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.

Restaurant Industry Trends: What to Expect in 2018

Restaurant Industry Trends: What to Expect in 2018

We have seen a number of shifts in the dynamic of how business models function over the past few years.

Consider this:

Airbnb, one of the largest travel accommodation providers does not own their real estate. Uber and Lyft, two of the most powerful personal transportation companies in power today does not own their vehicles. Alibaba, a world-renowned powerhouse retailer, owns no inventory. The world’s most popular media content company, Facebook, creates none of its own content. One of the newest and most popular forms of currency, Bitcoin, arguably holds no value.

 

The new consensus is that companies who build the quickest bridges from the consumer to the goods or services bring enormous value into the equation. In essence, a third-party company avoids paying any of the costs of providing the goods or services, but has the opportunity to capture a small percentage of the profits by inserting themselves as the middle man. Businesses that are unable to adjust and provide the same bridge to their products lose that percentage from their bottom line and must learn how to adapt to shifting consumer preferences and expectations. Investors still see restaurant investments as a hedge against the risk of these disappearing business models because ultimately, people still need to eat. The need to consume food is not going anywhere, but how, where, and why it is consumed is seeing a shift. We’re entering an operational evolution and the restaurant industry is no different. As new delivery systems attempt to bridge the gap between consumer couches and the dinner table, everyone has been pushed off an edge and they are all simply learning how to fly again. With all these changes occurring, what kind of shifts in trends can we expect to see in 2018? Based on an article from Restaurant Business Online, here are a few changes we can expect to watch unfold in 2018:

 

The Evolution of the Term “Restaurant”

A restaurant is defined as a “business establishment where meals or refreshments may be purchased”, but businesses are melding, models are changing, and footprints are reshaping in a way that is demanding new definitions. By today’s definition, a restaurant could encompass the typical quick service concepts and full service dine in concepts, while also including food kiosks, food trucks, the self-serve salad bar in a Whole Foods grocery store, and carry-out meals at Wawa gas stations. Are they all restaurants? Or will the term restaurant be redefined in an industry where there seems to be 10 new terms for every five new concepts that pop up each week?

 

A Bursting of the Meal-Kit Bubble

The various meal-kit concepts popping up worked to bridge the gap between consumers shopping at the grocery store and sitting down to finally eat their meal. Because it was in line with where consumer preferences have been heading, it has captured a lot of buzz. The intrigue has sparked a number of companies finding success in the space, but the small profit those companies are capitalizing on acting as middle man may be phased out as consumers discover how to bridge that gap themselves. There may still be space for the Meal-Kit business model with niche consumers, but the consensus is that we can expect some consolidation in the space.

 

Super Food Frenzy

Consumer preferences continue to trend towards more healthy, natural, and sustainable food offerings that allow for customization. Concepts continue to work towards a customer experience that allows guests to fully customize their offering while maintaining economies of scale in preparation and operations. Offering health conscious choices to supplement preconceived base options will allow concepts to add a little more to their bottom line by charging consumers a premium for those customizable upgrades to their food offerings. Consumers, hungry for customization and the satisfaction of being health conscious, will likely continue to pay those premiums.

 

Indulgence Among Consumers

On the other side of the coin, consumers want to treat themselves for being so health conscious. In an effort to balance the scales, you can also expect to see consumers paying premiums for regular indulgence in the instant gratification found in those carb-heavy, sugar loaded, unique out of the box craft food offerings. Sometimes even the health-conscious consumer wants to let loose and devour a maple brown sugar loaded donut with greasy bacon on top.

 

Enter Italian Fast Casual

A number of pizza based fast casual concepts have had recent success, but you can expect more pasta fast casual concepts to enter the sector. As operators and innovators work to discover the best economies of scale and sustainable business models around balancing fresh pasta with food costs and quickness of service, it can be expected that one or two pasta based fast casual concepts may begin to find significant success and lead the pack.

 

Shift in Leading Consumer Action

The use of technology will spur a learning curve amongst consumers. Some generations will be reluctant to evolve, but eventually will be forced into submission by necessity, while younger generations may find the learning curve refreshing as they begin to see the integration of the new technology they know so well into new lifestyle environments that have never found a use for the technology. Either way, operators will focus on teaching consumers how to use these new automated tools to enhance the customer experience, streamline ordering and checkout, while also helping to crack down on quality control of food product output. With successful implementation of new technology, restaurant operators may be able to cut down on labor costs, lost costs, and quality control, while actually improving the customer experience and engagement.

 

Beefing up IT

With new technology implementation comes new technology support. Operators may need to find a balance between improving profits by cutting costs with implementing these new technologies and maintaining secure systems by beefing up their IT at an added cost. This shift in expenses should still prove profitable overall, however, it will take some trial and error before figuring out the perfect recipe for cost percentages in the industry. Tech support costs will not only be necessary to maintain the new technology being implemented, but also in ensuring security and safety for their guest’s personal and sensitive information in a world where hackers are digitally lurking around every cyber corner.

 

Reset and Settle

Like many things, the restaurant industry is cyclical. There are always going to be ups and downs. Generally, when things in the space begin to slow, concepts will reset their strategies, settle into their unit growth, and look to take a breath while they optimize their existing operations to mitigate risk of slow times in preparation for their next growth spurt. Although the economy appears to be the strongest in years, some concepts continue to see decreases in sales and are adjusting their overall strategies accordingly. Concepts like BJ Brewhouse are taking the opportunity to perfect their operations at existing locations scaling back on development until they are ready again to go full steam ahead. Other concepts are being acquired at a time when their existing operations may be having challenges, but investors are still bullish on acquisitions in the space. It is likely you will see those concepts take a step back after an acquisition to assess process, adjust business models, and settle into their new cultures before heading into more aggressive expansion.

 

The Experiential Revolution

Consumers everywhere, not just in the restaurant sector, are looking for richer experiences from their retail providers. Malls are evolving; large department stores are shutting their doors and being backfilled by experiential tenants looking to draw crowds. Full service dine-in cinemas are taking the outdated “Dinner and a Movie” date and allowing guests to have both at the same time. Breweries and Wineries are backfilling large spaces with their ability to attract large groups of people offering them a venue to socialize with friends and a customized craft offering for their palate. Restaurants are the perfect compliment to these venues and concepts finding themselves as outparcels to such anchors may see a spike in guest traffic. The use of technology is freeing up the on-site labor to provide more unique and personable experiences to guests as well. You can expect more and more unique experiences on the horizon for 2018.

 

The Restaurant Industry will continue to be focus for investors and concepts that put a priority on changing with the times will be the ones to stick around for the long haul. Both consumer preferences and technology are evolving at exponential rates and what works today may very well fail tomorrow. That is why it is more important than ever to stay on your toes in the space. People may always need to eat, but they won’t always need to eat here or there. Whether you are an investor in restaurant assets or an operator of restaurant assets, we welcome the opportunity to help you stay informed on what is happening in the restaurant sector on a regular basis. If you are looking for more specific information or data regarding the restaurant industry, restaurant real estate, or strategy around all of the above, do not hesitate to reach out to us directly.

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.

Why Invest in Restaurant Net-Leased Assets

Why Invest in Restaurant Net-Leased Assets

There are plenty of investment options to choose from in the single-tenant net-leased sector and they all come with their own pros and cons. Drug Stores tend to be on high traffic hard corners backed by solid credit, but house a large box with a cash flow stream to match that may be difficult to replace if it ever became vacant. Dollar Stores come with great credit, but often times in tertiary markets. The auto sector can provide higher returns and high rents for specialty buildings, but can also be on odd shaped parcels with their own potential environmental concerns, while banks can provide the same high rents for a specialty building backed by excellent credit, but tout the same replace-ability issue if they ever became vacant.

So Why Invest in Restaurant Net-Leased Assets?

The variety of price points paired with long-term leases, rental increases, and well-known popular brand name concepts make the restaurant sector especially attractive to investors. Many 1031 exchange buyers look to the sector for a passive place to park their money because many of the factors just named provide a certain sense of security and perceived safety in an investment world riddled with risk. A few years ago the market was labeled one of the biggest peak markets we have seen in the past 10 years, which rang true. Since 2015, cap rates for restaurant net-leased properties have continued to compress, further than most other net-leased sectors, stabilizing on average somewhere between 50-65 basis points lower than other similar net-leased assets. Because of the high demand and increased equity in these types of investments, corporations and franchisees operating business on these parcels of real estate have been actively taking advantage of the market by accessing the built up equity under their operations through sale-leasebacks and using the proceeds to grow into more units, remodel existing units, and pay down debt among other things. In an environment where investment supply is limited, the additional deal inventory is driving transactional velocity even further for the many selling investors who then become 1031 exchange buyers.

Investors also choose to place their money in the restaurant sector because it has been perceived to be somewhat recession proof. “Recession-proof” is stated with a grain of salt as the more high-end casual dining segment may take a hit when the economy is down and consumers have less money in discretionary spending, but ultimately people need to eat. While some casual dining concepts are recently struggling, due to changing consumer preferences, they are working to increase their sales by changing up business models, implementing new technologies, and utilizing delivery and online ordering services. The overall sentiment in the marketplace is that “most of them will figure it out”. The casual dining segment provides some benefits over the QSR segment in that the price points tend to be higher since the footprints are larger and rent per square foot remains fairly the same. However, the segment provides risk in that lower discretionary spending could hurt a higher end casual concept during a downturn. That is why many investors look to the quick service restaurant segment as a hedge against the inherent risk of recession. Many QSR concepts have a focus on a cheap and fast food offering that can feed an entire family for a very reasonable price. Even concepts with middle of the road average ticket prices ebb and flow through the ups and downs of the market. In addition, the industry as a whole provides jobs at fairly cheap labor, which remain a necessity in a downed economy.

Then there are the core aspects of real estate to consider. Most restaurant sites provide the benefit of adhering to many of the core retail necessities when it comes to desirable core real estate. Restaurants tend to be located on hard corners with frontage on high traffic corridors. They tend to have strong parking ratios in high density metro markets on parcels with great ingress/egress. Restaurants simply tend to be on good core real estate sites. If the restaurant were ever to leave, these aspects of the remaining real estate could provide you with more options to redevelop the property than a small specialty building such as a quick lube oil change facility might provide.

There is also the tenant base and the market for restaurants in general. Although investment supply in general is lacking compared to the large pool of buyers out there, compared to other sectors, restaurant inventory is in plenty supply and has transactional velocity over most other triple net property segments. Restaurants tend to be a high demand asset sector, which bodes well for owners when it comes time to exit or exchange their investment. Why is the restaurant sector in such high demand? Well when it comes to restaurants, you have a plethora of well established strong credit tenants. You also have two sub-segments of QSR and Casual Dining, which together provide a very wide range of price points, business models, and rent structures. An investor choosing an investment in the restaurant segment is like throwing a kid into a candy store full of different gum ball machines and saying,

“Which type of gum ball would you like to receive every month?”

You can also find a wide range of risk and return. You have corporate credit grade investments that could trade for as low as 3% or 4% cap rates, while also having the upside of taking on smaller operators or franchisees with similar lease terms but at double the returns or higher. With these smaller operators and franchisees comes the opportunity for even an unsophisticated landlord to structure a blend and extend for added value. Smaller operators have the flexibility to get creative in their holdings, operations, and business growth opposed to some of the larger corporate structures that stick by strict policies and standards. There are numerous reasons to invest in the restaurant sector and any investor building a diversified portfolio of net-leased investments would be wise to include a healthy number of restaurant assets into their mix.

The downsides? The downsides include all the many risks associated with any real estate investment. Each tenant, lease, property, and market has its own inherent risks, challenges, and pressure points to watch out for. I would encourage you to use the information you gather here to your advantage, but also seek advice from your trusted real estate advisor to ensure you understand the intricacies of each deal, how they might affect your investment decisions, and to gain a comprehensive understanding of all your options when it comes to your long-term investment strategy.

If you have any specific questions regarding an asset, a concept, or your current investment situation, feel free to reach out to me directly at 813-387-4796 as I welcome the opportunity to help you in any way that makes sense for you.

 

Checkers and Rally’s: Leveraging Modular Development

Checkers and Rally’s: Leveraging Modular Development

Checkers is one of the largest double drive thru chains in the United States. Having served hamburgers, hotdogs, French fries and milkshakes since 1986, Checkers today is headquartered in Tampa, Florida and operates over 850 locations in 29 states. Rally’s, a similar concept out of Louisville, Kentucky, was purchased by Checkers in 1999. Since the acquisition, Rally’s has began adopting design from Checkers and the two concepts look virtually identical aside from the name on their signs.

Despite construction costs ticking up and some concepts pulling back on development, Checkers is pushing forward hard. Checkers is slated for a future 30 new locations in the D.C. area; a future 30 new locations in Houston; With over 60 locations around its headquarters in Tampa, even franchisees local to Tampa Bay are still growing.

What is enabling the company to pursue such aggressive expansion? A big factor seems to be the modular design they are using for their new construction. Modular construction involves an off-site process where buildings are constructed under a controlled environment. Although the same codes and standards employed under traditional construction are adhered to throughout the process, the construction can be completed in half the time. The buildings are built in sections, which are then put together like Legos, on site. Not only can the buildings be built in half the time, but modular buildings are typically stronger than conventional construction since each portion of the building is built with its own structural integrity to withstand the stress of travel. The process also includes a number of other benefits including safe and secure storage of construction materials, reducing site disruption from weather or pedestrian traffic, and reduced waste for a more sustainable construction process. With the new prototype designed by Checkers, building each modular location ends up being 20% cheaper in addition to being much faster. With the nimble flexibility of popping a location up faster to avoid “dead rent” periods and a cheaper upfront capital injection for new locations, it is allowing Checkers corporate and franchisees the opportunity to expand into denser, higher rent, competitive markets where barriers to entry are high. Another model includes Checkers re-using shipping containers for constructing their new prototype, which is also both cost effective and sustainable.

As a real estate investor, this can be good news if you are eyeing Checkers as an investment, which tends to have a higher cap rate when compared to other concepts in the QSR sector. It can build confidence around an investment into Checkers as a tenant, who appears to be making shifts in technology to take advantage of the evolving landscape, while also adapting in ways that are allowing them to expand the concept and capture more market share. Like anything else, investors should also be aware of the risks associated with these deals. The Checkers prototype can go as small as an 800 square foot building, while the average QSR concept operates in 2,800 square feet. This can present a potential metric of risk to watch. The average unit sales volume for Checkers was around $970,000 in 2016; about the same volume as the average KFC ($999,500), Captain D’s ($1.04MM), and Arby’s ($1.07MM), but operating with a building square footage almost 2,000 square feet smaller than the other above referenced concepts. This can equate to a higher rent per square foot paid by Checkers; a high rent per square foot in markets that are generally lower income areas where the Checkers concept thrives.

Why is this a potential pressure point?

The average rent per square foot paid by QSR concepts was $35 per square foot in 2016, while Checkers, on average, was paying $47 per square foot in rent with an average square footage in 2016 of 1,800 SF. That rent per square foot could be inflated even further with their 800-1,000 SF prototype design. I have seen investors purchase new construction Checkers locations and after a few years, Checkers had decided to vacate. While Checkers may still be paying their rent obligation in these scenarios, the realization may set in that replacing $40-$50 PSF in rent will be impossible in a market where the average rents may be as low as $10-$15 per square foot gross due to the demographics and household income capacity. Now, with the new smaller footprint and an aggressive campaign to secure urban locations by getting competitive with rent, some new Checkers leases are approaching $80-$100 per square foot in rent. These very well may be slam dunk locations and great investments, but it cannot be argued that these deals also bring exposure to risk in rent sustainability. Pair that risk with the fact that Checkers is one of the few concepts that can develop on 0.25 acres of land, which does not provide many future opportunities for redevelopment, and the risk in these deals must be weighed accordingly.

All in all, there are positive things happening for Checkers as a concept as they remain bullish on further expansion. Investors looking to take a dive into the concept should look at every deal on a case by case basis. If you have a deal you are currently looking at and determining how to underwrite the deal to hedge against risk, but also remain aggressive in securing the asset for purchase, I am happy to walk through the details of the deal with you and help you determine your best strategic move. As always, I’m available to help wherever it makes the most sense for you.

 

 

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.