A Complete Guide For Restaurant Real Estate Investments


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Restaurants are a favorite commercial property for many investors because:

Tenants often sign a very long term, e.g. 20 years absolute triple net (NNN) leases. This means, besides the rent, tenants also pay for property taxes, insurance and all maintenance expenses. The only thing the investor has to pay is the mortgage, which in turn offers very predictable cash flow. There are either no or few landlord responsibilities because the tenant is responsible for maintenance. This allows the investor more time to do important thing in life, e.g. retire. All you do is take the rent check to the bank. This is one of the key benefits in investing in a restaurant or single-tenant property.

Whether rich or poor, people need to eat. Americans are eating out more often as they are too busy to cook and cleanup the pots & pans afterwards which often is the worst part! According to the National Restaurant Association, the nation’s restaurant industry currently involves 937,000 restaurants and is expected to reach $537 billion in sales in 2007, compared to just $322 billion in 1997 and $200 billion in 1987 (in current dollars). Burgerking franchise In 2006, for every dollar Americans spend on foods, 48 cents were spent in restaurants. As long as there is civilization on earth, there will be restaurants and the investor will feel comfortable that the property is always in high demand.

You know your tenants will take very good care of your property because it’s in their best interest to do so. Few customers, if any, want to go to a restaurant that has a filthy bathroom and/or trash in the parking lot.
However, restaurants are not created equal, from an investment viewpoint.

Franchised versus Independent

One often hears that 9 out of 10 new restaurants will fail in the first year; however, this is just an urban myth as there are no conclusive studies on this. There is only a study by Associate Professor of Hospitality, Dr. H.G. Parsa of Ohio State University who tracked new restaurants located in the city Columbus, Ohio during the period from 1996 to 1999 (Note: you should not draw the conclusion that the results are the same everywhere else in the US or during any other time periods.) Dr. Parsa observed that seafood restaurants were the safest ventures and that Mexican restaurants experience the highest rate of failure in Columbus, OH. His study also found 26% of new restaurants closed in the first year in Columbus, OH during 1996 to 1999. Besides economic failure, the reasons for restaurants closing include divorce, poor health, and unwillingness to commit immense time toward operation of the business. Based on this study, it may be safe to predict that the longer the restaurant has been in business, the more likely it will be operating the following year so that the landlord will continue to receive the rent.

For franchised restaurants, a franchisee has to have a certain minimal amount of non-borrowed cash/capital, e.g. $300,000 for McDonald’s, to qualify. The franchisee has to pay a one-time franchisee fee about $30,000 to $50,000. In addition, the franchisee has contribute royalty and advertising fees equal to about 4% and 3% of sales revenue, respectively. In turn, the franchisee receives training on how to set up and operate a proven and successful business without worrying about the marketing part. As a result, a franchised restaurant gets customers as soon as the open sign is put up. Should the franchisee fail to run the business at the location, the franchise may replace the current franchisee with a new one. The king of franchised hamburger restaurants is the fast-food chain McDonald’s with over 32000 locations in 118 countries (about 14,000 in the US) as of 2010. It has $34.2B in sales in 2011 with an average of $2.4M in revenue per US location. McDonald’s currently captures over 50% market share of the $64 billion US hamburger restaurant market. Its sales are up 26% in the last 5 years. Distant behind is Wendy’s (average sales of $1.5M) with $8.5B in sales and 5904 stores. Burger King ranks third (average sales of $1.2M) with $8.4B in sale, 7264 stores and 13% of the hamburger restaurant market share (among all restaurant chains, Subway is ranked number two with $11.4B in sales, 23,850 stores, and Starbucks number 3 with $9.8B in sales and 11,158 stores). McDonald’s success apparently is not the result of how delicious its Big Mac tastes but something else more complex. Per a survey of 28,000 online subscribers of Consumer Report magazine, McDonald’s hamburgers rank last among 18 national and regional fast food chains. It received a score of 5.6 on a scale of 1 to 10 with 10 being the best, behind Jack In the Box (6.3), Burger King (6.3), Wendy’s (6.6), Sonic Drive In (6.6), Carl’s Jr (6.9), Back Yard Burgers (7.6), Five Guys Burgers (7.9), and In-N-Out Burgers (7.9).

Fast-food chains tend to detect new trends faster. For example, they are open as early as 5AM as Americans are increasingly buying their breakfasts earlier. They are also selling more cafe; latte; fruit smoothies to compete with Starbucks and Jumba Juice. You also see more salads on the menu. This gives customers more reasons to stop by at fast-food restaurants and make them more appealing to different customers.

With independent restaurants, it often takes a while to for customers to come around and try the food. These establishments are especially tough in the first 12 months of opening, especially with owners of minimal or no proven track record. So in general, “mom and pop” restaurants are risky investment due to initial weak revenue. If you choose to invest in a non-brand name restaurant, make sure the return is proportional to the risks that you will be taking.

Sometimes it is not easy for you to tell if a restaurant is a brand name or non-brand name. Some restaurant chains only operate, or are popular in a certain region. For example, WhatABurger restaurant chain with over 700 locations in 10 states is a very popular fast-food restaurant chain in Texas and Georgia. However, it is still unknown on the West Coast as of 2012. Brand name chains tend to have a website listing all the locations plus other information. So if you can find a restaurant website from Google or Yahoo you can quickly discern if an unfamiliar name is a brand name or not. You can also obtain basic consumer information about almost any chain restaurants in the US on Wikipedia.

The Ten Fastest-Growing Chains in 2011 with Sales Over $200 Million
According to Technomic, the following is the 10 fastest growing restaurant chains in terms of revenue change from 2010 to 2011:

Five Guys Burgers and Fries with $921M in sales and 32.8% change.
Chipotle Mexican Grill with $2.261B in sales and 23.4% change.
Jimmy John’s Gourmet Sandwich Shop with $895M in sales and 21.8% change.
Yard House with $262M in sales and 21.5% change.
Firehouse Subs with $285M in sales and 21.1% change.
BJ’s Restaurant & Brewhouse with $621M in sales and 20.9% change.
Buffalo Wild Wings Grill & Bar with $2.045B in sales and 20.1% change.
Raising Cane’s Chicken Fingers with $206M in sales and 18.2% change.
Noodles & Company with $300M in sales and 14.9% change from.
Wingstop with $382M in sales and 22.1% change.
Lease & Rent Guaranty

The tenants often sign a long term absolute triple net (NNN) lease. This means, besides the base rent, they also pay for all operating expenses: property taxes, insurance and maintenance expenses. For investors, the risk of maintenance expenses uncertainty is eliminated and their cash flow is predictable. The tenants may also guarantee the rent with their own or corporate assets. Therefore, in case they have to close down the business, they will continue paying rent for the life of the lease. Below are a few things that you need to know about the lease guaranty:

In general, the stronger the guaranty the lower the return of your investment. The guaranty by McDonald’s Corporation with a strong “A” S&P corporate rating of a public company is much better than a small corporation owned by a franchisee with a few restaurants. Consequently, a restaurant with a McDonald’s corporate lease normally offers low 4.5-5% cap (return of investment in the 1st year of ownership) while McDonald’s with a franchisee guaranty (over 75% of McDonalds restaurants are owned by franchisees) may offer 5-6% cap. So figure out the amount of risks you are willing to take as you won’t get both low risks and high returns in an investment.

Sometimes a multi-location franchise will form a parent company to own all the restaurants. Each restaurant in turn is owned by a single-entity Limited Liabilities Company (LLC) to shield the parent company from liabilities. So the rent guaranty by the single-entity LLC does not mean much since it does not have much assets.

A good, long guaranty does not make a lemon a good car. Similarly, a strong guaranty does not make a lousy restaurant a good investment. It only means the tenant will make every effort to pay you the rent. So don’t judge a property primarily on the guaranty.

The guaranty is good until the corporation that guarantees it declares bankruptcy. At that time, the corporation reorganizes its operations by closing locations with low revenue and keeping the good locations, (i.e. ones with strong sales). So it’s more critical for you to choose a property at a good location. If it happens to have a weak guaranty, (e.g. from a small, private company), you will get double benefits: on time rent payment and high return.

If you happen to invest in a “mom & pop” restaurant, make sure all the principals, e.g. both mom and pop, guarantee the lease with their assets. The guaranty should be reviewed by an attorney to make sure you are well protected.
Location, Location, Location

A lousy restaurant may do well at a good location while those with a good menu may fail at a bad location. A good location will generate strong revenue for the operator and is primarily important to you as an investor. It should have these characteristics:

High traffic volume: this will draw more customers to the restaurant and as a result high revenue. So a restaurant at the entrance to a regional mall or Disney World, a major shopping mall, or colleges is always desirable.

Good visibility & signage: high traffic volume must be accompanied by good visibility from the street. This will minimize advertising expenses and is a constant reminder for diners to come in.

Ease of ingress and egress: a restaurant located on a one-way service road running parallel to a freeway will get a lot of traffic and has great visibility but is not at a great location. It’s hard for potential customers to get back if they miss the entrance. In addition, it’s not possible to make a left turn. On the other hand, the restaurant just off freeway exit is more convenient for customers.

Excellent demographics: a restaurant should do well in an area with a large, growing population and high incomes as it has more people with money to spend. Its business should generate more and more income to pay for increasing higher rents.

Lots of parking spaces: most chained restaurants have their own parking lot to accommodate customers at peak hours. If customer cannot find a parking space within a few minutes, there is a good chance they will skip it and/or won’t come back as often. A typical fast food restaurant will need about 10 to 20 parking spaces per 1000 square feet of space. Fast food restaurants, e.g. McDonald’s will need more parking spaces than sit down restaurants, e.g. Olive Garden.

High sales revenue: the annual gross revenue alone does not tell you much since larger–in term of square footage–restaurant tends to have higher revenue. So the rent to revenue ratio is a better gauge of success. Please refer to rent to revenue ratio in the due diligence section for further discussion.

High barriers to entry: this simply means that it’s not easy to replicate this location nearby for various reasons: the area simply does not have any more developable land, or the master plan does not allow any more construction of commercial properties, or it’s more expensive to build a similar property due to high cost of land and construction materials. For these reasons, the tenant is likely to renew the lease if the business is profitable.


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