Rick Ormsby:
Welcome to the Restaurant Boiler Room, Season Four, Episode Eight. I'm your host, Rick Ormsby, managing director at Unbridled Capital. Today in the Boiler Room, I'll be replaying a recent webinar on Q3 2022 Franchise Real Estate, with guests, Josh Lewis of National Retail Properties, and Chelsea Mandel of Ascension.
Rick Ormsby:
We will talk real estate deal flow, cap rates, due diligence, change in market conditions, risk factors, rent coverages, brands, geographies, and many other nuances that affect real estate valuations, acquisitions, and divestitures, particularly in these changing operating environments for underlying franchise businesses.
Rick Ormsby:
The Restaurant Boiler Room is a one-stop-shop for multimillion dollar merger and acquisition activity and financial complexities affecting the franchise restaurant industry. We talk money, deals, valuations, and risk, delivered to the front door of franchisees, private equity firms, family offices, large investors, and franchisors on a monthly basis. Feel free to find our content at Unbridled Capital's website at www.unbridledcapital.com. Now, let's enter the Boiler Room.
Rick Ormsby:
Well, I'll just start rambling a bit, and then we'll get going. I thank you for joining our webinar. For those of you who will listen to this on podcast, probably, in maybe 21 or 28 days, at the Restaurant Boiler Room, when you hear my voice, I just want to say, thank you for listening. Podcast is really going really well. We're excited about it. We do that every month.
Rick Ormsby:
Let's see. Just a bit of ground rules here. We'll go for one hour, and then when we go for one hour, you guys and gals can ask a question, if you like. There should be a "chat" feature at the bottom, and if you want to ask any kind of question during the presentation, please do. Let's the three of us eyeball the questions as they come in, and we can just answer questions as they come in.
Rick Ormsby:
Keep in mind, we will have a replay available on our website at unbridledcapital.com, and then we will email you a copy of the replay if you signed up, as well. Look for that in the next 72 hours. Other than that, I think I would like to say a couple things, like I usually say, state of the business for Unbridled, just think for the Franchise M&A activity this year, we've seen a bit of a pullback. It's been quite a bit slower for us than it was last year.
Rick Ormsby:
A lot of that was expected. If you'd listen to me a lot, you've heard this before, but 2021 was super pumped and super charged with M&A, and there are a lot of reasons. We had COVID sales, we had record profits, we had low interest rates, we had a lot of buyers coming back to the marketplace. Clearly, as well, we had the threat of increased taxes that were driving a lot of decisions on the seller's ends to try to beat what they thought would be capital gains tax increases. That didn't happen, ultimately.
Rick Ormsby:
That's what happened in 2021. We knew it'd be down a bit in 2022, we'd have a sophomore slump, but with the inflation, the high gas prices and the rising interest rates, combined in sagging consumer demand. It combined together to slow things down a bit more than I expected. So, we continue to be a bit off in terms of volume and activity. We're hoping that'll happen, they'll pick up later this summer and into the fall.
Rick Ormsby:
Clearly, we have a situation where a lot of operators' businesses are worth a bit less than they were last year because EBITDA is down as a measure of EBITDA and the multiple of EBITDA in business just isn't worth as much. We're going through that adjustment a bit, but I expect, like everything else, it'll pick up in probably six months, maybe a bit less. We'll just keep an eye on it. And you'll always hear my perspective on here.
Rick Ormsby:
Here we go. Let's get started with two minutes in, and I wanted to just thank both Josh and Chelsea for being here. I'm excited for today's webinar. When you're here at the podcast, these are two really cool experts that know the single tenant market on, say, a leaseback, plenty of experience and franchise and restaurants, particularly. They also know that the 1031 market, the sale-leaseback market really well.
Rick Ormsby:
Both have different areas of expertise, both are excellent at what they do. I would just start off, and let's start with Chelsea and then go to Josh. You guys introduce yourselves. Thank you for joining.
Chelsea Mandel:
Thanks, Rick. No, glad to be here. Yeah. I'm Chelsea Mandel, co-founder, managing director at Ascension. We focus on corporate real estate and sale-leasebacks, typically working on behalf of private equity firms and other middle market and lower middle market companies. We do a lot in the restaurant space, a lot of the franchise space. QSR, also active, and just broader single tenant real estate, like industrial, medical, healthcare, et cetera. My background, I started on the principal side, went to the advisory side. Have since launched Ascension earlier this year, and specialize in sale-leasebacks. Glad to be here.
Josh Lewis:
Thanks, Chelsea. Rick, thanks for having me. I'm an SVP of acquisitions at National Retail Properties. We're a public REIT that invests exclusively in single tenant retail, including restaurants. We own about 3,300 properties in 48 states, including over a 1,000 restaurant properties. About a 12 billion dollar enterprise value, 8.5 billion dollar market cap. Principally doing sale-leaseback transactions, also do some reverse build-to-suits and quite active.
Josh Lewis:
I've been doing franchise restaurant stuff for a long time. I've been here 14 years prior to NNN, I was in investment banking, real estate capital markets, and did sale-leaseback advisory work. I've switched sides of the table in the opposite manner as Chelsea.
Rick Ormsby:
You said you're an SVP, and for me, I'm like SVP, SVP, that sounds like Scott van Pelt on ESPN. You look like him a bit. I [crosstalk 00:05:57]. You got no hair, man.
Josh Lewis:
Yeah, I'm folically challenged, like he is.
Rick Ormsby:
Well, very cool. Thanks so much for the introductions, guys. First question to both of you is macroeconomic picture. First question here is, how's the real estate market for buyers and sellers changed so far this year? I gave you my perspective on businesses. You're the experts on real estate. What do you think? We want to go in the same order? Chelsea, you don't want you to go first and Josh second. We'll just tackle it. Yeah.
Chelsea Mandel:
Yeah. Obviously, a lot going on in the market. Interest rates are up a hundred plus basis points since earlier this year. We have inflation at 9%, there's a lot of things just macro economically that we're all dealing with, but I think in terms of deal volume and, pricing, I would say interest rates have certainly moved, but cap rates, thankfully haven't moved as aggressively. What we're seeing is, I would say about 50 to, 80 basis points of cap rates spreads. What you are seeing is a lot of volatility, right? CMBS market CLO market, you are seeing groups that are relying on asset level financing, maybe having a bit of a harder time, getting their deals done and creatively.
Chelsea Mandel:
I would say from our perspective, on the seller advisory side, we are seeing a widening gap between those cash buyers. Groups like Josh and his firm, and groups that are private equity funds are relying on asset level financing. It also takes us into the 1031 market pretty frequently. A lot of these buyers are cash. They are a bit more insulated from the challenges in the financing markets. I think generally, from a demand perspective, for the product that we offer on the sale-leaseback side, the demand is still there, especially with the volatility. Buyers are flight to quality assets and sale-leasebacks with long term leases and good credits, good operators, good brands, those are still the deals that people are wanting to do. From a volume perspective, we're still running competitive processes. I think activity has still been actually very strong.
Rick Ormsby:
Maybe stronger than what we're seeing on the operating company side in the M and a world. Interesting. What do you say, Josh? What do you think?
Josh Lewis:
I mean, you guys covered the macroeconomic backdrop. GDP is negative two quarters, inflation 40 year high, the 10 years moved north of a hundred basis points since year one, li B O and two, and the two year treasury have moved even more than that. High yield spreads have moved even wider than that. Sale-leaseback, looks pretty attractive on a relative basis. Particularly, in a lot of the transactions we're involved in, which would be, say an M&A sale-leaseback, the sale-leaseback, a marginal move in cap rates 25, 50 basis points is pretty de minimus, relative to how the cost of other capital has moved.
Josh Lewis:
Frankly, it's not only a movement in underlying rates and spreads, but there's also just less liquidity in other capital markets. It's hard to do a high yield deal. It's hard to do a high grade deal. Fortunately, as Kelsey said, NNN's an unsecured borrower. We don't use any asset level financing. We've got a big balance sheet and very long-dated capital. That's been very advantageous, versus those folks that are relying on debt financing.
Rick Ormsby:
You guys got a war chest of money. Let me see if I can unpack this. You got a war chest of money, you don't borrow money to buy real estate. You're a little less sensitive to changes in interest rates relative to other people who do borrow 80% of the money to buy the real estate. Either way, the interesting point of the comment also is, and comment on both these things, that what I just said, and also the second piece of it is, you're seeing that, and I agree with you that there's been less negative movement in both cap rates and interest in acquiring on the real estate side then there has been from an M&A standpoint on then on the corporate side, on the business side where restaurant lenders have tightened a little faster and a little more.
Josh Lewis:
Yeah, and just to be clear, we do use that capital, but it's all on a senior unsecured basis. It's a corporate basis. It's, roughly 40% leverage in our capital structure and our cost of capital has moved higher. Fortunately, we were well-positioned for that, and we're not reliant on, say, the CMBS market or doing mortgage financing to fund an asset or portfolio of assets.
Josh Lewis:
Equity prices have dropped pretty much across the board. Debt costs have gone up. Cost of capital has moved higher, but on a relative basis, it hasn't had that meaningful an impact on cap rates. I think cap rates will likely continue to move a little wider as the fed continues to tighten, but again, a 25 or 50 basis point move in cap rates really isn't all that meaningful from a multiple perspective. We'll talk a bit more about that later, but, that effective move, just isn't all that meaningful relative to other types of cap.
Chelsea Mandel:
Our real estate transactions, they could be, thankfully as quick as like 30 days, but it could also be 120 days. I think cap rates are a bit of a lagging indicator, versus the debt market, which prices, spot, they could retrain your terms today. I think there is that timing component that also is taken into play here.
Josh Lewis:
I would say that, because of that, there is a lag. We have seen some deals. Fortunately, we haven't been in this camp, but I mean, deals have gotten retreaded. We've seen deals that have fallen apart as a result of moved in the capital markets. The longer nature of these types of transactions does make it harder to value deals or price deals initially, because we're all looking at the yield curve and listening to the fed talk about rate movements and wondering when and if that's going to happen and how that's going to happen. A month ago, the 10 year was at three point a half percent. We're down to 2 80. We've got an inverted curve. It's strange times, but I think we're doing our best to navigate it. I think sale-leaseback market is very open. They're just, there are some players that are sitting on the sidelines because they are more debt reliant, more asset level financing reliant.
Rick Ormsby:
Well, it's an interesting comment about the retrade portion, because, when you're selling businesses, there's all kinds of things that can happen that can cause a force, a retrade, or a discussion about a retrade. Some of it is that you go through and you find, the EBITDA drops a ton during due diligence when you're selling a company, or maybe you come in and there's all kinds of deferred CapEx in the stores. There's a number of reasons, but typically you don't hear about real estate getting retraded much. To even just to hear that comment, at least on the deals that we've done, we haven't seen a whole lot of that historically, but we're doing one deal right now that has that element in it, too. I think that's something that we should, as people listening and being concerned about real estate, we should know that's maybe a bit more on the table going forward because of the interest rate environment that we're in. Let's talk a bit, let me change an to ask this question, how is deal flow right now in single unit sale-leaseback market and in portfolio deals in restaurants? To the extent you have a comment on that, does it mimic my earlier comment? Things are a little slower than they have been. What do you think?
Chelsea Mandel:
Yeah, I think they're, they're a bit slower than things have been. Obviously Q4 was everybody's favorite quarter. Things were just booming, but generally, just given all the different macro factors this year, year to date, it has been a bit slower, but I think from our standpoint, what we're doing is we're seeing a lot of valuations. We're seeing a lot of proposals. On the deal side, a lot of the deals that we're seeing are like the M&A deals where, we're bringing in a group like Josh's, or another buyer to execute a simultaneous sale-leaseback. Typically it's private equity firm.
Chelsea Mandel:
They're, they've been consolidating up these family owned operators, the sale-leaseback's a big component of their entire caps stack. We're structuring that simultaneous deal, so we're relying on the institutions to come in with our clients taking down OPCA while they buy the real estate. Then a lot of what we're seeing is, they're going out and they're flipping these deals into the 1031 market and, good for them. They're making a nice spread on it, but it is a different deal, coming into that simultaneous transaction, replacing a big piece of the sponsor's equity check. It is a higher risk deal. I would say that's a lot of what we're working on. We're seeing a lot of proposals, for Pizza Huts and Sonics, Zaxby's. We just did a number of Taco Bells, so we are seeing good activity, I think on the single unit side, it's typically after that initial, institutional portfolio deal that we're then flipping those out into the 1031 market.
Rick Ormsby:
Yeah. Good. What about you, Josh?
Josh Lewis:
Yeah, I would say, Rick, it has been a bit slower on the larger M&A rest QSR or even casual dining restaurant deals where, as Chelsea said, there's either a strategic or perhaps a sponsor that's coming in and wanting to use, say a leaseback capital to fund an acquisition. We are seeing it perhaps more in some other asset classes outside of restaurants. We're working on something with Chelsea right now in that regard, but as far as big restaurant portfolios, not seeing as many deals. I think that's to your point earlier that a lot of deals got pulled forward. You're also dealing with a year ago, you were working off of great TTM set of numbers and today your TTM set of numbers are maybe showing some positive comps on the top line, but you're seeing margin contraction.
Josh Lewis:
There's a bit of a disconnect between what seller's expectations are and what buyers expectations are. I think that leads into, where we're very focused and that gets into the underwriting of the unit level cash flows among other things. Deal flow on restaurant stuff is a bit slower. We are looking at one very large transaction right now in the restaurant space, and I think that deal has some elements of that uncertainty around cash flows associated with it, which is complicating matters.
Rick Ormsby:
Yeah, and it's interesting. I want to talk... I'd love to make sure we don't forget this because I want to later talk a bit about rent coverage ratios and how you guys think about rent coverage ratios, which is a key metric at which buyers look to stay above 2.0 when they do that. Matter of fact, let's just tackle it now.
Rick Ormsby:
Typically good old redneck here like me says, oh boy, I got a store doing a million dollars in sales and I'm going to slap an 8% rent on her and then I'm going to give her a five and a half cap rate and then off we go into the sunset and that's a, whatever the number is, it's probably a million four, give me a million four, less transaction costs and then I'm going to take an $80,000 lease on 20 years with 10% increases every five years. That's how we do it. Everyone's going to take that 8% rent just because that's what everyone does and the end.
Rick Ormsby:
Clearly you guys are interested not only in cap rates, but rent coverage ratios and rent coverage ratios are dependent upon your view of EBITDA. Inherent in my question is, what do you think? I mean, how do you look at EBITDA? How do you think, think about rent coverage ratios and how do you go about buying real estate? I mean, how do you think about pricing it and buying it?
Chelsea Mandel:
Yeah, I can start and then, Josh, if you want to weigh in. I think that the metrics that you mentioned is typically what we're looking for when we're sizing up our proposals, 8% rent to sales, two times coverage at the unit level, making sure the cap rate's taking into account the brand, the sponsor, the operator, all of that. I think what we're seeing now is that EBITDA, that numerator in your EBITDA to rent isn't as straightforward as it used to be. Like Josh said, you're not looking at a clean TTM and saying, okay, great, that's the number. You're looking at the COVID bump. You're trying to make your adjustments.
Chelsea Mandel:
The buyers, and Josh could definitely speak to this, they're asking for more detail, they want more financials. They really want to make sure that they're understanding that EBIDA and that they're giving credit to all the different factors in the macro environment that have either led to outsize numbers or below average numbers. I think that adjustment, true adjusted EBITDAs is really being looked at a lot more carefully. Josh, I would love to hear from your perspective to make sure that our valuations are going to be acceptable by buyer.
Rick Ormsby:
Look at him over there. He's just got a little frown on his face. He's got the Ebeneezer Scrooge look about EBIDA. Go ahead, Josh.
Josh Lewis:
Look, all of our deals are a four-legged stool and they always have been. It's real estate. It's unit level economics. It's credit. It's the more art than science piece, which is, brand and management team and competitive dynamics and all that. We think about all of those things. It isn't just a rent to sales or coverage equation that is how you determine rent or how you determine cap rate. It's all of those things. It's not a perfect box. It's not all science, but there has been more art to the unit level economic underwriting. We're going back to, if the store's been around for a while, we're going back to maybe 18 or 19 and seeing how that store was performing pre COVID. Maybe we're taking a 19 to 21, 3 year average.
Josh Lewis:
Then we're looking at the latest set of TTM numbers and folks that think that they can... Look, I think some of the buyers that Chelsea might go to in the 1031 market may not be as sophisticated as that and maybe, okay, they take an 8% rent off of a TTM March set of numbers and they live with that. I'm going to say, well, let me look at the June numbers because all the labor and cogs stuff, you may not be fully capturing that in a TTM, March 31 set of data. We want to make... And Chelsea mentioned that, some buyers such as ourselves are buying portfolios and then flipping the assets. We aren't generally in that category, we are long term buy and hold investors. I want to collect rent for 15 or 20 years.
Josh Lewis:
I need to make sure that whatever rent I put in place is sustainable. That I'm going to collect that annuity stream of cash flows. I need to make sure that rent is going to be covered in a downside scenario. If my tenant should fail, I also need to make sure that rent is from a real estate fundamental standpoint, something that's replaceable or close to replaceable. You gather all this data and utilize your expertise and try and evaluate what is the appropriate set of numbers. The other piece of this is that some buyers are wanting to put more rent on the asset. Some buyers think like I do, and they say, look, I want to make sure that, maybe we're a family office buyer and we're in the business of owning QSR because it's a great cash flowing business. It's survived for eternity. It made it through COVID so well. We want to make sure that continues. They may not want to push rents to the umpteenth degree. It's all fuzzy, but you work to a number and say, look, these are acceptable level of rents, and then you put a cap rate on it.
Rick Ormsby:
I think that's really good. Josh, thank you for that. I didn't mean to cut you off, but I mean, I'd make a couple quick comments to that. Number one, I think hopefully for those of you who are listening and watching, you're going to, I think you hopefully heard that there's a bit more scrutiny on the business operations now than what there has been historically, okay? That's just the state of the world that we're now living in and you can expect that your buyer of your real estate, whether it's through an advisor like Chelsea or a direct buyer like Josh, they're probably going to look at a bit more like a buyer of the business, maybe. They're going to want to know the EBITDA, they're going to want to know how the business fundamentals have changed to protect their real estate investment decision. That's number one.
Rick Ormsby:
Number two, I guess I'll just punt on it. We'll keep going or we'll be fast. 1 22. Okay, so here we go. Let's go to the next question, then, instead of me ramble. Number five on the list. Well, number four was, why would an operator do a sale-leaseback? It's a... Go ahead, give your 2 cents. Why would I want to do a sale-leaseback?
Chelsea Mandel:
Yeah, I can start. It comes down to just operators and private equity firms, whoever, they have a higher and better use of capital than owning buildings. It's whether you're paying down debt or using the proceeds to finance growth, buying new locations, opening up new stores or buying new equipment. It's just not a good use of their capital to be tied up in these non-earning assets for the company. If you're in the business of operating restaurants, you want to operate restaurants and not be in the business of being at Josh. Being a landlord.
Josh Lewis:
Couldn't agree with more with what Chelsea said. Then, it's the math piece of this, and that's the fact that a six cap is a 16 plus times multiple on cash flow and your business probably isn't worth that multiple, unless you're somebody very special.
Rick Ormsby:
I'm special. I'm very special.
Josh Lewis:
Look, there are some businesses out there that are trading at multiples higher than that, but I like to think of rent as basically foregone EBITDA. If you can get a materially higher multiple on that rent, on that EBITDA, then you should try and do that. Oftentimes there's a pretty big gap between, where you're selling a business at 5, 6, 7, 8 times, maybe it's 10 times in a Taco Bell and a, 15, 16, 17 times multiple that you're effectively getting through the cap rate. Again, as I said before, even if cap rates have moved 50 basis points, you're probably only looking at a turn or so of lower multiples, so 16 and a half becomes a 15 and a half. It's still a big number.
Chelsea Mandel:
It's just financial arbitrage. Either you have a use of proceeds or you're just a financial engineer.
Rick Ormsby:
Yeah, the changes in valuation of someone's total company are relatively low with a slight shift in cap rate versus a big shift in the change of debt financing on the... Well, actually, I say that opposite. You'd actually see a really big change in valuation of the company based off the change in cap rate. Well, let me ask you guys this, let's tackle this idea of 8% rents. I get this asked a lot, not so much in the Yum system, KFC, Taco Bell, Pizza Hut because, corporate, the franchisor will come in and say, we're capping rents at 8% of sales fixed at closing on trailing 12 month financials. In other brands where there's not maybe as much of a policy, I field the question a lot, why can't I put my rent at 9% of sales or why can't I put my rent at 10% of sales?
Rick Ormsby:
Of course, my answer is that once you do that and you do a least adjusted leverage calculation, you almost have, because, it's so heavily factor that calculation into how high the rents are, you really aren't left with any business value and no one will lend money against you. Most of the franchisors are also doing those same calculations and not wanting the least adjusted leverage to be over like five or five and a quarter or five and a half, depending on the brand. What say you to someone who gets through to you and says, I want 10% of sales rent on my piece of property in restaurant property, let's say?
Chelsea Mandel:
Yeah, it's hard. We've had operators, a lot of the time it could be the private equity owners who just want to juice proceeds, and we get it, especially it's simultaneous with the deal, right? It's directly replacing equity, but I think at the end of the day, there's the operational concern for, is this sustainable for the operator? Do you want to be in business for the landlord, or do you want to actually have a healthy company that generates positive cash flow? It's also, from the investor's perspective and from having been on the investment side, that rent's not going to be reproducible. It just makes the whole real estate fundamental equation, much more challenging because maybe this operator could afford it, but then you're thinking about your exit, potential dark value, you're in the real estate for a basis that makes no sense, you can't replace the rent, because this is an acre site and that rent never makes no sense in the context of what you could actually release it for if this operator were to go away.
Chelsea Mandel:
There's a lot of different considerations, both from the financial health of the company and being able to pay this rent for what could be 20 years. I mean, these are long term obligations that you have to live with, but also from the investor's perspective of do the real estate fundamentals checkout from the basis standpoint, and is this rent going to be replaceable?
Rick Ormsby:
What you said about working for the landlord, I think that's a really... I always tell people that my heart is always in the, I come from the standpoint of the mid-size operator. That's where I cut my teeth, right? The 30 unit Taco Bell operator or whatever. I have watched, in my 20 years of doing this, operators who have done, Chelsea, what you've said, which they have either inherited leases or they've done sale-leasebacks either at too high of a number, or the business dropped in sales and the rent therefore was really high and I've seen them do what you've described, which is working for the landlord, operating this business with a noose around their neck and really working just for the landlord. It's some of the most miserable stuff I've ever seen. People who are under that because you can't get out of it. It's almost like it's a self-fulfilling prophecy of spiraling. I think it's a really, really common thing to be thinking about. Josh, you got a comment on it, too?
Josh Lewis:
I mean, I think Chelsea nailed it. Again, we're looking at it on a long term basis. The rent's got to be sustainable. There's probably some rent bumps in the lease as well. That rent's going to be increasing over time. There's got to be a margin of safety. Again, to us, the coverage metric is probably more important than the actual rent of sales, but I've seen very few businesses that can truly support something north of eight, eight and a half percent rent to sales. I mean, you could have some very high margin businesses. There's some very high margin concepts, but generally speaking, we got to think about, what are those absolute level of rents? Are those replaceable? Our executive team always harps, low rents, low price points. At the end of the day, that's how we best protect ourselves. I'd rather get a little lower yield at a lower rent of sales or higher coverage than higher yield, higher rent. That's not really the trade off I want to make.
Rick Ormsby:
I saw a question come in here, which won't surprise you guys. We decided to pun on it when we did the practice session. Are the risks real that the 1031 tax deferrals will be restricted in the Biden 2023 budget? What's the cap rate impact of that? I suppose you guys are going to say, I don't know, but there has been banter that anything more than a half million dollars of gain would have to be... Is that what it is? It would have to be realized in tax this year?
Chelsea Mandel:
Yeah, it's half a million. Yeah, I think half a million is protected and that's everything else is just subject to, I guess, traditional gains. I don't know. I don't want to be, I hate being wrong, so I'm not going to set myself up for a year from now to be wrong.
Josh Lewis:
Yeah, nor am I. They just did this small build back better or whatever they're calling it. The tax element of it changed overnight. The idea that Chelsea and I would have a real clue as to what the 1031 rules might look like at some point in the future, we don't know, there's-
Chelsea Mandel:
... Real estate, sell your real estate now, if you're worried.
Josh Lewis:
Yeah.
Rick Ormsby:
It's funny, there's a... It's crazy, I shake my head at the level of distrust with the government. I was just getting a driver's license today because we just got a new house and they asked me if I wanted to be an organ donor. The lady said, well, most people don't do it around here because they're afraid the government's going to knock on their window and come steal their organs from them. I'm like, really? Geez, there's a... There's a lot of fear that could go around, but if it is true that if someone owns a hundred million dollars of real estate and they've got a $50 million gain on it and they have to realize 49 million, $500,000 of that gain and pay taxes on it, and can't defer through 1031, now, I have no knowledge about whether this will happen or not, but if that were to ever become in play, I think everyone would be jumping from tall buildings in a real estate.
Josh Lewis:
Yeah, there's a pretty big lobby around this. I mean, private equity got carried interest pushed to the sidelines. I think it is a pretty big issue. Again, I don't want to make predictions either, but I'll leave it at that.
Rick Ormsby:
Take me to cap rates, then. Another question was asking specifically in brands, okay? It was that specifically, we won't mention the brands particularly, but the two brands that were mentioned were QSR brands that are typically two of the three or four best performing, most attractive brands. Take us through your all's thought on when you're selling real estate and let's call it a bucket A, bucket B, and bucket C, okay?
Rick Ormsby:
Bucket A is going to be the highest quality QSR assets, and great geographies. Bucket B is a bit less, but still pretty good. Then Bucket C are smaller concepts. Take us through those buckets, how you think about cap rate pricing. Then after that, I'm going to ask how is that going to be changing in the next three to six and nine months? What do you think, Chelsea? What do you got?
Chelsea Mandel:
Yeah, I think your best stuff, somewhere in the fours, high fours, then just goes fives to sixes, a lot of the portfolio deals are getting done, in the six-ish range, when they're the M&A deals. Imagine before, not really a Josh strategy, but if they are going to be flipped out after, or if we are just looking at them at one offs. We're looking at something in the fives, but, I think everybody thinks that cap rates are going up. We've already seen it. Like we said, I would say if I had to put a number on it, they're probably up 50, 80, somewhere in that range, basis points. I think they're going to continue going up.
Chelsea Mandel:
There's no reason to expect that cap rates are going to go lower with everything that we're seeing. If they went back to 2016, 2017 levels, I think there's probably another a hundred basis points or so to go. I think like Josh said, even if those movements come to fruition from a multiple arbitrage perspective, it still makes a ton of sense. You're still have a ton of spread. You're still, even if you're at like a seven cap, it's 14 times, you're really not selling your business for 14 times or greater than that. I think maybe the spread shrinks, but when you look at alternative forms of financing and what that means for if you're not going to do this and you're just going to finance your real estate, what does that mean for your interest rates on a mortgage? I still think that the relative arbitrage still makes sense.
Rick Ormsby:
Yeah, I'm still doing the math equation here. This is interesting, though. Even if we think it's going to go up the 80, as you say, a hundred basis points from here, that would make, on its simple million dollar deal, if you were going to sell it at a five, five and a half cap rate, right, you'd be getting 1.4, 5 million. If you're going to sell it at a six and a half cap rate, you're going to get 1.2, 3 million, right? That's over 200,000, which is a 20% drop in valuation. Just to hear it, if you're listening on this call, man, or on the podcast, what you just said is not immaterial. Prices are going to be getting worse for the value of your real estate because the interest rates are changing. If the cap rates change by a hundred basis points or 1%, and if we use the example of going from 5.5% cap rate to a six and a half percent cap rate, you're talking a 20%, possibly 15 to 20% drop in your valuation. Now, that's if you were paying all cash.
Josh Lewis:
Rick, that also assumes that the cash flow of that asset hasn't moved and I would suggest that the change in margins, and they've directionally been go... EBITDA margins have been declining. That's probably a more meaningful driver of the difference in valuation. Yes, you're correct. In terms of your question, I agree with Chelsea. Look, there's a whole category of QSR that we've never been able to touch. The McDonald's, the Chick-fil-A's, the Chipotles. Those have been really the bevy of the 1031 buyer. Those yields have never been in a place that have made sense for a institutional buyer. There's no spread. We are in the spread business, really. Your garden variety, Taco Bell and Wendy's were mentioned in the question, those deals that might have been high fives on a portfolio basis, say, end of last year are probably in the low sixes, is a good number. Maybe it's six and a half, if it's a slightly more marginal credit or weaker performing assets or-
Chelsea Mandel:
Outsized rents. Rents that are too [inaudible 00:37:01]
Josh Lewis:
No, there's so many variables that come into play. Again, I think directionally... And one other way to think about it is that, some of the stuff that was trading at the lowest cap rates, those have probably moved wider than the middle market franchisee credit that, Rick, you generally have been selling. Again, those deals are probably 25 to 50 basis points. We did a deal that you were involved in that closed, I think, December 30th of last year. That deal, today, is probably 25 basis points wider today.
Rick Ormsby:
Okay. I thought it was interesting, too, Chelsea was the one bringing it up earlier about how on another call about how geography makes a difference, too. We've always known that, right? To put, and you were saying, Chelsea, maybe expound on this, that California is an area that where when you're doing single unit, selling single properties, that's a really hot area. Then you pick no tax states like Texas, Florida, and Tennessee, right?
Chelsea Mandel:
Yeah.
Rick Ormsby:
Yeah, tell us a bit about how you think about geography when you're selling these assets.
Chelsea Mandel:
Yeah, for sure. I think in terms of those markets, it's the 1031 driven component there on pricing. The tax free states, California it's really, I would say heavy loaded 1031, but in terms of the geography, I think it's a consideration right now, especially in like flight to quality, right? The real estate fundamentals, again, we come back to that. Can you do something else with this property? People are going to pay more. They're going to focus more on these better located assets. Maine and Maine. You do have to think about your downside more than you would in just a not as volatile market. I think that's coming into play. Then just like on the rent side, obviously, if you're in the middle of nowhere and it's a challenging credit and it's not one of the top brands, you're paying more attention to your rent numbers, making sure that your coverages, your rent to sales, all these different factors when you're underwriting, that these all check the box and make sense.
Chelsea Mandel:
I think you can be a bit less stringent on your underwriting criteria when you have the real estate fundamentals backing you up. Your basis makes sense, land values, your real estate is stronger, you're at the broad intersection, you have the traffic counts. It just prevents you from having to be so strict on those four prongs that Josh mentioned.
Rick Ormsby:
Yeah, it's good. It's great. Thanks for sharing that. What about, talk to us a bit about the process and timeline of selling real estate? Give us a 1 0 1, so assume I don't know anything.
Chelsea Mandel:
Yeah.
Rick Ormsby:
What happens? I got a piece of real estate out in the field with a KFC sitting on top of it. What happens?
Chelsea Mandel:
Yeah, obviously we always start with valuation just like you do. I'm sure when you're pitching business, make sure we're on the same page, we're setting expectations, we come to you with a proposal here's where we can execute. We're typically giving a range, we're showing them our proposed lease terms. If they say, hey, we want to pay 10% rent to sales, we're saying, no, here's our valuation. This is based on this set of lease terms, and this is what we would recommend that buyers will get on board with. This is what we should go to market with. We'll present that range evaluation, those lease terms.
Chelsea Mandel:
Typically, if they're ready to make a decision quickly, it moves rather fast. Maybe a week, we're signed up. About a week and a half to get our packages ready. We get a data room going just like you. We go out to our buyer network and I would say typically within three weeks we have offers in. Maybe another week or so to refine LOIs, get our best and final, get to a point where we're ready to execute an LOI. Then, this is where, the market has moved a bit. I would say traditionally, it's like a week and a half to two weeks to get a PSA executed. Then you have your 30 day diligence and then 15 day closing. That was the norm. Now I'll tell you, we signed a deal. It's a 25 day diligence, five day closing, and the diligence is starting upon and executed LOI.
Chelsea Mandel:
That's extremely fast, but we're doing this because we're trying to box in risk as much as possible and really try and mitigate any potential retrades because we're just boxing in that time so that they have to move so quickly. Even if the markets move, they're hopefully not going to move that fast, that we could run the risk of a potential retrade. In order to accommodate that and make that possible, we're taking some steps, to make that timing work. We're having our sellers, our clients, order third party diligence. Get their phase ones going, get the survey started, start opening title, and then we're assigning those reports to the buyer so that they can just come right into third parties instead of waiting for that executed PSA.
Chelsea Mandel:
A lot of buyers, I know, Josh, on one of our last deals, you guys are comfortable starting diligence with the executed LOI. We're getting an access agreement in place versus waiting for a PSA. It's just helped us speed up a lot of these processes and we're keeping the deals on the market shorter so that we're able to close quicker and make sure we're really mitigating that period of risk.
Rick Ormsby:
Let me jump in, and I want you to answer, too, Josh. Chelsea, that was a great answer to that question. I would say the same thing's happening in bridals business, too.
Chelsea Mandel:
Yeah.
Rick Ormsby:
Probably half of the deals we're doing this year we're not taking to a broader market because we're worried about the amount of time that it's going to take, and we're really under pressure to get it done quickly with changing interest rates and changing borrowing, and credentials from the buyers. I echo that. You sound almost exactly like we do. Your timelines are a bit real unrealistic for selling a company because we got to deal with franchisors and we got to deal with all these things that take more time. It's the same steps. Obviously, I would just say the same steps, but I didn't follow the numbers exactly, but probably double everything she says, and that's what we go through. Noted. Noted that we want speed because we have a lot of, you said boxing in risk. We want to box in risk in a time where we have a lot of uncertainty.
Chelsea Mandel:
If it were up to the buyers, most of them probably wouldn't retrain, but they're getting retraded by their lenders. It's really just for groups that are financing, especially if this is a bigger consideration, but it's not always in their control. There's always vendors and other people that are just slow in these processes. We're just trying to do everything we can't to speed it up.
Rick Ormsby:
What do you say, Josh?
Josh Lewis:
Chelsea kind walked through her timeline. Ours is a little different, depending on how the deal is being sourced. Sometimes we're seeing deals from Chelsea and her peer brokers. Sometimes it's a relationships tenant. Sometimes it's somebody that calls out of the blue and says, hey, I've got 10, this, that, or the others. Can you take a look? What can you do? Ultimately it starts with gathering data, addresses, store level P&Ls, some kind of at least high level corporate financials, pretty quickly, based on technology and our having done this a million times, we can chapter and verse say, here's what can be done in terms of, here's acceptable level rents, here's cap rate. Here's what the least term's going to look like. Here's what the basic terms of the triple net lease are going to look like.
Josh Lewis:
We can have an LOI to somebody on a deal in a couple days. I mean, it's obviously easier if you've got more data, but oftentimes, we can turn around our thoughts on a particular opportunity very quickly. That LOI may get negotiated. Once it's signed, you go to negotiating a contract and a lease. If it's in the context of an M&A deal, you have to marry that to the underlying PSA or LOI on the M&A deal. Chelsea talked about third party reports. We need title, survey, environmental zoning reports. We don't do appraisals. We don't have a lender looking over our shoulders, which helps us from a certainty of execution standpoint. The third party reports tend to be a gating item. It's taken longer. It's taken longer since pre-COVID. Even to pull title depends on the jurisdiction.
Josh Lewis:
Environmental services providers have tried to skinny down their liability. There's all kinds of issues that you encounter, but ultimately you get through the third party reports. You get through the negotiation of the contract and lease, and address any titles survey type of issues, environmental stuff. Then you close. We can start a deal and be done in realistically 45 to 60 days. Have we moved faster than that if the stars are aligned? Sure. We're working on a deal today where the third parties were ordered and you close in 30 days.
Josh Lewis:
It also depends on if it's a repeat deal. We tend to do a lot of repeat transactions with folks. You don't spend a lot of time renegotiating the lease or the contract. That's how it works. As Chelsea said, some folks, some buyers have lenders that they've got to work with. That adds a layer of uncertainty to things, particularly in this world that we're, this macroeconomic environment, capital markets environment, et cetera.
Rick Ormsby:
One of the things I just would, again, highlight is these, these are good comments. Getting in front, whether you're selling someone's company or selling someone's real estate or both or whatever you're doing, getting in front of the key gating items early in the process is really a wise thing to do now. Sometimes, if we're selling a large company for somebody and we know that there's going to be quality of earnings that's going to be ordered by the family office or private equity group, in the past we haven't been so aggressive at trying to pull that forward and to do that quality of earnings before the business goes up for sale, because that cost then has to be born by the actual seller of the business. It can be 50, 100 thousand dollars. It's expensive on a larger transaction. Those are the types of things in our process that sometimes if you delay it towards during due diligence, it can stretch the deal out a bit more. Those are some of the things like ordering appraisals and things that you can get in front of.
Josh Lewis:
Well, yeah, and as Chelsea said, we're seeing more and more deals, particularly when a seller knows that the real estate component of the transaction is likely to be large. It's a large piece of the capital stack. There's going to be a sale-leaseback regardless of buyer. Now, not every buyer wants to monetize every asset. There could be elements of a real estate that doesn't get financed. If the seller is wise, they get those third parties ordered ahead of time. It expedites the transaction and it's all math. Some of those costs might be eaten by me, ultimately, if I end up buying the assets, but it's an upfront cost that may be worthwhile for a seller to expend up front to add certainty to the transaction.
Rick Ormsby:
Also, from an advisor standpoint, and Chelsea, you'd probably agree with this, if the seller agrees to spend the money to make the deal go faster, you probably feel better that you've got to a committed seller. We typically don't have that problem as much, but some people do. I know, so yeah-
Chelsea Mandel:
No, we would appreciate that. For us, it's typically our clients are bringing us in when they're bidding on a business or when they're looking at a deal with the banker. They're even spending money before they know that they're awarded the opportunity and we're advising them saying, hey, look, you're going to need phase one surveys, title work, property condition reports. We are trying to actually encourage them to order as much as they can, even before they're awarded the business. Some of them are just running full speed at trying to get it closed and whatever structured deal that is, but they're not actually like signing an APA and then getting their diligence process. They're just doing it all at the same time.
Chelsea Mandel:
In those situations, we're telling them what the sale-leaseback buyer is going to need. Like Josh said, especially if the real estate is a larger component of the deal, if there's environmental issues, we want to get in front of it. We don't want surprises when we have the sale-leaseback buyer already in the mix and then things could fall apart. We lose our leverage with the competitive process. We're now working with one buyer. We don't have our three backup buyers and so things can get challenging. To the extent that we know of any issues or to the extent that we can just convince our clients to really get a jumpstart on those reports, we definitely, we go that route.
Rick Ormsby:
Awesome. Let me say something here that I really think is a great question. I'm sorry to cut you off, Josh. I know you had something to say. There's a question that I think is a really good one, here. It's, how do you value the sub 2.0 rent coverage sites in a portfolio? How do you value many master leases and sub 1.0 sites and big franchisees? This is a very good question. Is this a-
Josh Lewis:
That's what I was pointing to. I saw Mike's question there. So-
Rick Ormsby:
Yeah, these are questions... I deal with this on every single deal, right?
Josh Lewis:
Maybe I'll tackle that one first. Some tenants slash sale-leaseback users won't do master leases. Perhaps the franchisor doesn't allow it, perhaps the lender to the tenant, say a leaseback partner of ours won't go for it. Master leases tend to be a credit enhancement tool, particularly in a scenario where you have some assets that aren't performing as well as others.
Josh Lewis:
I guess our thought around that is, you got to be really cautious about wanting to monetize those assets that have weak coverage. You shouldn't be entering into 15 or 20 year sale-leasebacks on assets that aren't covering or are barely covering. Usually those are low volume stores, so low volume, lower margin. Those may not be assets that the operator slash tenant is likely to operate for a long time. There could be plenty of reasons why a certain store, there was a road closure, there were some circumstances that are driving that coverage. I would certainly say if it's a lower volume store or it's always been a low margin store, or it's always been one of those, questionable is this a long term, has the market moved stores, those perhaps shouldn't be in the sale-leaseback to begin with.
Josh Lewis:
I think you can get away with some sub 2.0 Coverage stuff in a master lease context. If it's probably sub one and a half times, one and a quarter times, depending on the circumstances, there isn't an answer for every situation. Those are just assets that beg spending more time thinking about whether they should be part of the sale-leaseback to begin with.
Rick Ormsby:
... a political answer. Look at you giving a political answer, man.
Josh Lewis:
Well, I know-
Rick Ormsby:
How much does it affect cap rates? How much? You got a bunch of them that dropped the cap rate 50 basis points, or are you more likely to walk away from the deal if you see [crosstalk 00:52:26]
Josh Lewis:
I would say, yes. Cap rates are a reflection of risk to some extent, but we never really solve risk with materially higher cap rates. All you're doing is potentially making it the situation, perhaps, worse. Again, that's the thoughtful process, whether you're NNN as buyer, or whether Chelsea's your advisor, is figuring out which assets to include and where to set the rent. It's only a sub 2.0 coverage because that's the rent that you put on it. Maybe it warrants lower rents. Those are all things that we consider it's very important. At the margins, that tends to be something we spend a... We spend probably more time thinking about those kinds of things than the store that's four times covered. Certainly.
Chelsea Mandel:
Yeah.
Rick Ormsby:
One of the things that... Go ahead, Chelsea.
Chelsea Mandel:
I was just going to say, I have two points on that. For us, when we see that it's, either what you said, like the rents are just too high and there's something wrong, or it's like an operational issue. Something happened at the site, like you said, maybe it was a situational factor. When we see those situations, we're trying to understand, are you leaving money on the table by trying a size off of a rent that has been impacted for some reason, maybe it's a new location or, and whatnot. We always run the analysis of like, maybe it makes more sense to just hold off on that site. Exclude it from the deal. Wait until it can support a market rent and, therefore, a market valuation based on a regular, recurring, or fixed EBITDA the site, whatever it is that's causing that issue.
Chelsea Mandel:
The flip side is, we do a lot of deals, not in the QSR space, but with, like a C store operator in south Florida. Really great real estate. Coverage is, a lot of the time, limited operational. It's just a small business or they're trying to juice proceeds. You're not at two times coverage, you're something south of that, but it's like a covered land play. The residual value is so strong that you almost don't care, right? If the coverage isn't there, the investor has value in the dirt, so you're not as worried. Those are the situations that we see, but if it's just an operator wants reduced rents, I agree with Josh. I don't think there is a price. You can't solve that issue with just a higher cap rate, because a lot of the buyers will just say, no, we don't want that in the deal, regardless.
Josh Lewis:
We did a deal with, I would call a questionable credit several years ago, and we were hopeful that the business could get turned around. COVID interfered, but the whole much of the thesis around the deal was, it was very low rents and low price points. To Chelsea's point, we obviously wanted the business to perform. We wanted the tenant to pass rent for a long period of time. If the rents are set at a level that it's low enough, there's some level of confidence you can garner simply by, it being very replaceable rents and, or, highly alternative, we can knock the building down and ground lease it to somebody. There can be other angles, but so-
Rick Ormsby:
Well, let me say this from the M&A advisory standpoint. You talk about a master lease, which is basically, you have an overall lease over all the stores so that if any one store can't pay the total amount, right, then the other stores will kick in the extra rent to make the total. Josh called that a credit enhancement and you could see why the buyer of the real estate, if they had an overarching master lease over top of it, would either do one of two things, either make them more comfortable with the deal, presumably, or it would maybe improve their price in terms of how much they're willing to pay you for the restaurants, right, or the businesses. From an M&A advisory standpoint, I would just caution the people listening that master leases are very difficult to sell. If someone is an operator who has a master lease on a lot of restaurants and then he or she comes to us and says, we want to sell this business and it's got master leases on it. It probably drops the buyer pool, unfortunately.
Rick Ormsby:
Those are just things that I would caution people to consider. This is not a knock on either of you, but it is an advisor's comment to say that you need to talk with an advisor that sees both sides of the picture before chasing a slightly higher price on the real estate side at the benefit of a higher price, but hard to impossible to sell later when you want to leave.
Josh Lewis:
I would also say, Rick, there are certain franchisors in QSR land that, frankly, won't allow for master leases anymore. They've been burned. Chelsea was going the direction of there's some benefits in a bankruptcy situation to the landlord and the tenant would have to reject, basically, the one lead a lot of assets, so that it's unlikely that the tenants would walk away, but from the franchisor's perspective, they may have to step into the shoes on a large master lease involving a lot of properties to preserve their royalty. Master leases can play a role in certain transactions. They're by no means the norm.
Rick Ormsby:
Yeah, great deal.
Chelsea Mandel:
I side with that, yeah.
Rick Ormsby:
Yeah, well, you guys... We have like another list of four or five questions, but, we got to have a hard stop here in a minute. I want to thank you both for your time. I thought this was a really good discussion. A lot of depth around the real estate discussion. Thank you both. For those of you who have watched today or listened on podcasts, you've got Josh Lewis and you've got Chelsea Mandel. They're both on LinkedIn and you can find them on their company websites, Ascension for Chelsea National Retail Properties for Josh. I'm sure they'd be happy to answer questions for you related to real estate. You can call me or, I could get you in touch with them, too. Thank you all for your expertise and thank you to everyone who's been a part of this webinar. Really appreciate it. Go get them. It's going to get better. Come on. We got it.
Chelsea Mandel:
Thanks, Rick.
Josh Lewis:
Thanks, Rick. Thanks, Chelsea. Enjoyed it.
Rick Ormsby:
Good to see you guys.
Josh Lewis:
All right, take care. Thank you.
Rick Ormsby:
Ciao.
Rick Ormsby:
Thanks so much for entering the Boiler Room today. You can find our podcasts on iTunes, Google play, Stitch, or tune in on Spotify. If you like these podcasts, please listen, rate and review. I also encourage you to visit our website at www.unbridledcapital.com for the best franchise M&A and financial resources in the industry. Our website includes webinars, podcasts, videos, white papers, and a list of our past M&A transactions. Please note that neither Rick Ormsby, nor Unbridled Capital Advisors, LLC give legal, financial, or tax advice. These podcasts represent opinions that have been prepared for informational purposes only. We expressly disclaim any and all liabilities that may be based on such information, errors therein, or omissions therefrom.