As we all know, many restaurant companies have stopped or slowed down new store development due to the economic downturn and uncertainty in the business due to pending government regulations. What has not changed, though, is the fact that these restaurant companies, especially those that have been in existence for 15 to 20 years and more, have existing stores with leases due to terminate or options needing to be exercised (or not). Based on a development timeframe of 15-20 months for ground-up projects and 13-16 months for in-lines or conversions, these companies need to have strategic plans for these units no fewer than 3-5 years out.

The strategic plans need to carefully demonstrate consideration to all facets of the real estate aspect of the business: Is the restaurant profitable? Does the option need to be exercised or the lease renewed? Is the restaurant unprofitable (or not satisfying profit goals) but located in a strong trade area and simply lacking individual site prominence? Should the unit be relocated within the trade area? Is the site unprofitable (or profitable) and located within a deteriorating trade area? Should stores be closed? How do relocations and closings affect the overall development of the market – opening up new trade areas previously too close to existing restaurants or just the opposite?

These are just some of the matters that must be studied. The process requires considerable time, and, moreover, expertise. (I must say the benefit of experience — having been through the real exercise a time or two, with large scale operations, in which the stakes are high and decisions must be made, also pays great dividends.)

What’s undeniable is how critical these matters are to a company’s immediate and sustainable prosperity. But, all too many times, the decision is made when the option renewal notice period comes up (typically 180 days prior to the end of the lease term or current option), and the decision is made “on the fly,” with no consideration given to the company’s overall business, not the least of which includes the amount of time it takes to find a replacement site and restore sales revenue.

Sorry to sound a little preachy. If it sounds like this matters to me, it’s because it does. I just can never get used to restaurant companies managing the real estate component of their business in a haphazard, “uh-oh” sort of way. Would they manage their operations this way? Of course not. How about their accounting? You don’t see many non-financial managers making key decisions about corporate tax liability. But the real estate part of their business? Too many times, it’s neglected — and the contribution it could make to the company’s overall performance, goes overlooked and under-utilized.

Restaurateurs know well the challenges of expansion. But what about expanding to new and faraway markets, outside of operational comfort zones, where their concepts have little or no brand awareness? While this sort of expansion is common for national brands, it’s a bold undertaking for even the strongest regional restaurant concepts.

In just one month, two Foremark casual dining restaurant clients accomplished this. In the same week in July, a Florida-based concept opened in Nevada and a Texas-based concept opened in Alabama.

Miller’s Ale House, one of Florida’s most successful sports-themed restaurant chains, considered a “Regional Powerhouse” by Nations Restaurant News, opened in Las Vegas, and Chuy’s, a successful, Austin, Texas-based Tex-Mex concept, popular throughout the state of Texas, opened its newest location in Birmingham, Alabama.

For any restaurant company, expansion is the surest way to achieve growth objectives. But, without argument, each of these concepts could have selected new, less challenging locations closer to markets each knows best.

“It’s gutsy, none of us will deny that. We’re accustomed to opening in places closer to home where lots of people know us,” explains Michael Hatcher, vice president of real estate and development. “We felt like it was time to go outside of our comfort zone, both operationally and from a customer standpoint. Sooner or later it’s a step we had to take. We believe we were up to it, though. We know we have the real estate support to identify good markets and sites and we’re confident we can manage the store successfully.”

For Miller’s Ale House, the expansion was even more challenging. “Las Vegas is a lot different than Orlando, or any Florida market, for that matter. And, besides that, it’s 2,300 miles and two time zones away,” jokes Ray Holden, President and COO, Miller’s Ale House. “We know we can compete once we’re there. We can run our restaurants. We provide good value. We needed to make sure we made good decisions about where we put the restaurant, that’s something we can’t change,” Holden adds. “It’s a growth step for us. But that’s the way it goes, right? If you’re working hard and doing what you need to grow, it never gets easy. If you’re comfortable, something’s wrong. In this business, everyone knows that.”

For us at Foremark, this was a big week for our clients, Miller’s Ale House and Chuy’s and us. While each of the companies have built a successful business with the capability to expand on this level, we know our broad knowledge of markets and trade areas along with our ability to identity conducive sites has played a key role in each of these ambitious moves.

In commercial real estate, the word “unforeseen” is often used to express regret. Unforeseen costs and unforeseen project delays are explanations of why a project was less successful than expected. The best protection against these disappointments is the process of due diligence.

We typically advise our clients to begin due diligence as soon as they have signed a Letter of Intent (LOI). We begin our Site Investigation Report (SIR) process, which includes a project site and jurisdictional visit, consultation with the landlord or developer, and thorough review of the executed LOI. Ideally, the SIR is reviewed by our client and the client’s architects, engineers and contractors before any large financial commitment is made.

For any new development project, the engineers, contractors and architects provide upfront estimated costs. Development fees levied by governing jurisdictions are sometimes overlooked. Impact fees are assessed on new development by cities and counties to fund growth infrastructure. These fees can amount to several hundred thousand dollars – enough to destroy budget integrity and nullifying a project’s pro forma financials.

When impact fees are identified during the due diligence process, there is ample opportunity to reach workable solutions. Here are some examples of how impact fees can be administered to create favorable outcomes for developers.

Transportation Fees: In some cases, a landlord can make accommodations to reduce transportation impact fees. A landlord might be able to absorb some of the transportation impact fee cost through already satisfied impact fee agreements within a larger development project. Some landlords, sympathetic to their tenants’ financial burdens, might even agree to reexamine lease terms. We have even worked with landlords to present arguments against a concept’s use categorization in the municipal code (quality restaurant, entertainment use, fast food, etc.). Additionally, the assessing jurisdiction may be willing to negotiate the reduction of impact fees when the fate of a project is jeopardized by such costs, especially in today’s economic climate.

Capacity Fees: Other large and often unavoidable site development fees are water and sewer connection fees, sometimes referred to as capacity fees. The fees are charged by most water and sewage providers; they are calculated according to a myriad of different factors and equations (meter sizes, plumbing fixture counts, total seat counts, etc.). If identified early enough, these fees can be reduced through redesign. If nearby utility lines have sufficient water pressure, smaller sized meters can occasionally be installed to reduce costs (larger meters generally increase costs). Because restaurant sewer connection fees are sometimes based on seat counts, a floor plan might have to be reduced or modified (bar stools vs. fixed seating) to decrease costs, or possibly even to meet an exceeded parking code based on a total seat requirement.

Understanding and recognizing transportation and capacity fees that affect time and costs, and ultimately determine the fate of a project, is just one aspect of comprehensive due diligence process. When undertaken early in the process and performed well, due diligence might be the most critical phase of any building construction project.

(Part II of the blog topic – advantages in early due diligence of discussing zoning ordinance regulations and how such regulations can restrict a tenant’s prototypical design and brand identity.)

From the mid-1990s through 2007, there were few real estate options available to restaurateurs. Although many operators would have preferred to own their real estate, purchase prices were prohibitively high.

Strong real estate prices combined with a large number of creditworthy operators made property ownership very attractive to developers and investors. Cap rates were low; property values were trending higher. Restaurateurs who wanted to own their real estate had to pay absolute top dollar. Instead, most contented themselves with negotiating the best leases they could get, and making their operations as profitable as possible.

Much has changed over the past three years. A tightening of credit since early in 2008 has forced some developers and investors to deleverage by liquidating certain properties. A number of tenants have either filed for bankruptcy or called for renegotiation of leases. For some landlords, the risks of ownership have begun to outweigh the rewards.

Market dynamics have changed enough to prompt some operators to reassess their real estate options. Desirable locations are available in good markets and prices are more affordable than they have been in years.

It was once rare to see smaller parcels available in good markets. Not only are the parcels available today, they are selling at substantial discounts to prices from three years ago. In several markets, asking prices for choice properties have fallen 30 to 50 percent.

Ownership of their real estate has always been important to some restaurateurs. Control over real estate facilitates long-term business planning and makes operations easier for a multitude of reasons. For the first time in a long time, it makes sense to run the numbers to determine whether ownership is a viable option.

Today, RestaurantChains.net released its quarterly list of Top 10 Growing Concepts Under 50 Units. The list is generated based on a concept’s percentage of growth over a 3-month period. Six of the chains were categorized as Fast Casual, three as Quick Service (also known as QSR), and one as Take-Out.

The exclusion of any casual dining or full-service restaurants, arguably the most successful segment over the past several decades, is noteworthy. It raises the question: can casual dining buck the trend? If so, how? Let’s take a look at today’s casual dining exceptions to determine any trends and similarities that may contribute to their successes.

For example, on August 9th, Nation’s Restaurant News reported Cooper’s Hawk Winery and Restaurant and Twin Peaks as two new “Hot Concepts” for 2010. Cooper’s Hawk of the Chicago area, founded by Tim McEnery, describes itself as an upscale casual eatery. Expanding primarily within the Chicagoland area, the concept plans to open its fifth location in Indianapolis within months. The new concept recently increased its financial stability by partnering with Karp Reilly LLC. Plans calls for 1 to 3 openings in 2011. NRN’s other “Hot Concept” is Twin Peaks. Randy DeWitt, the Twin Peaks founder whose 9 locations are quickly gaining in popularity throughout Texas, said he wanted to create a “concept that was just for guys.” He did just that, providing a full-service restaurant constructed as a log cabin, where customers are served quality food and cold beer by impressively dressed lumberjack-themed waitresses.

There are two common denominators to focus on, first, both Tim and Randy built concepts in a specialized segment that wasn’t over-saturated with similar concepts. Sure there was Hooters. But this is America, the country where people crave variety and choice. We put value on uniqueness and creativity. As consumers, we also enjoy the thrill of experiencing “the next cool thing”. That’s the feeling you get at these two concepts. When was the last time you ate in a log cabin with attractive waitresses down the road from your home or office? How often do you eat an affordable upscale meal accompanied by wine produced in-house? Probably, not often.

Secondly, look at geographic stability. Not that they escaped unscathed, but the South and Midwest fared exceptionally well during our “Great Recession” compared to the East and West Coasts. Lower costs of living and a reasonably healthy economy are two reasons restaurateurs have begun to focus on the South, particularly Texas. Concepts are weighing the economic stability of a market before diving deeper into the site selection process.

Casual dining has slowed, but it’s being improved, refined. The most innovative restaurateurs will succeed; established chains will have to adapt. All of this benefits the consumer.

Could it be that restaurant companies are becoming more accepting of new locations that lack the integrity and design standards of their prototypical building designs?

I think so.

Much of the space available now is second or third generation space. And no matter the effects of the recession, remodels and retrofits of existing buildings typically result in compromised designs anyway. If restaurant companies must build properties according to specification with budgets less than what they are accustomed and TI money from landlords is also less than usual, then compromising building design is probable.

Reduced construction budgets and increased building costs are other reasons restaurant companies might be willing to compromise proto building design. With many material plants and manufacturers closing due to the economic downturn, we are seeing an increase in building costs due to increased material costs. This could get worse as new construction rebounds and construction demand outpaces supply. This might not be a bad thing in the long run, however. If companies can value-engineer their buildings by cutting costs in areas that do not affect customer experience or the operation of the restaurant, i.e. less expensive finish materials and finishes customers don’t see, etc., the result could be greater revenue falling to the bottom line.

Diluting brand standards companies work so hard to establish — especially ones in building design, so integral to differentiating restaurant brands — is a decision restaurant companies will struggle to make. Still, though, we should keep at least two things in mind: For one, competing profitably is a top priority; an economic recession of historic proportion seems like an acceptable reason to temporarily compromise brand aesthetics. Secondly, let us not forget the customer experience, the undeniable and main reason for restaurant success. Surely operations managers agree that a customer’s choice to return is more a function of food and service than the aesthetics set by crown molding and window casings.

Second generation restaurant space is where the action continues to be for expanding restaurant companies. Read any restaurant publication from the past couple years, and you will likely find expanding operators mentioning conversion opportunities as their current growth vehicles. The main factors for this trend are the savings in invested capital and construction time. Consider the lack of growth capital and the practically non-existent pipeline of new retail centers, and it becomes clear that expanding restaurant companies must consider conversions in order to achieve growth goals.

Having worked on numerous conversion opportunities for our restaurant clients, we understand the scarcity of available new sites and the enticement of capital savings, saved time and mitigation of development risk promised by converting an existing restaurant space. Our experience, however, is generally that what is frequently perceived as a bargain can ultimately turn into a costly venture.

Take for example a freestanding restaurant in Houston, Texas that in its lifetime had operated as two concepts. The building seemed structurally sound. When contractors began demolition work, though, two conditions were eventually revealed: load-bearing walls set for the original restaurant space not shown in the plans and severe rodent infestation.

A five-year old restaurant building in San Antonio is another good example of unanticipated obstacles. The structure had an oversized ramp due to the large grade change between the building and the parking lot positioned above it. When the architects submitted plans to the city, the ramp was determined to be in violation of ADA compliance because of the excessive grade where the ramp was built. Reconfiguring the ramp to meet ADA guidelines lead to a significant cost overrun.

Unforeseen issues such as these wreak havoc on operators’ rates of return, and in some cases, force budget changes that affect other company projects or, worse, even the company’s expansion plans.

So, how can you evaluate conversion opportunities to avoid problems and help ensure prudent use of capital and resources? Here’s a quick checklist guaranteed to reveal most serious issues:

1) Building Age. Unless you are trying to maintain the historical significance or period architecture of a building, a good rule of thumb is that any building more than 10 years old might not function efficiently without costly retrofits.

2) Time Spent Vacant: Without routine maintenance, a building’s overall condition declines quickly when sitting vacant. Beware of buildings that haven’t been in use for an extended period of time.

3) Conduct Field Verifications. Examine as-built surveys and plans with your architects and contractors sooner rather than later. This usually requires some minor, up-front costs, but the study will mitigate your risks by revealing potentially costly issues early. The benefits far outweigh the costs.

4) Inspect for Code Compliance. Verify conformance to current codes such as fire, ADA, parking requirements and buildable areas. Remember to think “current;” what might have complied then, might not now. Remodeling a structure may rescind items made permissable by a grandfather clause.

5) Inspect Functionality. Determine if the existing floor plan accommodates functionality necessary for your concept. Be mindful, for instance, that moving a kitchen or bar presents significant cost implications.

On conversion projects we find time after time, vigilance pays great dividends. Keeping this in mind and the factors discussed here while evaluating conversion opportunities will assist you in avoiding a conversion pitfall.

Our business is restaurant real estate. We help growing restaurant companies meet their expansion plans with trade area and site selection. After the sites are chosen, we usually negotiate real estate contracts on behalf of our clients. In many cases, we provide development services for the same projects.

Of course, everyone in our office believes real estate has a significant bearing on a restaurant’s performance. In fact, we believe a restaurant’s chances for a prosperous future are determined about the same time the real estate deal is signed.

But, we also have the highest regard for operations and how a restaurant performs – both financially, and in terms of customer experience. We work very closely with our clients. We are fortunate to see firsthand the practices and obsessions of the best operations mavens in the business.

I read an article in the New York Times recently. The author, a restaurateur, set forth a list of mandatory dos and don’ts, which his staff is required to honor. He lists one hundred in all, and none are trivial.

Each time I read the list, I’m impressed not just by its thoroughness, but by what it implies about restaurant operations – and, for that matter, restaurant real estate. Competence is expected. Its basis is thoughtfulness towards the patron. Real professionalism is characterized by faithful execution of the job’s smallest details. Execution of those tiny details makes a huge difference, for it constitutes a job well done.

Read these articles. Pass them along to your friends in the trade. They contain valuable lessons for all of us.

Part 1: 100 Things Restaurant Staffers Should Never Do (Part One)

Part 2: 100 Things Restaurant Staffers Should Never Do (Part Two)

You’re opening a new restaurant, and everything seems to be working in your favor. The current economic malaise meant less competition for your location of choice. And, you’ve been able to hire the best team ever. Staff training was an absolute homerun. The managing partner is fired up, and morale is high. The local marketing effort is a hit; customers have been knocking on the door for a week, hoping to dine with you. All systems are GO except for one. The landlord hasn’t completed the parking lot as promised.
 
What happens when you are ready to open your restaurant, but the landlord/developer can’t provide his deliverables? This recently happened to a friend of mine, Doug Lanham, Partner of Aspen Partners, operator of Jinja Bar & Bistro in Santa Fe, New Mexico.
 
“We are confident we can work through this,” Doug told me. “The landlord has good intentions, but he’s having a tough go of it right now.” Because of the economy, only half of the landlord’s shopping center is occupied. His financial challenges adversely affect the store opening, and that strains the tenant-landlord relationship.
 
Many aspects of a new project are beyond a restaurateur’s control. However, there are ways to mitigate the damage caused when a landlord does not deliver.

• In the project’s infancy, create a thorough timeline to identify all
  activities that need to happen prior to your store’s opening.
• Create accountability by assigning responsibility for each activity and
  deadline.
• Focus on the activities of the other parties and determine the “what ifs”
  in case they are unable to meet their responsibilities.
• Imagine a worst case scenario.

 
Once you fully understand what has to happen, who has to do it and what is the result if it does not happen, you can create a contingency plan. That plan should allow you to step in and complete any landlord work. And, you should have access to the funds necessary to complete that work. That’s possible if your lease agreement contains a provision to escrow funds related to the landlord’s responsibilities.
 
In summation, I encourage you to live by the old adage: “Protect the downside and the upside will take care of itself.”

Twenty years ago, I negotiated a deal for Grady’s American Grill in Johnson City, TN. Grady’s was a small regional chain at the time. The other party to the negotiation was Toys R Us, the largest toy retailer in the USA. In trying to finalize the contract, a fairly amicable negotiation turned heated. A seemingly reasonable request on Grady’s part was deemed overreach by the retailing giant’s negotiator. He said, “that would be like the ant eating the anteater!”
 
In reality, the risks of a restaurant investment are similar for a small regional chain or a publicly traded national chain. Whatever the risks, they need to be addressed or the long-term investment won’t be viable. Given today’s economic challenges, the need for financial and operating flexibility is great.
 
A restaurateur’s financial and operating flexibility is largely a function of its real estate contracts. A knowledgeable adviser can help maximize that flexibility. For a new client, Foremark creates a Letter of Intent that starts with the basics, like rent and term of lease, but covers other important issues too.
 
Lease Guaranty:  The Tenant is usually liable for the entire rental stream of the lease term whether the restaurant succeeds or not.  Is the full amount of the rental stream objectively fair, or should the amount be the unamortized Landlord/Tenant Improvement Allowance? And, for what period of time? The entire primary term, or the first half of it? The point is this: all terms are negotiable. Through negotiation, it is possible to reduce your exposure.
 
Use:  Concepts go in and out of favor. Landlords typically ask Tenants to operate as the original concept for the entire length of the lease.  In uncertain economic times, the ability to re-concept a location, or to assign or sublease is imperative.
 
Common Area Maintenance:  For most restaurant leases, the Landlord passes through the costs of taxes, insurance and common area maintenance (CAM).  If not well managed by the Landlord, CAM costs can increase significantly over time.  A restaurant may be able to “opt out” of CAM, or at least cap the Landlord’s CAM increases.
 
There are many other points like these that can be addressed and successfully negotiated by an experienced real estate and legal team.  This complement of talent on your side can allow the “ants” of this great industry to at least snack on the “anteater” landlords we sometimes face.