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Fast Food - Valuing Real Estate Not Franchise Leases

If you told a banker that this property's Leased Fee Value was $780.70 per square foot after it just sold for $230.26 per square foot, they would probably think you were trying to pull a fast one. If you told the Assessor that the Fee Simple Value was only $230.26 per square foot when it just sold for $780.70 per square foot, he might say the same thing. In January of 2014 a Kentucky Fried Chicken at 1901 W. Dempster Street in Evanston sold. The sale price was $230.26 per square foot - there were no leases in place and the transaction reflected a fee simple sale. In February of 2015 the same property resold after a renovation to a Starbucks for $780.70 per square foot. While the owner put some money into the property the difference in value is a function of a high lease to a national tenant and not the property value itself. In other words, in the latter transaction, the buyer is purchasing an income stream from a national credit tenant - not the land and building.

For property tax appeals we are estimating real estate and not the business value. Fast food buildings are the poster child for radical differences between fee simple and leased fee values. In a prior article a few months ago we reported that restaurants typically can pay about 6% of gross restaurant sales on a net basis or 10% of sales on a gross lease basis. This means that more successful franchise business operations can pay dramatically more in rent because they do a better business. The average sales of various franchise operations per store was recently reported as follows:

Franchise           2014 Avg. Sales Per Store

McDonald's               $2,600,000
Subway                         $481,000
Starbucks                  $1,223,000
Wendy's                     $1,483,800
Burger King               $1,195,000
Dunkin Donuts             $857,400
Pizza Hut                      $883,000
KFC                                $957,000
Panera Bread           $2,427,200
Chipotle                     $2,113,000
Boston Market          $1,184,000
Jamba Juice                 $714,700

Source: Statistic Brain Research Institute

It is critical to remember that in ad valorem we aren't appraising McDonald's as an enterprise but the land and building that McDonald's happens to be occupying. Fast food franchises often pay very high rents at well above market levels. Businesses with very strong sales have the luxury of paying more rent even if the real estate itself wouldn't support that amount because with their business model they still make an acceptable profit. The rents can also include custom build-outs specific to their operations.

People may ask why a sophisticated national corporation would pay an amount well above the market value or market rent for these custom-built properties. David Lenoff, MAI answered this question in a Winter 2009 Appraisal Journal article. "The Cost of real estate might not make sense on a stand-alone basis but makes complete sense as a part of the overall business operations of the owner or tenant. When a nationally known fast-food establishment was asked why it had paid what was seemingly well above the market value for land for one of its restaurants, the response was, ‘We're not in the real estate business, we are in the hamburger business. The land price is completely acceptable as a part of the overall business plan, and that is all we care about.' However, no one else would be willing to pay either rent or a sale price for custom-built improvements that fit perfectly into someone else's business plan, but not their own. The price a buyer is willing to pay would be well below the cost-based amounts, and this represents the very crux of this valuation issue."

A guaranteed income stream from a credit national tenant would also command a substantially lower capitalization rate than for a local property owner. This artificially low capitalization rate increases the overall value but is a function of the tenant's attributes, not the real estate.

Some people will raise eyebrows when you are arguing that the real estate under the Starbucks is only worth $230 per square foot when it just sold (subject to a lease) for $780 per square foot. Leased fee values are often higher, sometimes dramatically so. The fee simple value is simply measuring a different bundle of rights.