The sustainability of London rents - Richard Negus
The restaurant market is dominated by leasehold property, for reasons of cost, the requirements of a good return on capital, and practicality. In London’s multi-storey buildings, restaurateurs generally only need part of a building, generally the ground floor and basement. With commercial property capital values in central London equating to a multiple of around 18 to 20 times the rental income produced from the whole building, restaurateurs can rarely afford to purchase freehold property and will prefer to focus their financial investment on the business rather than the building that is the business’s home.
Accordingly there are two main routes for a restaurateur to acquire a restaurant: either by taking a new lease direct from a landlord and fitting out the premises, or by purchasing an existing restaurant lease/business. The latter will generally involve the purchaser paying a premium for the lease and the trade contents – fixtures, fittings, furniture, equipment, plant and so on.
Very crudely, restaurateurs can afford to pay rents amounting to around 8% to 12% of the restaurant’s net-of-VAT food and drink sales, or turnover. This percentage can vary widely, and in airports, shopping centres and major railway hubs, operators may agree to pay higher percentages, above certain levels of turnover. The amount restaurateurs can afford to pay creates the market for rental value. This is particularly relevant when rents are revalued, as the vast majority of leases provide for rents to be reviewed to the “open market rental value” (typically) every five years.
New lettings are the best example of market rental evidence because they are reflective of tenant demand and property supply at the time of the letting. Rent reviews, on the other hand, require a negotiation between landlord and tenant (who have a contractual relationship through their lease), and the rent will, to an extent, be what the tenant is prepared to pay. But if the rent cannot be agreed between the parties, then valuers will be instructed to undertake a hypothetical assessment of the rental value of the property as per the terms of the lease. Valuers will be required to interpret comparable rental transactions and have an understanding of market supply and demand. In central London there are many more sales of leases than new lettings, because of the shortage of supply of new restaurant space, and hence most rents will be negotiated between landlords and tenants at the time of the rent review.
Valuers (employed by landlord and tenant respectively) will draw from comparable restaurant lettings, analysing the rents on a unit area basis and making adjustments for location, property configuration (ground floor compared to other floors), the split between front-of-house and back-of-house areas, terms contained in the lease, rent-free periods, and so on. Naturally, rental inflation that outstrips 8% to 12% of turnover will cause financial pain to less successful restaurants, possibly forcing their sale or closure.
While restaurants take a wide range of shapes and sizes, broadly, the chain restaurants (Prezzo, PizzaExpress, Nando’s and so on) will aim to achieve around 100 to 120 covers, preferably on the ground floor, which will be accommodated in a total floor space (including kitchen, toilets, storage, and so on) of around 3,500 sq ft. Central London, however, contains many historic buildings and accordingly restaurateurs have had to be flexible, to fit into accommodation in prime locations in Soho or Covent Garden, for example. The shortage of supply, and particularly of new purpose-built accommodation has further increased demand for prime restaurant space.
The cost of fitting out a restaurant can be anything from £300,000 to more than £1m (for a 100-cover restaurant), or £200 to £400 per sq ft, which, pro rata is considerably more than retail or office premises. Consequently, restaurateurs require longer-term leases of, say, 20 to 25 years to spread (depreciate) their high fit-out costs. Long (20 to 25-year) restaurant leases and legal rights for tenants to extend or renew their leases at the end of the lease term further add to the shortage of supply of new restaurant lettings.
Accordingly, restaurant lettings make for attractive investments for landlords who can secure tenants of good covenant strength on long leases in areas where there is strong tenant demand and, therefore, good prospects for rental growth. Conversely the 20 to 25-year term is a considerable commitment for tenants to enter into with landlords, particularly if things do not work out for the restaurant, because the tenant will be responsible for rent and repairs until the end of the term (which can amount to many millions of pounds). This liability can end if the tenant of a lease created after 1 January 1996 is able to assign (sell) the lease and then the purchaser subsequently assigns the lease again, that is, there are successive assignments.
If a restaurateur decides to sell their lease, then invariably the seller will be able to command a premium from the purchaser for the leasehold interest and trade contents. For restaurants in prime locations, premiums can be many hundreds of thousands and even millions of pounds. The level of premium, as with rent, is what a purchaser is prepared to pay to secure the premises and will be affected by the length of the lease, the level of passing rent, the condition of the property, the existence or not of a premises licence and the reusability of the existing fit-out. Importantly, the landlord does not receive any of the premium.
Eating out continues to grow year-on-year. Restaurateurs are expanding their numbers to capitalise on the increased consumer demand. The chains, such as Frankie & Benny’s, PizzaExpress, Prezzo and Nando’s, are each expanding their estates by 30 to 50 new sites a year as they look to repeat their formula for restaurant success. The expansion by the chains has been largely provincial, as their success has been in areas away from London’s high rents.
Demand for eating out is greatest in London, a combination of tourism, high population density and consumer wealth. Restaurant trading in London was largely unaffected by the recession. Now that the UK’s economy is in growth, and with consumer and investor confidence improving and London being one of the most popular tourist destinations on the planet, demand for restaurant accommodation has never been greater for London’s prime locations, with rents and premiums accordingly rising to record levels.
Not all restaurants in London are guaranteed success, and the market is fiercely competitive. However the restaurant industry is used to “churn”. According to the Restaurant Association, one in two new restaurants fail, resulting in sale or closure, which, of course, creates opportunities for purchasers. Even the successful branded restaurant chains have failures and will sell units, often to their competitors. During the past ten years I have bought and sold more than 400 branded restaurants, with the vast majority remaining as restaurants.
In prime areas of Soho and Covent Garden, restaurant rents have broken £150 a year per square foot . This roughly equates to £4,000 rent a year per cover. Very crudely, and assuming an average spend per customer of around £25, the restaurant requires roughly three customer “sittings” a week just to cover the rent alone. If a restaurant is successful, the number of sittings can be 20 and more. However, if the number of sittings is fewer than six, then the likelihood in central London is that the restaurant will be unviable. Rent (assuming the restaurant is profitable) is typically the third highest operating cost, behind stock (food and drink) and staff respectively. If rent becomes the highest cost, then closure will be inevitable.
With strong demand and a shortage of supply, some landlords have sought to buy out their tenants to create new lettings, and therefore provide rental evidence for review purposes, to increase rental values and, ultimately, asset values. I have been involved in a number of recent transactions where the landlord has chosen to outbid a restaurant purchaser and pay many hundreds of thousands of pounds to secure possession of premises. Landlords of estates in London stand to benefit most by creating new lettings and demonstrate tenant demand, as the increase in rental values positively impacts on the landlord’s restaurant asset values.
It is new lettings that provide evidence on which rent review negotiations will be contested by landlords and tenant. However, rents negotiated at review are hypothetical, and therefore not necessarily reflective of demand for the actual premises. There are plenty of examples where rents of restaurants in secondary locations have been increased off the back of rents on restaurants in prime locations nearby, but the resulting increases have made the secondary location restaurants unprofitable, and, because of the inflated rents, unappealing to purchasers. In such circumstances, the tenant can be burdened with a substantial financial liability, and, in some cases, for a considerable time, because of the length of the lease term. Rent review negotiations should not be taken lightly, and tenants really should take valuation advice before agreeing to any rental uplift, as the impact will affect a restaurant’s profitability and marketability.
A long-term lease can sometimes work against a restaurateur when they wish to sell, particularly for the financially strong tenants such as Prezzo, Nando’s and the Restaurant Group (owner of Garfunkels, Frankie & Benny’s and Chiquitos), because landlords are reluctant to release them from their liabilities. Hence the stronger tenants may have to effect sub-lettings, which means that they may not be able to exit their liabilities. Some tenants of new leases have tried to mitigate future potential liability by requesting the ability to “break” their leases after ten or 15 years, so that they can walk away from their lease if the restaurant falls on hard times. However, breaks are less attractive to landlords, who are desirous of securing strong tenants for as long as possible. Moreover, with strong demand and a short supply of prime restaurant accommodation, landlords have the upper hand in negotiations and hence are able to reject such requests.
If rental levels increase significantly above menu price inflation, restaurant profit margins will be squeezed and some restaurants will become marginal or, at worst, unprofitable. Naturally the successful restaurants will be able to afford rental increases, and there are many examples where restaurants are trading very profitably. However the restaurant business is a fickle one and today’s “hot” operator may not be so hot by the time the rent comes to be reviewed, or halfway through the lease term. Landlords of property in prime locations are (and, it can be argued, always will be) spoilt for choice for tenants, and may be happy to see a churn of tenants as they seek the highest rent. But this can be at the expense of long-standing relationships between landlord and tenants. Some restaurant tenants, such as Pizza Hut, Spaghetti House and PizzaExpress, have been in occupation of certain restaurant premises for more than 40 or 50 years, but high rents may see these more established brands disappear from certain locations as new and untested operators overpay on rents to secure a London presence, with no guarantee that they will succeed.
The result of London’s current high rental levels is that established operators (and, one might argue, those who are more knowledgeable and experienced) are being extremely cautious about expanding in London, choosing to shy away from central London sites. Similarly, existing operators will be very nervous as rent reviews approach, as rental increases dent restaurant profits. Some restaurateurs will look to capitalise on the high premiums being paid by purchasers and seek to relocate to secondary, cheaper accommodation. Having said that, there is no shortage of demand from restaurateurs to lease accommodation in the capital.
Historically, restaurants could not compete for ground floor space with retail and commercial users in central London, forcing restaurateurs to take basement and first-floor accommodation. Current rental values, however, are not being pushed up by alternative uses, but by confident restaurateurs who believe that they can operate profitably where others may have failed. It is the new entrants who are more desperate to seek representation in London’s prime sites and are being forced to bid aggressively to secure sites and who thus push rents up. The gamble on a tenant’s business being a success will be less of a concern to landlords during periods of high tenant demand, as there will be plenty of alternative operators to take their place should a tenant fail. Not surprisingly, in a market where there is strong tenant demand, it is the landlords who hold the position of power.
Rents may be at record levels for operators. However, the demand for eating out in the UK, and in London in particular, shows no sign of abating, and where one restaurateur fails in London, there seems to be plenty of other operators who are willing to take their place. While there may be a levelling-off of rents at some stage in the future, at present there appears little prospect of tenant demand slowing. Ultimately, the consumer will continue to benefit from being spoilt for choice for venues, menus and offers.
Richard Negus is a director at the specialist leisure property consultancy AG&G and has more than 25 years’ experience of dealing with leisure property.