Leasing Nightmares: Preventing the Dreaded Radius Restriction from Impacting Future Growth

Note:  Blackacre LLP is a boutique fixed fee real estate law firm with a restaurant leasing specialty.  From its experience serving as counsel to numerous restaurant clients, Blackacre’s attorneys know that a good lease is crucial to a restaurant’s success, while a bad lease can doom an otherwise successful restaurant to failure.  In the coming articles, Blackacre’s attorneys will write on how to prevent a restaurant lease from becoming the next “Leasing Nightmare."

While some entrepreneurs establish their first restaurant with bold and grand visions of becoming a ubiquitous and popular nationwide or regional chain, the vast majority of entrepreneurs are simply focused on one thing, the success and viability of their initial restaurant.  As such, when tenants review their leases (often without the assistance of legal counsel in their earliest stages), they usually notice that the lease may contain a radius restriction for establishing business at other locations. 

With the modest goal of just creating one successful restaurant in mind, tenants are often too humble to even consider that their concept may one day expand beyond the current restaurant.  Plus, what is the impact a restriction covering a few miles, really?  That’s a fraction of most daily commutes.  With this logic in mind, tenants tend to ignore this portion of the lease and focus on other areas pertaining to operations and finances.  Fast forward six months, and the tenant’s initial restaurant is a smash success.  Landlords from all different parts of the city are calling the tenant and its broker to try and establish a new location into their project.  The tenant recalls the radius clause and reviews a map of its city.  To its horror, the restricted radius is a lot larger than it first seemed, with multiple viable submarkets covered by the radius, which are now blocked by the tenant’s lease.  As discussed in this article, in order to avoid this potential Leasing Nightmare, it is critical to negotiate, or even absolutely reject, radius restrictions to avoid impairment to future growth. 

Why Landlords Request Radius Restrictions

As with all Leasing Nightmares, in order to effectively negotiate radius restrictions, tenants must understand the logic behind them.  Landlords primarily request radius restrictions when tenants are paying percentage rent (a percent of gross sales above a certain threshold) in the lease.  The logic is that landlords do not want an adjacent location cannibalizing sales of the restaurant, thereby reducing percentage rent under the lease.  Even when percentage sales are not included in the lease, landlords do not want general consumer traffic to the center to be reduced by a nearby alternative location.

This rationale is quite weak from a tenant’s perspective, which is why a radius restriction should be greatly reduced if not eliminated.  For the cannibalization of sales argument, all tenants consider this variable already and obviously would not place a new restaurant in an area which would result in material sales cannibalization.  For the consumer traffic argument, many shopping centers are overparked and overburdened and it can actually be a relief to have less consumers visiting the center. 

Given the extremely weak rationales for including radius restrictions versus the compelling reasons to maintain complete control over the future of the brand, tenants should reject placing radius restrictions in leases.  To the extent such restrictions are acceptable, the following questions must be addressed:

• What area is covered?
• What businesses are restricted?
• Who is restricted? 
• What is the penalty for violating the restriction?

What Area is Covered?

Landlords generally define the restriction by utilizing a radius drawn from the outside boundaries of the shopping center. A simple Google search can yield multiple tools to draw a radius around the shopping center’s address. 

Each tenant should analyze this radius in detail and make peace with the fact that no competing businesses may be established within such radius.  If there are some submarkets or shopping malls in the radius that the tenant is unwilling to accept the restriction on, such exception to the restriction should be explicitly made in the lease.  If the radius is simply too large, tenants should draw a more acceptable radius and propose it to the landlord. 

What Businesses are Restricted?

Most leases contain language stating that tenant may not conduct any “similar” or “competitive” business.  These words are vague and can easily lead to litigation, as there is no clear answer to what is similar or competitive, especially as restaurant concepts continue to blur and mix the lines within various types of cuisine. 

In an ideal lease, the restriction will only apply to the particular restaurant chain and no other concepts whatsoever.  To the extent the landlord is not willing to specifically limit the restriction to a particular business, tenants should define what constitutes a similar business so that it is abundantly clear what is covered (and more importantly, what is not covered). 

For instance, if the concept is a fast-casual Mexican restaurant, the restriction should only apply to fast casual Mexican and not to sit down Mexican, which is not a competitive business. In summary, tenants should either have the restriction cover their particular chain (i.e. a restaurant using the same trade name) or have a very clear definition regarding what is “similar” or “competitive."

Who is Restricted?

Landlord lease forms generally include a robust list of parties restricted from establishing a competitive business, which often includes principals, investors, officers and directors, including direct and indirect interests of such parties. The only parties which should be restricted in a lease are the tenant and any affiliated entities.  Principals, investors, officers and directors often are involved in numerous restaurant concepts and it should not be acceptable to have any of these parties restricted in their capacity as either a manager or investor, particularly if such interests are indirect or non-controlling interests.  Most landlords understand this request and will agree to drop all individuals, as landlords understand these sorts of restrictions may deter the restaurant business from being managed by the best qualified managers or receiving investment from the best investors.

What is the Penalty for Violating the Restriction?

As the radius restriction is a term of the lease, violating the restriction is a breach which can lead to a landlord exercising all rights and remedies, including eviction.  Normally, landlords do not want to evict or sue a tenant in these circumstances (as the tenant is usually still otherwise performing).  Accordingly, landlords usually insert rent penalties into the lease of the tenant having to pay double or 150 percent rent while the restriction is being violated.  These penalties are extremely draconian and are almost always not representative of the landlord’s actual damages.  The more fair and typical compromise penalty is to include the violating restaurant’s gross sales in the gross sales figure for the premises, greatly increasing landlord’s percentage rent. 

While these penalties should be negotiated, there is no excuse for a tenant not keeping an accurate and complete map and database clearly depicting all radius restrictions, as the triggering of these penalties is entirely within the tenant’s control. 

Conclusion

The early stages of a restaurant business are often focused on creating a viable brand versus future expansion plans.  While tenants should always prioritize brand viability in the early business stages, tenants should always be considering the possibility of expansion plans in the future.  Because the landlord needs for a radius restriction are rather weak and the tenant needs to expand in the best way possible are strong, even the toughest of landlords are usually willing to negotiate an appropriate radius restriction. 

Tenants should consider the best-case, most aggressive expansion plan possible when considering radius restrictions.  Either eliminating or greatly reducing the radius restriction will help avoid this future Leasing Nightmare and ensure the business can expand in the most appropriate manner.