Changing of the Guard
Fast food rents have skyrocketed over the last decade — as a result, the hierarchy of these tenants has shifted. The “Big Three” (Raising Cane’s, Chick-fil-A, and In-N-Out) are able to outbid everyone else for the best sites, reshaping the landscape for everyone outside their cohort. What hasn’t been widely discussed is how these changes have reshaped the landscape for tenants once thought to be incumbents, and the subsequent impact on property owners and developers.
Today, any property owner that has a prime site of appropriate size is first going to attempt to secure one of the Big Three tenants. That’s obvious. If those guys are a pass or are already in the trade area, the next logical tenant is a car wash. That’s how owners are getting the highest rents. Higher rent drives higher property value — almost always.
(Note: It is possible for rents to be too high, resulting in backend values that are out of line with investor expectations. When this happens, investors expect a higher yield to adjust for risk. An investor might ask, 'Why should I pay $12M for one building when historically I could buy two or three for the same $12M?')
I digress.
In my view, McDonald’s, Jack in the Box, Del Taco, Taco Bell, Carl’s Jr., Wendy’s, Panda Express, and a few others that were once A-tier tenants are now B-tier tenants. McDonald’s is probably somewhere closer to being in the A-tier than the rest just because they are still a behemoth even though they just don’t measure up to the Big Three in terms of average unit sales volumes. Tenants like El Pollo Loco, Arby’s, Sonic, KFC, Popeyes, and a bunch of others are now C-tier tenants. No owner wants these guys unless they have no other choice.
I realize I didn’t add Burger King to either of those lists. When was the last time you heard of anyone you know eating at a Burger King? When was the last time you saw a new Burger King property built from the ground up? I was probably still in high school when that happened (joking but I’ve been doing this for 28 years and I can’t think of a single one). Burger King is closing stores and losing leases left and right. It will not surprise me to see Burger King totally gone in the next 5-7 years. In fact, a Burger King franchisee with 57 units (or 75 depending on the source you believe) just filed for bankruptcy in the last week or so. This is not to say that there aren’t Burger King deals out there that aren’t amazing opportunities, There are Burger King deals that are certainly walk-off home run buys if you can find them. Remember, you aren’t (or shouldn’t ever be) buying a tenant, you are buying land. People are already foaming at the mouth to get their hands on these sites. I’ve personally repositioned two Burger King sites in AAA+ locations in SoCal with Starbucks and Raising Cane’s. Both deals were grand slams.
Quite simply put, the B and C tier tenants have no shot at the A sites unless the Big Three are already in the trade area.
For years, the fast food tenants did an amazing job of convincing the commercial real estate world that they could only afford rents capping out around $175,000 / year. It was like they all had some secret cabal and colluded to artificially keep rents in check. It worked for a long time until the Big Three let the cat out of the bag. The generally accepted metric for rent-to-sales was 6% - 8% for a healthy store. Don’t get me wrong, rent-to-sales is an important metric for every operator. If the ratio is too high, the tenant won’t make money. If the tenant isn’t making money, the tenant is not going to be able to afford to pay rent. Easy, right? Not really. You need to understand tenant sales volumes to understand the shift that has taken place.
Back around 2008 we were working with McDonald’s to secure new sites in Orange County, CA. We were told that their average sales volume in Orange County, CA (where I am based) was $2.4M. That was a very strong sales number compared to “known” volumes for the other operators like Carl’s Jr. Taco Bell, Del Taco, Jack in the Box, etc. Those guys were doing average sales in the $1.2M - $1.8M range. Those were sustainable sales numbers when you consider that these tenants were paying rents in the $80,000 - $150,000 range.
What changed? First, Chick-fil-A came into the market in a big way (I know those of you in the Southeast will say they have always been here - that wasn’t the case out West). In-N-Out started leasing sites instead of only buying in order to grow unit count and compete with Chick-fil-A taking down the best sites that could accommodate massive drive-thru stacking and thus support monster sales volumes. Land owners were no longer willing to sell to In-N-Out because they knew they could get huge rents from Chick-fil-A (or a car wash and later Raising Cane’s). In-N-Out had to change their long-standing preference for real estate ownership and start to lease in order to grow. Then along came Raising Cane’s big push and the horses had left the barn. When I say monster sales volumes I am talking about reported store sales in the $6M, $7M, $10M+ range. What is 8% of $10M? This operator can pay huge rent. The other guys simply can’t compete for these sites.
With each deal that goes down, property owner expectations go up. In the last few weeks a Chick-fil-A came out on the market in SoCal. The developer paid $5.7M for the land. Add in carry, tenant contribution, leasing commissions, potential on and off site costs and I’d guess the developer is in this deal for $6.2M or more. You need pretty big ground rent to make money with a $6.2M basis. In order to make $1M on this deal, the sales price needs to be $7.5M (after 4% costs of sale - commissions, title, escrow, legal, etc.). At a 5.00% CAP (which is conservative in my market), that translates to $375,000 in ground rent. Guess what every property owner in that trade area thinks their land is worth and what their rent expectations are now?
Where does this leave all the operators outside the Big Three? Well, they are either relegated to B or lower sites only or they need to adapt their site plans to allow for locating on smaller sites that the Big Three can’t lay out due to the size constraint. The Big Three need large parcels to accommodate double stacked drive-thru lanes each stacking 15+ cars per lane. There are, however, plenty of A+ sites that are in the 20,000 - 25,000 square foot range that are just too small for the Big Three. You may be thinking I haven’t mentioned Starbucks. Starbucks (and Dutch Bros) can fit on these smaller sites and still do high sales volumes. They both have been much more agile and adaptable. Starbucks has opened stores with limited or no seating allowing for less parking and therefore more drive-thru stacking, which means they can pay very healthy rents. I have personally done Starbucks deals in the $260,000 - $275,000 range and have seen Starbucks pay as much as $440,000 on a 28,000 square foot parcel according to data from DealGround. Starbucks figured out how to do the sales volumes without the need to compete with the Big Three for the same sites. This is what the rest of the pack needs to figure out.
To stay relevant, the tenants outside the Big Three need to examine smaller store sizes with limited seating to secure the best locations. They need to embrace digital delivery services in a big way (notice you can’t order In-N-Out from the delivery apps? - they don’t need any help with sales). Taking over existing fast food sites is an obvious strategy to open new locations but the rents are still going up because you have Starbucks, Dutch Bros and all the newcomers in the drive-thru / digital pick up space (Chipotle, Pollo Campero, Hawaiian Bros, Shake Shack) competing for these same sites. Competition for good fast food sites is only getting stronger.
Investors and developers have a massive appetite for existing fast food buildings. Starting with an existing building can significantly reduce costs, reduce or even eliminate a difficult entitlement process, and speed up time to store openings. Entitlement timelines continue to drag out, creating harmful risks to developers through adding unknowns in total carry costs and market uncertainty as CAP rates / interest rates can shift drastically and thus impacting back end value. The demand for existing fast food sites is only going to increase. Increased demand means that rents are going to continue to increase as well, compounding the problem faced by the lower-tier operators. They need to figure out how to generate higher sales on smaller sites to support these higher rents or face being relegated to secondary locations in secondary markets. Doing $1.5M in sales isn’t going to cut it. You can’t do business in a major MSA with sales this low. Adapt or die. It’s really that simple.
I’d like to make one last point about the Big Three which is not real estate related. As stated throughout this article, these guys generate huge sales volumes. What is the one thing they all have in common? Very simple menus. They each do one thing and they do it very well. There may be a lesson in this insight. Who knows, I’m just a real estate guy.
For the brokers and investors reading this…….imagine if you had been tracking every fast food property that has ever crossed your desk and had it all stored in a single, unified repository where you could search and extract lease and tenant data in seconds? This would enable you to get ahead of the curve and find the most opportunistic deals upstream of your competition. Market expertise at your fingertips - instantly. If a tool like that is of interest, please check out DealGround. Hundreds of professionals are using it every day to unearth market data and insights from current and historical information. If you are in the commercial real estate industry, you will find it extremely valuable.
Cheers.
P.S. - This article is not intended to provide an exhaustive list of all fast food operators. I know there are several others outside the Big Three that I neglected to mention. It’s just not necessary to name them all to make my point.
Last but not least, as a former Cal Bear, I couldn’t resist showing Jason Kidd and team beating defending national champion Duke in the NCAA tournament back when I was in college. That changing of the guard was a big day for us. Haven’t had many since.