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Fast Food Franchise Leases often Above Market Levels

Many of us have seen leases that appear to be unbelievably high for credit national tenants like a Starbucks, McDonald’s or Walgreens and even banks.  This creates a major sticking point when the Assessor is intent upon using actual leases to establish a value.
There is a world of difference between a traditional real estate lease and one to a credit tenant for a built-to-suit basis, whether for fast food or otherwise.According to McKissock’s online appraisal course Appraisal of Fast Food Facilities: “In a typical credit tenant lease, the lease rate was originally structured in order for the lessee to pay for the development cost of the specialized facility built by the lessor for the lessee’s custom requirements.  The lessor obtains a long-term lease in exchange for construction of the building that is owned by the lessor.  And the lessee, spreads the cost of construction over the lease term and has tax benefits from leasing and depreciation.  These leases are typically called either capital leases or financing leases.  Therefore, the lease rates for credit tenants are normally well above real estate “market rents” during most of a long-term lease.

The McKissock course cites 2013 data indicating that FF&E for most newly franchised, free-standing restaurant facilities that require cooking, cost in the range of $200,000 to $475,000 ($80,000 to $275,000 for the sandwich/snack segment).  These massive personal property expenses are rolled into the lease rate yet they have nothing to do with real estate.  

Donald Sonneman, ASA, who authored the McKissock course, stated, “It is not surprising to see rents of $1.50 to $2.00 per square foot triple net per month for second generation restaurant space with modest tenant improvement allowances … versus $3.00 to $7.00 per month absolute triple net range for first generation fast food tenant.” A more concrete example was for the drug store market. Sonneman noted “build-to-suit big box stores and drug stores suffer from the same situation.The American Property Tax Counsel performed a study of drug store rents for first and second generation tenants.The study showed an average rent of $26 per square foot per year for first generation tenants vs. $7 for second generation tenants, or a drop of 73% in the rental rate for second generation tenants.”

Most of us already know that capitalization rates for national tenants are very low, reflecting the strength of their credit and mimicking bond rates more than real estate returns.  The underlying lease rate itself, however, is also way out of line with the market, which further complicates the fee simple analysis required for ad valorem assessments.