| Restaurants are a favorite commercial property for | | | | early 2009, it was almost impossible to find any lenders |
| many investors because: | | | | in the US willing to finance regional restaurant |
| | | | purchases due to the tight credit market. However, |
| 1. Tenants often sign very long term, e.g. 20 years | | | | things seem to have improved a bit. |
| absolute triple net (NNN) leases. This means besides | | | | When the cap rate is higher than the interest rate of |
| the rent, tenants also pay for property taxes, insurance | | | | the loan, e.g. cap rate is 7.5% while interest rate is |
| and all maintenance expenses. The only thing you | | | | 6.5%, than you should consider borrowing as much as |
| have to pay is the mortgage, so your monthly cash | | | | possible. You will get 7.5% return on your down |
| flow is very predictable. There are no landlord | | | | payment plus 1% return for the money you borrow. |
| responsibilities so you have time to do what is | | | | Hence your total return (cash on cash) will be higher |
| important to you, (e.g. to retire). All you do is take the | | | | than the cap rate. Additionally, since the inflation in the |
| rent check to the bank. This is one of the key benefits | | | | near future is expected to be higher due to rising costs |
| in investing in a restaurant or single-tenant property. | | | | of fuel, the money which you borrow to finance your |
| 2. Whether rich or poor, people need to eat. | | | | purchase will be worth less in the following years due |
| Americans are eating out more often as they are too | | | | to inflation. So it's even more beneficial to maximize |
| busy to cook and cleanup the pots & pans | | | | leverage now. |
| afterwards which often is the worst part! According | | | | Due Diligence |
| National Restaurant Association, the nation's restaurant | | | | You may want to consider these factors before |
| industry currently involves 937,000 restaurants and is | | | | deciding to go forward with the purchase: |
| expected to hit $537 billion in sales in 2007, compared | | | | |
| to just $322 billion in 1997 and $200 billion in 1987 (in | | | | 1. Tenant's financial information: The restaurant |
| current dollars). In 2006 for every dollar Americans | | | | business is labor intensive. The average employee |
| spend on foods, 48 cents were spent in restaurants. | | | | generates only about $55 thousand in revenue yearly. |
| As long as there is civilization on earth, there will be | | | | The cost of goods, e.g. foods and supplies should be |
| restaurants! So you feel comfortable that the property | | | | 30-35% of revenue; labor and operating expenses |
| is always in high demand. | | | | 45-50%; rent about 7-12%. So do review the profits |
| 3. You know your tenants will take very good care of | | | | and loss (P&L) statements, if available, with your |
| your property because it's in their best interest to do | | | | accountant. In the P&L statement, you may see |
| so. Few customers if any want to go to a restaurant | | | | the acronym EBITDAR. It stands for Earnings Before |
| that has a filthy bathroom or trash in the parking lot. | | | | Income Taxes, Depreciation (of equipment), |
| However, restaurants are not created equal, from an | | | | Amortization (of capital improvement), and Rent. If you |
| investment viewpoint. | | | | don't see royalty fees in P&L of a franchised |
| Franchised versus Independent | | | | restaurant or advertising expenses in the P&L of |
| One often hears that 9 out of 10 new restaurants will | | | | an independent restaurant, you may want to |
| fail in the first year; however, this is just an urban myth | | | | understand the reason why. Of course, we will want |
| as there are no studies with such conclusion. There is | | | | to make sure that the restaurant is profitable after |
| only a study by Associate Professor of Hospitality, Dr. | | | | paying the rent. Ideally, you would like to see net profits |
| H.G. Parsa of Ohio State University who tracked new | | | | equal to 10-25% of the gross revenue. In the last few |
| restaurants located in the city Columbus, Ohio during | | | | years the economy has taken a beating so |
| the period from 1996 to 1999 (Note: you should not | | | | restaurants revenue has dipped. So don't get panic if |
| draw the conclusion that the results are the same | | | | you to see around 3-4% reductions in gross revenue. |
| everywhere else in the US or during any other time | | | | This seems to have affected most if not all |
| periods.) Dr. Parsa observed that seafood restaurants | | | | restaurants everywhere. In addition, it may take a new |
| were the safest ventures and that Mexican | | | | restaurant several years to reach potential revenue |
| restaurants experience the highest rate of failure in | | | | target. So don't expect new locations to be profitable |
| Columbus, OH. His study also found 26% of new | | | | right away even for chained restaurants. |
| restaurants closed in the first year in Columbus, OH | | | | 2. Rent to revenue ratio: this is the ratio of base rent |
| during 1996 to 1999. Besides economic failure, the | | | | over the annual gross sales of the store. It is a quick |
| reasons for restaurants closing include divorce, poor | | | | way to determine if the restaurant is profitable, i.e. the |
| health, and unwillingness to commit immense time | | | | lower the ratio, the better the location. As a rule of |
| toward operation of the business. Based on this study, | | | | thumb you will want to keep this ratio less than 10% |
| it may be safe to predict that the longer the restaurant | | | | which indicates that the location has strong revenue. If |
| has been in business, the more likely it will be operating | | | | the ratio is less than 7%, the operator will very likely |
| the following year so that the landlord will continue to | | | | make a lot of money after paying the rent. The rent |
| receive the rent. | | | | guaranty is probably not important in this case. |
| For franchised restaurants, the franchisee has to pay | | | | 3. Parking spaces: restaurants tend to need a higher |
| a one-time franchisee fee about $30 to $50 thousand | | | | number of parking spaces because most diners tend |
| and on-going royalty between 4% to 12.5% of sales | | | | to stop by within a small time window. You will need at |
| revenue. In turn, the franchisee receives training on | | | | least 8 parking spaces per 1000 Square Feet (SF) of |
| how to set up, and operate a proven and successful | | | | restaurant space. Fast food restaurants may need |
| business without worrying about the marketing part. As | | | | about 15 to 20 spaces per 1000 SF. |
| a result, a franchised restaurant gets customers as | | | | 4. Termination Clause: some of the long term leases |
| soon as the open sign is put up. The king of franchised | | | | give the tenant an option to terminate the lease should |
| restaurants is the fast-food chain, McDonald's with | | | | there be a fire destroying a certain percentage of the |
| 30,823 locations (about 14,000 in the US) as of 2006 | | | | property. Of course, this is not desirable to you if that |
| with an average $2M in revenue per US location. | | | | percentage is too low, e.g. 10%. So make sure you |
| McDonald's currently captures 46% market share of | | | | read the lease. |
| the $58.88 billion US fast-food market. Distant behind is | | | | 5. Price per SF: you should pay about $200 to $500 |
| Burger King with 14.3% of the market share. Fast-food | | | | per SF. In California you have to pay a premium, e.g. |
| chains tend to detect new trends faster. For example, | | | | $1000 per SF for Starbucks restaurants which are |
| they are open as early as 5AM as Americans are | | | | normally sold at very high price per SF. If you pay |
| increasingly buying their breakfasts earlier. They are | | | | more than $500 per SF for the restaurant, make sure |
| also selling more café latte to compete with | | | | you have justification for doing so. |
| Starbucks. | | | | 6. Rent per SF: ideally you should invest in a property in |
| Independent restaurants will take a while to for | | | | which the rent per SF is low, e.g. $2 to $3 per SF per |
| customers to come in and try the food. Their business | | | | month. This gives you room to raise the rent in the |
| is especially tough in the first 12 months of opening, | | | | future. Besides, the low rent ensures the tenant's |
| especially to those whose owners have not had a | | | | business is profitable, so he will be around to keep |
| proven track record. So in general, mom and pop | | | | paying the rent. Starbucks tend to pay a premium rent |
| restaurants are a riskier investment for you because | | | | $2 to 4 per SF monthly since they are often located |
| revenue is initially weak. If you choose to invest in a | | | | at a premium location with lots of traffic and high |
| non-brand name restaurant, make sure the return is | | | | visibility. If you plan to invest in a restaurant in which the |
| proportional to the risks that you will be taking. | | | | tenant pays more than $4 per SF monthly, make sure |
| Sometimes it is not easy for you to tell if a restaurant | | | | you could justify your decision because it's hard to |
| is a brand name or non-brand name. Some restaurant | | | | make a profit in the restaurant business when the |
| chains only operate, or are popular in a certain region. | | | | tenant is paying higher rent. Some restaurants may |
| For example, Johnny Carino's restaurant is a very | | | | have a percentage clause. This means besides the |
| popular Italian restaurant chain in Texas and Georgia | | | | minimum base rent, the operator also pays you a |
| but there is only one in California as of 2007. Brand | | | | percentage of his revenue when it reaches a certain |
| name chains tend to have a website listing all the | | | | threshold. |
| locations plus other information. So if you can find a | | | | 7. Rent increase: A restaurant landlord will normally |
| restaurant website from Google or Yahoo you can | | | | receive either a 2% annual rent increase or a 10% |
| quickly discern if an unfamiliar name is a brand name | | | | increase every 5 years. As an investor you should |
| or not. The website "entrepreneur dot com" also has | | | | prefer 2% annual rent increase because 5 years is a |
| useful information for investors about various | | | | long time to wait for a raise. You will also receive |
| restaurant franchises. You can also obtain basic | | | | more rent with 2% annual increase than 10% increase |
| consumer information about almost any chained | | | | every 5 years. Besides, as the rent increases every |
| restaurants in the US on "Wikipedia dot org". | | | | year so does the value of your investment. The value |
| Lease & Rent Guaranty | | | | of restaurant is often based on the rent it generates. If |
| The tenants often sign a long term absolute triple net | | | | the rent is increased while the market cap remains the |
| (NNN) lease. This means besides the base rent they | | | | same, your investment will appreciate in value. So |
| also pay for all operating expenses: property taxes, | | | | there is no key advantage for investing in a restaurant |
| insurance and maintenance expenses. For investors, | | | | in a certain area, e.g. California. It's more important to |
| the risk of maintenance expenses uncertainty is | | | | choose a restaurant at a great location. |
| eliminated and their cash flow is predictable. The | | | | 8. Lease term: in general investors favor long term, e.g. |
| tenants may also guarantee the rent with their own or | | | | 20 year lease so they don't have to worry about |
| corporate assets. Therefore, in case they have to | | | | finding new tenants. During a period with low inflation, |
| close down the business, they will continue paying rent | | | | e.g. 1% to 2%, this is fine. However, when the inflation is |
| for the life of the lease. Below are a few things that | | | | high, e.g. 4% to 5% as it is now, this means you will |
| you need to know about the lease guaranty: | | | | technically get less rent if the rent increase is only 2%. |
| | | | So don't rule out properties with a few years left of |
| 1. In general, the stronger the guaranty the lower the | | | | the lease as there may be strong upside potential. |
| return of your investment. The guaranty by McDonalds | | | | When the lease expires without options, the tenant |
| Corporation with a strong "A" S&P corporate | | | | may have to pay much higher market rent. |
| rating of a public company is much better than a small | | | | 9. Risks versus Investment Returns: as an investor, |
| corporation owned by a franchisee with a few | | | | you like properties that offer very high return, e.g. 8% |
| restaurants. Consequently, a restaurant with a | | | | to 9% cap rate. And so you may be attracted to a |
| McDonalds corporate lease normally offers low 6-7% | | | | brand new franchised restaurant offered for sale by a |
| cap (return of investment in the 1st year of ownership) | | | | developer. In this case, the developer builds the |
| while McDonalds properties with a franchisee guaranty | | | | restaurants completely with Furniture, Fixtures and |
| may offer 6.5-7.5% cap. | | | | Equipment (FFEs) for the franchisee based on the |
| 2. Sometimes a multi-location franchise will form a | | | | franchise specifications. The franchisee signs a 20 |
| parent company to own all the restaurants. Each | | | | years absolute NNN lease paying very generous rent |
| restaurant in turn is owned by a single-entity LLC | | | | per SF, e.g. $4 to $5 per SF monthly. The new |
| (Limited Liabilities Company) to shield the parent | | | | franchisee is willing to do so because he does not |
| company from liabilities. So the rent guaranty by the | | | | need to come up with any cash to open a business. |
| single-entity LLC does not mean much as it does not | | | | Investors are excited about the high return; however, |
| have much assets. | | | | this may be a very risky investment. The one who is |
| 3. A good, long guaranty does not make a lemon a | | | | guaranteed to make money is the developer. The |
| good car. Similarly, a strong guaranty does not make a | | | | franchisee may not be willing to hold on during tough |
| lousy restaurant a good investment. It only means the | | | | times as he does not have any equity in the property. |
| tenant will make every effort to pay you the rent. So | | | | Should the franchisee's business fails, you may not be |
| don't judge a property primarily on the guaranty. | | | | able to find a tenant willing to pay such high rent, and |
| 4. The guaranty is good until the corporation that | | | | you may end up with a vacant restaurant. |
| guarantees it declares bankruptcy. At that time, the | | | | 10. Track records of the operator: the restaurant being |
| corporation reorganizes its operations by closing | | | | run by an operator with 1 or 2 recently-open |
| locations with low revenue and keeping the good | | | | restaurants will probably be a riskier investment. On the |
| locations, (i.e. ones with strong sales). So it's more | | | | other hand, an operator with 20 years in the business |
| critical for you to choose a property at a good location. | | | | and 30 locations may be more likely to be around next |
| If it happens to have a weak guaranty, (e.g. from a | | | | year to pay you the rent. |
| small, private company), you will get double benefits: on | | | | 11. Trade fixtures: some restaurants are sold with trade |
| time rent payment and high return. | | | | fixtures so make sure you document in writing what is |
| Location, Location, Location | | | | included in the sale. |
| A lousy restaurant may do well at a good location | | | | 12. Special Considerations for 2009: while fast-food |
| while those with a good menu may fail at a bad | | | | restaurants do well during the downturn, sit-down (non |
| location. A good location will generate strong revenue | | | | fast-food) restaurants tend to be more sensitive to the |
| for the operator and is primarily important to you as an | | | | recession due to higher prices. These restaurants may |
| investor. It should have these characteristics: | | | | experience double-digit drop in year-to-year revenue. |
| | | | As a result, many sit-down restaurants are shut down. |
| 1. High traffic volume: this will draw more customers to | | | | And so there are quite a few sit-down restaurants on |
| the restaurant and as a result high revenue. So a | | | | the market for sale with over 10% cap and long-term |
| restaurant at the entrance to a regional mall or Disney | | | | absolute NNN leases by regional restaurants, e.g. |
| World or a major shopping center is always desirable. | | | | Smokey Bones BBQ. Some of these are located at |
| 2. Good visibility & signage: high traffic volume | | | | super-prime locations which are rarely available during |
| must be accompanied by good visibility from the | | | | normal markets, e.g. in front of regional malls. This |
| street. This will minimize advertising expenses and is a | | | | presents an opportunity for investors who see the |
| constant reminder for diners to come in. | | | | glass of water as half-full. If a restaurant location in the |
| 3. Ease of ingress and egress: a restaurant located on | | | | chain has good revenue such that it survives the |
| a one-way service road running parallel to a freeway | | | | toughest times then your investment may have strong |
| will get a lot of traffic and has great visibility but is not | | | | upside potential when the economy recovers. |
| at a great location. It's hard for potential customers to | | | | Sale & Lease Back |
| get back if they miss the entrance. In addition, it's not | | | | Sometimes the restaurant operator may sell the real |
| possible to make a left turn. On the other hand, the | | | | estate part and then lease back the property for a |
| restaurant just off freeway exit is more convenient | | | | long time, e.g. 20 years. A typical investor would |
| for customers. | | | | wonder if the operator is in financial trouble so that he |
| 4. Excellent demographics: a restaurant should do well | | | | has to sell the property to pay for his debts. It may or |
| an area with a large, growing population and high | | | | may not be the case; however, this is a quick and |
| incomes as it has more people with money to spend. | | | | easy way for the restaurant operator to get cash out |
| Its business should generate more and more income to | | | | for good reason: business expansion. Of course, the |
| pay for increasing higher rents. | | | | operator could refinance the property with cash out |
| 5. Lots of parking spaces: most chained restaurants | | | | but that may not be the best option because: |
| have their own parking lot to accommodate | | | | |
| customers at peak hours. If customer cannot find a | | | | 1. He cannot maximize the cash out as lenders often |
| parking space within a few minutes, there is a good | | | | lend only 65% of the property value in a refinance |
| chance they will skip it and/or won't come back as | | | | situation. |
| often. | | | | 2. The loan will show as long term debt in the balance |
| 6. High sales revenue: the annual gross revenue alone | | | | sheet which is often not viewed in a positive light. |
| does not tell you much since larger--in term of square | | | | 3. The interest rates may not be as favorable if the |
| footage--restaurant tends to have higher revenue. So | | | | restaurant operator does not have a strong balance |
| the rent to revenue ratio is a better gauge of success. | | | | sheet |
| Please refer to rent to revenue ratio in the due | | | | 4. He may not be able to find any lenders due to the |
| diligence section for further discussion. | | | | tight credit market. |
| 7. High barriers to entry: this simply means that it's not | | | | You will often see 2 different cash out strategies |
| easy to replicate this location nearby for various | | | | when you look at the rent paid by the restaurant |
| reasons: the area simply does not have any more | | | | operator: |
| developable land, or the master plan does not allow | | | | |
| any more construction of commercial properties, or it's | | | | 1. Conservative market rent: the operator wants to |
| more expensive to build a similar property due to high | | | | make sure he pays a low rent so his restaurant |
| cost of land and construction materials. For these | | | | business has a good chance of being profitable. He |
| reasons, the tenant is likely to renew the lease if the | | | | also offers conservative cap rate to investors, e.g. 7% |
| business is profitable. | | | | cap. As a result, his cash out amount is small to |
| Financing Considerations | | | | moderate. This may be a low risk investment for an |
| In general the interest rate is a bit higher than average | | | | investor because the tenant is more likely to be able to |
| for restaurants due to the fact that they are usually | | | | afford the rent. |
| single-tenant properties. To the lenders, there is a | | | | 2. Significantly higher than market rent: the operator |
| perceived risk because if the restaurant is closed | | | | wants to maximize his cash out. Investors are |
| down, you could potentially lose 100% of your income | | | | sometimes offered high cap rate, e.g. 9%. As a result, |
| from that restaurant. Lenders also prefer brand name | | | | the restaurant business at this location may suffer a |
| restaurants. In addition, some lenders will not loan to | | | | loss due to higher expenses, i.e. rent. However, the |
| out-of-state investors especially if the restaurants are | | | | operator gets as much money as possible for his |
| located in smaller cities. So it may be a good idea for | | | | investment, e.g. business expansion. This property |
| you to invest in a franchised restaurant in major metro | | | | could be riskier for you. If the tenant's business does |
| areas, e.g. Atlanta, Dallas. In 2009 it's quite a challenge | | | | not make it and he declares bankruptcy, you will have |
| to get financing for sit-down restaurant acquisitions, | | | | to offer lower rent to another tenant to get your |
| especially for mom and pop and regional restaurants. In | | | | building leased. |