Restaurants are a favorite commercial property for many investors
because:
1=2E Tenants often sign very long term, e.g. 20 years absolute NNN
leases. This means there are no landlord responsibilities so you have
time to do what is im****tant to you. The only time you have to raise
a finger is when you start your car engine to take the rent check to
the bank for deposit! Some tenants even wire the rent to your savings
account on the due date.
2=2E People have to eat whether it rains or ****nes. 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
National Restaurant Association, the nation's restaurant industry
currently with 937,000 restaurants is expected to hit $537 billion in
sales in 2007, compared to just $322 billion in 1997 and $200 billion
in 1987 (in current dollars). As long as there is civilization on
earth, there will be restaurants! So you feel comfy that the property
is always in high demand.
3=2E 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 toilet or lots of trash
flying in the parking lot.
However, restaurants are not created equal from an investment
viewpoint.
Franchised versus Independent
You often hear that 9 out of 10 new restaurants will fail in the first
year. However, this is just an urban myth as there are no studies
with such conclusion. There is only a study by Associate Professor of
Hospitality, Dr. H.G. Parsa of Ohio State University tracking new
restaurants from 1996-1999 just in Columbus, Ohio (you should not draw
the conclusion that the results are the same everywhere else in the
US.) Dr. Parsa observed that seafood restaurants were the safest
ventures and that Mexican restaurants experience the highest rate of
failure. His study also found 26% of new restaurants closed in the
first year. Another 19% closed on the second year and 14% closed on
the third year. So 59% of the new restaurants closed within 3 years.
The closing rate is slightly different between franchised and
independent restaurants - 59% versus 61%. Besides economic failure,
the reasons for closing include divorce, poor health, and
unwillingness to commit immense time to operate the business. Based on
this study, it may be safe to predict that the longer the restaurant
has been in the business the more likely it will be around next year
to pay you the rent.
For franchised restaurants, the franchisee has to pay a one-time
franchisee fee about $30-50K and on-going royalty between 4-12.5% of
sales revenue. 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 up. The king of franchised
restaurants is the fast-foods chain McDonalds with 30,823 locations
(about 14,000 in the US) as of 2006 with an average $2M in revenue per
US location. Fast foods chains tend to detect new trend faster. For
example, they are open as early as 5AM as Americans increasingly buy
their breakfast earlier. They are also selling more caf=E9 latte. All
these things should increase the revenue and in turn make your
investment safer.
Independent restaurants will take a while to for customers to come in
and try. Their business is especially tough in the first 12 months of
inception, especially to those whose owners have not had a proven
track record. So in general, mom and pop restaurants are a riskier
investment for you because revenue is weak initially. If you choose
to invest in a non-brand name restaurant, make sure the return is
pro****tional to the risks you take.
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, Johnny Carino's restaurant
is a very popular Italian restaurant chain in Texas and Georgia but
there is only one in California as of 2007. 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 tell if an unfamiliar name is brand name or not. The website
www.entrepreneur.com also has useful information for investors about
various restaurant franchises.
Lease & Rent Guarantee
The tenants often sign a long term absolute NNN lease. On top of
that, they may also guarantee the rent with their own or cor****ate
assets. So in case they have to close down the business, they
continue paying rent for the life of the lease. However, not all
guarantees are the same. The guarantee by McDonalds Cor****ation with
a strong S&P cor****ate rating is much better than a small cor****ation
owned by a franchisee with 4 restaurants. 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 LLC (Limited
Liabilities Company). So the rent guarantee by the single-entity LLC
does not mean much as it does not have much asset.
Financing Considerations
In general the interest rate is higher than average for restaurants
due to the fact they are a single-tenant properties. To the lenders,
the risk for lending to purchase a restaurant is higher because when
the restaurant is closed down, you could potentially lose 100% of
income. They also prefer brand name restaurants. In addition, some
lenders will not loan to out-of-state investors especially if the
restaurants are located in smaller cities. So it may be prudent to
invest in restaurants in a major metro area, e.g. Atlanta.
Due Diligence
You may want to consider these factors before deciding to go forward
with the purchase:
1=2E The restaurant business is very labor intensive in which on the
average each employee generates only about $55K of revenue a year.
The foods cost should be 25-30% of revenue, labor around 30-40%,
operating expenses 10-20%. As a rule of thumb if the revenue is less
than 10 times the annual rent than it's likely the business is not
profitable. So do review the profits and loss (P&L) statements if
available with your accountant. In the profits & loss statement, you
may see an acronym EBITDAR. It stands for Earnings Before Income
Taxes, Depreciation (of equipment), Amortization (of capital
improvement), and Rent. If you don't see royalty fees in P&L of a
franchised restaurant or advertising expenses in he P&L of an
independent restaurant, you may want to understand the reason.
2=2E Parking spaces: restaurants tend to have higher number of parking
spaces because diners tend to stop by within a small time window for
lunch. You will need at least 8 parking spaces per 1000 Square Foot
(SF). Fast food restaurants may need about 15-20 spaces per 1000 SF.
3=2E Some of the long term leases give the tenant an option to terminate
the lease should there be a fire. Of course, this is not desirable to
you. So make sure you read the lease.
4=2E Price per SF: you should pay about $200-500/SF. In California you
have to pay a premium, e.g. $1000/SF for Starbucks restaurants which
are normally sold at very high price per SF. If you pay more than $500/
SF for the restaurant, make sure you can justify for doing so.
5=2E Rent per SF: ideally you want to invest in a property in which the
rent per SF is low, e.g. $1-2/SF per month. This gives you room to
raise the rent in the future. Besides the low rent ensures the
tenant's business is profitable so he will be around to keep paying
rent. Starbucks tend to pay a premium rent $2-3/SF a month since it
is often located at a premium location with lots of traffic and high
visibility. If you plan to invest in a restaurant in which the tenant
pays more than $3/SF a month, make sure you could justify your
decision because it's hard to make a profit in the restaurant business
when the tenant pays that kind of rent.
6=2E Location: a lousy restaurant may do well at a good location.
However, a restaurant with a good menu may fail at a bad location.
Please refer to the article title "What Location Means in Commercial
Real Estate" by the same author.
7=2E Risks versus Investment Returns: as an investor, you like
properties that offer very high return, e.g. 8-9% cap rate. And so
you may be attracted to a brand new franchised restaurant offered for
sale by a developer. In this case, the developer builds the
restaurants completely with Furniture, Fixtures and Equipment (FFEs)
for the franchisee based on the specifications of the franchise. The
franchisee signs a 20 years absolute NNN lease paying very generous
rent per SF, e.g. $4-5/SF per month. The new franchisee is willing to
do so because he does not need to come up with any cash to open a
business. Investors are excited about the high return. However, it
may be a very risky investment. The person who is guaranteed to make
money is the developer. The franchisee may not be willing to hold on
during tough times as he does not have any equity in the property.
Should the franchisee fail, you may not be able to find a tenant
willing to pay that kind of high rent and end up with a vacant
restaurant.
About the author:
David V. Tran is the President/CEO of eFunding Inc., a commercial real
estate brokerage, commercial loan brokerage, property management, self-
directed IRA investment and TIC company in San Jose, CA. His website
is www.efundingcom.com. He may be contacted at (408) 288-5500.
eFunding does business in all 50 states. He is the #1 Commercial Real
Estate Expert Author out of over 100 on www.ezinearticles.com, a
premiere internet magazine. He is also Pensco Trust's (a major self-
directed IRA custodian) Preferred Professional. David currently offers
3 FREE real estate investment seminars till 12/2007:
1=2E How to invest in commercial real estate for retirement income NOW.
2=2E How to maximize cash flow with 1031 tax-deferred exchange.
3=2E TIC: strategy for small investors and self-directed IRA investors
to acquire high-valued properties
(c) eFunding, Inc. 2007
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