Fixing Key Financial Issues in the Restaurant Industry

Last month I addressed specific financial fixes for casual dining. This month, I’ll dig deeper into three areas of concern: dealing with problem stores, leases and senior debt.

There are always underperforming stores, both franchised or non-franchised. Sometimes, franchisors won’t deal with bad stores until the franchisee is on the steps of bankruptcy court. And landlords are often not interested in dealing with the problems either, especially when they are sitting on above-market rents. And finally, lenders are often reluctant to deal with these situations despite having available tools.

Let’s deal with problem one—store closings. Closing stores is a last resort. Usually, before closing a store, an operator has tried operational changes and is no longer able or willing to put additional money into the store.

A franchise store creates a unique situation. The franchisor must be reasonable in assessing actual damages. If a store doesn’t make enough profit, the franchisee can’t pay royalties—they have an investment they’ll lose, and will still incur fixed costs, such as rent. So, the franchisor should consider whether to continue to charge royalties, and whether to invoke personal guarantees on closed stores. Store-closings should be approached in a systematic way with the franchisor involved from day one—not to derive financial benefit from a distressed franchisee, but to help them so other stores are not jeopardized.

The truth is, many mature systems have stores that should be closed. Systems have overbuilt, population centers have changed and all parties must recognize this reality. Some of the franchisor’s issues, such as cross-default and development agreements, should be reexamined and revised. In many cases, development agreements were too aggressive. One approach franchisors take is to offset a closing by building another store. But there has to be time to find an appropriate site, and often the offset timelines are too short. In some cities, opening a new store within a year is a problem. Bottom line: Reasonable, non-punitive collaboration must prevail.

The second problem is above-market leases. Landlords come in three different groups: There are developer landlords who develop and own the single-tenant restaurant real estate. There are sale/leaseback groups where the property has been sold to an investor and leased back. And finally, there are landlords that own and manage multi-tenant properties. Each scenario requires a slightly different approach.

The landlord who’s developed and leased a store to an operator is the easiest one to deal with, because they’ve usually been involved from the beginning. Plus, they’ve
probably borrowed money for the development. If that’s the case, debt service on the property and the interest rate need attention. If the site needs to be closed, maybe there’s a way to get a buyout on the lease, particularly if the debt is a lot less than the original cost of the project. Secondly, if the site is viable but the rent is too high, negotiate a lower rent to cover the landlord’s debt service, or try to tie the rent to the interest-only portion of the debt service.

In case of sale/leaseback groups, a bad store may be part of a master lease. Try to get the landlord to think of the properties individually, and how you can make them viable so the overall master lease is more feasible. Under individual leases, the operator may have a stronger bargaining position, including the option of closing the store. Many leases involve personal or corporate guarantees, which need to be addressed, too. The question is what, if any, are the damages? In some cases, commercial leases require the landlord to find another tenant. The best thing is to talk—perhaps offer the landlord a percentage of sales vs. a fixed rent lease. Or, you might consider substituting another property for a bad one. Many leases have a right of substitution of properties.

Finally, for leases that are part of larger leased premises, landlords don’t like vacancies. If they want to sell the property eventually, they need long-term leases from high-performing tenants. Often, if there are other national tenants surrounding a poor-performing restaurant, replacement tenants may be an option for the landlord, so explore potential lease assignments and subletting.

The final problem is the structure and level of senior debt. Many lenders in this sector are large, and have a specialty in restaurant lending. These lenders are now grappling with the value of their collateral. In almost all cases, lenders do not want to take back the stores in any form of legal proceeding. In the case of franchise locations, lenders may have remarketing agreements with the franchisor that allow them to sell a store as an ongoing business. In most situations, lenders don’t want to see a bankruptcy, because they may be under-secured and may not be able to count on a secondary source of repayment such as personal guarantees.

The key here is to understand exactly what debt service level the operator can afford and then restructure accordingly. It’s not uncommon to enter into a forbearance agreement, where the lender stands still and provides time to dispose of assets to pay down the loan or negotiate a restructure and deal with documentation issues. Consider the options you have with a lender: Look for real estate or other collateral you can sell, or stores to close to improve performance within the remaining stores. An operator may have stores that haven’t been placed under the credit agreement. They can be added. At the same time, try to get royalty relief to help you continue to service the bank debt.

To have good projections, there must be an understanding of what the future brings, and cooperation among all parties. Be realistic, so you don’t have to keep renegotiating. There are practical solutions and it may be possible to work these
things out without getting near the bankruptcy court steps.

By Dennis Monroe

From the June 2018 issue of Restaurant Franchise Monitor

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Dennis Monroe