A Complete Guide For Restaurant Real Estate Investments

Restaurants are a favourite business property for a lot of buyers as a result of:

  1. Tenants typically signal a really long run, e.g. 20 years absolute triple web (NNN) leases. This means, moreover the hire, tenants additionally pay for property taxes, insurance coverage and all upkeep bills. The solely factor the investor has to pay is the mortgage, which in flip affords very predictable money circulation. There are both no or few landlord obligations as a result of the tenant is accountable for upkeep. This permits the investor extra time to do essential factor in life, e.g. retire. All you do is take the hire examine to the financial institution. This is likely one of the key advantages in investing in a restaurant or single-tenant property.
  2. Whether wealthy or poor, individuals have to eat. Americans are consuming out extra typically as they’re too busy to cook dinner and cleanup the pots & pans afterwards which frequently is the worst half! According to the National Restaurant Association, the nation’s restaurant trade presently entails 937,000 eating places and is anticipated to succeed in $537 billion in gross sales in 2007, in comparison with simply $322 billion in 1997 and $200 billion in 1987 (in present {dollars}). In 2006, for each greenback Americans spend on meals, 48 cents had been spent in eating places. As lengthy as there’s civilization on earth, there will probably be eating places and the investor will really feel comfy that the property is at all times in excessive demand.
  3. You know your tenants will take excellent care of your property as a result of it is of their finest curiosity to take action. Few prospects, if any, wish to go to a restaurant that has a grimy lavatory and/or trash within the parking zone.

However, eating places usually are not created equal, from an funding viewpoint.

Franchised versus Independent

One typically hears that 9 out of 10 new eating places will fail within the first yr; nonetheless, that is simply an city fable as there aren’t any conclusive research on this. There is barely a examine by Associate Professor of Hospitality, Dr. H.G. Parsa of Ohio State University who tracked new eating places situated within the metropolis Columbus, Ohio in the course of the interval from 1996 to 1999 (Note: you shouldn’t draw the conclusion that the outcomes are the identical all over the place else within the US or throughout another time intervals.) Dr. Parsa noticed that seafood eating places had been the most secure ventures and that Mexican eating places expertise the very best fee of failure in Columbus, OH. His examine additionally discovered 26% of recent eating places closed within the first yr in Columbus, OH throughout 1996 to 1999. Besides financial failure, the explanations for eating places closing embody divorce, poor well being, and unwillingness to commit immense time towards operation of the enterprise. Based on this examine, it could be protected to foretell that the longer the restaurant has been in enterprise, the extra seemingly it is going to be working the next yr in order that the owner will proceed to obtain the hire.

For franchised eating places, a franchisee has to have a sure minimal quantity of non-borrowed money/capital, e.g. $300,000 for McDonald’s, to qualify. The franchisee has to pay a one-time franchisee charge about $30,000 to $50,000. In addition, the franchisee has contribute royalty and promoting charges equal to about 4% and three% of gross sales income, respectively. In flip, the franchisee receives coaching on methods to arrange and function a confirmed and profitable enterprise with out worrying in regards to the advertising and marketing half. As a end result, a franchised restaurant will get prospects as quickly because the open signal is put up. Should the franchisee fail to run the enterprise on the location, the franchise might exchange the present franchisee with a brand new one. The king of franchised hamburger eating places is the fast-food chain McDonald’s with over 32000 places in 118 international locations (about 14,000 within the US) as of 2010. It has $34.2B in gross sales in 2011 with a mean of $2.4M in income per US location. McDonald’s presently captures over 50% market share of the $64 billion US hamburger restaurant market. Its gross sales are up 26% within the final 5 years. Distant behind is Wendy’s (common gross sales of $1.5M) with $8.5B in gross sales and 5904 shops. Burger King ranks third (common gross sales of $1.2M) with $8.4B in sale, 7264 shops and 13% of the hamburger restaurant market share (amongst all restaurant chains, Subway is ranked quantity two with $11.4B in gross sales, 23,850 shops, and Starbucks quantity 3 with $9.8B in gross sales and 11,158 shops). McDonald’s success apparently isn’t the results of how scrumptious its Big Mac tastes however one thing else extra complicated. Per a survey of 28,000 on-line subscribers of Consumer Report journal, McDonald’s hamburgers rank final amongst 18 nationwide and regional quickly meals chains. It acquired a rating of 5.6 on a scale of 1 to 10 with 10 being the most effective, 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 are inclined to detect new developments sooner. For instance, they’re open as early as 5AM as Americans are more and more shopping for their breakfasts earlier. They are additionally promoting extra cafe; latte; fruit smoothies to compete with Starbucks and Jumba Juice. You additionally see extra salads on the menu. This provides prospects extra causes to cease by at fast-food eating places and make them extra interesting to completely different prospects.

With unbiased eating places, it typically takes some time to for purchasers to come back round and check out the meals. These institutions are particularly robust within the first 12 months of opening, particularly with house owners of minimal or no confirmed monitor file. So normally, “mom and pop” eating places are dangerous funding as a result of preliminary weak income. If you select to put money into a non-brand title restaurant, make sure that the return is proportional to the dangers that you can be taking.

Sometimes it’s not straightforward so that you can inform if a restaurant is a company title or non-brand title. Some restaurant chains solely function, or are widespread in a sure area. For instance, WhatABurger restaurant chain with over 700 places in 10 states is a very fashionable fast-food restaurant chain in Texas and Georgia. However, it’s nonetheless unknown on the West Coast as of 2012. Brand title chains are inclined to have a web site itemizing all of the places plus different info. So if you could find a restaurant web site from Google or Yahoo you may shortly discern if an unfamiliar title is a company title or not. You can even get hold of primary client details about nearly any chain eating places within the US on Wikipedia.

The Ten Fastest-Growing Chains in 2011 with Sales Over $200 Million

According to Technomic, the next is the ten quickest rising restaurant chains when it comes to income change from 2010 to 2011:

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

Lease & Rent Guaranty

The tenants typically signal a long run absolute triple web (NNN) lease. This means, moreover the bottom hire, in addition they pay for all working bills: property taxes, insurance coverage and upkeep bills. For buyers, the danger of upkeep bills uncertainty is eradicated and their money circulation is predictable. The tenants can also assure the hire with their very own or company property. Therefore, in case they’ve to shut down the enterprise, they’ll proceed paying hire for the lifetime of the lease. Below are some things that you want to know in regards to the lease warranty:

  1. In common, the stronger the warranty the decrease the return of your funding. The warranty by McDonald’s Corporation with a powerful “A” S&P company score of a public firm is significantly better than a small company owned by a franchisee with a number of eating places. Consequently, a restaurant with a McDonald’s company lease usually affords low 4.5-5% cap (return of funding within the 1st yr of possession) whereas McDonald’s with a franchisee warranty (over 75% of McDonalds eating places are owned by franchisees) might supply 5-6% cap. So work out the quantity of dangers you might be keen to take as you will not get each low dangers and excessive returns in an funding.
  2. Sometimes a multi-location franchise will type a mother or father firm to personal all of the eating places. Each restaurant in flip is owned by a single-entity Limited Liabilities Company (LLC) to protect the mother or father firm from liabilities. So the hire warranty by the single-entity LLC doesn’t imply a lot because it doesn’t have a lot property.
  3. A good, lengthy warranty doesn’t make a lemon a superb automotive. Similarly, a powerful warranty doesn’t make a awful restaurant a superb funding. It solely means the tenant will make each effort to pay you the hire. So do not choose a property totally on the warranty.
  4. The warranty is sweet till the company that ensures it declares chapter. At that point, the company reorganizes its operations by closing places with low income and protecting the great places, (i.e. ones with sturdy gross sales). So it is extra vital so that you can select a property at a superb location. If it occurs to have a weak warranty, (e.g. from a small, personal firm), you’re going to get double advantages: on time hire cost and excessive return.
  5. If you occur to put money into a “mom & pop” restaurant, make sure that all of the principals, e.g. each mother and pop, assure the lease with their property. The warranty ought to be reviewed by an lawyer to ensure you are properly protected.

Location, Location, Location

A awful restaurant might do properly at a superb location whereas these with a superb menu might fail at a nasty location. A good location will generate sturdy income for the operator and is primarily essential to you as an investor. It ought to have these traits:

  1. High visitors quantity: it will draw extra prospects to the restaurant and because of this excessive income. So a restaurant on the entrance to a regional mall or Disney World, a significant shopping center, or schools is at all times fascinating.
  2. Good visibility & signage: excessive visitors quantity have to be accompanied by good visibility from the road. This will reduce promoting bills and is a continuing reminder for diners to come back in.
  3. Ease of ingress and egress: a restaurant situated on a one-way service highway working parallel to a freeway will get loads of visitors and has nice visibility however isn’t at an incredible location. It’s arduous for potential prospects to get again in the event that they miss the doorway. In addition, it is not doable to make a left flip. On the opposite hand, the restaurant simply off freeway exit is extra handy for purchasers.
  4. Excellent demographics: a restaurant ought to do properly in an space with a big, rising inhabitants and excessive incomes because it has extra individuals with cash to spend. Its enterprise ought to generate increasingly more earnings to pay for rising increased rents.
  5. Lots of parking areas: most chained eating places have their very own parking zone to accommodate prospects at peak hours. If buyer can’t discover a parking area inside a couple of minutes, there’s a good probability they’ll skip it and/or will not come again as typically. A typical quickly meals restaurant will want about 10 to twenty parking areas per 1000 sq. ft of area. Fast meals eating places, e.g. McDonald’s will want extra parking areas than sit down eating places, e.g. Olive Garden.
  6. High gross sales income: the annual gross income alone doesn’t inform you a lot since larger–in time period of sq. footage–restaurant tends to have increased income. So the hire to income ratio is a greater gauge of success. Please consult with hire to income ratio within the due diligence part for additional dialogue.
  7. High boundaries to entry: this merely implies that it is not straightforward to duplicate this location close by for varied causes: the realm merely doesn’t have any extra developable land, or the grasp plan doesn’t permit any extra development of economic properties, or it is costlier to construct an analogous property as a result of excessive value of land and development supplies. For these causes, the tenant is more likely to renew the lease if the enterprise is worthwhile.

Financing Considerations

In common, the rate of interest is a bit increased than common for eating places as a result of the truth that they’re single-tenant properties. To the lenders, there’s a perceived threat as a result of if the restaurant is closed down, you can doubtlessly lose 100% of your earnings from that restaurant. Lenders additionally desire nationwide company title eating places. In addition, some lenders won’t loan to out-of-state buyers particularly if the eating places are situated in smaller cities. So it could be a good suggestion so that you can put money into a franchised restaurant in main metro areas, e.g. Atlanta, Dallas. In 2009 it is fairly a problem to get financing for sit-down restaurant acquisitions, particularly for mother and pop and regional eating places as a result of tight credit score market. However, issues appear to have improved a bit in 2010. If you wish to get the most effective fee and phrases for the loan, you must persist with nationwide franchised eating places in main metros.

When the cap fee is increased than the rate of interest of the loan, e.g. cap fee is 7.5% whereas rate of interest is 6.5%, then you must contemplate borrowing as a lot as doable. You will get 7.5% return in your down cost plus 1% return for the cash you borrow. Hence your complete return (money on money) will probably be increased than the cap fee. Additionally, because the inflation within the close to future is anticipated to be increased as a result of rising prices of gasoline, the cash which you borrow to finance your buy will probably be price much less. So it is much more useful to maximise leverage now.

Due Diligence Investigation

You might wish to contemplate these components earlier than deciding to go ahead with the acquisition:

  1. Tenant’s monetary info: The restaurant enterprise is labor intensive. The common worker generates solely about $55,000 in income yearly. The value of products, e.g. meals and provides ought to be round 30-35% of income; labor and working bills 45-50%; hire about 7-12%. So do evaluation the income and loss (P&L) statements, if obtainable, together with your accountant. In the P&L assertion, you may even see the acronym EBITDAR. It stands for Earnings Before Income Taxes, Depreciation (of apparatus), Amortization (of capital enchancment), and Rent. If you do not see royalty charges in P&L of a franchised restaurant or promoting bills within the P&L of an unbiased restaurant, it’s possible you’ll wish to perceive the rationale why. Of course, we’ll wish to be sure that the restaurant is worthwhile after paying the hire. Ideally, you wish to see web income equal to 10-20% of the gross income. In the previous few years the financial system has taken a beating. As a end result, eating places have skilled a lower in gross income of round 3-4%. This appears to have impacted most, if not all, eating places all over the place. In addition, it could take a brand new restaurant a number of years to succeed in potential income goal. So do not count on new places to be worthwhile straight away even for chained eating places.
  2. Tenant’s credit score historical past: if the tenant is a non-public company, you might be able to get hold of the tenant’s credit score historical past from Dun & Bradstreet (D&B). D&B supplies Paydex rating, the enterprise equal of FICO, i.e. private credit score historical past rating. This rating ranges from 1 to 100, with increased scores indicating higher cost efficiency. A Paydex rating of 75 is equal to FICO rating of 700. So in case your tenant has a Paydex rating of 80, you might be more likely to obtain the hire checks promptly.
  3. Rent to income ratio: that is the ratio of base hire over the annual product sales of the shop. It is a fast option to decide if the restaurant is worthwhile, i.e. the decrease the ratio, the higher the placement. As a rule of thumb it would be best to maintain this ratio lower than 10% which signifies that the placement has sturdy income. If the ratio is lower than 7%, the operator will very seemingly make some huge cash after paying the hire. The hire warranty might be not essential on this case. However, the hire to income ratio isn’t a exact option to decide if the tenant is making a revenue or not. It doesn’t bear in mind the property taxes expense as a part of the hire. Property taxes–computed as a proportion of assessed value–vary from states to states. For instance, in California it is about 1.25% of the assessed worth, 3% in Texas, and as excessive as 10% in Illinois. And so a restaurant with hire to earnings ratio of 8% could possibly be worthwhile in a single state and but be dropping cash in one other.
  4. Parking areas: eating places have a tendency to wish a better variety of parking areas as a result of most diners are inclined to cease by inside a small time window. You will want not less than 8 parking areas per 1000 Square Feet (SF) of restaurant area. Fast meals eating places may have about 15 to 18 areas per 1000 SF.
  5. Termination Clause: a number of the long run leases give the tenant an choice to terminate the lease ought to there be a fireplace destroying a sure proportion of the property. Of course, this isn’t fascinating to you if that proportion is simply too low, e.g. 10%. So ensure you learn the lease. You additionally wish to make sure that the insurance coverage coverage additionally covers rental earnings loss for 12-24 months in case the property is broken by hearth or pure disasters.
  6. Price per SF: you must pay about $200 to $500 per SF. In California it’s a must to pay a premium, e.g. $1000 per SF for Starbucks eating places that are usually bought at very excessive worth per SF. If you pay greater than $500 per SF for the restaurant, ensure you have justification for doing so.
  7. Rent per SF: ideally you must put money into a property by which the hire per SF is low, e.g. $2 to $3 per SF monthly. This provides you room to boost the hire sooner or later. Besides, the low hire ensures the tenant’s enterprise is worthwhile, so he will probably be round to maintain paying the hire. Starbucks are inclined to pay a premium hire $2 to 4 per SF month-to-month since they’re typically situated at a premium location with a lot of visitors and excessive visibility. If you intend to put money into a restaurant by which the tenant pays greater than $4 per SF month-to-month, ensure you might justify your resolution as a result of it is arduous to make a revenue within the restaurant enterprise when the tenant is paying increased hire. Some eating places might have a proportion clause. This means moreover the minimal base hire, the operator additionally pays you a proportion of his income when it reaches a sure threshold.
  8. Rent improve: A restaurant landlord will usually obtain both a 2% annual hire improve or a ten% improve each 5 years. As an investor you must desire 2% annual hire improve as a result of 5 years is a very long time to attend for a increase. You will even obtain extra hire with 2% annual improve than 10% improve each 5 years. Besides, because the hire will increase yearly so does the worth of your funding. The worth of restaurant is usually based mostly on the hire it generates. If the hire is elevated whereas the market cap stays the identical, your funding will admire in worth. So there is no such thing as a key benefit for investing in a restaurant in a sure space, e.g. California. It’s extra essential to decide on a restaurant at an incredible location.
  9. Lease time period: normally buyers favor long run, e.g. 20 yr lease so they do not have to fret about discovering new tenants. During a interval with low inflation, e.g. 1% to 2%, that is advantageous. However, when the inflation is excessive, e.g. 4%, this implies you’ll technically get much less hire if the hire improve is barely 2%. So do not rule out properties with a number of years left of the lease as there could also be sturdy upside potential. When the lease expires with out choices, the tenant might must pay a lot increased market hire.
  10. Risks versus Investment Returns: as an investor, you want properties that provide very excessive return, e.g. 8% to 9% cap fee. And so it’s possible you’ll be interested in a company new franchised restaurant supplied on the market by a developer. In this case, the developer builds the eating places fully with Furniture, Fixtures and Equipment (FFEs) for the franchisee based mostly on the franchise specs. The franchisee indicators a 20 years absolute NNN lease paying very beneficiant hire per SF, e.g. $4 to $5 per SF month-to-month. The new franchisee is keen to take action as a result of he doesn’t have to provide you with any money to open a enterprise. Investors are excited in regards to the excessive return; nonetheless, this can be a really dangerous funding. The one who’s assured to become profitable is the developer. The franchisee will not be keen to carry on throughout robust instances as he doesn’t have any fairness within the property. Should the franchisee’s enterprise fails, it’s possible you’ll not be capable to discover a tenant keen to pay such excessive hire, and it’s possible you’ll find yourself with a vacant restaurant.
  11. Track information of the operator: the restaurant being run by an operator with 1 or 2 recently-open eating places will most likely be a riskier funding. On the opposite hand, an operator with 20 years within the enterprise and 30 places could also be extra more likely to be round subsequent yr to pay you the hire.
  12. Trade fixtures: some eating places are bought with commerce fixtures so ensure you doc in writing what’s included within the sale.
  13. Fast-food versus Sit-down: whereas fast-food eating places, e.g. McDonalds do properly in the course of the downturn, sit-down household eating places are usually extra delicate to the recession as a result of increased costs and excessive bills. These eating places might expertise double-digit drop in year-to-year income. As a end result, many sit-down eating places had been shut down in the course of the recession. If you contemplate investing in a sit-down restaurant, you must select one in an space with excessive earnings and huge inhabitants.

Sale & Lease Back

Sometimes the restaurant operator might promote the true property half after which lease again the property for a very long time, e.g. 20 years. A typical investor would marvel if the operator is in monetary bother in order that he has to promote the property to pay for his money owed. It might or will not be the case; nonetheless, this can be a fast and straightforward approach for the restaurant operator to get money out of the equities for good cause: enterprise enlargement. Of course, the operator might refinance the property with money out however that will not be the most suitable choice as a result of:

  1. He can’t maximize the money out as lenders typically lend solely 65% of the property worth in a refinance state of affairs.
  2. The loan will present as long run debt within the stability sheet which is usually not considered in a optimistic mild.
  3. The rates of interest will not be as favorable if the restaurant operator doesn’t have a powerful stability sheet.
  4. He might not be capable to discover any lenders as a result of tight credit score market.

You will typically see 2 completely different money out methods once you take a look at the hire paid by the restaurant operator:

  1. Conservative market hire: the operator needs to ensure he pays a low hire so his restaurant enterprise has a superb probability of being worthwhile. He additionally affords conservative cap fee to buyers, e.g. 7% cap. As a end result, his money out quantity is small to reasonable. This could also be a low threat funding for an investor as a result of the tenant is extra seemingly to have the ability to afford the hire.
  2. Significantly increased than market hire: the operator needs to maximise his money out by pricing the property a lot increased than its market worth, e.g. $2M for a $1M property. Investors are generally supplied excessive cap fee, e.g. 10%. The operator might pay $5 of hire per sq. foot in an space the place the hire for comparable properties is $3 per sq. foot. As a end result, the restaurant enterprise at this location might endure a loss as a result of increased rents. However, the operator will get as a lot cash as doable. This property could possibly be very dangerous for you. If the tenant’s enterprise doesn’t make it and he declares chapter, you’ll have to supply decrease hire to a different tenant to lease your constructing.

Ground Lease

Occasionally you see a restaurant on floor lease on the market. The time period floor lease could also be complicated because it might imply

  1. You purchase the constructing and lease the land owned by one other investor on a long-term, e.g. 50 years, floor lease.
  2. You purchase the land by which the tenant owns the constructing. This is the most definitely situation. The tenant builds the restaurant with its personal cash after which sometimes indicators a 20 years NNN lease to lease the lot. If the tenant doesn’t renew the lease then the constructing is reverted to the landowner. The cap fee is usually 1% decrease, e.g. 6 to 7.25 p.c, in comparison with eating places by which you purchase each land and constructing.

Since the tenant has to speculate a considerable sum of money (whether or not its personal or borrowed funds) for the development of the constructing, it needs to be double certain that that is the proper location for its enterprise. In addition, ought to the tenant fail to make the hire cost or fail to resume the lease, the constructing with substantial worth will revert to you because the landowner. So the tenant will lose much more, each enterprise and constructing, if it doesn’t fulfill its obligation. And thus it thinks twice about not sending within the hire checks. In that sense, this can be a bit safer funding than a restaurant which you personal each the land and enhancements. Besides the decrease cap fee, the main drawbacks for floor lease are

  1. There aren’t any tax write-offs because the IRS doesn’t permit you to depreciate its land worth. So your tax liabilities are increased. The tenants, however, can depreciate 100% the worth of the buildings and equipments to offset the income from the enterprise.
  2. If the property is broken by hearth or pure disasters, e.g. tornados, some leases might permit the tenants to gather insurance coverage proceeds and terminate the lease with out rebuilding the properties in the previous few years of the lease. Unfortunately, this creator isn’t conscious of any insurance coverage firms that will promote hearth insurance coverage to you since you do not personal the constructing. So the danger is substantial as it’s possible you’ll find yourself proudly owning a really costly vacant lot with no earnings and an enormous property taxes invoice.
  3. Some of the leases permit the tenants not having to make any construction, e.g. roof, repairs in the previous few years of the lease. This might require buyers to spend cash on deferred upkeep bills and thus may have destructive impression on the money circulation of the property.

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