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!
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 & 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). 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 tenants will take very good care of your property because it’s
in their best interest to do so. Few customers if any 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
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 in Columbus, Ohio by Associate Professor of
Hospitality, Dr. H.G. Parsa of Ohio State University tracking new restaurants
from 1996-1999. 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 business as soon as the sign is up.
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. 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 risk 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 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 & 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 have
to 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). 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. 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 statements with
your accountant.
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.
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.
by David V. Tran, President/CEO of eFunding Inc.
