Historically in the franchise industry, real estate was coveted as a key strategic asset. Most franchisees overwhelmingly preferred to acquire the real estate as part of any new development and/or acquisition they were contemplating. Over the past 20 years we have observed an evolution in this Franchise-Real Estate dynamic. Many franchise owners with substantial real estate holdings have been selling properties, and fewer new units are being developed with fee-owned real estate. Why the change?
As the franchise industry has entered into a state of maturity, many franchisees have amassed large portfolios of owned real property. Because many of these portfolios have little to no debt on them, a large untapped component of value exists.
Additionally we have seen an overall decline in interest rates over the past decade. This translates into Lower Cap Rates on Real Estate, which in turn results in higher values. Single tenant RE properties are trading at 15-20 year peaks. Not too long ago double-digit Cap Rates were the norm, but today we are seeing mid-single digits. On a location with market rent of $100,000 annually, a decline in Cap Rates from 8.0 to 7.0 translates into an increase in value of approximately $180,000. Multiply this by the number of fee parcels owned, and it can be a compelling argument.
Most Franchisees (entrepreneurs, private equity and institutional) are generally seeking higher returns from their franchise investments. As the saying goes,” if you’re not a seller at that price, then you’re a buyer”. Tying up capital in single-digit return real estate assets means you are willing to accept a lower real estate return on the capital invested in those assets. For many franchisees, this does not achieve their return objectives. As a result, many franchisees have opted out of their lower return real estate and put their capital to work in higher returning operating assets.
Although real estate is a different asset class from the franchise itself, the success of both is linked together. Some dynamics affecting the franchise don’t impact the real estate and vice versa, however in most cases the two are joined at the hip. Selling fee-owned real estate and redeploying it into another type of investment provides overall portfolio diversification for the seller.
Historically, real estate financing was available with much longer terms and amortizations. The current climate has changed, with lenders generally electing to reduce their risk by shortening the lives of their loan portfolios. The ability to secure longer-term financing with lower debt service is not as available as it has been in the past.
Depreciation benefits from real estate have also been reduced over time. Congress has systematically lengthened the effective life of the benefits on depreciable real estate assets, resulting in a loss in the present value of those benefits effectively making real estate more expensive to purchase. Furthermore, franchisees with real estate they have owned for longer periods of time have seen many locations use up their allotted depreciation benefits.
From a capital gains perspective, selling has never been more attractive. While capital gains taxes have risen marginally since 2012, they continue to be at relatively low levels, historically speaking. There is no guarantee that rates will not increase in the next few years given the growing government deficit.
Sale of Business
Finally, one frequent situation we encounter is the Seller’s decision process of whether or not to sell their owned real estate along with the sale of their business.
From early on in their development, many franchisees, especially long-time operators, adopted a strategy that one day they would sell their business while keeping the real estate so they may enjoy the rental income as an ongoing source of cash flow and security. The thinking is “I have a debt-free (or nearly debt free) asset, I am familiar with it, I don’t have to pay capital gains taxes on the sale of the real estate and I will live off the cash flow”.
Is it truly that simple? NO. Is this really the right answer? Like most things, it depends. Every situation is different. Here are a few important factors to consider:
Personal Financial Plan
First things first, make sure you develop a post-sale financial plan. Different sellers will be at different stages of their lives, resulting in different long and short-term needs. Investment risk profiles can be very different; the decision to sell or keep your real estate should fit into this plan.
This is often overlooked by sellers. Real estate has a different risk profile in the hands of a new owner/operator of the franchise business. Don’t fail to recognize these risks and assume that you are collecting a risk-free annuity.
For many selling franchisees, the value of their real estate represents a significant percentage of their overall new worth. If so, be careful not to fall into the trap of allocating too much of your net worth to a single profile investment; one brand, concentrated geography, same asset class, single lessee, etc... Look at the value of the real estate and ask yourself; “If someone gave me a check for this amount, would I commit all of it to buy nothing other than this real estate”? This analysis often provides an interesting perspective. Always consider alternative investment options. Just because current real estate holdings have been a successful investment to date (as the owner of the operating business), it doesn’t mean keeping it is the right investment for the future.
Performance of the Brand
The value of the underlying real estate is directly related to the overall success of the brand and the operator of the franchise. If the real estate you own is in a struggling or down trending concept, or the strength of the buyer/lessee is substandard, it will impact the long-term value of the real estate.
Underlying Market Dynamics of the RE
Is it subject to a possible decline in market value over time? Can the market move away from your location? Does your location have substantial long-term upside for alternative tenants? Make sure to adequately consider the quality of your real estate from the perspective of alternative uses and don’t solely focus on the income aspects from the proposed new tenant.
Don’t make the decision to keep the real estate because you won’t have to pay taxes on the sale. The fact of the matter is eventually you will be held accountable for paying these taxes in some way, shape, or form. If keeping the real estate is not ideal, you might be better off paying the tax man and redeploying your assets. Capital Gains taxes are at an all-time low; therefore selling today might be more advantageous than in the future. Also consider the possibility of a tax-free exchange as an effective deferral strategy that can also provide asset diversification.
Consider that by electing to keep the real estate, you accept the future operations and asset condition of the new buyer. Many sellers find out after the fact that they have a very difficult time accepting the way their stores are managed post-sale. If you continue to own the real estate, it only makes it more difficult to sit on the sidelines and watch someone else run what used to be your business.
Finally, keep in mind that the decision to sell doesn’t have to be an “all or nothing” decision. Consider the possibility of keeping a balanced portion and selling the rest.