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.

Most companies want their restaurants or retail businesses to open on schedule. Opening ahead of schedule is every development manager’s goal.

We find we can accelerate the schedule specifically, the duration of the entitlement period, when we pay special attention to some specific steps. Of course, the potential payoff is significant.

Here are some measures in our development work that help reduce the duration of the entitlement period.

• Ask questions about permits. Remember the adage, “measure twice, cut once?” Ask all the questions necessary to ensure each permit submittal is thorough and complete. Comments from your local jurisdiction usually result in a re-submittal, and re-submittals mean delays. Make the effort to get permit submittals right the first time.
• Build a detailed timeline. It’s straight from the project management handbook, but there’s no substitute for a detailed timeline. Establish benchmarks. For each step of the process, spell out what needs to happen, by whom, and in what sequence. Get buy-in from all parties involved. Once people see the plan and understand their roles, a coordinated effort is possible and accountability is established.
• Appoint a captain. This one is our favorite. It’s the key to opening as soon as possible. Get someone – one person – to take charge and serve as the project manager. When there’s one point of contact coordinating everyone involved (architect, civil engineer, landlord, tenant, developer and jurisdiction), things go smoother. Bet on it.
• Consider expedited reviews. Sometimes the state or local jurisdiction will offer expedited reviews at a surcharge (typically, a percentage of the project’s construction cost). If an expedited plan review is available, weigh the time savings against the surcharge. Clients tell us that it sometimes takes only one or two days’ sales to cover the cost of an expedited review. Expediting might mean you can open the store several weeks early, so the potential benefit is huge. Of course, having an approved building permit in hand is pointless if construction can’t begin due to other issues. So do your homework, and make sure all your ducks are in a row.

These are some of the fundamentals of development, but they don’t always get the attention they deserve. Sound execution during the entitlement period may lead to big gains.

Judging by attendance at ICSC conventions this past year in Las Vegas, San Diego and New York, there are very few new retail developments on the boards for 2010. A scarcity of high-quality retail and restaurant space has been evident in recent years, and it will not be relieved by new construction in 2010.

Many retail centers that were in the early stages of development have been put on hold due to a lack of financing and tenants. Most notable is the absence of national retail brand anchor tenants, which typically drive shopping center development and provide the guarantees developers need to obtain financing.

Retail and restaurant companies in expansion mode often ask about potential locations. In many regions, available inventory consists of second-generation space that has come onto the market as a result of business failures. Most of those failures will be written off as victims of adverse economic conditions. But, it’s safe to say that poor quality sites contributed significantly to the tenants’ demise. Many businesses were in locations that would have under-performed even in a bustling economy. I can’t recommend those locations to my clients.

For a couple of years now, there has been a notable undersupply of quality retail space. Without new retail development, there is no relief of pent-up demand. What does it mean for retailers and restaurateurs as they plan expansion for 2010 and 2011? Is an increase in prices of the available sites likely? It looks that way to me.

Due to the economy, we’ve seen a softening in asking rents and purchase prices over the past year or so. But, I’m concerned the lack of new product will trigger higher prices this year. Tenants returning to expansion mode will begin to compete for the quality locations. I don’t believe this return to expansion mode will be sudden. Most tenants will test the waters cautiously. We’ll closely monitor the situation, so please stay in touch.

You’d be hard pressed to find a successful restaurant company that is unconcerned about the physical locations of its restaurants. Location is a key component of restaurant performance – period.

One obvious reason is accessibility. For one thing, patrons like locations that are easy to reach. Another important factor: many restaurants are selected impulsively as hungry guests search for a place to eat as they drive. For this group, highly visible signage and a recognizable brand identity are paramount. This is particularly true for restaurants in the fast casual, quick service and lower-average-customer-check categories.

But, finding the perfect site in the perfect trade area is never easy. In fact, high quality trade areas typically do not offer many, if any, high quality sites. Expanding restaurant companies often face a difficult question. Should they acquire a lower quality site in a high quality trade area or an A+ site in a lower quality trade area?

Our experience tells us that concepts in a “hot brand” trend are prone to ride the happy tide of invulnerability. They often take a high-risk, low-visibility site in a sought after trade area. Their thinking is that “people will find us.” It’s easy to see how this happens. Decisions are made when the popularity of their restaurants is peaking. The lower quality sites might work well for a few years, until the inevitable happens. The hot brand loses momentum. The real pain comes when a new competitor enters the same trade area in a higher quality location. You guessed it. The once hot concept is now neither hot nor visible. And, the operator is trapped five years into a twenty-year lease.

It’s a mistake you must avoid, because the consequences are so difficult to overcome. You can market aggressively, change menus, paint the building and hope a new manager will restore the glory days, but the building cannot be moved. High quality trade areas are sexy, no doubt. In the long run though, high quality sites provide the best chances for success. Long-term profitability is the only way to keep operators happy.

I spent most of last week at the Restaurant Finance & Development Conference in Las Vegas, the annual event for growing restaurant company owners and executives. In one place at one time we meet with restaurant owners and lenders who focus on restaurant industry growth, like representatives of banks, finance companies, investment banks, private equity firms and merger and acquisition specialists. Of course, companies like us, who specialize in restaurant real estate are there, too.

The conference is touted as the must attend event for growth-minded restaurant company owners and executives focused on the business side of the restaurant business. I’ve attended this event for nearly as long as it’s existed, missing it just once in twenty years. It’s always a productive time for me and our business.

For Foremark, the event is more than a special opportunity to meet industry people and learn. (Funny how when you attend an annual event for twenty years, you get a sense of what you look forward to.) For me the conference has come to represent an exciting preview of the next year, that is, an opportunity to learn the attitudes of industry players about growth in the upcoming year. I’ve come to find the tone of this meeting usually depicts what our business will be like, what we can expect, how ambitious we can be, expansion plans we’re likely to encounter from our clients, on and on.

Here are the highlights of what I took away this time. This is a list of what we’ll discuss in our planning meetings:

• Keynote speaker, economist, Paul Kasriel, said “the recession is over and we are in a recovery.” Not back to where we need to be, of course, but, according to Kasriel, the worst is over. Proceed cautiously and optimistically. (Imagine the cheer that received.) * The recovery will be very long and slow. Unemployment will remain high and peak at near 10.5%.
• Over-supply is still a problem. Anticipate more closings, 5,000-6,000 restaurants are likely to close in 2010. A lot of closings means a lot of opportunities.
• Restaurant sales will be flat to down. Operators will maintain profits by managing costs – labor, food, etc.  Commodity prices are in favor.
• For the first time in years, more meals are being eaten at home; grocery prices are down.
• Lenders are generally credit sensitive. Lenders will favor larger companies with respectable balance sheets. Smaller companies will find it difficult to obtain financing.
• Analysts claim the quick-service operating model is the most promising for the future.
• Because taxes and health insurance, companies are paying special attention to Obama’s healthcare plan.
• Restaurant companies must grow to survive; for restaurants choosing not to grow is not an option.

The message: smart growth. The economy is improving. Restaurants must grow, but growth will not come from over-flowing demand, cheap money and a robust economy. Instead, growth must be fueled by savvy and prudent management decisions.

We often hear that a restaurant company’s expansion is “deal driven.” What exactly does that mean? In too many instances, it means site selection was determined when a landlord offered a hefty allowance on one or more properties. The restaurant company jumped on the allowance, instead of relying on high-quality site metrics. I’m amazed each time I see it happen, because it’s a mistake that is very difficult to overcome. It affects operations for the term of the lease.

It’s easy to understand the reasoning. Restaurants are capital intensive; cash is king for a small growth company. If a new restaurant can be opened with a reduced cash outlay, it must be a good deal. The cash-on-cash return will be huge – right?

Wrong. While high landlord allowances require a smaller initial cash outlay, such deals almost always come with high rents. And, high rents raise the break-even hurdle, resulting in a highly leveraged P&L. That means the restaurant company needs to generate high sales just to stay in business. Here’s the ironic twist: high landlord allowances never generate high sales, but high-quality sites do.

The amount of landlord allowance is a finance decision, not a real estate decision. A solid real estate strategy differentiates between the two. Sites should be evaluated on the basis of potential, merit and capability to generate sales – independent of the deal structure. For our partners, we create a new store pro forma analysis using a return on invested capital approach. If the unfinanced returns meet the company’s hurdle, then the question can be asked, “How much cash outlay will this potential site require?”

I attended the Western Region ICSC Conference in San Diego last week. While most I encountered seemed confident the economy had bottomed out and that business is improving, the typically high-energy ICSC conference was hardly evidence. Registered attendance was down to about 3,000 from 5,000 in 2008. (As I recall, registered attendance in 2007 was near 7,000.) There were considerably fewer tenant booths, and one could only surmise from the notable, large developers who hosted meetings at nearby hotels that the $300+ per person ICSC registration fee made on-site participation cost-prohibitive. The conspicuous absence of new development projects, typically unveiled in celebratory fashion at this conference, was another sobering observation. And, sadly, many of the proposed projects that have been on the boards for the past few years remain noted as “future.”

Count me as an ardent supporter of the ICSC. I know most of us respect the association and the benefits it provides our trade. But I think the ICSC missed an opportunity last week to step-up, assert itself as the leading business platform we know it is and provide an evocative and inspiring conference centering on the matters of the economic situation. Why not a downturn economy-specific show theme? We’re all in this together, right? Aren’t we all looking for an edge, if nothing more than reasons to believe things are getting better?  What if exhibitors and speakers had been asked to address ways we can work around such difficult times? What if attendees could have hoped attending would send them home rejuvenated, with new ideas to stimulate business? Even discounted fees for exhibitors and attendees would have made a difference. Goodness knows we need it. By anyone’s measure, it’s no time for business as usual.