When it comes to franchises, not many people know that the franchisor usually doesn’t own the business premises (the land and property).
Instead, the franchisor will hold the head lease with the landlord and sublet to you as the franchisee.
What are the pros and cons of a head lease and do banks see less risk in this type of arrangement?
How does it work?
Very few companies that run on a franchise model are landlords themselves.
Instead, the franchisors will typically buy up leaseholds in what they deem to be prime locations and eventually sublet them to new franchisees.
In this way:
- The landlord (also known as the head lessor) is the owner of the property.
- The franchisor is both the head tenant and sublessor and holds the lease on the property (head lease) with the head lessor.
- You, as the franchisee, are known as the subtenant and hold the sublease with the franchisor.
As the franchisee, you simply pay rent to the franchisor and meet all of your rights and responsibilities under the sublease agreement. You have no contractual arrangement with the landlord themselves.
Because of the nature of the lease that’s in place, these type of arrangements are sometimes known as tripartite agreements.
You will often see this with large office buildings where the building itself (the freehold) is owned by a strata company and the head lease is held by a property management company (or even a few of these companies in the same building) for several floors and/or suites.
So where does my security deposit go?
You will hand over your bond or personal guarantee to the franchisor rather than the landlord or shopping centre owner directly.
They will take care of depositing the bond with your state’s relevant retail bond board.
Why do franchisors do this?
Franchisors tend to prefer the head lease model in order to protect and maintain their reputation.
If for example, you’re a Subway franchisee and you’re in a situation where your business is failing and you can no longer make rent, Subway will “take over” the rent entirely.
Depending on the franchisor, they will often do this until such time that you’re back on your feet and can continue running profitably.
It costs them much less to support a struggling a franchisee (at least for the short term) than to go through the time and money of signing up and training a new recruit.
In this way, the franchisee also benefits from the head lease model.
What other benefits are there?
The other benefits of a head lease arrangement include:
- Leveraging franchisor negotiating power: The franchisor will already have long-standing lease arrangements with commercial landlords and shopping centre owners meaning they will be offered competitive rent and good lease terms. Having this bargaining power is even more advantageous when it comes time to renewing the lease. As an independent business owner, you won’t have this negotiating muscle.
- Leveraging long-term location: Unless it’s a new site, it’s likely that the franchisor has held the leasehold in the property for a while meaning they already have a presence in the local area. Not only are you taking advantage of a brand name but you get free local marketing even before you start working!
- Forget maintenance and repair costs: You can save thousands of dollars over the life of the lease by leaving the responsibility of repairs and maintenance, including electrical, plumbing, fixtures and the building structure itself, to the franchisor.
- Limited personal liability: Overall, a franchisee has less personal liability under a head lease agreement since the franchisor actually holds the lease on the property. This means you can simply focus on running the business rather than having to get involved in lease disputes.
Banks prefer head leases
Banks tend to prefer head lease arrangements because, in the event that you default, you’re not primarily liable for the rent and outgoings of the leasehold.
This is a risk that the franchisor wears when they sign you on.
Coupled with the strength of the franchise model, it’s the reason why some banks will allow you to borrow at a higher LVR (Loan to Value Ratio) than if you were to buy a franchise business that doesn’t operate under a head lease.
What are the drawbacks of a head lease?
The benefits of operating under a head lease can also work against you depending on how long you’ve been running the franchise.
Landlord disputes can take longer to resolve
Since you’re involved in the daily operations, you can see problems with the property and the lease agreement before the landlord or the franchisor can.
Although you won’t have to cover the costs of repairs and maintenance, having no legal right to communicate with the landlord directly can be frustrating for some franchisees, particularly when you know exactly what solution is needed so you can keep operating.
Having to communicate concerns via the franchisor instead can be time-consuming and often feel like a game of Chinese whispers.
Like any business, franchises come with a level of risk that you must wear as the franchise owner but have you considered that you’re also tied to the success of the franchisor?
Franchise systems are popular among budding business owners because they are often promoted as “turn key” and, in some cases, a way of buying into a business model that is seemingly too big to fail.
Of course, franchisors are just as susceptible to failure and bankruptcy as any other company so rent default is a reality that you should take into account.
Even if you’re running a profitable enterprise, you may find yourself in a situation where your franchisor has gone bankrupt, putting your sublease agreement in the hands of corporate administrators.
In many cases, you may lose some of the control and flexibility in your sublease that you had with your franchisor.
You may even struggle to renew your lease if the intention of the administrator is to wind up the business.
Franchisors may not always pass on cheap rent
Instead of passing down those sweet rent and lease incentives, some franchisors may take advantage of the existing business agreements they have with landlords and hold on to those benefits themselves.
It’s not fair by a long shot but they have every right to do so.
Selling the business can be difficult
Even though you’re only dealing with one, you essentially have two landlords in the form of the franchisor and the head lessor.
If you decide to sell the business, you may sometimes have to continue paying rent until a new tenant is found.
The time it takes to find another tenant then compounds itself since the franchisor and the landlord will need to come to an agreement.
Speak to a solicitor first!
In most cases, the franchise agreement and lease agreement are documents that you’ll need to sign together once an appropriate site selection has been made.
After that, the agreement is final and fit-out and construction will begin.
Before you do this, it’s always important to speak with a financial professional to ensure that you’re in a stable enough position to be running a business over the long term.
Secondly, a solicitor and lawyer can help you to go through the sublease agreement (and franchise agreement) and identify clauses that may not be in your best interests.
Depending on the franchisor and the strength of your financial situation, you may be in a position to negotiate these terms.
Do you need a franchise loan?
Check out our franchise loans page for a list of franchise systems that our lenders can help finance.
Some lenders are better than others when it comes to lending to your maximum borrowing limit!
We can help you put together a strong application so you have the best chance of getting approved for a competitively-priced franchise loan.
Call 1300 889 743 or complete our free assessment form to speak with one of our specialist mortgage brokers.