I have the privilege of working with landlords and operators alike in our line of business across multiple geographies. One of the biggest choices they both have to make is to figure out how to structure their relationship with each other.

In my experience, I notice 3 main types of contracts between the entities with each having their own advantages and disadvantages. In this article I hope to cover

• 
  Overview of Contract Types
• 
  How to choose the best model for your business

Overview of Contract Types

In all 3 methods, the operator focuses on running the operations on the ground.

On a month to month basis, the operator focusses on 2 main things:

1. 1.
   Increasing the revenue: By increasing the occupancy, marketing on different channels, identifying ideal price points, etc.
2. 2.
   Decreasing the expenditure: By streamlining operations, striking better deals with marketing partners, etc.

Meanwhile, the Landlord has to ensure that the asset overall meets the requirements of the market and complies with all local laws.

This method has been championed by the hospitality industry where profit share has become a very common method of engagement. At the end of every month (or quarter), the operator shares a clear statement which highlights the overall revenue, and operating expenditure, which combined help derive the Operating Profit from the asset.

Then, the landlord and operator have an agreement on how these profits are to be split. In many cases, the operator keeps between 10% to 40% of the profits with the rest going to the landlord. A waterfall method is also not uncommon here wherein the share of profits that go to the operator increase along with the operating profit.

Example of the waterfall method is given below:

The operator bills back almost all expenditures that are required to keep the property up and running including marketing expenditures to fill vacancies, staff cost for upkeep of the premise, and maintenance expenditures like fixing a faulty pipe. The operator DOES NOT bill back their corporate expenditures like their own brand marketing costs, management salaries, and others.

Revenue sharing is becoming a preferred method in many asset classes as it balances the risk on both parties. Similar to the profit share arrangement highlighted above, this method simply allows both parties to share a cut in the revenue derived from the asset, but manage expenditures in their own balance sheet/income statements.

The concept of ‘Cliff’ isn’t uncommon in revenue share arrangements wherein the operator gets a share of the revenue only after a certain revenue threshold has been reached, and the waterfall method mentioned in the previous section is also gaining traction.

Example of revenue sharing arrangement:

Before proceeding with this arrangement, the landlord and operator need to have full clarity on who would incur what expenditure. Ex. If there’s a leaky faucet in the wash room that needs repair, will the operator bear the expense? What if the faucet needs to be replaced altogether?

This is a more traditional approach where the operator takes the entire asset on a master lease from the landlord, and then subleases the asset (either in full or in parts) to tenants. The landlord gets clear cash flow in their bank every month without any surprises, and the operator, who takes the risk, can enjoy higher levels of profit if they do a great job.

This might be the most popular method in markets which has not reached full maturity, especially if the operator is yet to have a proven brand or track record to push the landlord towards either revenue or profit sharing models.

Given it’s a well understood model, I won’t go into the details and explain this further.

Choosing the Right Model

In a nutshell, all 3 methods try to balance risk with rewards - whoever takes more risk, stands to profit more from it.

I would encourage landlords to answer the following questions before choosing the same:

1. 1.
   How much risk am I willing to take on occupancy?
2. 2.
   Does the operator have a proven track record for monetizing an asset to its maximum value?
3. 3.
   Do I need stabilized cash flow or can I take some risk on cash flows to earn an upside?
4. 4.
   Am I aligned with the operator on expected expenditures for the asset?
5. 5.
   How long a horizon do I intend to hold this asset on my balance sheet before selling it to a new investor?

Similarly, I would hope operators have a clear answer to the following questions before deciding their best model:

1. 1.
   How confident am I about pricing this asset?
2. 2.
   Would I be able to achieve above average occupancy in comparison to competitors?
3. 3.
   How will I finance the asset transformation (if required)?
4. 4.
   Am I confident about collections coming on time from tenants?
5. 5.
   Are my investors aligned with the risk I’m taking if I lease <> sublease for this asset? Does the up-side make this risk worth it?

If an operator (say a coworking company) already has an anchor tenant who is willing to take up (say) 70% of the available floor area, then choosing a lease <> sublease model may well work.

If a landlord who has a prime asset in a marquee location believes that no matter who operates on the asset, the occupancy would definitely be above (say) 90%, then they may well choose to opt for a profit sharing model.

There is no ‘right’ way to go about this, but both parties have to think deeply before committing to a choice. At the end of the day, landlords and operators need to work together to create long term value for the end user of the asset, and hence navigating the deal structure is a critical 1st step.