Shopping Center Leases and Franchises: A Landlord's Checklist

Date: September 12, 2012

Takeaway:  Because of their brand recognition, consistency of operation and support network, franchised businesses can be wonderful tenants at shopping centers and other multi-use commercial properties.  Franchisees are small business owners with substantial investments and drive to succeed, but who are able to use brands and business systems that provide competitive advantages.   However, a lease with a franchisee raises concerns separate and distinct from those with independent small business owners or with regional or national chain store operators.   What follows is a summary of some important issues and suggestions on how to navigate through them.

  1. Franchisor's Options to Assume the Lease.  Franchisors typically want the option to keep a franchised business operating at the leased location even if a particular franchisee develops financial or operational problems.   This option applies if the franchisee defaults under the lease and does not cure by the applicable deadline, or if the franchisor terminates the franchise agreement due to a franchisee default.   Some matters of concern with such options are:
    • Does the Franchisor Have Adequate Net Worth as a Tenant?  Franchisors of well-established franchise systems typically (although not always) have strong balance sheets and cash on hand, making them at least as credit worthy as the franchisee tenant.   However, many early and medium stage franchisor entities have limited assets and, for legal compliance and liability reasons, do not themselves operate any of the businesses being franchised -- instead stores are operated through affiliated entities that may be thinly capitalized.   Since the original franchisee entity tenant is likely to be in financial distress if the franchisor is exercising this option, and the franchisee's principals may no longer be credit worthy guarantors, the landlord should be careful to reserve its ability to require adequate security as a condition of allowing “smaller” franchisors to exercise lease assumption options.
    • How Long Will the Franchisor Have to Exercise The Option?  In the case of a tenant's failure to pay rent a landlord wants to retain the right to move quickly to evict.  A franchisor typically wants thirty days from when the tenant fails to cure the default to determine whether it wants to assume the lease.  Since evictions take time, a landlord may want to require a shorter option period. 
    • What Happens if the Franchisee Resists Turning Over the Premises?  If the franchisor's option is triggered by a failure to pay rent, the franchisee will rarely stand in the way of the franchisor's assumption, and if it does so the cost of eviction is properly the responsibility of the landlord (with the defaulting franchisee liable for the attorneys' fees).  However, if the franchisor's option is triggered due to termination of the franchise agreement and the tenant is not in default under the lease, the franchisee may resist forced assignment on the basis that there is not good cause for termination.  In that situation, the landlord can feel caught in the middle and should be able to require the franchisor to pay the legal costs to enforce its termination and obtain a court order requiring the franchisee to release the premises.    In either scenario, if the franchisee has ceased paying rent, then the franchisor may be required to pay rent into an escrow account pending resolution of the legal proceeding.
    • What are Franchisor's Rights to Re-Assign to a New Franchisee?  The franchisor will want the absolute right to subsequently assign the Lease to a new franchisee and to be released from future lease obligations.  The landlord will want recourse against the franchisor if the new franchisee defaults.  A compromise is that the landlord will consent to such a subsequent full assignment if the new franchisee is credit-worthy under the landlord's then-current standards for new tenants.  
  2. Use Clauses.  Franchise systems change product and service offering in response to market conditions, and franchisors want the right to require the franchisees to adopt new products and methods in accordance with overall system changes.  Landlords want to restrict tenant uses to assure proper tenant mixes and also to be able to retain current tenants and recruit new ones.  A franchise's use clause should be sufficiently broad to adopt to change within its industry sector but not so broad as to harm other current or future tenants.  For example, a tutoring center's use could be for academic instruction services, which would be broad enough to cover methods of instructions other than traditional tutoring, but not so broad as to compete with a children's fitness facility (like My Gym®) or a day care center.
  3. Protected Territory.  If a portion of the rent will be a percentage of the franchisee's gross sales, then the landlord should require that no other businesses operating under the same trademark operate within a specific distance of the premises.  If the franchise agreement provides the franchisee with such a “territory” in which neither the franchisor nor any other franchisee may open a competing business, then the franchisor should not object to a similar clause in the lease, except for locations in special use facilities like sports facilities and military bases.  If there is no such commitment by the franchisor to the franchisee, then the landlord should consider eliminating percentage rent in favor of a higher fixed rent unless the franchisor (as well as the tenant) will specifically make such a commitment to the landlord.   
  4. Signage, Trade Dress and Renovations.  Franchisors want to have the ability to require implementation of the franchise's updated interior and exterior signage, trade dress and interior design in reasonable intervals during the course of the lease.  Landlords want to have some control over the exterior signage and over substantial changes to the interior premises.  The franchise should be able to update signs at the premises' entrance and the premises' trade dress and decor, provided that it does not fundamentally conflict with the design of the shopping center or any applicable laws.  For structural changes that would require a governmentally-issued permits or licenses, the franchise should have a right to either obtain consent to the changes by providing specific information, insurance and fees, or the franchisee should be able to terminate the lease after a suitable notice period.  
  5. De-Identification.  If the Lease or the Franchise Agreement is terminated, the franchisor needs to have access to the leased premises to remove signs, décor and materials displaying any marks, designs or logos owned by the franchisor.  The landlord needs to make sure that the franchisor is responsible for any damage or disturbance to the property caused by such a “de-identification” process.  The landlord should include provisions in the lease addressing such an eventuality. 
  6. Renewal.  If the franchisee-tenant has a renewal option under the lease, but does not choose to exercise it, the franchisor may want to have the option of assuming the lease for the renewal period.  If the franchisor requests such a right, it is reasonable for the landlord to attach strict conditions on the franchisor's exercise of that right, including timing and notice requirements.