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Favoring Franchises

Cash-hungry franchisees create opportunities for net-lease investors.

A common misconception pervades the retail net-lease industry today — the idea that most of the properties on the market are distressed. After all, why else would a seller put his property on the market when real estate values are low and cap rates are high?

The net-lease investment may be on the market because the seller is a franchisee who intends to use the sale proceeds to fund ongoing operations or as a source of capital to grow the franchise. These net-lease investments, which are freestanding, single-tenant properties with long-term leases, are available at attractive cap rates ranging from 7% to 11%.

From Subway to Aaron Rents, many well-known retailers and restaurants are owned and operated by entrepreneurs rather than large corporations. Entrepreneurs who own and operate franchise stores or restaurants are known as franchisees, and franchisees self-fund their own operations.

Until recently, franchise net-lease investments were trading at prices and cap rates similar to those owned and operated by corporations. Investor demand for net-lease properties, particularly retail assets, was strong. The risk premium typically associated with franchise properties was almost nonexistent.

Many franchisees sold off their real estate during the height of the market, realizing aggressive cap rates and pricing. But that pricing is unlikely to be repeated anytime soon.

Real Capital Analytics reports that in 2007 the U.S. average cap rate for corporate-owned retail net-lease assets was 6.5%. By the end of 2008, the cap rate had risen to 6.8% and then to 7.3%. in the first quarter of 2009. The typical franchisee can expect to add 50 to 100 basis points to the national average compared to corporate-owned properties.

Many retailers have chosen franchises as their growth vehicle and are moving away from corporate-owned stores and embracing the franchise model because it allows them to expand without large capital outlays.

7-Eleven Inc., based in Dallas, for example, has an aggressive plan to convert the vast majority of its company-operated stores in the U.S. to franchised operations by 2012. Roughly 75% of the chain's 5,600 U.S. stores are franchised.

Some retailers are growing because of the recession and have chosen franchises to expand. Aaron's Inc., which leases furniture and appliances, is benefiting from consumers' limited buying power. The Atlanta-based chain has more than 1,500 locations nationwide, including 500 franchised stores, and expects to continue to open 150 to 200 franchises annually.

Leveraging real estate strength

Like every other sector, national retailers, as well as franchisees, have seen their lines of credit cut as banks struggle with liquidity. However, many franchisees have sought alternative sources of expansion capital to take advantage of today's favorable retail real estate market for tenants and buyers.

In fact, weak demand for retail space, coupled with decreased land and construction costs, is allowing franchisees to improve existing locations or establish a presence in markets that previously were too costly. As franchisees expand and upgrade their existing portfolios, net-lease buyers will be able to invest in high-quality properties with strong tenants.

Retailers that need capital from their real estate to stay afloat are riskier than those with strong balance sheets. That means these investments trade at higher cap rates than properties leased to strong franchisees, and investors focus less on the franchisee's credit and more on market rents, sales performance and the underlying value of the real estate.

Lenders set high standards

Many net-lease investors are bypassing mortgages altogether and paying cash for their acquisitions. Since most franchise net-lease properties are priced below $2.5 million, they're an ideal investment for high-net-worth individuals and all-cash buyers using the 1031 tax-deferred exchange vehicle.

Net-lease investors who require debt to purchase an asset need to be aware that lenders are cautious when it comes to properties that are leased to franchisees. Net-lease investors who plan to use debt to acquire franchise net-lease properties should be prepared to contribute between 50% and 60% equity in order to close a property sale.

Beyond the franchisee's experience and financial standing, investors and lenders should evaluate the franchise. Some have momentum where the brand is growing, while others are clearly declining. All of these elements determine the value of the net-lease investment.

Jonathan W. Hipp is president and CEO of Calkain Cos., based in Reston, Va. He can be reached at [email protected].

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