When a restaurant closes its doors, it can happen for a number of reasons. Commonly cited reasons include poor management, various issues with the food, bad customer service, bad location, rising costs, or increased competition. Sure, these may all be confounding variables, but how do you explain a restaurant that was in business for more than a decade, or even two decades? And they suddenly have to shutter operations? If they lasted 10 plus years, we typically consider that to be a relatively strong, successful business. This is usually the case if they survive beyond the 3-year mark.

There is a hidden factor that may not be so apparent to most of us. Can you guess what it is? I’ll give you a hint. Typically, when a restaurant goes out of business, it’s going to be unrelated to any of the reasons we touched on earlier.

The reason has to do with the commercial lease agreement: landlords. Commercial lease agreements can be complicated, but don’t worry, I’m here to simplify everything.

Unlike a residential rental agreement, you typically cannot lease year-to-year in a commercial lease. The landlord is going to want to lock you in, usually for a minimum of 3 years; and sometimes upwards of 5 years at a time in desirable areas.

When you sign a commercial lease, after the first year, the rent typically increases 3% each year thereafter. This usually works out to be an additional $100 increase each year. The amount of the increase varies based on the rent cost. If the rent is $3500/mo and you sign a 5-year lease, the following is a very basic depiction of how everything breaks down:

In year 1, you will pay $3500 + $3500 (security deposit plus first month's rent)

In year 2, you will pay $3500 + $105 = $3605.00 (where $105 represents 3% of $3500)

In year 3, we pay $3605 + $108.15 = $3713.15

In year 4, we pay $3713.15 + $111.39 = $3824.54

And then finally, in year 5 we pay $3824.54 + $114.74 = $3939.28

It gets even better. After fulfulling all financial obligations, an owner then decides, “Hey, I really like this location.” They would now have to extend their lease in order to continue operations.

First, you don’t really extend a commercial lease. You have to begin a new lease or a renewal. When you do this, something interesting happens: the new lease goes up by a minimum of about 20%, and then each year thereafter it continues to rise by 3%. Each time you renew, it will again jump by 20%.

So from our previous example, we ended the 5-year lease at $3939.28. With a 20% jump, we start the new lease at $4727.14, and then it just goes up from there. So we rented the space initially for $3500. Now, we are at almost $5000 after 5 years.

At some point, it just doesn’t make sense to absorb these increases in perpetuity. In this case, the restaurant owner might attempt to negotiate with the landlord. But often, the talks will end in futility, leaving the restaurant owner no choice but to close down and seek out another location. Landlords are rarely loyal and understanding of your situation. Everything will default to the legalese if you try to reason with them.

By the way, if the restaurant owner fulfills all financial obligations on the lease agreement, but remains undecided as to whether or not to renew, they then become what is known as a holdover tenant. Usually, they can remain in the space on a month-to-month basis, but the rent cost will typically have a holdover fee attached, which unfortunately is going to be more painful than the 20% jump discussed earlier. Entering into holdover status is also risky because at any point, the landlord can kick the restaurant owner out once they find a new tenant. The holdover tenant will then have approximately 30 days to vacate.

So, you might ask, “Is there a way to avoid these incremental leases?” Yes. To an extent, every contract is negotiable.

The first thing you can do is leverage cash. If you are exploring, for example, a 5-year lease, you can pay maybe 1 or 2 years up front in cash. As part of the cash deal, you would ensure that the rent cost remains constant for the entirety of the lease.

The second thing you can do is sign a longer lease in exchange for non-incremental rates. Again, this would be subject to negotiation. National tenants such as restaurant chains will often utilize this strategy in their lease agreements.

A third strategy is to try to cap the 3% annual rate hikes. Now, this technically isn’t eliminating the escalating annual rates. Instead, you would negotiate a fixed annual rate hike; because the percentage increase is always going to be larger than a capped/flat rate. So instead of a percentage, you would negotiate that the rent not exceed, say, $55 annually. And there are other strategies, but these are the most common.

So let’s summarize everything. Today, we learned about a unique reason that is generally not cited for why a restaurant might go out of business. The reason is related to the commercial lease agreement. Essentially, what you have is the rent going up by 3% year over year. Then after all lease obligations have been fulfilled, a tenant that wishes to remain in the location must re-negotiate their lease, which comes with a 20% rate hike on the new lease, followed by 3% annual rate increases in perpetuity.

Businesses need stability and constants, especially when it comes to pricing. There may be nothing wrong with the restaurant itself. The concept might be great. The food, great. The ownership, great. But almost no one can survive escalating rent costs forever. Often times, the restaurant doesn’t actually go out of business. They simply relocate. If you found this information helpful, please share it with a friend.