*A Shared Problem
One of KJF Partners’ Core Values is:
“We are driven by our personal commitment to create value for our investors, tenants, teammates and brokers.”
To serve our broker partners, we send occasional emails that focus on lessons I’ve learned through my brokerage history or observations from my current role on the principal side of the business.
A shared problem:
A broker friend recently asked me who our biggest competition is for the types of properties we typically pursue — short-term or vacant QSR sites.
My response was that our biggest obstacle right now comes from build-to-suit developers who tie up properties at aggressive prices for long periods of time while they attempt to secure a national tenant. When that tenant doesn’t materialize, the developer walks away and the deal dies.
What remains is a seller with price expectations aligned with national tenant locations but, a property that may not meet the requirements for those tenants. As buyers underwriting deals based on real tenants and realistic rents, we’re often submitting offers that can close, only to see them rejected because the seller is anchored to a number created by a deal that never happened.
This appears to be a consistent theme in the market right now.
A large gap in the market:
The rent gap between national, build-to-suit tenants and second-generation regional or local tenants has never been wider.
Rising construction costs and increased competition for sites have pushed national tenant rents to extreme levels. In many cases, the difference between first-generation and second-generation tenant rents can be two to three times higher.
For example, new QSR construction costs — excluding land — can easily exceed $1.5 million, with land costs frequently approaching $1 million. A total project cost of approximately $2.5 million built to an 8.5% return requires rents of roughly $210,000 per year.
To support that level of rent and operate profitably, a tenant typically needs to generate more than $3 million in annual sales. Very few tenants can consistently achieve those sales volumes, and those that can are highly selective about location, traffic counts, and site characteristics.
If a national tenant deal does not materialize, the regional or local tenant that ultimately occupies the site will often generate annual sales closer to $700K to $1million and can reasonably support rents in the $60,000–$80,000 range.
That gap in achievable rent creates a dramatic and very real change in property value. Yet when a property is tied up at a price supported by national tenant economics, that number often becomes the seller’s expectation — even though the market for second-generation tenants cannot support it.
Property valuation for second-generation QSR properties is largely dependent on just a few variables:
- What will the next tenant realistically pay to occupy the location?
- What will it cost to make the property suitable for that tenant?
- What return is a developer or investor willing to accept for their efforts?
Pricing, or valuation, of the asset is largely a function of those variables. When rent expectations shift from national tenant levels to what regional or local tenants can realistically support, the resulting change in value can be significant — and your seller, and mine, is often still attached to pricing from a deal that never closed.
What can you do to avoid those situations:
What is most helpful in avoiding these situations is to properly educate yourself, and your potential seller on how these properties are valued and what type of tenant is most likely to ultimately operate at the location. Most importantly, understand what that regional or local tenant can and will probably pay.
There are certainly sites that will end up as tier-one, national tenant locations, but most do not. Most second-generation locations previously occupied by national names become future locations for local and regional restaurant concepts, or the use changes altogether.
When you receive a high-priced offer from a developer, ask lots of questions – and understand why you are asking them. Some examples may include:
Deal Economics:
What rent do you need to achieve to make that price work? What will it cost to build the proposed building, including site work? If this is a retrofit, what is the budget, and have they completed this type of project before?
Tenant’s Sales Requirements:
What sales number will the tenant need to generate to make the deal work? Is that number within the tenant’s historical AUV range? Remember, there is only one Chick-fil-A, one In-N-Out Burger, and one Raising Cane’s. They can pay the highest rents in the QSR category because they generate the highest sales and are extremely selective about location and site characteristics.
Tenant Commitment:
Do you have a tenant identified for the site? If so, who is it and what is their process? Has the tenant driven the site? If necessary, consider offering a limited non-compete if the developer can provide a legitimate LOI from the tenant. Many developers are reluctant to disclose tenant information, and in many cases, they may not yet have a tenant at all. In my experience, deals that are tied up while a tenant is still being sought have the lowest probability of closing.
Developer Commitment and Timing:
At what point will the developer spend money on environmental reports, surveys, inspections, and other third-party due diligence items? Developers who are still shopping for a tenant are often unwilling to commit real dollars.
Be clear about timelines and extension requests, and why they are being asked for. Many developer deals require 180 to 365 days and include extension language. If extensions are requested, build in clear milestones that must be achieved to earn that additional time, a signed LOI, a fully executed lease, or evidence of site plan submittal, and keep those time frames as short as is reasonable.
Ask, ask, ask until you feel you and your seller have enough information to gauge the real probability of a close of escrow — on time and at the offered price.
Choosing a buyer with a high likelihood of closing, on time and at the offered price, is the best way to serve your seller. Helping your seller understand these variables up front can prevent unrealistic expectations and wasted time.
Good luck and Happy Hunting!
Joe
Joe Faris
KJF Partners, Inc.
Cell Phone: 949-275-5038
Email: [email protected]
Website: www.kjfpartners.com