Pros and Cons of Buying vs. Leasing Space for Franchise Tenants

Written by: Greg Aguirre

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Working with franchisees and franchisors is a big part of what we do at Capital Rivers Commercial.  As a commercial real estate firm, we work collaboratively with the franchisors and franchisees to help them find the real estate that best fits their own unique business model.  Every business is different and because of this, we strive to understand the inner workings of each business. This type of action allows us to give our clients the competitive advantage in an ever-changing commercial real estate marketplace.  We are able to create a purposeful expansion strategy and customized site criteria created by using existing customer data as well as other technology tools such as artificial intelligence tools (a.i.).  In addition, we negotiate specific lease structures that support the client’s specific goals to ensure success. 

Capital Rivers Commercial frequently acts to bridge the gap between the franchisors and franchisees with clear communication and a defined strategy.  The franchisor wins when the franchisee is successful, which includes paying royalties and representing the brand appropriately. Success is achieved by both parties when it is truly a team effort.  

The following are important points for Capital Rivers Commercial when we are working with a franchisor or franchisee:

  • Detailed understanding of the “brand” including its origin, purpose and culture.

In addition, a detailed understanding of the financial operation of the business.

  • Detailed growth development “Roll-Out Plan” for the current year and subsequent years. 
  • Detailed analysis of critical real estate criteria specific to the brand, including: demographic analysis, traffic study, co-tenancy study, traffic generators, etc. 

Ray Kroc: Commercial Real Estate and Franchise Opportunities

On a larger scale, think back to what McDonald’s founder Ray Kroc said in 1974: “I’m not in the hamburger business, my business is real estate.” Fast forward almost four decades to a true example in terms of commercial real estate and franchise investment opportunities. An independent Burger King franchisee is looking to secure the real estate as part of their expansion plans.  Utilizing the brand name and strength of the franchise concept, the real estate will be acquired by the following:

  1. Development through ground-up construction 

or 

  1. Acquisition or retrofit of an existing building

or 

  1. Leases the real estate and gets an option to acquire the real estate at a later date

If the franchisee sells the business (Burger King), the investor/former franchisee will then keep the real estate and lease the real estate back to the new business owner. This makes for a valuable long-term real estate strategy because: 

a.) the property owner now collects the income from the tenant (new business owner) 

b.) the value of the real estate will significantly increase with a new long-term lease. 

HOT TIP: This can now be a big part of the investor’s retirement plan or legacy real estate holdings.  It’s a wise play in regards to the franchise investment opportunities that will happen in the long run.

This small business will make more money on the real estate side than they will by selling the business.  But remember: the primary focus starting off in franchise investments should be building a successful sustainable business. 

Control: Benefits of Owning the Real Estate Your Franchise Occupies 

Control is probably the No. 1 benefit of owning the real estate where the business operates.  The franchisee may invest a significant amount of capital in tenant improvements at the outset of signing a lease as part of a franchise investment. The lease agreement grants the franchisee the rights to utilize the space for their business.  But there can often be restrictions within the lease, including:

  • Can’t sell certain products 
  • Limitations on type and/or style of signage 
  • Restrictive operating covenants. IE: limitations on parking, operating hours, etc. 

When the lease expires, the owner could: 

  • Negotiate the terms, including raising the rent 
  • Terminate the lease (IE: they have a better tenant)

When this happens, because the franchisee doesn’t own the real estate where they’ve built their business with loyal customers – they may have to move. But, in the long run owning the real estate would give the franchisee more control over the future of their business. 

If they own the real estate, typically they won’t have those same limitations or restrictions. This allows the franchisee more flexibility to grow the business and ensures long term stability.  However, not all franchisees have the financial capacity to purchase the real estate and maintain a commercial real estate mortgage.  There are a few questions an investor (the franchisee) should ask themselves before signing a lease or buying commercial real estate:

  • Is the investment financially sound?
  • Are these the kind of commercial real estate franchise opportunities the business is looking for?
  • What’s best for the franchisee business?
  • What’s best for the brand reputation?
  • Is this the best location to be successful? 
  • Is this the best short and/or long-term investment?

Is Your Team Ready for These Franchise Investments?

If a client is considering buying or leasing, they need to surround themselves with people who are savvy and knowledgeable.  A franchisee or franchisor needs the following people on their team: 

1.) an experienced real estate broker with strong relationships 

2). a tax advisor

3). an accountant

4). a capital market advisor 

The top line growth in sales is very important. The bottom line is more important.  The franchisee or franchisor should be asking:

  • What is my after tax cash flow? 
  • How much of every dollar that I make do I get to keep after I pay taxes? 
  • Are these sound franchise investment opportunities?

When Is It A Good Time to Buy?

If the franchisee’s business is doing well, with cash flowing, and they can afford to make that payment without putting their business at risk, then it might be time to buy. But before anything is done, the investor’s team should be involved to determine if these are the right commercial real estate franchise opportunities. Before they move forward, they should huddle up with the real estate broker, tax advisor, and capital market advisor to evaluate any potential  decisions to ensure they are looking at it from all angles.  If the client can control their destiny and it doesn’t create a situation where they’re over leveraged and putting their business at risk, it could be a good move. 

Building Equity

If the franchisee is paying down the balance on their commercial real estate mortgage, they’re building equity. If the investor sells the business down the road, they can hold onto the real estate and do a sale leaseback.  It would look like this: 

  • Build the business and increase the EBITDA  
  • Sell the business at a multiple 
  • Retain the real estate
  • Lease the real estate back to whoever it is that purchased the business
  • Secure new financing, if needed, based on the increased value with the new long-term lease. 

Capital Rivers Commercial Philosophy 

We understand commercial real estate is complicated.  To help our clients maximize their efforts with franchise investment opportunities, Capital Rivers Commercial operates in a collaborative environment. All of our brokers specialize in a specific sector of commercial real estate, but we work together to share industry expertise and market knowledge.  This approach allows us to have many resources available when working on a project. The variety of expertise developed in our careers prior to and at Capital Rivers benefits the real estate brokers when working with franchisees and franchisors

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At Capital Rivers, we love discussing commercial real estate, especially when it comes to Sacramento. If you are interested in learning more, sign up for our email blast or contact us.