Can Owning Real Estate Provide Franchisees Income and Security?
“I’m not in the hamburger business. My business is real estate.” – Ray Kroc, Founder of McDonald’s
The well recognized quote above from Ray Kroc, founder of McDonald’s, is often quoted by business owners when justifying their model to vertically integrate their most basic need: real estate. McDonald’s serves as an exemplary model of growth and success, so it is no wonder that business owners around the world choose to emulate their strategy, real estate and otherwise. The understanding of McDonald’s’ real estate strategy, however, is usually limited to Ray Kroc’s famous statement to the University of Texas MBA Students in 1974. Few business owners have taken the time to study exactly what McDonald’s real estate strategy is and how it works to their advantage.
In taking a deeper look into this strategy, we understand why Mr. Kroc said McDonald’s is not primarily a restaurant operator. Specifically, McDonald’s has franchised approximately 85% of its restaurants, which serves as evidence of leadership’s desire to distance themselves from the day-to-day operations of the fast food business. What sets McDonald’s apart as a franchisor from other similar burger chains is that in addition to the approximately 4% of sales it receives in royalties from its franchised locations, it also receives rental income from those locations. This figure can be as much as an additional 10% of the sales. In short, this is one of the major reasons McDonald’s owns real estate. Not only does McDonald’s own the real estate of its own locations, but (more importantly) the real estate of the many franchised stores. In fact, this is the strategy that pulled McDonald’s out of years of lackluster performance and annual losses and prepared the company for its successful debut on the stock market in 1965. It is the same strategy that led Ray Kroc to state so famously that they were no longer in the hamburger business but the real estate business. It also makes sense why McDonald’s continues to aggressively pursue new markets and new locations, where the returns on the real estate and store openings are compelling and less volatile than focusing solely on improving sales at existing locations.
So, the question is: how can a business operator implement the strategy of this mega franchisor? The reality is that it can’t, at least not in the same way. The result of McDonald’s strategy and the catalyst of McDonald’s success is that they became one of the world’s largest landlords. Leasing real estate to their own corporate locations (where the franchisor is responsible for occupancy costs) does not attain the same result as leasing to the franchised stores, where the operators are responsible for occupancy costs. Fortunately for McDonald’s, the majority of their stores are franchised.
However, regardless of McDonald’s success, few business owners choose to hold on to their real estate with the goal of getting rich from owning real estate. In other words, the majority of business owners primarily seek security rather than profit. Of course, it’s difficult to assign a value to the sense of security business owners receive from having the land in their name. With constant demographic and legislative changes, it is understandable that a franchisee would want the ability to sell the building and move to a new, more favorable location thereby immediately severing any financial obligations tied to the old location (assuming the mortgage balance does not interfere).
Other business owners point to owning their businesses’ real estate as an investment. Security and investing are valid arguments. Yet, it is important to note that simply holding real estate does not always make a person a real estate investor. Under that assumption, all homeowners would classify as real estate investors. Contrary to popular belief, commercial real estate values do not always go up. The value of commercial properties rises and falls along with the use of the property and its ability to generate and sustain rental income. A building customized for a fast food restaurant has a considerably higher investment value with a business occupying it and paying rent, than it would as a vacant building without a tenant. As for security, there can be much more economical and efficient forms of insurance, one of which we will explore below.
Consider that owning real estate isn’t as profitable (or profitable at all) for the franchisee as it is for the franchisor. However, McDonald’s was on to something with viewing their real estate as more than just the place where hamburgers are made. There are several ways to make real estate work the way business owners want it to and provide them with the investment returns and the security they seek. For one, let’s look at Sale Leasebacks (the most commonly used real estate strategy among publicly traded companies). Most recognize sale leasebacks as a tool large companies use to access capital tied up in their real estate and minimize their tax liability. What few realize, however, is that sale leasebacks often create capital, as much as 1.7 times what was originally put into the property according to one franchisee.
The reality is that investors are indeed willing to pay substantially more than the cost of the property. If the notion that someone would be willing to pay up to 70% more than the value of the building seems far fetched, consider the following: investors are (at least partially) paying for the stable rent checks guaranteed over the course of the lease. These payments are backed by the security of the business, the real estate and, most importantly, the strength of the guarantor. The stronger the guarantor, real estate, and sales, the lower the risk premium investors assign and the higher the sales price. Conservative private investors seeking alternatives to the volatile stock market, insurance companies, and REITS are the most common buyers of these single-tenant net leased investments. In fact, demand for single tenant net leased properties has been in the 11% to 12% range since 2012, suggesting sustained strong investor demand in the sector. Moreover, single tenant net leased properties comprised 15.1% of all retail transactions in 2019 Q2, the highest since 2013. These transactions effectively allowed business owners to forgo one of the tightest lending markets in history and begin to access a source of capital that was at one time reserved only for the largest companies. What’s more is that this source of capital put business owners back in the driver’s seat and allowed them to set the terms, not the bank.
With the capital from a sale leaseback, business owners are now open to several new options. The funds can be reinvested back into the core business to improve or expand, where returns are often higher and expertly monitored by the owner. At this point, the business owner would now be earning returns not only off the money tied up in the real estate construction costs, but the equity that came from the creation of a lease agreement. The premium paid for the property because of that lease can now be used to diversify the business. Business owners are now free to open different concepts less susceptible to the legislative changes, invest in stocks, bonds, or even fortify the diminishing retirement account. Overall, these various strategies of reinvesting the proceeds and capital through the sale of the real estate allow the business owner to diversify, thus insuring the health of the business itself.
In reviewing the benefits of real estate, it would be foolish not to note one of the most solid arguments for owning owner operated real estate. Upon repayment of the mortgage, a business owner can enjoy the location without rent or mortgage obligations allowing the location to cash flow at a much higher rate. While this is certainly the case, it is important for the franchise owner to evaluate the tax rate on that income with lower expenses to offset the income. In most cases, by the time the mortgage has been retired, the property is close to being fully depreciated, ending this beneficial tax deduction. With the current fear of tax rates increasing, franchise owners are reexamining every option available to reduce their tax basis and annual liabilities to hold on to returns.
When taking these points into consideration, it’s no wonder so many businesses have chosen to create and redeploy capital by means of sale leasebacks. In fact, this is an issue which McDonald’s itself faces regularly. While McDonald’s originally established its revenue stream by collecting rental income and grew it by opening new stores, the mega franchisor will need to reevaluate their strategy at some point as new markets are fewer and farther between. Shareholders demand growth and that growth is difficult to achieve with an estimated $6.9 billion in real estate holdings tying up the balance sheet and those holdings generating returns more akin to annuities than a company listed on the Dow. Other fast food concepts are taking note. Burger King, Taco Cabana, Starbucks, Church’s Chicken, BJ’s Brewhouse, and many others have been implementing sale leasebacks for years.
In short, owning the real estate can in fact be lucrative for a business owner. It can most definitely provide financial and security benefits, but maybe not in the way you would have thought. It just takes looking at the real estate from a different perspective, just as McDonald’s did fifty years ago.