Restaurants that were once a taboo real estate investment are now a hot commodity with more than $4 billion in net-lease restaurant properties expected to change hands in 2006. Traditionally, buyers have shied away from restaurants because of the highly specialized use of the real estate. But that is no longer the case. In fact, restaurants are in huge demand among both individual and institutional investors, according to industry experts.

Buyers such as the Franchise Finance division of GE Capital Solutions offer a fitting example. In May, the Scottsdale, Ariz.-based firm finalized a $50 million sale-leaseback of 34 Burger King restaurants from franchisee Simmonds Restaurant Management.

Investors are attracted to restaurant properties for a variety of reasons. Chief among them is a thriving restaurant industry fueled by consumers who are increasingly dining out. The nation's 925,000 restaurants are expected to generate more than $511.1 billion in sales in 2006 compared with $308.2 billion a decade ago, a 66% increase, according to the National Restaurant Association.

“Within the restaurant sector, particularly the quick-service and fast-casual concepts, there has been a secular shift in people's behavior where people go out to eat more,” according to Ethan Nessen, principal of Boston-based CRIC Capital, a net-lease specialist.

Currently, 47.5% of the money Americans spend on food is allocated to the restaurant industry, and that volume is expected to exceed 50% in the next decade, according to the National Restaurant Association. “Even in economic downturns, people still have to eat,” emphasizes Nessen.

Roll all of those factors together and it's no wonder that restaurants represent a sizable slice of the growing net-lease investment pie. The number of net-lease restaurants marketed for sale as of mid-May totaled 2,136 properties valued at $4 billion. That accounted for roughly 10% of the nearly $42 billion in net-lease properties on the market, according to The Boulder Group, an investment real estate firm based in Northbrook, Ill (see chart, page 104).

Avid 1031 interest

The entire net-lease investment sector has grown dramatically over the last few years due largely to a booming 1031 exchange market, which enables sellers to roll the proceeds from one real estate sale into another real estate purchase, and thereby defer any capital gains taxes.

Those 1031 dollars are increasingly flowing into single-tenant, net-lease investment properties that are known for their steady incomes and relatively minimal management responsibilities.

Restaurant deals also are drawing 1031 investors because they are very affordable for smaller players. The vast majority of restaurant properties — 44% — are priced between $1 million and $2 million, according to The Boulder Group.

“Overall, we have seen an increase in demand in triple-net-lease properties in the last five years across all property types,” says Michael Houge, a principal at Minneapolis-based Upland Real Estate Group Inc. “Restaurants in the price range of $1 million to $3 million in particular are a really hot area, and most restaurants fit smack dab in that range.”

The incredible demand for net-lease properties has resulted in cap rates — the initial return for a buyer based on the purchase price — that have been steadily dropping over the past five years. As of mid-May, the cap rate on net-lease restaurant properties averaged 7%, down 25 basis points over a year ago, according to The Boulder Group.

“There is an insatiable appetite for this type of product,” says Paul Domb, vice president of asset management at United Trust Fund LLP, a Miami-based investment group specializing in the purchase and leaseback of commercial properties.

And certainly there are those 1031 buyers that are making questionable decisions. They are willing to pay a premium for restaurants as part of a like-kind exchange in order to avoid capital gains taxes. The tax ramifications seem to outweigh the fact that they are not being compensated for the risk they are taking, according to some experts.

Competitive environment

The higher prices 1031 buyers are willing to pay are making acquisitions tough for institutional buyers. Top brands such as Applebee's, Starbucks, Taco Bell and Jack in the Box are all selling at average cap rates between 6.25% and 6.75%, according to The Boulder Group.

That is too rich for companies such as Realty Income, which typically shops for cap rates in the high 8s and low 9s. Competing for restaurant deals on a one-off basis is extremely difficult because 1031 exchange buyers have driven down prices, says Tom Lewis, CEO of Escondido, Calif.-based Realty Income.

“The only restaurants we are looking at are a few chains where we have relationships, as well as some of the larger transactions,” according to Lewis. In August, Realty Income purchased 89 Pizza Hut properties for $59 million from NPC International Inc., one of the largest franchise operators in the country.

UTF has bought about $40 million in restaurant properties in the past year, which represents about 5% of the firm's overall transaction volume. The company would certainly like to buy more restaurants, but its efforts have been limited by high pricing in the past few years.

“You are seeing extremely low cap rates on restaurants that I have never even heard of,” Domb says. One recent offering listed a Skipper's in Anchorage, Alaska at a 7% cap rate, which is incredibly low for a small chain that is not publicly traded, Domb notes.

Pullback on pricing

The good news for investors is that pricing may be reaching a plateau, with some indications that cap rates are even inching higher. According to Marcus & Millichap, which tracks only data from deals brokered by its own firm, cap rates rose about 25 basis points in the past three months. After reaching a low of 6.99% in May, average cap rates crept up to 7.18% in June and 7.26% in July, according to Marcus & Millichap. The firm has closed $543 million in net-lease restaurant transactions year-to-date through July.

One of the factors contributing to a decline in pricing is a surge in supply. More properties are coming to market as restaurant operators continue to seek capital to fuel expansion and acquisitions. As of mid-June, The Boulder Group was tracking 2,136 available net-lease restaurant properties — a 75% increase in the number of available properties compared to the same period last year.

Although Realty Income has seen its restaurant holdings decline in the past few years, falling from 25% to 11% of the firm's $2.9 billion in assets, Lewis expects the firm's restaurant holdings to climb higher as more large restaurant portfolios come to market. “Some of the chains that have traditionally owned their real estate are now bringing it off the balance sheet with sale-leaseback financing,” he says.

“Right now, there are lots of opportunities. We're very busy. But we think there are going to be even more opportunities in the near future,” predicts Joe Ciardiello, senior vice president of acquisitions at Orlando-based National Retail Properties, a publicly traded REIT that specializes in retail and restaurant properties.

Ciardiello expects higher gas prices and rising interest rates to trigger a decline in consumer spending in the casual dining sector. “We believe a lot of investors will shy away from the casual dining sector, while at the same time the casual dining operators will be looking for additional capital from sale-leasebacks,” Ciardiello says.

Restaurant deals were getting too pricey, which was largely a function of the overheated market, Nessen notes. There was a lot of 1031 money coming out of apartment sales and looking to reinvest in net-lease restaurants, which drove up demand and pricing.

“Our conclusion is that real estate fundamentals were getting a little bit out of whack,” Nessen says. Now pricing is beginning to swing back the other way. Prices are going down because buyers are underwriting deals with more focus on the real estate, he adds.

More discriminating buyers

Another added benefit of the cooling market is that properties are taking somewhat longer to sell, which gives investors more time to look at a myriad of options and make prudent decisions. “Twelve months ago you had to make a full price offer that day, or it was off the shelf,” says Upland's Houge.

But the bump in interest rates over the past year has helped inject some sense of normalcy back into the market. Top restaurant deals are still selling quickly — about a week — while average deals are on the market for 30 to 45 days. “I think we are reaching this equilibrium market. There is not too much supply and not too much demand, so everyone can play on an even playing field for once,” Houge says.

Buyers now appear to be more focused on quality. In 2004 and 2005, investors — particularly 1031 buyers — were buying all shapes and sizes of restaurant deals, even those in less than ideal situations. “People were getting caught up in the fervor,” says Bernie Haddigan, a managing director at Encino, Calif.-based Marcus & Millichap Real Estate Investment Brokerage Co.

The best deals — well-located restaurant properties whose operators have a strong credit rating — are still flying off the shelves. Yet the lower-quality deals in secondary locations that feature operators with mediocre credit ratings are taking longer to sell.

“Sellers have to offer a higher yield to induce buyers to those secondary properties,” Haddigan says. So, while higher-quality deals are still priced at a premium, cap rates on lower-end transactions have risen 100 to 200 basis points, he observes.

In addition, investors are paying close attention to both credit quality and the underlying real estate. “If an investor is looking at a concept that doesn't have the credit behind it, he wants to make sure that it is a good concept with solid financials,” Ciardiello says. Such diligence is especially important considering the fact that the majority of restaurant properties are leased to the franchisee.

Certainly, some buyers have purchased restaurant properties they probably shouldn't have because of the nationally recognized brand. “Some of these buyers confuse brand name with credit,” Haddigan says. But the reality is that someone who buys a Burger King is not getting a lease that is backed by Burger King, but instead is backed by an independent operator.

The net-lease industry is not without risk. One concern is that any slowdown in consumer spending could have a negative impact on restaurant spending. Yet such concerns have not seemed to derail demand for restaurant properties.

“I think investors are buying into restaurants because the future looks good for casual dining and fast food,” Houge says. Added to that is the fact that restaurants are sitting on great real estate locations in a climate where construction costs and land prices are both rising, he adds.

“If a Jack in the Box doesn't make it, a Starbucks might be able to go into that building and hit a home run,” Houge says. “Consequently, investors don't have to worry so much about sitting there with a shuttered restaurant.”

Beth Mattson-Teig is a Minneapolis-based writer.

Max & Erma's embraces sale-leasebacks

The volume of net-lease restaurant transactions could top $4 billion this year, according to industry experts. The huge appetite for single-tenant, net-lease properties has created demand for restaurants operated by lower-credit, or even non-rated, companies.

“Franchisees that didn't have access to capital are now having money thrown at them,” says Paul Domb, vice president of asset management at United Trust Fund LLP, a Miami-based investment group specializing in the purchase and leaseback of commercial properties.

Restaurant operators are clearly taking advantage of sale-leaseback financing as a less expensive capital source. Max & Erma's Restaurants Inc. is embracing the benefits of sale-leaseback financing. In June, the Columbus, Ohio-based restaurant chain announced that all of its future restaurants will be financed via sale-leasebacks.

The company's development team has partnered with a private investment firm that will finance the acquisition of the land, and then purchase the restaurant once construction is complete. Going with a sale-leaseback vs. owning the real estate is expected to reduce Max & Erma's cash investment from $1.9 million to $750,000 or less per new store.

“If a restaurant really works, the upside potential is enormous,” says Bill Niegsch, executive vice president and CFO at Max & Erma's (Nasdaq: MAXE). “There is always that tendency by restaurant owners to not tie up so much money in real estate and instead open up more restaurants.”

Max & Erma's currently has 100 restaurants in its chain, 80% of which are company owned. The company plans to open 10 restaurants in 2007, including seven franchise restaurants.

Going forward with its expansion plans, Max & Erma's realized that it needed to make a choice between the restaurant business and the real estate business. Despite steady returns of about 9% on the real estate side, the decision to focus solely on the restaurant business was clear. “As operators, the more restaurants you can open,” explains Niegsch of Max & Erma's, “the more our profit potential goes up.”
— Beth Mattson-Teig