What gives a franchisor nightmares?

Try the escalating costs of retail space for their franchise system.

Let’s imagine I am a franchisor in Australia today, in a predominantly retail business. My biggest fears are the cost of retail tenancies in shopping centres, and how we control these costs for the future. I can fuel my fear by adding in the power of the shopping centre executives to alter the retail mix. I’ll throw in some pop ups/short term rentals to darken the mood. Suddenly there’s a nightmare scenario: the changes that can be made outside of my control can drastically harm my business.

In my view as an analyst, we have too much retail space in Australia. The space has become significantly over priced, and all the power lies with the shopping centre management.

So what can be done?

These are the crucial issues:

  • Sales changes in shopping centres vs rental increases
  • Five year leases with a litany of demands on renewal
  • Rental increases expected to be CPI + about 3 per cent per annum
  • How to control the retail mix to your advantage
  • The prevention of short term rentals / popups
  • Whether Government can influence shopping centre owners to create fairer terms

What gives a franchisor nightmares?

Shopping centre rentals in Australia are particularly high in comparison to mall lease costs in other countries. In fact in the US some shopping malls are closing so the land can be used for better purposes. In Australia to date, I cannot recall this happening, but we hear talk of shopping centres struggling to keep attracting good tenants. While we all know the likes of Chadstone, Castle Hill and Bondi Junction are going very well, other centres are struggling.

Big centres seem to be doing the best, and often re-invent themselves with new movie centres and outdoor alfresco dining centres. Many of the smaller centres lack these opportunities or financial backing and continue to struggle, often with decreasing revenues.

The question for a franchisor is how to evaluate the good centres from the poor performers. 

Shopping centres vs shopping strips

Most food based retail systems have a mixture of centre and shopping strip locations. The shopping centres have normally taken the lion’s share of stores. These outlets are where they not only achieve the most sales – they pay the highest rents.

The Sumo Salad experience a couple of years ago was very interesting. The company placed all its shopping centre leases into two holding companies separate from the main trading company. Luke Baylis, heading up Sumo Salad, then placed these two holding companies into administration.

Baylis’ action was intended to establish a negotiating position with shopping centre owners who were rejecting requests for rent reductions based on diminishing sales and profitability. Obviously the company had made a decision to exit all shopping centres, wanting to trade in lower cost shopping strips. This was a way they could break all the uneconomical leases.

I am sure Luke Baylis from Sumo Salad would receive fewer Christmas Cards from the shopping centre owners than I do. His actions were a real source of desperation to reopen negotiations on poor performing stores, but very effective.

Some may argue with the ethics of voluntary administration to nullify the leases. We can also question if this plays a part in some companies’ attempts to restructure or to renegotiate their retail leases.

Rental costs

I am not hear to defend RFG and the troubles they seem to have created for themselves. It is apparent that the largest and most public company facing criticism at the recent franchising inquiry is one which may place many of its issues down to retail rents. The majority of brands in its portfolio operate predominantly in shopping centres.

I recently discussed these matters with Jacqui Mance, former national leasing manager for Nandos. She spent much of her last year with Nandos trying to close stores in shopping centres, and minimising the costs. The terms required by shopping centres to release a failed location were extremely costly. Even though Nandos was a major tenant with some of the larger landlords, each one wanted to maximize their return – even in closure.

Mance believes rents have kept escalating despite strong evidence of sales decreases. The disruptors in food delivery services have added a further cost to franchisees. At the same time fewer customers are eating in restaurants which means a reduction in high profit sales such as alcohol.

5 year lease terms

Five years is the predominant time frame for a shopping centre lease. A brand with significant strength may increase this to six or seven years. However the idea of an option is something that has vanished from shopping centre vocabulary. Unfortunately this fails to deliver long term security, and the power remains with the shopping centre. Landlords can make very high demands on tenants near the end of the lease period.

A tenant rejecting these demands is faced with walking away, the loss all the fit out costs, and incurring significant costs to restore the site back to a vacant shell. Power is totally in the shopping centre’s favour, and every franchisor will have horror stories along these lines.

One friend of mine, a long term jeweler, has been astonished at the demands he regularly faces near the end of the lease period, specifically around the re-vamping of his stores. He recalled one leasing executive forcing him to spend about $50,000 to redo the internal lights of a store. Five years later, the next executive demanded a return to the original!

So what’s the solution? The best answer would be to create a fairer environment with retail legislation altered to create lease periods with options, and suppress the power of the lessors to make unreasonable demands at the time of tease renewals.

Rental increases

The Government and the Australian Bureau of Statistics spend significant monies reporting the Consumer Price Index (CPI) as a way of measuring the level of inflation in Australia. As an oil industry property manager, I went through a process of changing our service station leases from fixed rental increases to CPI. The situation changes over time, and what may seem a fair increase five or 10 years into the future can be completely crazy when the time arrives. 

The oil industry use to work on the lesser of CPI or 7 per cent as the increase which many land owners demanded be written into their leases. At one stage Australian inflation was running well above 7 per cent, and within a few years we had a year of -0.3 per cent. The companies who were locked into what we call a “ratchet clause” increase suffered very badly.

Our view has always been the CPI should be a major part of the measure – but not numbers like CPI + 3 per cent. The problem is obviously the compounding effect of this. CPI is acceptable but a compounding of the 3 per cent in effect causes a further rise to 19.4 per cent above the five-year CPI increase.

The changing retail mix

Over many years we have seen the destruction of the small retail fashion chains, which took up a significant amount of the specialty retail sites– the areas where the shopping centres charge their highest rentals. Brands like Roger David, Pumpkin Patch, Metalicus, Laura Ashley, Ed Harry, Herringbone and Rhodes & Beckett have all closed in recent years. 

Much of the reason has been the shopping centre owner’s willingness to lease out large spaces to brands like Zara at a very low entry rent. I am keen to see a level playing field, especially in their fixed costs like rentals, and rent increases.

Flogging the food space

As this part of the business has created large vacancies, we see the replacement of this space often in food related services, and in the end – we can only eat so much! Shopping centres used to have a few café’s and coffee shops scattered around, each with about 10 tables and 30 to 40 seats. Now you see more outlets, with many of the larger coffee shops able to seat 150 customers.

We undertook a measure at one shopping centre (where we had been an expert witness in a legal case), and the number of seats available for cafés had trebled over a 10 year period. Some of the coffee shops we saw had relocated from a 30-seat café neighbouring the food court to a 100-seat café about 30 metres away. The typical Gloria Jean’s or Coffee Club is now a much bigger store than 10 years ago.

It becomes very tempting for landlords to open more food businesses despite no upturn in customer traffic. I guess this eventually affects the overall Australian health and lifestyle as we are continually tempted to eat more cake and drink more coffee.

The advent of pop ups

We have lost the sense of spaciousness in shopping centres with layouts that made it easy for customers to walk around. Progressively, this space became a new income source as landlords developed short term rentals. What probably started as a use of a general area for four weeks by a tenant selling books or gifts in the lead up to Christmas has now become permanent. 

This has a couple of effects on existing tenants. These pop ups are normally placed down a wide aisle which creates a visual barrier preventing customers spotting other shops. They also create significant new competition.

I was recently in Hong Kong where the retail spaces are beautiful, and space seems to be respected. One shopping centre had a couple of pop ups in fairly fixed locations, and the existing tenants could pay for the use for a period for a special event. In one case Salvatore Ferragamo had a free paper folding class for a few days, where customers could learn how to fold up and make small gift boxes in the Ferragamo colours.

In another case a fantastic stage was set up for high-end retailer Tod’s, which had a special showing of its new products.

Pop ups can have their place but this should not be to the detriment of the long term store lessees.

Summary

Overall, the current retail laws and regulatory environment has placed the strength with the owners and lessors of shopping centres, and it seems our Government is happy to leave it that way. The franchise sector has taken a hard hit from the franchise inquiry. But we must ask how much of the plight of the retail industry is caused by the actions of the shopping centre owners. We should also question whether the ways they operate should be critically reviewed by Government and the regulators .