive than previous years. Many share the problem that just about whatever they do to make their business better above-the-line, the question of below-the-line occupancy costs remains their greatest challenge. All their efforts sourcing best buys to improve sales and margins, all the hard work merchandising, improving recipes, training staff and communicating with customers – in other words, being better retailers – is eventually passed to the landlords. They love their work, yet many small retailers with meagre resources and facing dwindling profits seem helpless as cash and credit lines dry up and they cannot wait to escape the clutches of their onerous lease.

For a huge chunk of retailers, the thing keeping them awake at night is how to meet the next month’s shop rent – often their single biggest overhead and risk. And it seems cries for rent relief often fall on deaf ears, singling out the likes of Westfield, Lend Lease, QIC and other listed property giants who are in the business of making money for their stakeholders, not assisting struggling retailers.

With overall annual rates of retail sales growth plunging from nine percent in mid 2004 to 2.5 percent currently, joining them have been WC Penfold, Lindcraft, Lawrence Mansours, Can Can, Kernels, Juice Station, NrGize, Collins Bookstores, Danoz, Wayne Copper, The Muses and Gaslight, all striking difficulties recently.

Lately, JB Hi-Fi, Just Group, Strathfield, Rebel Sport and Millers Retail have indicated their earnings will be affected and some have announced store closures. Not all the problems are specifically rent related, but are these early warning signals, perhaps a bellwether of things to come? Is there anything that retailers can do now?

On the other hand, many retailers are expanding. Nespresso, Kookai, Zarraffa, Shakespeare’s Pies, Husk and Fellas to name just a few are reported to be hunting for sites. When one store closes, another one opens. National chains won’t disappear from the mall or strips, national franchisors are always advertising for franchisees and there are not that many empty shops in my neck of the woods.

But what about the small guy, the one of 40,000 shops in the nation’s malls, perhaps operating in one, two or three locations and looking to the future with trepidation. What can they do?

“Landlord’s brace for lower rents” headlined Carolyn Cummins in the Sydney Morning Herald’s property section mid July, explaining that lower sales throughout the economy and squeezed margins mean a smaller piece of the pie for retail landlords. She predicts “a year of flat to negative rent increases from tenants who are feeling the pressure of falling consumer sales”. She goes on to say that, “if income at the cash register is lower then the landlord will have to keep occupancy costs flat or face retailers leaving”.

“Danger signs emerge” says Jacqui Walker in a recent issue of BRW, writing about vulnerable franchise operations that have ridden high on upbeat consumer demand, quoting Cassandra Michie from PricewaterhouseCoopers who says, “The economy has been very good and there has been a natural growth that may have covered inefficiencies in the business” but, she warns, “…a huge number of franchise systems are operating in marginal territory – about 60 percent hold fewer than 30 franchise units. To survive we estimate that franchise systems will have to achieve critical mass of at least 20-30 stores to generate enough revenue to sustain marketing campaigns and system overheads”. Are these franchise systems facing the same battles as the small guys? My guess is yes.

As I go about my business of consulting to retailers at grass roots level, it is obvious seasoned retailers saw danger long ago and implemented a program to protect themselves. And they didn’t have a secret formulae or employ overseas retail gurus. The astute retailers watched mall occupancy costs slowly creep from an average of 10 percent of turnover in the 1980s to 14 percent in the 1990s and with it now edging 20 percent, many realised that to survive they needed to do things differently. Other retailers just watched.

In the last edition of Franchising, Deacons Consulting managing director, Rod Young, said: “Many speciality retailers have developed an unhealthy dependence on shopping centres to provide traffic.” He went on to say that, “It is not unusual for retail franchise networks to have three percent of their turnover or less committed to advertising and marketing programs, and in many circumstances expenditure below one percent of sales, especially in food service franchises is seen as the norm. This has created a dependence on the location to create traffic rather than the brand and marketing program and as a result retailers without marketing skills will be ‘trapped’ in shopping centres.”

Young is exactly right. So to start with, smart retailers developed a unique offer and most lifted their brand recognition programs long ago.

But what Young doesn’t say when he writes “…Subway , Bakers Delight , Boost Juice , Nando’s and Hairhouse Warehouse . These companies have spent considerable time and effort in their branding and marketing program to create a model that survives in strip and CBD locations” is that those retailers are also best in their breed and have developed a product offer with a range of width and depth customers go out of their way to buy. In other words, they have become destinations in their own right. And that’s the second so-called ‘secret’. If retailers want to be beholden to often insatiable landlords, they just need a ‘me-too’ offer, a ‘ho-hum’ range and keep quiet about their shops.

If you’re an existing retailer seeking escape from the clutches of a landlord seemingly cavalier with your business interests, there are normally three pressure points to watch out for. These are commencing a lease, during the lease, and near the end of the lease!

First, it seems obvious that choosing the best location and completing a proper retail analysis and other homework before committing to any retail lease is the foundation of any sound retail decision, right? Think again. In my experience, too few retailers take enough time and effort in pre-lease enquiries and negotiations. And for franchisors, recent court actions make this process a legal ‘must do’. Many neophytes over estimate store revenue potential and ignore demographics, competition and other location characteristics, seduced by industry averages and landlord incentives. As a consequence, those retailers load themselves with high rents relative to sales and as one retailer put it, “when the rent train pulls out of the station, the hill ahead can be long, slow and very arduous”. Equally important is the capital and running costs of the enterprise. All costs must be factored in and be complete before being committing to a lease. If retailers haven’t done the retail homework to produce a robust business model, they should keep their pens in their pockets.

Second, small retailers often misunderstand the nature of a lease and fail to be proactive in their lease portfolio management. Too often a lease is signed and shoved in the bottom drawer. A lease is a contract setting out rights and obligations of landlords and tenants for a fixed period of time, but most speciality shop leases are governed by state-based retail legislation and also common law – a set of complex rules overriding retail leases regardless. Because it is almost impossible for most retailers to fully understand all aspects of lease management without a dedicated legal and property team, if the governing law and documentation is hard going, retailers must engage specialists in the area. To avoid leasing blues, it is vital retailers consistently inform themselves of changes to legislation and the retail property market operating in their local environment.

In fact, lease management is too important to ignore, delegate to an in-house junior or even a law firm without the necessary commercial and retail negotiation experience. Further, lease management software programs can impart a false sense of security. In the average NSW shopping centre lease, there are at least 20 critical notices that can impact retailers heavily. Ignoring them can have disastrous consequences. Many of these operate in complex areas of law, and clearly if a small retailer with, say, three shops is busy running the day-to-day and not across lease issues, potential for damage to the fledgling chain is high.

Moreover, most landlords will not hesitate to use lawyers to protect their interests, so the potential for unnecessary costs are compounded. In a one-off operation or single franchise, mistakes can wipe out owner operators and create a private financial hell.

Third, and to the most contentious issue in retail leasing today. What to do at lease end? Every few years, sitting retailers face the same agonising challenge and ask themselves: “How much is the landlord going to slug me this time?” and it’s a difficult time for many. In all states and territories, a landlord’s or tenant’s notice normally triggers renewal negotiations or generates a ‘bye-bye’ letter. Renewals should seem straight forward enough but one could be excused for thinking some retailers and mall managers live in fairyland. In general terms and unless compelled by legislation, the landlord is under no obligation to renew a lease. Normally it’s their freehold; they can do what they want with it. Equally, tenants have every right to walk away at the end of a lease. Things can get hairy if a landlord elects to deal with a tenant under a renewal, the tenant relies upon that conduct and the landlord changes its mind (lawyers, please note), but correct renewal decisions are vital.

Mall managers know many tenants are in weak positions at lease end and with livelihoods at stake, negotiations can be emotive. With assets on the line, mall management can easily kill a retailer’s business that may have taken many years of hard work to build up. They also know that a lease non-renewal may leave a crippling debt or bankrupt a retailer. Cavalier conduct may well attract a lawsuit.

A retailer with a five-year rent escalated five percent compound pays $63,814 going into the sixth year compared to a commencing rent of $50,000. At 50 percent gross margin, to maintain a 14 percent occupancy cost ratio, sales must rise 21.5 percent to keep up with rent increases. In many locations, sales are stagnant or falling due to macro-economic factors, competition, cannibalisation or mall lifecycle constraints. Any increase on renewal will obviously gouge the retailer’s profit or add to its loss. One retailer’s story is typical: “The rent was $117,064, but they [the landlord] demanded $208,366. We spend over $200,000 per year advertising. After 10 months of discussions they said they would settle at $153,000. The centre is in Sydney’s top five, but its overall sales were down three percent and down about 20 percent in our category. We relocated to another centre with annual rent at $105,000 all up with better exposure, higher traffic and a longer lease.”

From mall management’s viewpoint, lease renewals are the one chance to raise revenue, so most do their homework. After analysing trends in tenancy mix and profitability of individual retailers, weighing up the retailer’s relevance, rental values and hot retailers seeking space, many managers will risk a few vacancies squeezing tenants.

Mall management has noted the best and worst traders and their occupancy costs. They know the doomed retailers, the ones to be retained and those to be booted out and replaced.

They know hot brands, the building, the footfall patterns, shops needing re-fits and the future of major drawcards such as supermarkets or department stores. In an over-shopped world, the constant impact of malls nearby would have been evaluated, even using sophisticated computer models to maximise potential rental income.

With so much at stake, it’s little wonder the anxiety levels are as high as the expectations. But put simply, mall managers know the overall target rent comprising of individual tenant’s lease rental income and in short, they have planned ahead. Unfortunately, many retailers have not even thought about the end of their lease.

Remember the famous saying: “You don’t get what you deserve, you get what you negotiate.” Here are my tips to avoid end of lease blues:

1. Research local property and retail rents at least a year prior to lease end. This is key to knowing how to respond to any renewal offer. Prime yourself with information and costs well before any lease renewal negotiation. Rents go down as well as up, so bargain hard or walk away and relocate if the deal on offer isn’t in your best interests.

2. Take the view that if landlords can take commercial advantage, they will. This means retailers should consult experienced industry professionals or an industry association if lease transactions are new to them.

3. If the business isn’t profitable enough over the term to clear all outstanding debts and settle ‘make good’ clauses at lease end, retailers should carefully rethink the deal. Amortise all capital investment over the term and never rely on a further renewal. Therefore, when it comes to negotiating a new lease, a neutral and dispassionate position can be taken because there’s no remaining liability.

4. Identify industry trends, any emerging competitive threats and all micro and macro forces affecting the region and the location. These forces operate regardless of whether retailers take notice of them, but a savvy landlord will surely know them – and perhaps use them against the retailer in lease renewals.

5. Never be fooled into re-signing up to a bad deal to protect perceived goodwill in the location or the franchise. If the business is barely profitable on the passing rent, goodwill is minimal or non-existent and the future risk may well outweigh any future benefits or ability to sell.

Engelbert Humperdinck once sang: “Please Re-Lease Me, Or Let Me Go.” Wise words.

To find out more information about buying a franchise and running a franchise, read on.