Occupancy Costs, Key in Location Profitability

ROSEVILLE, CA-“As the economy recovers, retailers and restaurant operators tend to overlook their underperforming stores,” says Jim Haslem, a principal with the real estate and financial restructuring firm Huntley, Mullaney, Spargo & Sullivan Inc. “Even if overall sales are up, companies need to maximize the profits from each location and align the real estate portfolio with the long-term corporate plan.” Haslem recently spoke with GlobeSt.com west coast editor Natalie Dolce on the many ways retail and restaurant operators can increase the profitability of their locations and to sync up their real estate portfolio with a company’s broader objectives.

Dolce: In what ways can retail and restaurant operators increase the profitability of their locations and to sync up their real estate portfolio with a company’s broader objectives?

Haslem: Occupancy costs are a key factor in determining the profitability of a location. Occupancy costs, which are often overlooked as fixed costs, are one of the largest costs in a store operation. If you can reduce those costs to the lowest level possible, the store can maximize its profitability. Occupancy costs can make the difference between making a profit or bleeding cash. At our firm, we conduct an “under the hood” evaluation of a company’s entire real estate portfolio. We identify the specific locations where occupancy costs are too high as compared with sales. We evaluate the location and what’s going on. Often we will visit the individual sites. We take a careful look at the lease. Then we engage the landlord in negotiations. The impact of restructuring the leases of underperforming stores can be significant on a portfolio basis.

- In general the commitment to a location should be aligned with the larger objectives of the business. For example, if you have a profitable location and you plan to remain at that location for the long term, you want to look for opportunities to set the rent at an attractive level for an extended term. This works in favor of both the landlord and the tenant because if the rent is priced right, the tenant is incentivized to make a long-term commitment to the location and the landlord won’t worry about filling the space for a long time. Typically, the minimum commercial lease is five years; however, if you are profitable and want to stay at a location, locking in the economics now is better than renegotiating when market conditions may be less favorable for the tenant.

Dolce: How does one go about identifying which stores to keep, which to shed and which need help?

Haslem: There are many factors that go into deciding which locations to keep, shed or help. We start by separating the stores into two categories – profitable and unprofitable. Once you have identified the unprofitable locations, the next step is finding out why. Oftentimes, the rent is causing the problem. Since occupancy costs are such a large part of the overall cost structure, making a significant dent in these costs can help turn around performance. There likely will be some stores that are losing so much money that no matter what you do, the store will not be able to turn a profit. Those stores should be closed. For instance, if the losses for the year exceed the rent, something is seriously wrong. That is a red flag that the store needs to be closed. There are multiple other factors that drive sales, such as location, visibility, access, concentration of competitors and demographics. These factors determine the value of a location to the tenant. If the rent is out of sync with the value of a location, action needs to be taken.

Dolce: What is your advice on renegotiating leases to increase store-level profitability and terminating those that need to close?

Haslem: In both cases, you are trying to find a solution that works for both the tenant and the landlord. That solution often requires compromises on both sides. If the landlord wants to retain a tenant at a location, then the landlord has an interest in making sure the tenant is making money at that location. If a location doesn’t make sense for a tenant, the landlord is better off to address the termination sooner rather than later in order to achieve the best negotiated termination possible and move on to a more suitable user. Vacancies don’t benefit anyone. Because of the multitude of issues that can arise and the potential for ego to be involved, an experienced third party often can achieve a better result for the tenant than the tenant could achieve on its own.

Dolce: How would you go about adjusting lease terms to align with corporate objectives and to profit from inflation? What is important to keep in mind?

Haslem: When renegotiating a lease, the tenant should examine the starting rent as well as the rent increase provisions. The trend of rent increases should be compared with the tenant’s best guess as to the rate of inflation over the primary and option terms. Tenants will want to keep their rent increases below the rate of inflation. For example, if the tenant thinks that inflation is likely to increase, then you want to make sure your rent is fixed or CPI-based with a cap. If, for instance, you have a 3% increase every 30 months, you can plan for this. If the landlord insists on CPI protection, establishing a reasonable cap is key. If inflation really takes off, the tenant will need to have real protection. A cap is a reasonable request from a tenant when committing to a location. Depending on how the landlord financed the asset, the landlord should be able to provide some cap on CPI. Another metric to consider is whether the anticipated growth in sales at a location will exceed the anticipated rent.

Dolce: What is important to keep in mind when monetizing locations through lease disposition or sale-leaseback?

Haslem: Lease disposition and sale-leaseback are two distinct ways to monetize a location. If the user is also the owner of a location, a sale-leaseback provides the opportunity for the owner/user to convert its real estate into cash and to remain at the location as a tenant. Often, the capital tied up in real estate can be used more efficiently in the operating business. If the owner converts the real estate asset to cash, the owner can use the proceeds to grow its core business.

A lease disposition should be considered where the tenant has a long-term lease at favorable rent, but the location does not work for the tenant. The tenant has the opportunity of transferring the leasehold interest to another user, potentially at a profit. You generally need the landlord’s consent, but leases contain provisions addressing this possibility and often the economics have already been agreed to. If a location isn’t working out, lease disposition should be on the checklist of options to consider.

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Natalie Dolce, editor-in-chief of GlobeSt.com and GlobeSt. Real Estate Forum, is responsible for working with editorial staff, freelancers and senior management to help plan the overarching vision that encompasses GlobeSt.com, including short-term and long-term goals for the website, how content integrates through the company’s other product lines and the overall quality of content. Previously she served as national executive editor and editor of the West Coast region for GlobeSt.com and Real Estate Forum, and was responsible for coverage of news and information pertaining to that vital real estate region. Prior to moving out to the Southern California office, she was Northeast bureau chief, covering New York City for GlobeSt.com. Her background includes a stint at InStyle Magazine, and as managing editor with New York Press, an alternative weekly New York City paper. In her career, she has also covered a variety of beats for M magazine, Arthur Frommer's Budget Travel, FashionLedge.com, and Co-Ed magazine. Dolce has also freelanced for a number of publications, including MSNBC.com and Museums New York magazine.