Former fast food owners have a chance to get rich
The daredevil cycle of COVID-19 has benefited greatly from prompt service, especially from an innovation perspective. Today’s brands are more intuitive, integrated, and aligned with omnichannel potential, whether through mobile ordering, pick-up lanes, lockers, sidewalk, kiosks, or a collection of all of the above. But pivots, though rushed through the pandemic window, came with a long view and, often, a high price tag. A side effect, says Andy Lapin, a real estate attorney with nearly four decades of experience advising franchise owners/operators, investors and developers, being inherited owners, selling franchises to large operators – those who bought real estate a long time ago and are profiting from a hot 1031 exchange market.
They’re essentially leaving the fast food industry for the real estate industry and increasing their wealth, Lapin says.
“As franchisors have demanded significant outlays for upgrades to their agreements and restaurant values depreciate every year, many older legacy owners are retiring from the business,” he says. “But the smart mom and dad owners who bought the real estate aren’t selling it to the big franchise buyers, but instead splitting it among 1031 exchange buyers, allowing them to avoid capital gains tax. values on what is now very expensive real estate. real estate and reinvest in other real estate.
Rabbit sat down with RSQ to discuss the dynamics – where 1031 exchange buyers are and where they are buying, as well as what 1031 sellers are investing in (it’s not always fast food properties). Also, if rising interest rates could dampen the market.
For those who don’t know, what is a 1031 exchange?
A very basic definition of a 1031 exchange is an investment tool based on Section 1031 of the Internal Revenue Code (“Code”). This section of the Code allows you to exchange (or exchange) an investment property for another property of the same nature. Compliance with the rules of the Code will allow the taxpayer to defer capital gains tax who would otherwise have to be paid following the sale.
A like-kind exchange is a type of non-recognition provision. The code requires that all realized gains and losses be accounted for, unless otherwise specified. Non-recognition status was given to similar exchanges. The rational being that only the form of the investment has changed while the substance of the investment has not changed. At some point in the future, the gain or loss realized on the original transaction will be recognised. Thus, the practical result is that the recognition of the gain has been deferred, thereby sparing the taxpayer the current tax liability.
Let’s start with the topic at hand. Why is the 1031 exchange market so hot right now, and how is it growing the wealth of former fast food owners?
Why is the 1031 Exchange market so hot right now?
The 1031 Exchange market has been white-hot over the past few years for several reasons. When the pandemic started in 2020, stock market valuations fell rapidly. Many asset classes were losing value. The Federal Reserve has lowered interest rates to historic lows. At the same time, the government was pumping money into the hands of consumers, some of which they were spending. The velocity of money has increased dramatically (the speed at which money moves through the economic system). Many businesses have been weakened, especially retail, travel, entertainment and restaurants. However, one particular class of restaurants has been posed to take advantage of the pandemic, quick service restaurants. Many fast services have entered the pandemic with an advantage. They already had both traffic lanes and online orders. And, consumers had few viable choices for spending their new found money. Quick service as a class has exploded as other food options have faded and in many cases died.
Despite all the pain, investors were teeming with cash from a strong pre-COVID economy. With low interest rates, a declining stock market, and many struggling asset classes, cash-strapped investors needed a place to park their money. The race has intensified to find well-located properties with strong tenants. And they discovered a thriving business-class quick-service restaurant. With this class of investment, investors could structure transactions as NNN leases that essentially allowed them, in principle, to buy the property and collect a rent check without having to do much else. And, they could also structure these transactions as 1031 exchanges so that the investor could defer paying the current tax if they had another “similar” property they could sell. As a result, the value of the underlying real estate of the fast service accelerated rapidly.
How does he increase the wealth of former fast food owners?
The growth of the 1031 Exchange has accelerated both the value and sale of quick service restaurant real estate. This acceleration in the value of real estate increases the wealth of all owners of the real estate on which fast service is located, whether they are inheriting owners, new owners or non-operating owners of the real estate. However, the value of real estate is primarily determined by the sales generated at a specific quick service restaurant and indirectly by the strength of the operator/tenant. Why, because rent paid is a derivative of sales volume. The higher the sales volume, the higher the rent that can be generated since rent is usually based on a percentage of sales. The better the operator, the better the sales, therefore higher rents, which leads to a higher valuation of the property.
What drives this? Is it a by-product of all the innovation demanded of the operator (and the prices that follow)?
It is definitely a factor. Former owners/operators are aging and not necessarily interested in renovations and innovations that cost large sums that they may never recover. If other family members are not interested in continuing the business, the increased value of the business and real estate provides an exit opportunity.
Where are the 1031 exchange buyers and where are they buying from?
Many are West Coast buyers buying in the Midwest and other more favorably rated real estate areas. Real estate located on the west coast trades at very high cap rates (cap rate: divide the net operating income of a property by the current market value). Real estate in the Midwest and other parts of the country is trading at what West Coast buyers appear to be at more attractive cap rates (less costs).
What does 1031 Sellers invest in?
Using 1031 exchange techniques generally allows the taxpayer to improve the type of real estate they are purchasing. They can buy quick-service properties from powerful operators. However, quick service restaurant owners/operators who own their real estate may negotiate upgraded properties. Typically, these properties will also be Net Rental Properties (NNN). They look at C stores, car washes, industrial spaces such as Amazon fulfillment centers, FedEX fulfillment centers, etc. The hope is to find properties with strong tenants in good locations that require little or no management from the exchange buyer.
Is rising interest rates a potential slowdown factor?
So far, rising interest rates haven’t had much of an effect. I believe there will be a moderating effect as rates continue to rise. Right now there is still a lot of money in the market and many people are in the middle of a 1031 exchange and need to find a replacement property. If interest rates continue to rise, leading to lower sales (lower pricing power), the need for replacement properties may decrease.
More broadly, how could all of this reshape the quick service franchise market?
As more traditional owners sell fast services, this will further accelerate industry consolidation in the hands of larger, well-capitalized carriers. In many cases, these operators have the resources to both expand the brand footprint by developing more stores and to invest in the renovation and innovation that brands need.
Who potentially has the most to gain from the movement?
As all parties win, former owners have a way to cash out, new buyers expand their holdings, and franchisors further expand and innovate their stores. But the real winner in the end is the consumer. They get new and newly renovated stores that promote the latest brand innovations.
Andrew W. Rabbit is a shareholder of Robbins DiMonte and has over 35 years of experience in real estate, business franchising, business transactions, banking and finance, and labor and employment. Its clients include business owners, franchise owner/operators, real estate investors, developers and syndicators. He can be reached at 312-456-0372 or [email protected].