Latest / Franchise Conversations with Fexingo: Buying, Running, and Scaling Franchise Businesses / How Franchisees Use Rent Escalation Clauses to Protect Margins
Transcript
- Lucas: Let me start with a number that should grab any franchisee’s attention: about 60 percent of franchise leases have automatic rent escalation clauses that kick in every year, often at a fixed 3 percent or more. Luna: And I bet most franchisees don’t even realize they’re signing up for that until the first increase hits. Lucas: Exactly. I’ve been looking into this because I talked to a franchisee who runs three quick-service locations in the Midwest. He had a standard lease with a 3 percent annual escalator, and in year five, his rent was nearly 16 percent higher than when he started. His revenue? Up maybe 8 percent over the same period. Luna: So his rent is eating into his margin year after year, even if sales are growing. That’s a slow bleed. Lucas: Right. And the worst part is, many franchisees treat the lease as a fixed cost they can’t control. But in reality, those escalation clauses are negotiable — especially if you’re an established operator with a strong track record. Luna: What did that franchisee do? Did he renegotiate mid-lease or wait for renewal? Lucas: He caught it at renewal. But he told me he wished he’d negotiated the clause upfront. He went from a fixed 3 percent escalator to one tied to the Consumer Price Index, capped at 2 percent. That change saved him about $42,000 over the next five years across his three locations. Luna: cpi linked with a cap — that seems like a smart middle ground for both sides. The landlord gets some inflation protection, but the tenant isn’t exposed to runaway increases. Lucas: Exactly. And the key is the cap. Without it, if inflation spikes — like we saw in 2021 and 2022 — the escalator could actually be higher than a fixed rate. So a franchisee might prefer a fixed 2 percent escalator over CPI if they think inflation will run hot. Luna: So the real skill is forecasting what inflation might do over a 10-year lease. That’s not easy. Lucas: No, but there are a few other levers. Some franchisees negotiate a ‘fair market value’ clause instead of a fixed escalator. That means the rent adjusts to what comparable properties are charging at the time. That can work in a soft market, but it’s risky in a hot one because you could get hit with a big jump. Luna: Right. That puts a lot of faith in the local real estate market staying reasonable. I’ve heard of franchisees using a ‘step-up’ schedule too — like no increase for the first two years, then 2 percent for years three through five, and so on. Lucas: That’s a great tactic. It gives you breathing room to build the business before the cost burden grows. And here’s something else: some franchisees tie the escalator to their own revenue growth. So if sales go up 4 percent, rent goes up 4 percent — but no more. That aligns the landlord’s interest with the tenant’s success. Luna: That’s clever. But landlords might push back on that. They want predictable income, not something that fluctuates with your sales. Lucas: True. But if you’re a strong operator with multiple units, you have leverage. Landlords prefer filling space with proven tenants than taking a chance on a new brand. So it’s worth asking. Luna: Speaking of leverage — what about the actual negotiation process? Do most franchisees even have someone review the lease before signing? Lucas: Surprisingly, no. A 2024 survey by the International Franchise Association found that only about 35 percent of first-time franchisees hire a lawyer to review their lease. Most rely on the franchisor’s recommended form or just sign what the landlord gives them. Luna: That’s terrifying. The franchisor’s interests aren’t always aligned with the individual franchisee on rent terms. They want consistency across locations, not necessarily the best deal for you. Lucas: Exactly. And the lease is often the second biggest fixed cost after labor. So if you’re not negotiating it, you’re leaving real money on the table. I’d say any franchisee should at least get a lease audit from a commercial real estate attorney who specializes in retail. Luna: And don’t forget about other rent-related costs: common area maintenance charges, property taxes, insurance. Those can escalate separately and sometimes faster than base rent. Lucas: Good point. Some landlords bundle those into a ‘gross rent’ that includes everything, with a single escalator. That’s often simpler, but you lose transparency. Luna: Speaking of transparency — I want to be transparent about something. If these conversations have helped you think more strategically about your franchise business, and you’ve found yourself applying even one idea from an episode, that’s exactly why we do this. Lucas: Yeah, and this show is ad-free because of listeners who’ve said, essentially, ‘this is worth a coffee.’ If today’s episode was that for you, the link is buy me a coffee dot com slash fexingo. That’s it — no pressure, just a way to keep the conversation going. Luna: And we truly appreciate it. Now, back to those rent escalators — there’s another tactic I want to mention: some franchisees are now asking for a ‘rent abatement’ period at the start of the lease, especially if they’re building out the space. Lucas: Absolutely. Rent abatement — usually three to six months of no base rent while you’re fitting out the location. That can save tens of thousands upfront, which is critical in the first year when cash flow is tightest. Luna: And if the landlord says no, you can sometimes negotiate a reduced rent for the first year instead. It’s all about understanding what’s actually negotiable. Lucas: Right. And one more thing: some franchisees are using a ‘co-tenancy’ clause. That means if a major anchor tenant — like a grocery store or a big retailer — leaves the shopping center, the franchisee can break the lease or get reduced rent. Luna: That’s becoming more common, especially in strip malls. If the foot traffic driver leaves, you don’t want to be stuck paying full rent for a dead location. Lucas: Exactly. So to wrap up: the three clauses every franchisee should focus on are the escalation mechanism, the co-tenancy protections, and the assignment rights — can you sell or transfer the lease if you sell the franchise? Those are the big ones. Luna: And the takeaway is really: don’t just sign the lease. Treat it as a business negotiation, not a formality. Lucas: Exactly. Because a few percentage points on rent, compounded over ten years, can be the difference between a profitable location and one that just breaks even.