How is Digital Tech Affecting Restaurants as an Investment

How is Digital Tech Affecting Restaurants as an Investment

Last month I talked about what we expect to see as the restaurant sector pushes forward this year. One of the anticipated shifts that we have already seen taking shape is the integration of digital tech into the consumer experience. Consumer preferences used to be convenience focused. As consumer preferences changed, business models shifted to offer guests a more custom and individualized experience, but the scale of offering such options cut into the convenience factor. Now concepts are learning new ways to offer consumers both convenience and individualization. How? Many of the solutions are being created through new technologies.

You used to have to browse direct mail magazines and call orders in to department stores if you wanted products shipped to you. Then, you could plan to receive them weeks later. Amazon has changed the game making orders a simple mobile click away with plans to standardize a 2-hour delivery window. As businesses started replicating the speed and efficiency of ordering through tech, you can now get groceries delivered through services like Shipt. Online ordering isn’t anything new to the restaurant sector, but concepts weren’t always been so eager to make those services available or to optimize their systems. Today, however, consumers want more, they want it faster, and they want it at a competitive price, so concepts big and small are brainstorming ways to deliver on those consumer demands.

Starbucks has done a great job making their mobile app an extension of their brand. Not only does it make it simple to pay (you just open up your app and allow the cashier to scan your barcode, which is tied to your Starbucks account and credit card), but it also offers new opportunities for guests to engage; partnering with music streaming services like Spotify to allow guests to customize their musical preferences; collecting stars for rewards programs that offer enticing discounts and promotions; a mobile store to purchase Starbucks merchandise directly from the app.

It is proving quite lucrative for Starbucks.

As a real estate investment, Starbucks is one of the highest paying QSR tenants on average paying over $60 per square foot, while the general average rent paid by QSRs floats around the $30 PSF mark. Part of what empowers Starbucks to be so aggressive on rent is their ability to turn a volume of transactions. This used to be a main function of their drive through stack; Starbucks locations with a drive through typically generate 20% more in sales revenue than a location without a drive through. Today, they are likely maintaining and increasing that guest volume through the technological efficiencies they are implementing. These technologies are not only making transactions easier for guests and catering to their changing preferences, but it is also making the entire transactional process faster allowing more foot traffic to get through the cash registers to check out. According to an article by Nation’s Restaurant News, 2017 saw 1.6 percent or 960 million restaurant visits being paid via mobile app. That was an increase of 50 percent over a year ago. Brands like Taco Bell have implemented similar apps, but aside from the convenience factor and efficiency factor, it is also allowing orders to be taken off site, which means less time guests have to stand around waiting for their food to be made, less congestion inside of restaurants themselves, and parking spaces being made available quicker allowing for additional guest volume to push through the stores. Guests can preorder their food and by the time they arrive, their food is ready. All guests have to do is sit down to eat or grab it and go.

In 2017, McDonald’s discussed their new “Experience of the Future” (EOTF) business model shift, which may take several years, but plans to utilize self-serve kiosks and more outdoor eating spaces aimed at cutting labor costs, increasing efficiencies, and improving the overall guest experience. McDonald’s is a master at guest volume. They are one of the lowest paying quick service restaurant concepts in terms of per square foot rent and in addition they have one of the lowest average ticket prices for guests across the board. The amazing thing about the concept, however, is that even with those items considered, they tout some of the highest average sales per unit across most quick service restaurant concepts and demand some really high investment sale prices when selling your real estate with them as a tenant. Why is that? Their strong credit guarantee and generally core real estate sites certainly help, but it is also because they churn such a volume of guests that their low average ticket price still yields them very aggressive unit sales figures, which translates to a low rent to sales ratio and a less risky investment for investors that will pay a premium for all of the above. Contact us about our restaurant report for more detailed information regarding average cap rates, unit sales, and year over year growth per specific concept.

These technologies are changing the game, but with these added benefits for these concepts comes added costs. Also according to the above referenced Nation’s Restaurant News article, 16 percent of cash paying non-tech users were concerned about identify theft or credit card fraud. Although it may be rare to find a completely cashless restaurant as it sits today, anyone implementing these technologies is going to have to bulk up their IT costs to ensure the apps run smoothly, safely, and prevent any sort of outside hacking.

The good news is that it is not only the smaller footprint Quick Service Restaurant concepts jumping on board. The casual dining sector has been shocked into some big changes as many larger footprint concepts have seen consistently declining sales as these consumer preferences continue to shift. These shifts have especially hurt the casual dining concepts offering cheaper meals as their average tickets do not generally have the profit margin fat to spare, which some of the more fine dining concepts can absorb due to higher tickets and heavy alcohol sales. It will be important to a casual dining concept’s success to get more people through their doors and turn over tables faster. Concepts like Chili’s have begun using tablets at tables, which allow guests to place their orders, order refills, and make their payments when they see fit in addition to adding other experiences such as games, news, and promotional upsells. Many think that the human connection a physical server brings is an experience people dine out for and cannot be replaced by technology, which may very well be true, but it seems the path to success is not a black and white, this or that philosophy. Instead, restaurants can leverage these technologies and use them in conjunction with physical servers to improve efficiencies, reduce human error, and give the guests totally new and unique dining experiences, while simultaneously allowing for more guest traffic by reducing the time it takes to turnover tables.

On the real estate investment side, many of the struggling casual dining concepts have seen cap rates go up due to some of the risk perception of their concepts increasing in the marketplace. There are many casual dining concepts still aggressively expanding, maintaining strong sales, and doing a great job of capitalizing on these technologies to cater to changing consumer preferences, but many are wondering how long it will take struggling concepts to figure things out and re-stabilize. The overall buyer pool for casual dining concepts has shrunk a bit as investors have begun moving more towards quick service restaurant investments. Because QSR concepts have smaller footprints, location centric sites with dense high traffic corridors, less of a need for an “experience” since guests are looking for speed and convenience, and the generally low ticket price that can remain in demand during a down market, these investments are perceived as a less risky alternative. With that said, some investors are viewing this as an opportunity to capitalize on how low their current QSR investment cap rates are and move into emerging or strong operating casual dining concepts where there may currently be more risk, but also more upside in the future. Some are simply following the old adage of selling what everyone is buying and buying what everyone is selling; the idea that you could sell your Starbucks for a 4.5% cap rate, but exchange into a well-located Applebee’s at a 7% cap rate with a strategy to hold on for the ride until the casual dining sector settles in, evolves, and starts demanding lower cap rates again. With core real estate principles at top of mind, those investors are weighing worst case scenario situations of re-tenanting the space, signing a new long-term lease with a new tenant down the road, and then looking to exit at that point once value has been created again.

There are a million ways to slice the salami and an investors appetite for risk can vary dramatically. A good deal to one investor can be a nightmare for another. One thing we can be sure of is that there is no lack of opportunity out there. We are helping clients strategize and exchange in and out of these types of opportunities on a daily basis. We welcome the opportunity to learn more about your situation and what we can do to compliment your existing investment efforts. We promise that if you work with us on a long-term basis, you will not only keep a pulse on ever changing market trends to avoid potential risks in the marketplace, but you will also undoubtedly find new opportunities to increase your cash flow, grow your portfolio, and maximize your equity along the way.

Restaurant Merger & Acquisitions: Expected to Maintain Steam in 2018

Outside of real estate investment, the restaurant market for business acquisitions has been warming for quite a while now. I say “warming up” modestly because it can be argued it has, in fact, been a fire hot space attracting investors big and small to concept acquisitions big and small. The M&A (Merger & Acquisition) market for restaurants has correlated to how the single-tenant net-leased real estate asset class has responded over the past 24 months; getting hotter than ever, then slowing down, but stabilizing at values that remain higher than most cycles have ever seen. Some of the higher profile news included JAB acquiring Panera Bread, Buffalo Wild Wings being acquired by Roark Capital, and Amazon acquiring Whole Foods in a parallel, but complimentary merging of sectors. In addition to bigger news, there has been some big news in smaller concept growth as well. R&R BBQ was acquired by Four Foods Group, while Beef ‘O’ Brady’s and Brass Tap franchisor FSC Franchising sold a majority of their stake to CapitalSpring. Ponderosa went to FAT Brands. Ruby Tuesdays went to NRD Capital.

 

Why is all of this happening? Investors have been consistently looking to take advantage of the rising consumer sentiment and there is still a ton of cash out there looking to be invested. The consensus among the restaurant lending arms of the world at the 2017 Restaurant Development and Finance Conference in Las Vegas was that the flow of capital is greater than ever right now. There is a lot of risk in many retail spaces right now and a lot of those investment dollars are being funneled towards the restaurant sector as a hedge against that risk. The newfound success by many smaller more craft concepts has sparked investors to take a more serious look at smaller growing concepts with significantly more upside than their more stable, seasoned, and proven concept competitors. Strong operators or investors with economies of scale in the space are more willing to take the risk on a potentially trendy concept if they can apply some of the basic growth principles to the brand that have worked for their other brands in the past.

 

Restaurant values are some of the highest we have ever seen with M&A multiples for franchising deals climbing higher and higher. This is making it tougher for smaller operators to grow their unit size as now there are some big money players coming into the mix, willing to throw some cash around at more aggressive prices than smaller investors may be willing to bite off on, but some of these strategic buyers backed by cash heavy big hitters have the scale and size to make the numbers work. Their long-term focus on their investments is driving some prices to 20 times EBITDA or higher. For instance, RBI paid 21 times EBITDA for Popeye’s, but they have the scale, systems, and supply chain to make even the international growth of such a well established concept a successful acquisition. According to the Restaurant Finance Monitor, Wedbush Securities analyst Nick Setyan has identified various restaurant concepts that might be acquired in 2018 based on cash flow yields. He identified BJ’s Restaurants, Fiesta Restaurant Group, and Cheesecake Factory as his top three to keep your eye on in 2018. As we all know, the restaurant industry is cyclical just like everything else, but the hope is that there is still some significant runway left in this cycle for investors, operators, franchisors and franchisees to find some win-wins and continue building concepts that will sustain profits in the long run.

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.

Restaurant Development, Construction Costs, and Sustainable Expansion in Casual Dining

Restaurant Development, Construction Costs, and Sustainable Expansion in Casual Dining

The restaurant sector continues to grow aggressively. From new trendy concepts popping up and gaining traction to well-established concepts expanding into other markets in order to capture more market share, restaurants remain bullish on development. Sometimes, however, more isn’t always better. When it comes to scaling any business, from franchisees just getting off the ground to well-established corporate structures, it is important to understand your bandwidth and how to scale under the premise of sustainability versus blind and rapid expansion that can lead to disaster. BJ’s Restaurants, Inc. is a prime example of this philosophy and how sometimes taking what seems like a step back can be a wise move toward a future two steps forward.

BJ’s Restaurants, Inc. is an American restaurant concept that operates under names such as BJ’s Restaurant and Brewhouse, BJ’s Pizza & Grill, and BJ’s Restaurant & Brewery. The first BJ’s concept opened in Orange County, California back in 1978 and in 2017, BJ’s Restaurants, Inc. plans to add 10 locations totaling 197 restaurants operated in 24 states across the nation.

Developing 10 locations in 2017 is light compared to the 17 locations that were developed two years ago. Plans for 2018 are even lighter. According to Nation’s Restaurant News (NRN), CEO Greg Trojan plans to add six more stores next year, stating, “The slower pace of expansion has allowed us to focus operationally on many new initiatives…It’s helped drive more management tenure, adding more local knowledge and team familiarity to our sales-building efforts.”

Recent trends in development has caused construction costs to rise, which has made a number of developers think twice about how to make the numbers work. Net-leased development in general remains the key driver of overall retail construction, accounting for more than 46 million square feet of the 60.4 million square feet delivered over the past year. Single tenant construction has averaged 45 million square feet over the past three years. Developers have been focused on net-lease property development amid labor market strength and extremely low unemployment. According to Marcus & Millichap’s Net-Leased Research Report for Fall of 2017, builders have been constructing projects favoring single tenant concepts, particularly in the quick-service restaurant, pharmacy  and dollar-store segments. Further, net-leased deliveries have accounted for more than 80 percent of retail development since 2009, up from below 70 percent before the recession. According to the Turner Building Cost Index—which measures costs in the non-residential building construction market in the United States— the third quarter 2017 index increased to a value of 1044, which is a 1.26% increase from the second quarter 2017 and a 4.92% annual increase from the third quarter 2016. In fact, costs all around have seemed to tick up a bit as the restaurant sector has been heating up, employment has improved, and supply and demand plays its part in the sector.

construction costsConstruction_Producer_Price_Indexes_Aug2016-1

Although these rising costs have played into some of the slowing development of certain concepts, it also appears that the top level management at BJ’s Restaurants, Inc. simply has a strong understanding of their bandwidth and capacity for growth. By taking a step back and slowing development, they are allowing themselves to settle into their new stores giving those stores an opportunity to mature and build steam. Just like everything else, there is an ebb and flow to growth. It is no wonder that cap rates for real estate assets backed by the publicly traded company have compressed in the recent past. Based on our research data, the average cap rate for BJ’s occupied property in the past 12 months has been 5.27%, while the average BJ’s leased property is on the market at a 5.00% cap rate. Compare that to the average cap rate across full-service restaurants for the past 12 months: 5.79%. The graph below highlights the 2016 average cap rate across a number of the top casual dining concepts in the sector.

Average Cap Rate - Casual Dining

That means BJ’s occupied property has performed over 50 basis points more aggressive than the average full-service nationally recognized brand. That is impressive. Many investors have expressed concern for the full-service casual dining sector as a whole. With many concepts failing to meet sales expectations and consumer preferences changing, some investors worry that the casual dining sector is disappearing altogether; however, as consumer preferences continue to demand customer experience, there is opportunity for the casual dining sector to evolve with consumers and technology in a way that is bound to keep the industry alive. Many champion leaders of the industry are already taking a proactive approach to these consumer changes adopting new technologies, catering to more take out and delivery services, while providing guests with the offerings and experiences they desire in order to get ahead of this evolution and remain relevant. Both QSR and Casual Dining real estate tends to adhere to certain core characteristics; main thoroughfare traffic, hard corners, visibility, ingress/egress, strong parking ratio, etc.

The fact is, from a real estate standpoint, the casual dining sector also provides investors with many benefits over quick service restaurant concepts:

  • Generally Larger Parcel Size for Future Development
  • Larger Building Footprint
  • Higher Guest Ticket Prices Equate to Higher Sales Volume Per Unit
  • Higher Guest Volume and Sales Equate to Higher Rental Figures
  • Larger Price Points to Place, Build, and Leverage Equity

The disappearance of the entire sector would eliminate an entire tier of investments from both a price point and a cash flow stance. Ultimately, there is inherent value in the experience the casual dining sector provides consumers from a social environment to the variety and quality of food it can provide over quick service concepts.

Do I expect the sector to disappear?

No.

Do I expect the sector to evolve?

That is inevitable.

Investors would be wise to identify these front-runner brands, such as BJ’s Restaurants, and opposed to avoiding the sector altogether, invest in concepts that are up and coming in addition to scaling in a sustainable way.

If you are an investor interested in taking advantage of some of the up and coming concepts in the casual dining sector, I am happy to share my insights and help you find a deal that meets your investment criteria. Whether you are looking to invest in the sector, gauge your current holdings, or build a strategy around how to maximize the value of your assets, I welcome the opportunity to learn more about your individual situation and what I can do to help.

Burger King: Corporate Owned to Franchise Run Investments

Burger King: Corporate Owned to Franchise Run Investments

Burger King has been part of quite the wild ride. As an income producing property investment, it can be considered one of the most popular options because of the attractive lease structures, experienced franchisees and powerhouse institutional parent backing. When looking to identify solid net-leased investments that also have upside, Burger King may be worth a strong look, but first let us start with a quick history lesson on how the concept has grown to what it is today.

It was 1953 when Keith Kramer and Matthew Burns built a stove called the “Insta-Broiler”. Living in Jacksonville, they were searching for a restaurant concept and settled on a burger joint called “Insta-Burger King”. After James McLamore, a student at Cornell, visited the hamburger stand operated by the McDonald’s brothers, he and his fellow classmate David Edgerton bought an Insta-Burger King franchise in Miami. By 1961, Burger King had begun expansion across the United States becoming famous for their signature burger, The Whopper. Just six years later in 1967, Pillsbury purchased the concept for a whopping $18 million and with Pillsbury’s support had the means to scale their operation becoming the second largest burger chain in existence, only behind McDonald’s.

Because of the intense competition between the two burger concepts, Burger King franchise agreements were restructured to restrict franchisees from operating franchises in other chains, in addition to regulating how far away your stores were from your home in order to cut down on absentee ownership. With the continued growth of the Burger King brand, TPG Capital paired up with Goldman Sachs and Bain Capital to purchase the concept for $1.5 billion before its IPO in 2006, which generated $425 million in revenue. Then, in 2010, 3G Capital purchased the concept for $3.2 billion.

That is about when Burger King began shifting its business model to focus heavy on franchising. Burger King makes its money from primarily three revenue streams: Sales from corporate operated locations, Income from leasing owned property, and Revenue from Franchise fees. In 2011, Burger King had 1,395 company owned and operated locations, but in 2012 Burger King began selling off stores. In 2012, about 59 percent of Burger King’s revenue came from store sales and operations. One year later, only 8 percent of the company’s revenue was from operating stores. Burger King had sold 96 percent of all their stores to franchisees in order to focus more on branding, product development, and other support resources that would help franchisees find further success.

Quarterly-Revenues-2014-09-01-BK

Their philosophy became:

Let the franchisees do what they do best so we free up time to find new ways to make the concept better.

That is why today, an investment in a Burger King net-leased asset, even operated by a small franchisee, can be an extremely safe, stable, and attractive option. That is also why many of these Burger King assets demand aggressive cap rates compared to other concepts on the market. In 2016, the average cap rate across all Burger King investment sales was 6.04%, while the historical all-time average cap rate across the restaurant sector lands at about 7.12%. This data includes both long term leases and short term leases; both corporate backed leases and franchisee backed leases. The graph below shows the average cap rate across a number of quick service restaurant concepts. You will notice that Burger King offers investors a very competitive return compared to other concepts, but while also offering a very well established brand and operation.

avg cap rate qsr 2017 trailing 12 months

For a long-term lease (10-20 years remaining), that cap rate can compress 50-100 basis points. In 2017, there have been a number of fee-simple properties backed by small franchisees (5-unit to 20-unit guarantees) selling at cap rates from 5.08% to 5.59%. Although corporate backed leases will demand a more aggressive cap rate in most instances, the franchise and support structure employed by the Burger King concept has proven a successful business model for smaller franchisees and those investments continue to demand a very competitive cap rate because of it.

So where is the upside?

Burger King is moving towards and would prefer to have fewer, but larger franchisees. Fewer franchisees operating more stores means less micromanaging, fewer contacts to keep in front of, and economies of scale. Fewer operators obviously means fewer moving parts. That is why purchasing a store operated by a small franchisee could provide very attractive upside in the future. Because a small franchisee backed lease still offers stability of concept and a hedge against risk, it will still demand an aggressive cap rate; however, an investor would still be able to capture a higher return than purchasing a corporate backed lease, which exposes the investor to even smaller risk. Why wouldn’t you capture that higher return on a solid long-term net-leased asset, while also keeping in mind the potential upside in the future. If you purchase a property operated by a 5-unit franchisee and plan to hold for 10 years, the chances of that operator being acquired by a larger more regional franchisee are fairly strong. That means that by the time you are ready to revisit an exchange, you will likely have built up equity in rental increases, real estate appreciation, but most importantly an increased financial guarantee or at the very least a stronger operator behind your original guarantee. Now, when you decide to bring the property back to the market, you will be able to demand a more aggressive cap rate having a larger, stronger operator having taken over your location.

That’s the potential upside!

Although Corporate will still back leases, most Burger King locations are owned and operated by the franchisee and provide a lease guarantee to match. As an investor, this is a benefit because your tenant has significant skin in the game, while also operating under a proven concept with monster support from its corporate parent. You are able to secure a long-term passive net-leased asset, but with upside in the future acquisition from a larger regional franchisee. This is why even a property housing a small franchisee operating under the Burger King umbrella can demand extremely aggressive cap rates in the investment sales arena. These deals should not be overlooked by investors looking to purchase or exchange into a net-leased restaurant property.

For more detailed information regarding Burger King properties, franchisees, or lease language and how it can impact the value of your investments, feel free to contact me directly at 813-387-4796. I am working with property owners, restaurant operators, and developers on a regular basis to connect the dots around where they are today and what they are trying to accomplish in the future. Even if there is no immediate business, I welcome the opportunity to learn more about your current investment situation and what I can do to help you maximize the value of your assets.

Does The Guarantee On Your Restaurant Net Lease Have Upside or Downside?

Does The Guarantee On Your Restaurant Net Lease Have Upside or Downside?

One of the biggest metrics investors look at when purchasing a single-tenant net-leased asset is the guarantee behind the lease. It is a major factor in weighing risk vs. return when it comes to net-leased assets.

It can also be a major factor that is misunderstood or overlooked without careful investigation.

For example, let’s say you are considering the purchase of a Taco Bell net-leased asset:

You perform a quick Google search to discover that Taco Bell is S&P rated BB and operates 7,000 locations!

That is quite a strong concept!

Hold on…You also learn that Taco Bell is actually a subsidiary of Yum! Brands, which owns Taco Bell, KFC, and Pizza Hut comprising of over 43,000 locations!

That must be a risk-free investment then…

Well, not necessarily.

Thinking this is the best investment since sliced bread, you put the property under contract. During the due diligence period, you investigate the lease to learn that it is actually only guaranteed by an entity named “Taco Bell 5 FL Tacos, LLC”…

What does that mean?

Come to find out, the franchisee operating this Taco Bell only has 5 stores…and only ONE of their stores is backing this lease through the referenced entity…

It is easy to see how an investment backed by corporate Taco Bell holds drastically different risk factors than an investment backed by a 5-unit franchisee only offering a 1-unit guarantee on their lease. These are important risk factors that have significant impact on the values you can demand for your investment property and the return you can expect to yield from purchasing one of these properties.

These are also important factors that your broker/investment advisor should be making you aware of and helping you analyze, not only prior to a purchase, but prior to a contract for purchase.

With that in mind, existing guarantees can have upside or downside tied to the strength of what is backing the lease.

The typical rule of thumb in any investment is:

The Higher The Risk, The Higher The Return!

A corporate 20-year Taco Bell lease may sell for a 4.5% cap rate, while a 5-unit Taco Bell lease with just 3 years remaining might sell for an 8% cap rate. With a weaker guarantee or lesser lease term comes more inherent risk, but also more reward.

This can be especially true for your guarantee.

You may take on more risk purchasing the 5-unit franchisee backed lease, but what if a larger 200-unit operator is considering buying out that smaller franchise? If that 200-unit operator buys out your tenant and decides to guarantee the lease with the entire lot of their locations, you could easily gain 100-200 basis points worth of value overnight.

That is what some like to call upside.

KBP Foods, a large franchisee of Yum! Brands concepts, recently acquired 78 KFC locations. According to Nation’s Restaurant News (NRN), this was just one of many recent acquisitions that have helped the operator reach 530 locations in 20 states. One of those purchases was an acquisition as small as four locations in Lawrence and Topeka, Kansas. These units were purchased from franchisees and the investors owning the real estate under those operations must be popping the champagne right about now because their small franchise tenant just evolved into a powerhouse operator and one of the largest Yum! Brand franchisees in existence. Even without a change in the guarantee, the perception of now having a very strong operator can alone impact the value and equity of the investment.

My warning is that it can work in the opposite direction as well.

Part of KBP Food’s feeding frenzy in acquiring locations included 41 locations in Texas directly from Corporate KFC. This is not unexpected. Last year, Yum! Brands announced they would shift the ownership of their stores drastically into the hands of franchisees; taking their 10,000 corporate run stores and shrinking that number to fewer than 1,000 by the end of 2018, according to USA Today.

Those investors that had a corporate KFC lease just had a change of tenant…From Corporate run to franchisee run…overnight. While in some lease structures, the landlord is protected for the life of the lease, there is certainly downside when it is time to re-up and your new tenant has a fraction of the net-worth your previous tenant came to the table with. In the KBP Foods scenario, the downside in equity may not be as dramatic; a tenant shift from Corporate run location to a 530-unit operation, although a sure hit in the risk department, is still a pill you can swallow. Some leases, however, allow for corporate guarantees to revert to franchisee guarantees as small as 10 or fewer units…

That  is where there can be downside.

Which scenario strikes a chord with your current portfolio?

Do you have upside or downside?

If these are factors you actively consider when looking at deals, then you are ahead of the game and I would be happy to take you to the next level with the specialized insight I can provide. If you were unaware of these factors or fail to consider them on a regular basis, you and I should connect immediately.

Please reach out and I will make myself available.

I’m helping clients all over the Nation evaluate their upside/downside on a daily basis; analyzing property value, risk, and equity to help clients get clear on their options at any given time within the market and execute on a proactive strategy around these seemingly reactive assets. Feel free to reach out to me for more specific insight around your restaurant investments as I welcome the opportunity to help you do the same even if there is no immediate business to be had on the horizon.

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.

Hurricanes Irma and Harvey: How Natural Disasters Can Impact the Market

Hurricanes Irma and Harvey: How Natural Disasters Can Impact the Market

I remember a few years ago, taking a phone call in front of our large conference room window. I was looking out at the downtown skyline of Tampa Bay, discussing deal points with a client on other end of the phone. Most of the office had cleared out to prepare for a brewing hurricane. The skies were blue and the sun was beaming, but grocery store parking lots were gridlocked as swarms of people flooded the aisles in search of water and canned goods. There was no indication that the storm would even continue heading our direction, but everyone was up in arms about being prepared for the worst. It turns out the Category 3 storm that was headed straight for us took a last minute detour and we maintained blue skies for the bulk of its passing.

Preparation, or non-preparation, becomes a double edged sword. Nine times out of ten, you will over prepare for a storm that never happens, but that one time you decide to overlook your preparations is when you will be hit the hardest. This year, hurricane season has been in full force. First it was Hurricane Harvey, which slammed coastal Texas with devastating power. Homes and businesses were flooded and cars were swept off the roads. The category 4 storm had 130 mph winds that ripped through the Texas coast overnight. At the end of it all there had been as much as 20 inches of rain in some places leaving over 300,000 people without power.

That type of devastation affects not only the residents, but the surrounding businesses, the infrastructure, and the real estate. Darden Restaurants, Inc., the parent company of a number of well known full-service restaurant brands such as Olive Garden, LongHorn Steakhouse, The Capital Grille, Bahama Breeze, and the newly acquired Cheddar’s Scratch Kitchen, reported the storm hurt same store sales and earnings in its fiscal first quarter. Between forced store closures, power outages, and other unfortunate circumstances, their earnings per share took a hit. The Cheddar’s Scratch Kitchen concept was hit particularly hard because of their strong presence in Texas according to Nation’s Restaurant News (NRN).

Hurricane Irma was expected to have a similar impact on Florida markets. With its last minute shift causing a direct hit on the entire state of Florida, there were many Florida markets that were hit hard as a result. The day after all the devastation, our team was out driving the market to help owners assess damages to their properties. Many of the coastal flood zones flooded some houses and businesses. Most of Tampa Bay, however, was able to weather the storm with minimal damage, although many businesses went without power for over a week in addition to having difficulty acquiring supplies to keep their doors open. Some businesses were raking in the sales and taking advantage of being the only restaurants open among some of the densest counties in Florida. One Taco Bell I visited was slammed with guests, but still struggling to save face in the wake of not being able to get the supplies they needed. A guest asking for a spork was met with a manager’s apologetic eyes:

“We don’t have anymore. I might have to go down the street and see if we can get some plastic forks from Publix”

Most of Central Florida, although arguably hit the worst, weathered the storm fairly well. Aside from debris and a few fallen trees paired with a massive loss of power, most structures stayed intact. Many of the restaurants maintaining power served to feed those residents who were going on 5 days without power in their homes.

Other Florida markets, however, were hit harder than they would have wished. South Florida markets on both coasts and everything in between were met with some tough times; properties flooded, power grids out for weeks, infrastructure ruined. Many markets are still working to recover their physical structures, not to mention swallowing the pill of lost sales during the times of closure. Franchisees have been forced to close doors on a number of stores and some have even abandoned specific locations that they deemed too much of a capital expense to get back up and running.

In terms of net-leased investment sales, these factors impacted the market there too. Some properties that were hit the hardest were actually under contract at the time of devastation. Many of the potential buyers in the midst of 1031 exchanges ended up dropping those contracts. We saw an influx of offers shifting from south Florida markets to West and Central Florida inventory we still had available. Investors were looking more critically at hedges against catastrophe than they had previously. In addition, a number of owners had never considered the potential risk of a natural disaster or at least never considered it a risk significant enough to impact their investment. Some owners have had to spend thousands to tens of thousands of dollars on repairs, while others made it out with little or no damage, but now have considered selling due to the increased perception of risk.

These storms have been eye opening for many people in a variety of ways, including the other side of the coin where there are many investors now looking hard at Florida markets trying to identify the opportunities to scoop up some of these properties that may suddenly have value to be added. At this point, most businesses are back up and running in most major markets, and while many are still recovering, everyone is working hard to move forward. Ultimately, though, it is amazing how resilient the market is. For every owner wanting to exit Florida markets for fear of the next natural disaster, there are three buyers looking to buy in the income tax free state.

The show must go on…but now it may just come with a higher price tag for flood insurance.

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.

Starbucks, New Leases, & Termination Options

Starbucks, New Leases, & Termination Options

Starbucks as a tenant is notorious for their hardball negotiation tactics.

Who can blame them? Starbucks, founded in 1971 out of Seattle, is one of the strongest quick service restaurant (QSR) tenants you could wish to have occupy your property. With over $20 Billion in revenue, over 26,000 locations nationwide, and a credit rating of A2, it is no wonder Starbucks is one of the highest paying restaurant tenants in rent averaging over $60 per square foot.

They negotiate hard simply because they have the leverage to do so.

If you would like a lesson on how to negotiate, I will reserve that for a separate article or you can contact me directly to discuss in more detail, but for now I want to address how these negotiations can impact the value of your property. These hardball negotiations on Starbucks end will certainly put them in a further position of power in regard to controlling their own destiny with their real estate and location growth, but it should be understood that it does not mean Starbucks is an investment to now shy away from. If anything, it should show that they are a stronger investment than ever. Not only are they one of the strongest guarantees you can secure, but they are looking out for their own long-term interests and success.

In recent years, Starbucks has been approaching landlords about signing new 10-year leases. Typically, when a store reaches the 10-year old mark, it is time to upgrade the store. For Starbucks, this could mean significant capital expenditures to bring the store up to new standards. They see these expenditures as a necessary evil and tend to ask the landlord in return for a new longer lease in order to secure their capital investment long-term. Sometimes they ask for a rent reduction or some other concessions, while other times they may just be looking to secure a new 10-year lease in lieu of exercising their next 5-year option. If you have been approached with this offer, I am sure you felt butterflies in your stomach as your eyeballs turned to dollar signs and you felt like your investment just became 10-years stronger. There is no doubt that Starbucks showing interest in signing a new 10-year lease is a solid opportunity to explore, but reel your excitement in a bit and prepare to read the fine print.

Many of these new 10-year leases include a termination option at year 5, which is not the end of the world. After all, if they are willing to put real dollars into renovations and sign a new 10-year lease, it would appear their intent is to stay for the entire 10 years; that 5-year termination clause is simply a hedge against an unforeseeable future. It is important, however, to understand how this will affect the equity of your entire investment. The value of your property is directly correlated to how much lease term you have remaining and the strength of your guarantee.

In this scenario, guarantee is not the issue, however, remaining lease term is. On paper, it appears you have a new 10-year lease. From the graph below, you can see that the average cap rate for a 10-14 year corporate lease over the past 12 months has been 5.88%. Talk about equity; if Starbucks is $60 per square foot on a 2,000 SF building ($120,000 NOI), then a 5.88% cap rate puts your value just over $2MM.

cap rate versus guarantee vs lease term graph

Here is the problem:

Investors and buyers will not see a new 10-year lease. Investors will see a termination option in year five and in order to hedge their own risk, they will assume the tenant will leave after 5 years. Effectively, that simple little 5-year termination clause crushes your current value as an opportunity cost versus a true 10-year lease. You will see from the graph above that the average cap rate for a 5-9 year corporate lease is at 6.27%. You just lost about 40 basis points worth of value and that is being generous because these figures include a range of lease terms lumped together. More realistically, you are looking at a 50-75 basis point hit in value by keeping that 5-year termination clause in a new 10-year lease. See more detailed recent cap rates for Starbucks specifically at my last cap rate market update.

When it comes down to it, however, fighting over striking the 5-year termination option from your new lease is not worth losing Starbucks as a tenant. There are few tenants willing to pay $60 per square foot and so the likelihood of replacing that rent and cash flow stream is slim if you do not come to an agreement with Starbucks. Hence, why they hold all the leverage.

Here is the silver lining: Do not beat yourself up if you have signed a new 10-year lease with Starbucks and it includes one of those 5-year termination options. The values are still strong for Starbucks net-leased properties and investor perception is still very strong for these assets as they are still great long-term investments with solid financial backing and stability.

DSC_0266

I listed this Starbucks location in New Port Richey, Florida (pictured above) recently and if you are looking to enter the net-leased investment realm, consider this deal. Just as mentioned above, this client had Starbucks approach him about signing a new 10-year lease. They were asking to include a termination option at year 5. Through working with me, the client was able to secure a very marketable deal. Starbucks signed a new 10-year lease, keeping their option to terminate in year 5, however they are required to give 6 months notice to the landlord and pay a penalty of about $50,000. Worst case scenario, that equates to almost an entire year of cash flow for the landlord if they do plan to exercise their option to terminate in year 5. In these situations, though, all signs point to an intent to stay long-term. Starbucks is investing dollars to renovate the location and if you ever visit, the drive thru stack consistently wraps around the entire building. As an investor, how can you go wrong with a new 10-year Starbucks deal on a hard corner with frontage on a thoroughfare that boasts 59,000 cars per day?

That’s Net-Lease Investor Gold.

You can find more details on this specific Starbucks Offering Here

Ultimately, it comes down to what your long-term strategy is for the property. It is often times easy with these “coupon clipper” properties to set them and forget them. Rent is deposited every month, year after year, and the landlord gets to sit back and sip the pina coladas, but I urge all my clients to stay fresh on their feet. Before you know it, you could be down to just 12 months remaining on your lease, which does not put you in much of a position of power when it comes to tenant renewal, property values, and retaining your existing cash flow. I work with clients on a regular basis to keep a pulse on the market and ensure they are maximizing their equity, exchanging in and out of the market, and over time increasing the overall portfolio value of their investments. Some of the strategies I help clients execute on include sale-leasebacks and blend-and-extends among other strategies to help them mitigate risk and maximize value in situations such as these.

More specifically, I have helped many Starbucks landlords find a Win-Win common ground with Starbucks during negotiations as referenced above in order to maintain their cash flow stream, maximize the value of their investment, and ultimately establish a successful future for Starbucks to stay at their property long-term. If you would like more detailed information around how to maximize the value of your property through new lease negotiations or if you have interest in purchasing a Starbucks net-leased property, please contact me directly at 813-387-4796 and I would be happy to help wherever it makes sense.