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New stores with no skin in the game


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Operators who are on a growth track are discovering they can build new stores with no skin in the game. It may sound too good to be true, but development sale-leasebacks provide a financing alternative that can fully cover land and construction costs.

“This trend is happening more often than it used to, especially among larger franchisees,” notes Gary Chou, senior vice president and senior director at Matthews Retail Advisors.

Several factors are driving development sale-leasebacks within the franchise space: People are more aware of sale-leasebacks and how they work; and franchisees understand the arbitrage and the financial opportunity to do a sale-leaseback to finance the construction of a new unit.

“You have more and more groups coming into the franchise space that have higher levels of sophistication,” says Chou. For example, more private equity money is entering the franchise sector looking to make a good return and real estate is an obvious place where money can be made, he adds.

Development sale-leasebacks also are becoming more common because of current market forces. Pricing has been favorable, with investors competing for properties, especially for high quality brands and good locations.

“Our prolonged economic recovery has given property owners more time to realize that their property is worth money, while in the past real estate was more of a secondary or tertiary thing to think about,” says Chou.

Sale-leasebacks are a financing option Fazoli’s discusses with its franchisees that are building new freestanding stores. The company has about 220 stores in the franchise system and has added about 15 new units per year. Franchisees looking for locations for the 3,300-square-foot fast-casual restaurants consider both in-line spaces and stand-alone restaurants.

“The real advantage for an operator is that they can get the whole thing 100 percent financed and not have to have a loan on their books,” says Perry Pelton, director of real estate at Lexington, Kentucky-based Fazoli’s. However, so far, the franchisees in the Fazoli’s network have gone with traditional construction financing, such as a bank loan or line of credit, as they prefer to own their own real estate, he adds.

Development sale-leasebacks do work for operators who are adding one or two locations. However, the financial tool is more popular among multi-unit franchise operators who have a strong expansion pipeline and are growing with three to five new units per year or more. The alternative for franchisees is to use cash or their existing real estate as collateral to finance construction. “You can’t grow as fast that way, because it requires more equity, but it is safer in terms of having fixed occupancy costs,” says Pelton.

Turnkey vs do-it-yourself

Operators have three different options when it comes to doing a development sale-leaseback. One route is to do a “reverse build-to-suit.” Essentially, a reverse build-to-suit is an arrangement where the tenant constructs a building for itself using funds provided by the landlord investor.

Once the building is complete, the tenant occupies the building under a long-term lease, which is usually structured as a triple net lease where the tenant is responsible for paying all taxes, utilities, maintenance and operating expenses. Reverse build-to-suits are more commonly used by do-it-yourself companies that have in-house development capabilities or are at least capable of managing project development with a general contractor.

A second option is for a company to work with a developer or merchant developer who provides more of a turnkey service of site selection, managing the entitlement and permitting process and constructing the project. The developer would construct the building and pay for all of the land and construction costs. Developers typically charge a fee or negotiate a higher cap rate to account for those services and the market/credit risk they are bearing. In most cases, developers are looking to sell the asset for a profit to an investor once it’s complete.

A third option is that a company with in-house development/project management capabilities, and capital availability, can do the work of developing a new unit on its own, and then also work with a broker or an investor directly to negotiate a buy-out of the property either before, during or after construction is complete.

“The pro there is that there is very little capital risk to the tenant. They just have to make sure that the rent they end up paying is healthy for them,” says Chou. Where franchisees can get into trouble is when they self-develop and aren’t efficient in managing their construction costs, yet they still want to make money and optimize the sale price. So, they end up raising rents higher to get a lower cap rate, even though the core fundamentals of the business aren’t there to justify and support the higher rents.

“I think doing it yourself makes sense if you know what you’re doing, because doing it from scratch can be very difficult,” says Chou.

Reverse build-to-suit programs

National Retail Properties (NNN) is a real estate investment trust, or REIT, that funds development for restaurant companies and other retailers that are growing their store base through its reverse build-to-suit program. NNN also uses the same program to fund major remodels, relocations or conversions, which combined accounts for about $125- to $150 million in acquisitions annually.

Once a restaurant or retail company identifies a development site and has negotiated a contract to acquire that property, the REIT steps in to buy the site and then provides a series of draws much like a construction loan to finance the store’s construction. The franchise tenant doesn’t have any out-of-pocket costs, except for paying for their own furniture, fixtures and equipment.

“At the end of the day, it looks very much like a typical sale-leaseback, we just don’t have a seasoned asset to underwrite,” says Josh Lewis, vice president of acquisitions at National Retail Properties. Because there is no operating history to underwrite, investors such as NNN are basing pricing or cap rates on other factors, such as the pro forma on sales projections, credit of the brand and track record of the operator or company.

Especially for franchisees that are building a lot of stores, they may only have so much “dry powder” to fund them, notes Lewis. “So, we’re providing capital to them versus them having to tie-up capital in these development processes.”

Eliminating the gamble

Another advantage of doing a development sale-leaseback versus waiting a year or two or longer after opening the new store is that there is more market certainty.

Operators that wait to do a sale-leaseback to see how the store will perform with a hope that it could boost the property value are taking a gamble that interest rates won’t move higher or investor appetite for net leased assets will diminish—all of which could lessen the value.

“You might do better funding it on balance sheet and then flipping the property on a sale-leaseback into the 1031 market, but you introduce all sorts of additional risks when making that sort of judgement call,” adds Lewis.

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