Wednesday, August 7, 2013

Paying the Rent (Tradecraft)

The second bucket in my three bucket expense model is rent. Rent is really about the lease, and there are two classes of leases. The first type of lease is the down market lease and the second type is a professional lease. Perhaps the world of real estate has better terms for these, but that's how I see them.

The down market lease is much like renting a mediocre apartment. Some guy has a space, you agree to pay month to month, and your financial exposure is limited. These leases appeal to shaky or under capitalized businesses and they're almost always in undesirable areas. Many game stores end up here either because the owners don't know any better, they have bad credit, they have strict, low budget rent requirements or their idea of a business plan to show a property manager is some scribbles on a napkin.

Once you've chosen a down market location, you've limited yourself severely. Parents will not want to drop off their children. Your neighbors may cause you problems. Your landlord is likely unresponsive. Crime is high and the area is dumpy. Primarily though, the location is just plain bad and geographically undesirable. You have created a gamer pit, mostly for older gamers and your chance at strong diversification, the key to a successful professional store, has been eliminated. You can run a store like this, a shaky fantasy den, but why would you want to? Why are so many game stores low market? This.

The professional lease is a serious commitment that requires much consideration on everyone's part. These are leases you'll usually encounter in good locations. They specify a number of years you're on the hook, and when I say you, I mean you personally. You'll sign a lease as both the business and as yourself, putting your personal assets on the line. The idea that a small business person can avoid personal financial obligation by forming a corporation is a myth.

To give you an example, our $2/square foot/month lease is for three years. As soon as I sign that lease, I'm on the hook for over $275,000. So put yourself in the position of a property manager and ask yourself, who am I going to trust to sign on the dotted line? Whose going to get to drive the Ferrari? It certainly won't be gamer den guy with his napkin business plan.

If my business fails, it now means I must personally declare bankruptcy or find a way to pay back a lease worth more than the average house. In fact, that number is what freaked me out when we moved to our larger location. It was a lease payment that I could no longer pay by going back to work. The business paid it with its revenue or I was toast.

With such a professional lease, you should now have the opportunity to build a solid business in a good location. It should be safe and clean enough where parents will bring their children and employees won't be afraid to walk to their car at closing time. It should have standards of cleanliness and repair. It should not tolerate shenanigans from your neighbors that are not specified. Our property managers can be hard asses sometimes, but I know it also works in our favor.

What Does a Lease Cover?
Leases are highly variable but they include what you have normally experienced as "rent," along with CAM charges. CAM, or Common Area Maintenance, means you're paying for the electricity in the parking lot, emptying the trash cans, and repairs to the roof or air conditioning. All of these things are negotiable in a lease, but negotiating will depend on your property manager.

Ours are all lawyers and won't play ball in most of these areas (but will in others) as they want standardized leases. However, most leases will have a bunch of junk that you'll not want to include, which means you'll want a lawyer to help you out with this. Before signing, carefully check CAM expenses and if you're serious, ask other tenants about past expenses.

Sometimes property managers pad their own compensation with these expenses. Ours owns their own maintenance company, pays themselves a management fee for managing their maintenance company and an administrative fee for administrating this management. Wow. Not surprisingly, our CAM is extremely high, probably 50% higher than it should be, but our rent is below market, so it evens out for us.

What your lease covers for repairs is also highly negotiable. It might cover interior repairs or it might not. Our last lease was like an apartment lease and when the plumbing broke, someone came to fix it. It was owned by a retired guy who was always lying on the beach in Hawaii. He would tell me to send him the bill. Our current lease leaves us responsible for everything inside the unit, and we've had to replace the toilets and fixtures along with repairs of doors and the like.

The key is to read your lease and know what you're dealing with, deciding if that will work or not. If you stay long term, which is what we're doing, it's clear in my mind that eventually I will have to fix absolutely everything. If you don't think this is fair, negotiate or find another location. When it came time to renew, we couldn't get them to cover plumbing, but we did get our base rent reduced by 25%.

I recommend you go for the professional lease. If you're going to put yourself out there and spend $50,000-$100,000 on a retail store, you should swing for the fence. Expect bankruptcy if you fail, but plan to succeed. Get your business plan sorted and expect to make a presentation to the property manager to win your case. Make sure you have money in hand to do this. They may not believe in your plan, but they'll be happy to entertain what they consider madness if you've got a fat bank account.

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