Stop Losing Your Franchise Outlets: Control the Real Estate

04/01/2004 / Joseph Fittante

You just received a notice from your franchisee explaining that he is three months in arrears to the landlord for rental payments under his lease for the franchised location, the landlord is threatening to evict him, and the franchisee is ready to throw in the towel. You contact the landlord and find out that the landlord has a new tenant lined up for the space. You also find out the new tenant is the franchisee of a competing concept. As visions of lost locational goodwill dance through your head, you quickly realize that all of the goodwill of your brand at the franchised location is about to be lost, and worse yet, there is nothing you can do about it. You vow to never allow yourself to be put in this type of situation again. The key is to get control of the real estate.

First, you can get into the “real estate” business by acquiring sites and leasing them to franchisees. By becoming a landlord, you not only create a new profit center for your business, you also guarantee yourself ultimate control of the sites. However, due to the costs associated with the acquisition of real estate, this option may not be economically feasible for many franchisors. Additionally, if the franchisee fails, you will be left with a mortgage payment and no corresponding rental income to offset the mortgage payment.

If real estate acquisition is not appropriate for you, you could lease sites and sublease them to your franchisees, thereby retaining control of the site in the event of a default by the franchisee. Although this option does not require the capital expenditure required to purchase the property - - - and presumably you will be able to negotiate terms with the landlord that are more favorable than your franchisees could negotiate - - - if the franchise defaults under his sublease with you, you will still be responsible for payments under your prime lease with the landlord, without the corresponding income from the franchisee to offset the rental charges to you under the lease.

If neither of these options appeals to you, there are ways to control the site without really controlling the real estate. For example, you could require that any lease signed by a franchisee contain a provision granting you the right to take an assignment of the lease upon default by the franchisee. If you opt for this approach, it is imperative your franchise agreement provide an opportunity to approve the lease for the franchised location prior to execution by the franchisee and that the lease for the franchised location contain the assignment language referenced above.

If you use this approach, the language in the lease must grant you the right to assign the lease to a new franchisee. In this situation, the landlord will probably insist that the new franchisee either be approved by the landlord or that you as the franchisor guarantee the new franchisee’s obligations. Recognizing that neither of these alternatives are desirable to franchisors, one method of avoiding these issues is to negotiate on the front end with the landlord for certain net worth requirements that the new franchisee would have to meet, thereby satisfying the landlord’s concerns that the new franchisee may not have the financial wherewithal to satisfy its obligations under the lease and getting you off the hook with respect to the guaranty. If this is not possible, and you are left in a situation where you are required to guaranty the new franchisee’s obligations, you may want to propose a letter of credit or other security, as opposed to an unlimited guaranty. If you go this route, you should negotiate for a descending letter of credit or other security, which amount would decrease as rental payments are made by the new franchisee under the lease (and perhaps terminate if there is no default for the first couple of years).

In the scenario, the landlord will typically also want you to cure any default of the former franchisee/tenant prior to taking an assignment of the lease. If this is the case, it is imperative that the lease provide that all notices of default be sent to you as well as the franchisee. Without this provision, you may find yourself in a situation where the lease is several months in arrears and in that case, it may not be economically feasible to take the assignment. The lease should also contain language requiring the landlord to remove the franchisee from the location and retake possession of the location

It is important to understand that even if all of these provisions are contained in the lease, in the absence of additional language to the contrary, there is nothing preventing the landlord and the franchisee from changing the lease after it is signed. Accordingly, the lease should contain a provision whereby both the landlord and the franchisee acknowledge that you are a third party beneficiary of the lease and that the lease will not be amended to adversely affect your rights under it, without your prior approval.

Another method you may use to control the real estate is a “conditional assignment.” Unlike the landlord’s promise to assign the lease to the franchisor as discussed above, this document is an actual assignment, subject to the franchisor’s approval, upon the occurrence of certain defined events, which events commonly include the failure of the franchisee to cure a default under the franchise agreement or lease. A landlord may be hesitant to sign this document because most landlords would rather take the “wait-and-see approach” and upon a default determine whether they want to assign the lease to you. Nevertheless, if your bargaining power is such that you can get the landlord to agree to a conditional assignment, this method is preferable over the prior method.

Each of the foregoing methods to control the real estate has distinct advantages and disadvantages. The trick is picking the “right” one. The one that may be right for your system today may not be right five years from now. Accordingly, it is imperative that you continually assess the need for control as well as the methods you are using. Remember, any method you pick must not only be beneficial for you, but also saleable to your franchisees.

This article originally appeared in the April 2004 issue of The Franchise Times.

Reprinted with the permission of Franchise Times, April 2004 © Franchise Times, 2808 Anthony Lane South, Mpls., MN 55418