There’s an infamous saying that’s often attributed to the driver behind McDonald’s rapid expansion, Ray Croc: “We aren’t in the restaurant business; we are in the real estate business.” I don’t think there is another quote in the real estate industry that is more repeated or more misused, except perhaps “If you build it, they will come.” After 15 years of working in retail commercial real estate, I hear both sayings regularly.
I hear the first quote used all too often to justify why restaurant owners insist on owning their own real estate. Convinced it is the true business they are in and thus a non-negotiable in the site selection process, some restauranteurs will sacrifice opportunity in pursuit of property ownership. The reality, however, is that the strategy of owning the real estate in which their business operates could not just be limiting their growth, but stopping it altogether — or at minimum, exposing them to unnecessary risk.
McDonald’s is in the real estate business; that cannot be argued. In its 2018 annual report, McDonald’s explains that leasing the real estate, equipment, furniture and décor is a primary business operation. Further, McDonald’s is both a franchisor and a landlord that the franchisees pay rent to on top of the franchise fees, service fees (not less than 4% of sales), etc. Typically, the rent the franchisees pay falls just under 8.5% of total gross sales for each location. It is McDonald’s — the franchisor, not the restaurant operator — that is the real estate owner.
The full thought from McDonald’s comes from its former CFO, Harry Sonneborn, who is quoted as saying, “The only reason we sell 15 cent hamburgers is because they are the greatest producer of revenue, from which our tenants can pay us our rent.” That same 2018 report stated that the company owned approximately 80% of the buildings for its restaurants, and 85% of the restaurants were operated by franchisees.
Owning the real estate works for the franchisor who leases it back to franchisees at huge markups, but it does not have the same benefits to a franchisee or independent restaurant owner. Below are a few reasons why:
1. Restaurant returns typically exceed real estate returns. If restaurant returns exceed the market cap rates on real estate leased by the restaurant brand and credit, then your equity is underutilized. In a healthy economy, this statement holds true for most restaurants.
2. Limited diversification of investments. No diversification exists in the strategy in which an operator invests heavily in an asset whose value is directly tied to the performance of the other assets in the portfolio, in this case, the restaurant operations.
3. The best sites aren’t typically for sale. As a result, site selection is limited to lower-quality locations, which directly impacts sales and future growth. The locations with the highest traffic and potential for the highest sales are rarely available for purchase. Strict adherence to an ownership strategy leads operators to open in inferior locations or limit openings all together.
Due to the above-mentioned reasons, many concepts expand regardless of whether they own, lease or ground lease the location. The true way to make money in real estate lies in another cliche: location, location, location. Savvy concepts place the location of the real estate above all other decision points due to its ability to drive sales. Even more decide to sell the real estate immediately upon opening the location. Why would they do such a thing? To redeploy the capital in a higher yield area of the business: operations.
As an example, let’s say a restaurant owner already owns the real estate on which the business operates. They plan on holding it and using the real estate as a means to retire when they sell the business. For the purpose of a simple mathematical example, let’s say they purchased the real estate and built a building for a total of $1 million. In that location, they generate gross sales of around $1.2 million annually. If they set their rent to the industry standard of 8.5% of sales, they would need to pay around $102,000 annually in rent. Assuming cap rates for their concept and credit were at 7% (most concepts are currently trading more favorably than this) for a 15-year leaseback, they would be able to sell the property for nearly $1.5 million. This would allow them to liquidate the $500,000 in equity created as well as redeploy any additional equity invested when they signed a long-term lease upon the sale. This equity can be used for additional expansion, working capital or profit. It is for this reason that many concepts will do sale-leasebacks as a cost-effective and tax-beneficial growth strategy for nationwide expansion.
So, if a restaurant owner does want to get into the long-term real estate investment business, how should they do it?
By utilizing the knowledge of which submarkets generate superior sales for restaurants. It is those sales that drive rents up for leasing space to other concepts and produce opportunities for development and redevelopment in those submarkets. This allows a restaurant owner the best of both worlds by leveraging their insider knowledge acquired in the day-to-day operations to generate superior returns in real estate while maintaining higher returns and diversification of their overall portfolio.
So yes, restaurant operations may be a business owner’s ticket to real estate investing after all. But it requires looking beyond their own locations to fully benefit from the investment strategy.