Capital Markets Update | 2017 Wrap Up

Capital Markets Update | 2017 Wrap Up

Transaction volume has been growing rapidly since things began turning around in 2009. When transaction volume rose over 25 percent year over year at the end of 2015, it almost reached levels seen in 2007 and had everyone holding their breathe as to the sustainability of the market. Fortunately, this go around, the market conditions were different than last time in that lenders and the capital markets as a whole saw the benefits of remaining conservative and disciplined. This has kept money from pouring out into the market for the sake of pouring money out there, which has kept both buyers and sellers on their toes to make sure the numbers still work for the deals they are engaged in.

 availability of capital for real estate

With that being said, there is still a ton of transactional velocity out there and deals are still getting done. Even though the availability of capital in 2017 has been pulled back a bit from 2016, there is still a ton of capital out there for real estate investments. The slight cooling off has even been perceived as a good thing to help keep the market at a steady hum opposed to the drastic spikes of an unsustainable rise leading to another dark dip. The conservatism in lending has led to an interesting shift in the availability of capital, however. From the data on the chart on the right, you will notice that commercial banks ranked last in availability of capital for real estate as compared to other lending sources in 2017. We have seen it from our end too; lenders that were bullish on lending for commercial deals have put a hold entirely on funding any new projects while they let the current dust settle. In addition, banks have a hard time exploring outside of the strict parameters that could attract more regulatory attention. That has opened up opportunity for other lending sources to lead the pack.

 

 

 

Commercial banks, over time, are expected to remain major players in the capital lending realm for real estate, it is just unclear as to how these shifts will change the dynamic for their deployment of capital. Commercial banks still house a huge inventory of real estate assets on the books. Although lending may be slower for commercial banks overall, the strength and stability of those lenders remains intact. To pair with that, we are also still seeing a number of lenders with a strong appetite for commercial lending and deals are getting done.

Capital Market ForecastThe availability of capital for development can still be a tricky path to navigate. The chart on the left shows that debt capital for development/redevelopment in 2017 was largely undersupplied versus 2016. Aside from that fact, however, most of the real estate capital market metrics have remained in balance. The influx of cash into the market from the increase in transactional velocity has compressed cap rates to levels much lower than we saw during the last cycle, however, with interest rates still historically low, buyers are still making money. Lenders have been forced to get competitive, which has narrowed spreads along with a few slight adjustments from the FED, but spreads are still hovering at healthy levels; gross spreads are still around 200 basis points, compared to a 100-130 basis point spread back in 2005-2007. Inflation is expected to remain fairly stable and at current levels over the next five years, but interest rates will undoubtedly creep up at a moderate pace within the same time frame. Both debt and equity underwriting standards are forecasted to become more rigorous as we continue to push forward in this market. As a result, it is likely that values and cap rates will shift in conjunction to maintain a healthy spread and return for investors. As long as the process is fairly gradual, it should provide more opportunity for buyers as debt on commercial assets comes due, while also providing a healthy post peak sales environment for owners to consider accessing their equity at a higher level than they entered into the investment and moving that equity into other commercial investments with continued upside in the future.

CMBS debt may have been one of the biggest question marks as the market has shifted over the past few years, but it appears that debt has matured at a healthy pace with the market and CMBS should have enough capital available to be a strong contributor to deal flow over the next number of years. Although we have seen a bit of a pullback, the consensus in the market is that the pullback is a healthy one for the market. Outside of any major economic shift, the real estate market is anticipated to continue moderate growth over the next couple of years due in large part to the health of the capital markets. The increase in construction costs and continued challenge of finding funding may slow down development to an extent and it may vary across different commercial sectors, but that could simply lead to rent growth and appreciation over the short term. Values for real estate in this market may have plateaued, but are still above and beyond any values that were attained during the last peak. The difference is that this peak appears to be more stable and supported than some of the smoke and mirrors experienced last go around.

If you are an owner or investor considering your options in the market, please feel free to reach out to us directly. We welcome the opportunity to learn more about your specific situation and help you understand your options for accessing your equity through a sale or refinance, as well as your option of holding the property strategically to add value over time. There is a lot of work we can do together outside of a transaction to help ensure you maximize the value of your real estate investments. You can reach James Garner or Jim Shiebler with any specific questions around the market, your existing investments, or what available investment inventory might be a good fit for you.

 

For more information on what happened in the market this year, contact us directly about our Annual Restaurant Report.

Applebee’s: Good or Bad Investment?

Applebee’s: Good or Bad Investment?

It was November of 1980 in Decatur, Georgia when the doors opened for T.J. Applebee’s Rx for Edibles and Elixirs. Six years later, the concept changed names to Applebee’s Neighborhood Grill and Bar to reflect the original vision for the concept being a local place that everyone could call home. Fast forward 20 years later and Applebee’s had grown large enough to attract the attention of DineEquity, formerly IHOP Corporation, which acquired Applebee’s for $2.1 Billion in 2007 to create the largest full-service restaurant company in the world.

Now we are in 2017 and times are changing! Fast casual concepts have been picking up steam since the early 2000’s. With consumer preferences continuing to shift towards a larger variety of tastes along with a desire for healthier choices, fast casual as a segment has began to take market share from both casual dining and quick service restaurant concepts with the rise of trendy concepts. In light of these changing consumer preferences, Applebee’s made a number of shifts over the past few years in strategy, offering, marketing, etc. in order to maintain that market share and recapture their customers.

Even still, the company has seen regular declines in same-store sales recently and it has hurt the perception of Applebee’s as an investment. The average cap rate for Applebee’s sold in 2016 was 5.90%; year to date 2017, the average cap rate is 6.21%. That means that over the past twelve months, cap rates have climbed over 30 basis points.

That doesn’t sound too bad…

The recent announcement that DineEquity would close up to 135 locations in fiscal 2017 is what has really created the most recent shift in perception and cap rates. The average cap rate for on-market Applebee’s properties right now is 6.73%; over 80 basis points from the 2016 average. Further, the average cap rate for Applebee’s properties hitting the market since August is 7%. That is over 100 basis points lower than where cap rates were for a comparable asset 12 months prior. This is not happening across the board for restaurant net-leased assets. The restaurant sector actually continues to see some of the most compressed cap rates across all other net-leased food groups; staying about 40-50 basis points lower than other comparable net-leased assets in other sectors. This is a direct result of buyer perception and an influx of inventory hitting the market.

So as a buyer, you should stay away, right?

Not necessarily.

Many argue that now is the time to enter the Applebee’s concept and take advantage of these inflated cap rates for a proven concept with a long-term lease in place. Applebee’s has been on a steady decline, however, recently there have been a number of changes within executive management and they are shaking things up. What they did not tell you prior to rolling out the breaking story of all the anticipated location closures was that they had identified most of these closures quite some time ago. In fact, half of the stores they plan to close have likely already shut their doors. According to Nation’s Restaurant News (NRN), the Applebee’s brand president, John Cywinski, said this was a strategic move and many of the store closures are stores that “need to close and perhaps should have closed a long time ago”. In addition, Applebee’s has vowed to get back to their American roots. Instead of continuing the attempt to capture a new demographic, they are going back to listening to what their core demographic is asking for. According to Inc.com, Cywinski made this statement regarding their new focus:

Now, let’s shift attention to our guests and perhaps one of the brand’s strategic missteps. Over the past few years, the brand’s set out to reposition or reinvent Applebee’s as a modern bar and grill in overt pursuit of a more youthful and affluent demographic with a more independent or even sophisticated dining mindset, including a clear pendulum swing towards millennials. In my perspective, this pursuit led to decisions that created confusion among core guests, as Applebee’s intentionally drifted from its — what I’ll call its Middle America roots and its abundant value position. While we certainly hope to extend our reach, we can’t alienate boomers or Gen-Xers in the process. Much of what we are currently unwinding at the moment is related to this offensive repositioning.

Applebee’s is upgrading image, equipment, and focus. They have embraced technology and begun implementing tablets into their POS systems. They have adjusted the menu and pricing strategies under new executive management. To top it all off, they are getting back to the roots of their core demographic and are revved up to crush it out of the park. Good or bad investment? It depends on your threshold for risk and your hunger for return. For every seller looking to transition from Applebee’s to a different asset or net-leased sector, there are three buyers trying to take advantage of the inflated cap rate environment around the concept.

Like any long-term net-leased investment, it is important to weigh all the factors heavily before moving forward. Ultimately, anything can happen over the next 15-20 years. If you are concerned with maintaining your cash flow for the extent of the new 15 year Applebee’s lease you are looking to purchase, then get critical of the guarantee behind the lease and weigh the risk that it holds. If you would rather take a 7% return when all other restaurants are trading 100 to 200 basis points lower, then simply assume they will vacate at the end of the lease and evaluate the core real estate for the future. If the financial strength of the guarantee holds weight and you are positioned on over an acre of land, on a decent thoroughfare, in a growing area, then a dive into an Applebee’s bottom might be your smartest move; worst case scenario you re-tenant after the base term with a growing concept after collecting an average of 7-8% on a passive net-leased asset…the upside, though, is that you could enter into the monster concept on a downswing and get to ride it back up through its transformation.

Church’s Chicken: A Work in Progress

Church’s Chicken: A Work in Progress

Church’s Chicken is an American chain of fast food restaurants specializing in fried chicken. The chain was founded as Church’s Fried Chicken To Go by George W. Church, Sr., on April 17, 1952, in San Antonio, Texas, across the street from The Alamo. The company, with more than 1,700 locations in 25 countries, is the third-largest chicken restaurant chain behind KFC and Popeyes Louisiana Kitchen.

Church’s is known for thriving in tough markets housing lower income demographics. Many investors actually prefer these investments because there is a sort of hedge against risk in these markets. The perception is that regardless of what hardships hit these markets, they will always need to eat cheap and Church’s is there to provide that service. In the recent past, however, with the chicken market exploding, Church’s has had some tough competition. Church’s as an organization has made serious strides towards improving their competitive position.

According to the organization itself, burger joints and grocery stores are stealing their thunder lately. It could be argued, however, that their biggest competition is the local shop across the street. Even they agree that the business is a battle of street corners. Essentially, it is all about real estate…Who has the hard corner with the highest traffic counts? Who is most likely to pull customers in from the street and capitalize on their impulse for dinner?

Admittedly, Church’s as an organization is working on both variety of offering and also increasing volume through drive-through efficiency. According to Nation’s Restaurant News (NRN), Church’s has been ramping up their technological offering in an attempt to improve their drive through experience.

Who is the drive through competition though?

Chick Fil A, Raising Cane’s, Zaxby’s…There is some tough competition out there. Church’s has clocked their drive-through time in at just over three minutes and 30 seconds, which is impressive, but you also have to get the order right. According to recent data published by QSR Magazine on the accuracy of QSR fast food joints, some of the top contenders include Raising Cane’s topping the list at over 97% accuracy…Chick Fil A pulling 3rd with over 93% accuracy…and Zaxby’s clocking in at over 90% accuracy. Church’s Chicken unfortunately did not make the top 15 on the list.

With a dinner oriented business, focused on a lower income demographic and catering to the entire family, there is still little competition for the type of value their $5 Real Big Deal brings. It is hard to beat a deal that cheap that can feed the family while also offering choices that allow you to customize your meal.

When it comes to Church’s Chicken as a real estate investment, there are certain characteristics the deal holds that you cannot ignore:

  • Like many QSR properties, the real estate tends to maintain core desirable properties:
    • Hard Corner
    • Main Thoroughfare
    • Good Ingress/Egress
  • The rents are low
    • With rents averaging around $20 PSF as a concept, if the demographics were to shift in a landlord’s favor, there could be some generous upside in rent appreciation.
  • Demographics have a sustainable need
    • The target demographic, although thrifty, has proven to spend money on convenience. The concept works and is typically recession-proof. Even when there is a downturn, the main household income for this demographic will not shift as dramatically as other higher income areas. Because the demographic is self-sustainable, they can often replicate the disposable income necessary to spend money on eating out more readily than other economically hard-hitting areas.

Over the past twelve months, Church’s Chicken has had an average cap rate of 7%. Similar to the story above regarding the sustainable demographic, the cap rate has also remained fairly stagnant compared to other concepts. Why? Mainly because while the risk or perception of risk in other concepts varies greatly around market traction, the perception of risk for these types of assets remains fairly the same over time. The guarantee has not shifted much; and although the demographics will never demand a certain amount of sales, the demand for the concept and product is there. The density of the population and demand from the surrounding population will sustain the concept.

The challenge for an owner is: what happens if they leave?

If you own a Church’s Chicken and the lease term is approaching, a major question is: Will they stay or will they go? As an owner with this question in mind, you hold significant risk. Although compared to other net-leased investments, the average Church’s Chicken pays a fairly low rent per square foot, the sustainability of the cash flow stream can still be unclear. The nature of the target demographic is a pro in the fact that it is in constant need of the product, but a con in the fact that even though the base rent is low, if Church’s left, you would be stuck trying to lease to a local tenant likely at half the market rate. Your cash flow would be cut in half. If you are a savvy investor and have enough tenant relationships to redevelop the parcel or sit on it until it can be redeveloped with a stronger tenant, then you are in good shape.

Most of us, however, are not in that kind of position.

I urge clients to look at their investments critically and evaluate their options on a regular basis. I am here to help. I’m evaluating risk, cash flow, equity, and future value for clients on a daily basis and I’m happy to do the same for you. As you plan your long-term investment strategy, it is imperative that you look at how your existing portfolio fits into your long-term plan. An investment like Church’s Chicken has its pros and its cons; it can certainly be a strong part of a comprehensive portfolio, but my point is that nothing should be left to chance. If you are not looking at these investments with a strict magnifying glass and comparing them to the rest of your long-term plan, then you need to re-evaluate your investment strategy. I am happy to help wherever it makes sense, so please reach out if you are curious about your existing portfolio, looking to diversify, or simply wish to keep a pulse on what is happening in the market and how you can best capitalize on the recent market changes.