The Question of Rent, Part 2
In my previous column, I introduced a concept that is often neglected in any discussion of sale-leaseback (SLB) transactions. That is, what can the store afford to pay in rent?
A convenience store must pay all expenses, including rent, out of its earnings. Our research shows the average convenience store can pay about 22 percent of its gross profit (gross sales minus the cost of goods sold) in net rent.
In this column, I contend that SLB transactions are not market value sales and show that SLB transactions result in reduced store-level profitability.
Sale-Leasebacks Are Not Market Value
Nearly all circulars and promotional literature on SLB transactions describe the sale and subsequent rent as fair market value and fair market rent. Experts in the valuation profession disagree. Court decisions, regulatory opinions and numerous peer-reviewed articles all concur that SLB transactions are not market value.
For example, in an article on big-box retail SLB transactions, David Lennhoff writes: “The lease does not represent market rent; in fact, it is usually simply amortized construction cost, often to include interior leasehold improvements.”
The Appraisal Practices Board of the Appraisal Foundation, the leading authority on real estate appraisal standards in the United States, discusses SLBs and describes them as financing arrangements. In speaking to the problem they present as evidence of market value, the board states that SLBs “may not provide a reliable indication of value.”
Sale-leasebacks are a form of off-balance sheet financing. SLB transactions often overstate the value of the real estate. When this happens, the rent for the store is also overstated.
C.F. Sirmans, a professor at Florida State University, published a study in 2010 of nearly 4,000 commercial real estate sales showing that, on average, SLB transactions overstate the price of the property by 13 percent when compared to non-SLB sales.
Reduced Store-Level Profitability
SLBs are in effect a purchase of a capitalization rate, or rate of return. The net-lease buyer looks at the offered capitalization rate, say 6.5 percent to 7.5 percent, as the primary investment criteria. Because the capitalization rate remains fixed, any increase in the price translates into increased rent for the seller, or operator of the store.
One question no one is talking about is: How does all of this affect store profitability?
Often, some vague evidence of earnings strength, such as nearby population levels and a map of neighboring properties, is presented in the “for sale” listing. However, the critical information is neglected – how much does the store earn and what can the store afford to pay in rent?
Using the Florida State University study as an average, how do SLB transactions affect store profitability? Let’s use an example of a store with a nominal real estate (site, store building, fuel service) market value of $2.5 million. With a 7 percent cap rate, this store would have a nominal net market rent of $175,000 per year. A 13-percent overstatement of value in the SLB transaction increases the price to $2,825,000. Using the same cap rate, the SLB annual net rent to be paid by the store is now 13 percent higher, or $197,000.
This is an increase in the rent obligation of $22,700 per year, which now must be absorbed or offset by the profits of the store. As measured against today’s industry-average annual pretax profit, the increased rent results in a 33-percent decline in store-level profitability.
When Krispy Kreme nearly unraveled in the mid-2000s, a spokesman acknowledged that their business model had been wrong by reflecting that “the economics of the business must make sense at the store-level.”
It is important for buyers and sellers of convenience stores to recognize that SLB transactions do not represent market value. Misinformation leads to wrong decision-making. Ultimately, the long-term health of any convenience store chain depends on the profitability of its stores.
Editor’s note: The opinions expressed in this column are the author’s and do not necessarily reflect the views of Convenience Store News.