What You Should Know Before Investing in a Restaurant

Restaurants are a favorite commercial property for many investors because

1. 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 important 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. People have to eat whether it rains or shines. Americans are eating out more often as they are too busy to cook and cleanup the pots and 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). In 2006 for every dollar Americans spend on foods, 48 cents are spent in restaurants. 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. You know your tenant will take very good care of your property because it's in their best interest to do so. Few people 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 Restaurants
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-food chain McDonalds with 30,823 locations (about 14,000 in the US) as of 2006 with an average $2M in revenue per US location. McDonalds currently captures 46% market share of the $58.88 billion US fast-food market. Distant behind is Burger King with 14.3% of the market share. Fast-food 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 café 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 proportional 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 and 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 corporate assets. So in case they 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 Corporation with a strong S&P corporate rating is much better than a small corporation 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) to shield it from further liabilities. 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. 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 and loss statement, you may see the 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 the P&L of an independent restaurant, you may want to understand the reason.

2. Parking spaces: restaurants tend to have higher number of parking spaces because diners tend to stop by within 2 small time windows. 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. 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. 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. 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. 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. 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.

8. Track records of the operator: the restaurant running by an operator with 1 or 2 recently-open restaurants will probably a riskier investment. On the other hand, an operator with 20 years in the business and 30 locations may be more likely to be around next year to pay you the rent.

Sale and Lease Back
Sometimes the restaurant operator may sell the real estate part and then lease back for a long time, e.g. 20 years. This is a quick and easy way for the restaurant operator to get cash out for various reasons: business expansion, other investments, or simply cashing out the capital gain. You will often see 2 different cash out strategies by looking at the rent paid by the restaurant operator:

1. Conservative market rent: the operator wants to make sure he pays low rent so his restaurant business has a good chance to be profitable. He also offers conservative cap rate to investors, e.g. 7% cap. As a result, his cash out amount is small to moderate. This may be a low risk investment for you because your tenant is more likely to be able to pay the rent.

2. Significantly higher than market rent: the operator wants to maximize his cash out. Investors are sometimes offered high cap rate, e.g. 8%. As a result, the restaurant business at this location may suffer a loss due to higher expenses, i.e. rent. However, the operator gets as much money as possible for his investment, e.g. business expansion. This property may be riskier for you. If the tenant's business does not make it, you will have to offer lower rent to the next tenant to lease it.

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