To rent or own real estate: pros and cons
Martin Schelling and his business partner, a franchisee of six Chicken Express stores in Texas, are the owners of Conifer Real Estate and the franchise sector landlords who have bought land and built buildings on behalf of franchisees for nine Dairy Queen locations.
Franchisees commit to a 20-year lease and have to pay for their own equipment, insurance, etc. Schelling says his company also will do development for a fee but prefer to own and rent out the buildings since it’s more profitable.
What’s in it for the franchisee? Schelling says it lets them expand much faster than they could otherwise. It’s a Faustian bargain when credit is tight and loans are hard to come by. Do you expand but at the cost of not owning your own buildings and land—and paying the piper every month for 20 years? Or do you stay where you are and forgo all the revenue you could have made? In markets where you are an early mover or growing markets in general, it’s not an obvious choice. And of course depending on franchisee real estate expertise it may be worth it to pay for at least the fee-based service if nothing else.
John Gordon, the principal of the Pacific Management Consulting Group, says real estate is a great deal for those who can get it.
“Generally older, more legacy restaurant brands that developed their stores in the ‘60s, ‘70s, ‘80s, they often tried to buy their real estate,” Gordon says. “Real estate prices and supply/demand conditions were better than they are now.”
Craig Mance, the senior vice president of development for North America for McLean, Virginia-based Hilton Worldwide, agrees. “Fee-simple land ownership is just a ‘cleaner’ deal,” he writes via email. “Lenders like financing land-owned deals better because the owner has title to the land and all improvements (i.e. the hotel) on the land.
“Probably the biggest advantage is when selling the hotel. Prospective buyers in a land lease situation have two entities to deal with, the lessee and the lessor, and it can get messy.”
There’s a double bind to being a tenant. If sales are low, you’re still committed to paying rent. But if sales are high, many leases have rate step-ups and even percentages tied to revenue. That makes a franchisee’s gain partly also a landlord’s.
This dynamic has led Gordon to do four or five expert engagements in sticky situations. “The landlord is trying to maximize their position; the restaurant is trying to maximize their position,” Gordon says. “Restaurants and landlords are just terrible.”
There’s another side to the issue, though. Don Davey is a franchisee for Firehouse Subs and has 17 locations in Orlando and Wisconsin. In the spirit of comedian Groucho Marx, he says he wouldn’t want to buy the type of land a guy like him could afford. “We want great locations, A+ locations,” Davey says.
“The real estate at those locations would be a lot of capital. Guys that buy or develop their own real estate tend to settle for B or B- locations. I never wanted to have that conflict.”
Inline stores in popular areas can be incredibly expensive. Davey’s franchisor, Firehouse Subs, leases most of its spaces. CEO Don Fox says paying off real estate is an arduous process that slows growth.
“One of the largest hamburger chains in the country has average unit volume of $1.2 million,” Fox says. “Do they produce high enough sales to make it worth that investment? My corporate restaurants average $800,000 a year—I couldn’t do a free-standing building. You’re looking at land or building costs that are just extraordinary.”
Schelling says when franchisees lease stores instead of buying them, it frees up capital for brand expansion and allows them to concentrate on what they do best. However, his business partner owns five of his six Chicken Express locations outright. His case, Schelling says, is a bit different—not just because he has enough access to capital to expand as fast as he wants, but because he’s got more experience with ownership than most.
“We’re in the real estate business,” Schelling says. “It’s easy for us, because that’s what we do.”
For those who want the land without the hassle, there’s a third option, according to Schelling: Paying a development fee, which runs around 3 to 4 percent of the project cost.
“We have done one Dairy Queen on a fee basis. We get a flat fee for getting the land acquired, entitlements, bidding the project to multiple contractors” and all the rest. “That’s what we do every day,” he says.