What’s the largest obligation that a company has on its books? For many companies, it’s debt. Perhaps less obvious is another cost gorilla that may be lurking in the room – it’s a company’s aggregate lease obligations.
This refers to a company’s obligations under its leases of premises, including rent, maintenance costs and taxes. For retailers, restaurant chains and other real estate-intensive businesses, the aggregate obligations owing under leases can be very large. Whether or not those costs are effectively managed can have a significant impact on profitability.
Lease obligations tend to fly below the radar because rents under operating leases are expensed on a company’s operating statement. That accounting treatment will change if lease accounting standards that are currently being developed are enacted. The new standards would effectively eliminate all operating leases and require them to be capitalized on a company’s balance sheet. The new standards will convert lease obligations from essentially off-balance sheet treatment to front-and-center treatment on the balance sheet, alongside debt.
Regardless of the accounting treatment, gross lease obligations, if significant, deserve the attention of the company CEO. Problem is – while gross lease obligations are important to manage, companies tend to relegate this duty to a real estate officer who reports to a C-level officer (often the CFO), who in turn reports to the CEO. In order to stay on top of lease obligations, the CEO will need to know the right questions to ask.
What then are the questions that a CEO should be asking about lease obligations (aka, occupancy costs)? Here are a few suggestions:
Question 1: What are our aggregate lease obligations?
Know where the aggregate lease obligations rank among the company’s largest obligations. On an overall basis, aggregate lease obligations may rank in the top handful of a company’s obligations, along with debt, payroll and cost of goods sold. The leasing obligations relating to even a single location can be significant. In many cases, the occupancy costs of a relative few locations can have a significant impact on profitability. For example, our firm recently saved a national restaurant operator over $3.38 million by reducing leasing costs at just seven locations.
Question 2: Are we actively managing our lease obligations?
Lease obligations and ongoing occupancy costs arise when a lease is inked. As such, the natural tendency may be to examine lease obligations before a lease is signed and when the lease comes up for renewal. We suggest a more rigorous approach. The success of a company’s locations, and the occupancy costs relating to those locations, should be examined in detail at regular intervals. This examination, which we call an “under the hood” analysis, is an essential first step in understanding where problems exist in the real estate portfolio and it provides a guide for solving problems.
Question 3: What does our lease review entail?
Experience suggests three levels of inquiry. First, has the company developed target lease metrics that are consistent with the company’s operating needs and objectives? Such metrics include targets for rent, rent escalations, term and options to renew. Second, is the company reviewing all of the lease obligations in its portfolio at regular intervals (such as, at least annually)? Third, is the company identifying problem locations within its portfolio and implementing a strategy to deal with each of them on an individual basis? For instance, is a location losing money, or has the profitability trend turned negative? If a location is losing money even before the occupancy costs are paid –a negative EBITDAR (earnings before interest, taxes, depreciation, amortization, and restructuring or rent) situation–, that’s a major red flag. This type of situation may mandate the closure of the location and a negotiated termination of the lease.
Question 4: What is our key metric for evaluating occupancy costs?
A review of the company’s leases should go beyond determining whether or not the rent payable under a lease is at, above or below market. Market rent rates may have little bearing on the success of a location. The more germane question is whether the occupancy costs of a location make economic sense for that location based on the location’s actual performance. For retail and restaurant locations, occupancy costs (rent, maintenance costs and taxes) should be compared with the sales generated at the location. If occupancy costs, expressed as a percentage of sales, exceed the target threshold, action should be taken.
The importance of occupancy costs as a percentage of sales cannot be overstated. In many cases, this single metric can foretell the success or failure of a location. Based on a recent sampling of 140 locations of two restaurant companies with similar businesses, there are some interesting trends. Of the stores whose occupancy costs exceeded 10 percent of the sales at the specific location, a majority of the stores were losing money. Of the stores whose occupancy costs percentage exceeded 13 percent, more than two-thirds of the stores were losing money. By contrast, of those stores whose occupancy costs percentage was less than 8 percent, fewer than 20 percent were losing money. Even stores with robust sales find that their profitability is less than optimal if occupancy costs are out of line.
Question 5: If our rent is too high, what are we doing about it?
Doing nothing is not an option. A signed lease contract should not deter taking action. In many cases, the landlord has a strong interest in retaining the tenant. There are multiple strategies that can be used to engage the landlord in discussions to renegotiate a lease. Finding the right strategy requires studying the lease and the specifics of each location. Bluffing and tales of woe generally won’t get results.
Question 6: Who is helping us?
A key factor in taking action to reduce occupancy costs is choosing the right team. Unless only a few locations need help, a team will need to be involved. Companies sometimes rely on internal personnel to handle the problems. Internal staff, however, may lack the negotiating experience and incentive required to achieve meaningful results. Emotions also can be an impediment to success. Internal staff may feel vested in prior decisions made and may lack experience in going toe-to-toe with the landlord. For these reasons, keep company personnel off the front lines and engage seasoned professionals to get the job done. Qualified outside professionals can achieve the best result for the company while, at the same time, preserving a good relationship with the landlord.