| Basics of Investing in Income Producing Properties

*This episode was recorded remotely so please excuse the sound quality.

Purchasing the best income-producing property for you depends on many personal factors such as risk tolerance and desired ROI.

In today's episode of The Restaurant Realty in 10 we walk you through the basic principles and considerations of purchasing a property with a lease in place.

These Triple Net (NNN) or Cap Rate Investments are one of the ways you can use commercial real estate to build personal wealth.

For more information on The Restaurant Realty in 10 or to get the show notes from today's show head over to TheRestaurantRealty.com 

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Transcript

Michael Carro : 0:01

Welcome to The Restaurant Realty in 10. Ten minutes of uncensored straight talk for restaurant entrepreneurs. Twice weekly The Restaurant Realty in 10 dives into restaurant operations, facilities, real estate, and investments. In this episode of The Restaurant Realty in 10, I wanted to talk about investment properties. When you buy a property that has a tenant in place, with a lease, this is commonly referred to as a triple net (NNN) investment or cap rate investment. The cap rate is a one year measurement of return on investment (ROI). Whereas a internal rate of return or IRR measures the return over the life of an investment. So I'm going to use an example that I typically bring my clients to my office, I usually kind of walk them through so they can better understand what we're talking about. Now, there's a lot of details to consider when you're looking at an investment property one investment over another. And so I'm going to walk you through some of the things that I look at then bring you into the examples. So details to consider is the quality of the signature. That's kind of a big deal. That means who's signing it? What type of financials they have behind that signature? Is it a corporate lease or an individual lease with a personal guarantee? How much term is remaining on the lease? Is it five years? 10 years? 20 years? What type of options? Do they have to renew? Is the lease rate at market? Or is it above market or below market? If the current tenant ever vacated the property? How easy can that property be re-leased? And at what lease rate? What are the landlord responsibilities, if any, is this an absolute triple net (NNN)? Or is this a double net (NN) meaning the landlord has some portion, typically the roof, that they have to maintain over the life of the lease. Are there any kickout clauses in the lease that would allow the tenant to vacate the premise maybe if they didn't hit a certain sales number or some other tenant of kickout opportunity? What's the age of the building? Are we dealing with a new building or is the building 30 or 40 years old? And construction type. Those are some of the factors that you might consider when deciding against two properties that are very, very similar. Now the cap rate calculation is fairly straightforward. Its net operating income, or NOI over the sales price equals the cap rate. So if you have a net operating income of $100,000, and the sales price is 1 million, well 100,000 divided by a million equals 10%. So your cap rate in this scenario would be 10%. Of course, you can take a million dollars, depending on the level of risk that you're willing to take. If you divide that by a cap rate of 5%. That means your NOI would be $50,000. If you had a different investment where the cap rate was 8%, you would be looking for an NOI of $80,000. So depending on your level of comfort in risk would determine what level of a cap rate you would be targeting. Of course, most of us think we want higher cap rate, which is what you do. But you only want that based on the level of risk you're willing to take. And so we're going to discuss a few of those types of risk in just a moment. Another factor is taking into account that cap rate is just a one year benchmark, whereas the internal rate of return (IRR) is the rate of return over the lifetime of your investment. So you have to take into account increases in rent. So some leases may have an increase of let's say, 10% every five years, whereas other leases may have annual increases of two or 3% per year. So again, when you take into account the lifetime return on investment (ROI), that also is a factor. Most investors take a very simplistic approach and use the cap rate, but as you become more sophisticated, you really want to dive into the internal rate of return (IRR), which will require you to take a more predictive approach in how you invest? So now I'm going to walk you through a comparison of two properties, which is what I like to walk my clients through to help them truly understand why they should look at one thing over another. And remember, this is a personal decision, there is no right or wrong answer. The higher the risk, the higher your personal rewards should be, as it relates to investing. So now let's walk through two properties that are exactly the same. They have the same location right on the corner of Main and Main, they have the same traffic count. They have the same demographics, same ingress/egress, they're the exact same size, construction type age, you get the picture. Now let's compare these two properties. And I'm going to ask you questions, and I really want you to answer these out loud. These should be obvious, but you're eventually gonna get to why it's so important to understand the decisions between one property over another. So let's say we're dealing with a QSR quick service restaurant, a fast food restaurant with a drive thru. Now, let's assume they're the exact same price. So everything's the same about the properties. Now, it just has these slight differences in them. So you have property one is Mike's Burger Shop. Mike is a owner of a single restaurant, and you can buy that, or across the street the exact same property, except it's owned by McDonald's. Which one would you buy? Would you buy the McDonald's? Or would you buy Mike's Burger Shop? If it was the same price, of course, you would buy the McDonald's. Now let's assume they're both McDonald's. One lease has McDonald's corporate that signed it, versus the other lease is a McDonald's franchisee and it's his first location between the two which would you rather own if the price was exactly the same? Well, McDonald's corporate lease, of course. Now, let's assume they're both McDonald's franchisees except one franchisee has 200 locations. And the other franchisee has two locations? Well, typically the signature with 200 locations would be much stronger. So now let's assume they're both McDonald's franchisees, they both have 200 locations Now, which one would you rather have? Assuming it's the same price, one restaurant has a 10 year lease, and the other one has a five year lease. The longer the lease, the better off it should be. Now, let's assume one is in downtown Manhattan, great location, and the other one is in a rural town in Mississippi, let's say. Well, again, if they're the exact same price, you would likely take the one in the larger town in a better area. Now, let's assume you got the sales figures. One of them does sales of $2 million and the other one does sales of $800,000. As we go through this, you see that okay, well, you know, if I knew that or if I had that data point. If I had this information, you might make some different decisions. So the point is, is you have to pay attention to not just the price The cap rate, you've got to dive deeper if you want to get a more strategic understanding of why you would invest in one thing over another. And I'm not saying that you would not choose these other ones that sound obvious, the way we normalize these is through price. So maybe through the example of the one with the 10 year lease versus the five year lease, maybe one of them is $2 million. And because the other one only has five years left, again, the same ROI, the same return on investment, maybe you would only pay $1.6 million for the one with five years, versus 2 million for the one with 10 years. So we tend to adjust the prices based on the risk. A five year lease has a higher risk because the tenant may not renew after five years. So you may have a time of vacancy. We're always hedging our bets against vacancy. So the higher the risk, the higher the vacancy if you have a lower volume restaurant that does $800,000 versus one that does 2 Million dollars, while the one that does $2 million likely wants to stay. And when it comes time to renew most restaurants that are doing a strong sales volume, want to renew, especially if it's a brand. Again, as you venture into the investment world, there's a lot of factors that you need to take into consideration. And of course, the other factors that we didn't talk about would be those demographics. Would be has the market shifted a few blocks in one direction or another. Whereas your property is sitting kind of in an old area, maybe a new road was built, and it kind of pulled a lot of traffic into a different direction. There's so many factors. Maybe there's a median cut that was just built in front of your restaurant location, and the sales of that restaurant plummeted 30%, which is not an uncommon sales decline when a median is put in. So there's so many hundreds, maybe thousands of factors that would go into determining whether or not you should invest in one property or another. And again, you can always make up for it with the sales price of that investment. Just some food for thought. See the show notes for additional information. Have a wonderful day. Thank you for listening to The Restaurant Realty in 10. If you're interested in restaurants, whether operations, facilities, buying, leasing or investment, The Restaurant Realty in 10 is for you. Please subscribe to this podcast and you can also visit TheRestaurantRealty.com for show notes, topics and additional information.