Real Estate Outlook: Where to Find Value in 2023 | Franchise Operations

As many franchise systems put their foot back on the gas for expansion, the real estate “bargains” many had hoped to find are not materializing. Rents on retail and restaurant space have not only held up in high-demand locations, but landlords have raised rates and available space can be difficult to find.

In an economy where just about everything is subject to the inflation effect, higher rents are not a huge surprise. The root of the issue is simple supply and demand. Demand for space has increased, while less new retail space is being built.

During the first half of 2022, net new store openings in the U.S. totaled nearly 2,500, according to JLL. If that pace of openings continues, 2022 will be the second straight year of positive net openings following three years of contraction in 2018, 2019 and 2020. Discount stores, especially dollar stores, top the list of announced openings with 1,910 new locations. Restaurants were second with a combined total of 838. The expansion pushed the retail vacancy rate lower to 4.4 percent at the end of second quarter, according to JLL.

Unleashed Brands is one franchisor seeing rents rise as it steps up expansion across its six youth enrichment brands that offer play and learning experiences. The company opened more than 230 new locations in 2022 and expects to open another 250 next year.

Over the last 24 months, rents have been trending 6 to 8 percent—and in some cases up to 10 percent—higher than where rates were prior to 2020, according to Josh Wall, chief growth officer at Unleashed Brands in Bedford, Texas. “It’s also a more competitive real estate environment, probably one of the more competitive I’ve seen in the last 10 years,” he said. “In order to compete for Class A and even Class B retail, we really have to know what we want and be ready to go for it.”

Retail rents were generally flat during the pandemic. Landlords had no leverage to raise rents when many of their tenants were requesting relief. As soon as there were signs that the market was healthy again, property owners took advantage of the opportunity. At the same time, landlords are feeling the effects of inflation and rising labor costs, which is fueling higher operating and construction costs.

“There is no way we’re going to see rents going down when everyone’s costs are going up,” said Emily Durham, senior vice president of the food and beverage advisory practice at JLL.

Demand drives higher rents

Landlords have more pricing power in areas that are experiencing strong growth. For example, space is in high demand across the Sun Belt in states such as Florida, Texas, Arizona and the Carolinas. “It’s a bit of a Catch-22, because bringing more people into these states is good for the economy, but it also increases the demand for locations and that ruins your bargaining power somewhat,” said Durham.

Annual rent growth nationally for retail space was averaging 4.3 percent in the second quarter. Almost all major metros were reporting gains, with bigger increases in metros that have seen strong leasing activity. Las Vegas rents rose 9.4 percent year-over-year, Miami rents rose 9.3 percent and Tampa rents increased 7.4 percent. One of the few exceptions is San Francisco, where rents fell 3.7 percent year-over-year, according to JLL.

Availability of space in New Jersey also has been fairly sparse, added Jason Pierson, president of Pierson Commercial Real Estate in Marlboro. New Jersey is the most densely populated state per capita in the country and there is a lot of density and wealth. During the pandemic, there was an outpouring of people that moved from New York to New Jersey and also more people who began working from home versus going into the city. The population in many New Jersey communities increased, with suburban markets in particular that are thriving, he said.

“For good locations, space is extremely tight. Especially for better shopping centers, landlords have their pick of good, solid tenants,” said Pierson. Some franchise groups are well-heeled and backed by private equity groups where they do have great financials, but it’s going to come down to credit and brand name, he continued. Landlords have the upper hand in making those choices, but those franchisees with a sought-after brand also have more bargaining power and won’t pay above market rents, he added.

In some cases, franchisees are experiencing sticker shock from the combined effects of higher rent, construction costs and common area maintenance charges. Another challenge in some of the stronger markets is that second generation or existing space is gobbled up quickly. New construction or space that requires more build-out is becoming increasingly costly. Durham recently worked with a franchise client that spent $1 million to open a new 2,500-square-foot store in Austin.

Creative solutions offer value

Franchise groups are looking at a variety of strategies to value-engineer occupancy costs, such as reducing footprints and choosing second-generation space that requires less renovation and buildout. In some cases, franchisees are looking at locations in emerging markets that are on a growth path and offer lower rents than some of the more established retail areas. Negotiating a percentage rent is another way to help lower the base rent. However, the downside of that for tenants is that it gives the landlord more upside if a franchisee performs very well.

One creative solution for Unleashed Brands is co-locating its brands in shared spaces. In October, the company opened its first co-located Little Gym and Snapology in Flower Mound, Texas, northwest of Dallas.

“We see this as a great opportunity to not just introduce both brands to local communities but also to provide an opportunity for our franchise groups to create some efficiencies in delivering guest service and also operations and profitability,” said Wall. Little Gym and Snapology will occupy a 6,000-square-foot former bookstore adjacent to a Hobby Lobby-anchored power center. The two brands will share a common entrance and waiting area.

Another initiative Unleashed Brands has put in place in 2022 is a corporate seeded development program. Specifically for its Urban Air Adventure Park and Snapology brands, the company is going after locations in strategic markets it has identified. Unleashed Brands will secure real estate with a corporate guarantee on a lease and then market that location to a prospective franchisee or even an existing franchisee who wants an expansion opportunity.

That corporate credit can lend itself to more favorable lease terms, such as a lower base rent or additional tenant improvement dollars. Unleashed Brands typically provides that corporate guarantee for up to 36 months and then corporate would stay on the lease as a limited guarantor with the new franchisee. “The benefit is significant, because we are able to deliver those projects about eight months faster, which gives our franchisee the opportunity to deploy capital more efficiently,” added Wall.

Prudent underwriting

A highly sought-after brand, a large franchisee group or a corporate credit guarantee on the lease are all things that will give a tenant greater bargaining power in negotiating more favorable terms with a landlord. Especially on the franchisee side, one of the factors that comes into play is the franchisee’s credentials, background and strength of experience.

“We always want to be as prepared as we possibly can; educate franchisees on what the landlord is going to be looking for; and the strength of all of that is what makes or breaks a decision to lease a space,” said Durham. “So, being prepared, having business plans and franchisor support, financial statements ready and expect a much harder time of it if you’re a first-time operator.”

Franchise operators also need to make prudent decisions in the high-cost environment. “I think there is going to be continued upward pressure on rents from the landlords,” said Durham.

For franchisees, there is only so much they can pay for their real estate and still be profitable. The general rule of thumb for food and beverage is that occupancy costs should be 6 to 8 percent of revenue. “The smart operators and franchisors will be discouraging anyone from taking a space where the numbers don’t work, because they would be setting themselves up for failure,” said Durham.

“It’s really about where franchisees think they can perform well, and it comes down to their underwriting,” agreed Pierson. If a franchisee is looking at a location where the rent and overall cost basis is high, but the sale projections also are high, then a deal can still pencil out. However, if the rates are extremely high and sales projections are low, then it doesn’t make sense. Operators need to take a hard look at occupancy costs in the context of sales projections and other budget costs, he added.