For years, c-store operators struggled to find the cash they needed to finance growth, finding themselves at the mercy of lenders who weren't eager to invest in an industry that was often spotted by bankruptcies and other failures. Those who wished to expand were forced to find alternate financing, and today sale-leasebacks have emerged as a long-term, stable capital source for c-store operators.

Recently, a wide range of investors have taken an interest in c-stores. Commercial Net Lease Realty Inc., for example, entered the net-leased c-store market when it acquired 17 convenience stores that were leased to Quick Trip as part of its $61-million acquisition of National Properties Corp. in June 2005.

The Orlando, Fla.-based REIT followed that acquisition with the $170 million sale-leaseback of a portfolio of 74 convenience store properties last December from Susser Holdings LLC.

The deals, which represented 50 percent of the REIT's total investment volume, signaled a changing attitude toward the sector and a new investment strategy, says Steve Horn, director of acquisitions for CNL Realty. “2005 was our first true push into c-stores,” he explains. “Because the retail investment market is so competitive, we had to broaden our definition of retail. With c-stores, we knew we could get higher yields.”

CNL Realty is just one of several investors who are taking a second (and third look) at the c-store sector, which was previously dominated by two REITs: Escondido, Calif.-based Realty Income Corp. and Getty Realty Corp., which is the real estate arm of Getty Petroleum Marketing Inc.

Today, more institutions, along with private 1031 investors, are interested in buying c-stores despite their vulnerability to credit and environmental issues, as well as competitive pressures and the volatility of gas prices.

C-store deals represent about 2 percent of the overall retail net least market, according to Randy Blankstein, president of The Boulder Group. But, the sector is growing quickly as more and more c-store operators look to sale-leasebacks to finance their growth plans, says Thomas Kelso, managing director and principal of Matrix Capital Markets Group Inc.

“C-stores used to be out of the mainstream, but now everyone seems to be buying them,” laments Tom Lewis, CEO of Realty Income Inc., which started buying c-stores in the mid-1990s.

Today, the REIT is one of the biggest c-stores owners and boasts a c-store portfolio valued at roughly $400 million, although it bought only $30 million of c-store properties in 2005, a dramatic decrease from $100 million the previous year.

“We think there's a risk of overpaying in today's market,” Lewis notes. “It's hard to identify any great deals.”

Playing with the big boys

Realty Income may have taken a break from c-store investing, but other companies have stepped into the breech. Over the past 12 to 18 months, a number of significant c-store transactions have closed, in addition to a larger volume of smaller one-off sales. One of the reasons for the increased investment activity is availability.

Baltimore-based Matrix Capital Markets, for example, is marketing a portfolio of 20 c-store and petroleum outlets in the greater Detroit area owned by Mapco Express Inc., a regional operator with 236 convenience/gas stores in eight states.

“Smaller operators are having a hard time competing with larger operators and even operators from other industries such as Home Depot and Wal-Mart,” Kelso explains. “The ability to compete is an issue of size in most instances so small operators either want to sell out or bulk up.”

For example, Prima Marketing LLC did a $12-million sale-leaseback with Brauvin Net Capital LLC for 13 7-Eleven stores in Ohio, Pennsylvania and West Virginia. The Fairmont, WV-based company, which operates 75 7-Eleven stores in four states, will use the proceeds from the sale-leaseback to reposition its balance sheet and to become a bigger player in the c-store arena, according to Brauvin president James Brault.

Eventually, the convenience store industry will consist of four to five large national players and hundreds, if not thousands of small mom-and-pop franchisees, says Bill Fideli, a director with Boston-based CRIC Capital LLC.

Today, however, the c-store industry is very fragmented, with the largest owner/ operator, 7-Eleven Corp., controlling less than 5 percent of the total market. Regional franchisees like Prima Marketing or smaller mom-and-pop operators with fewer than 10 stores make up the bulk of the industry.

“Over time the middle market of regional players is going to disappear,” Fideli predicts. “It's almost like this new class is being created: super-regional operators.” In fact, larger operators are buying middle-market operators to get even bigger, leaving behind the mom-and-pops.

Dealing with gas pains

Regardless of size, c-stores across the nation are under pressure from a variety of sources. It's still a growing segment; it reached $400 billion last year, according to the National Association of Convenience Stores. But too many c-stores still derive the bulk of their revenues from fuel.

The association says that more than 60 percent of c-store revenue comes from fuel. (The average c-store revenue is $80,000 per week.) Unfortunately, c-store operators make only pennies on the gallon for fuel and there's plenty of pricing pressure from competing retail sectors. Nearly 4,000 discount and grocery stores sell fuel (compared with 110,000 traditional c-stores). They represent roughly 2 percent to 3 percent of all fuel retailing outlets in the U.S., but capture 7.7 percent of total fuels sales in 2005, according to Energy Analysts International (EAI). And in just three years, these nontraditional c-stores will sell 13 percent to 15 percent of all the fuel in the U.S.

Today, consumers can fill up their tanks at 1,300 fuel stations owned and operated by Wal-Mart or just about any supermarket chain. Even The Home Depot is horning in on the industry, planning to open four c-stores — branded as “Fuel — during the first half of this year in the Nashville, Tenn. area.

With so much competition for gas dollars, many c-store operators are focusing on non-fuel revenues such as in-store goods and car washes. Dallas-based 7-Eleven Corp., for example, has managed to decrease its dependence on fuel, with only 30 percent of its revenue derived from fuel and the rest from in-store items like sandwiches and coffee.

In-store items such as fresh foods tend to have higher margins, Fideli notes, adding that smaller and regional franchise operators usually have a harder time building up their non-fuel revenues than stores that benefit from corporate ownership and credit.

Questionable credit quality

Like other net leased properties, investors favor c-stores that are backed by a corporate credit rather than a franchise credit. Some investors, such as U.S. Realty Advisors, “would not invest in assets that are not leased back to substantial credit,” says Laurie Hawkes, president of the company. “We have to have a substantial credit — in other words, no small operators.”

Brauvin, on the other hand, is fine with franchise credits (even the large regional operators such as Prima Marketing are still considered as franchise credit because their leases aren't backed by the corporate flag). However, the company also likes credit tenants. For example the Chicago-based firm recently bought a portfolio of five c-stores in Anchorage, Alaska, for $5 million. All units are backed by 10-year leases with San Antonio-based Tesoro Corp., a Fortune 500 company.

“C-store properties with a credit story are certainly more desirable,” Blankstein says, estimating that half of the c-store properties that come to market are backed by credit-tenant leases, while the remaining half are franchise credits. “C-stores without corporate credits have a higher default rate.”

The lack of credit quality is particularly critical when pricing and cap rates are considered, says Jon Hipp, president and CEO of Calkain Realty Investments.

“The big concern is paying aggressive cap rates for these non-credit tenants,” he contends, noting that pricing for well-located, newer c-stores with several gas pumps has escalated to more than $1.5 million and cap rates have dipped below the 8 percent range, a decrease of more than 100 basis points over the past 18 months.

“You don't know whether or not the company is going to be there in five years, and if they're not, what are you going to do with the land?,” he asks.

Blankstein agrees that 7 percent cap rates are only O.K. for c-stores backed by credit tenants. “Investors who buy c-stores with franchise credits should be looking for higher yields,” he warns. “I don't think people understand the risk…When you're looking at leaving the credit tenant part of the c-store world you really need to be focused on the real estate valuation.”

Fortunately, most c-stores, especially newer ones with gas pumps, are located on hard corners where the land could be used for other types of retail, says Robert Miller, president of Millco Investments.

The Canton, Ga.-based firm has brokered the sale of nearly 40 7-Eleven properties and dozens of White Hen Pantry stores. “In general, c-store sites are even more attractive than other retail sites because of the shortage of good corners,” he explains.

The added security that comes from the underlying real estate comforts many investors and encourages them to pay the higher prices, says Ethan Nessen, principal of CRIC Capital. “Based on the cash flow, we're still pretty comfortable in terms of the value for the c-stores,” he says.

In fact, c-store cash flows tend to be slightly better than other net lease investments, primarily because they offer strong rental escalations. In fact, it's not usual to see two percent annual rent bumps, when most net-lease properties increase at the rate of inflation.

“This sector is still higher yielding than others, and because of that, we take a closer look at it,” Hawkes says. “We think c-stores with gas are a very interesting investment, but you have to be very careful where and with whom you invest.”

And, there's growing uncertainty regarding America's future dependence on gas. “There are 20-year leases,” reminds Jason Lind, director of acquisitions at Howard & Mills Inc. “Who knows if we'll still need gas to power our cars?”

Lind points to the increasing popularity of hybrid cars, even among wealthier consumers. “People who used to not care about gas prices are now buying hybrid Lexus SUVs,” he notes. “This could radically change the face of the c-store, especially one that is reliant on gas revenues, and it's the reason why c-stores are the only type of triple net investment where the future is so ambiguous.”