The break-neck cycle of COVID-19 largely benefited quick service, especially from an innovation angle. Brands today are more intuitive, integrated, and aligned with omnichannel potential, whether it’s via mobile ordering, pickup lanes, lockers, curbside, kiosks, or some collection of all of the above. But pivots, although hasted through the pandemic window, came with a long-term view and, often, a hefty price tag. One side effect, says Andy Lapin, a real estate attorney with nearly four decades’ experience advising franchise owner/operators, investors and developers, being legacy owners are selling franchises to big operators—those who long ago purchased the real estate and are taking advantage of a red-hot 1031 exchange market.
They are essentially leaving the fast-food business for the real estate one, and growing their wealth, Lapin says.
“As franchisors have required major expenditures for upgrades in their agreements, and as the value of restaurants depreciates each year, many older legacy owners are getting out of the business,” he says. “But smart mom-and-pop owners who bought the real estate are not selling it to the large franchise buyers, instead they are parceling it out to 1031 exchange buyers, which allows them to avoid capital gains taxes on what is now very expensive real estate and reinvest in other real estate properties.”
Lapin sat down with QSR to discuss the dynamic—where the 1031 exchange buyers are and where they’re buying, as well as what 1031 sellers are investing in (it isn’t always more fast-food properties). Also, if rising interests 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 investing tool that is based upon Section 1031 of The Internal Revenue Code (“Code”). This Section of the Code allows swapping out (or exchanging) investment property for another like-kind property. Following the rules of the Code will allow the taxpayer to defer capital gains tax that otherwise would have to be paid as a result of the sale.
A like-kind exchange is a type of non-recognition provision. The code requires that all realized gains and losses must be recognized except as otherwise provided. Non-recognition status has been conferred to like-kind exchanges. The rational being that only the form of the investment has changed while the substance of the investment has not. At some point in the future, the realized gain or loss from the original transaction will be recognized. So the practical result is that recognition of the gain has been deferred thus saving the taxpayer 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 legacy 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, the stock market valuations fell rapidly. Many asset classes were losing value. The Federal Reserve forced interest rates down to historically low levels. At the same time, the government was pumping money into the hands of consumers, some of which they were spending. The velocity of money increased dramatically (how quickly money circulates throughout the economic system).Many businesses were weakened, particularly retail, travel, entertainment and restaurants. However, one particular restaurant class was posed to take advantage of the pandemic, quick-service restaurants. Many quick-serves went into the pandemic with an advantage. They already had both drive through lanes and online ordering. And, consumers had few viable choices to spend their new found money. Quick service as a class boomed as other restaurant options wilted and in many cases died.
In spite of all of the pain, investors were flush with cash from a strong pre-COVID economy. With interest rates low, the stock market down and many asset classes hurting, investors flush with cash needed a place to park their money. The race heated up to find prime located properties with strong tenants. And they discovered a booming business class, quick-service restaurant. With this investment class, investors could structure the transactions as NNN Leases that essentially, in principal, allowed them to purchase the property and collect a rent check without having to do much else. And, they could also structure these transactions as 1031 Exchanges so the investor could defer paying current tax should they have another “like-kind” property they could sell. As a result, the value of the underlying real property of quick service quickly accelerated.
How is it growing the wealth of legacy fast-food owners?
The growth of the 1031 Exchange market has accelerated both the value and sale of quick-service restaurant real estate. This acceleration of real property value increases the wealth of all owners of the real property upon which a quick-serve is located, whether they be legacy owners, new owners or non-operator owners of real property. However, the value of the real property is primarily driven by the sales generated at a specific quick-service restaurant location and indirectly by the strength of the operator/tenant. Why, because the rental paid is a derivative of sales volume. The stronger the sales volume the higher the rent that can be generated since rent is typically based up a percentage of sales. The better the operator the better the sales thus higher rents resulting in a higher valuation of the real property.
What’s driving this? Is it a byproduct of all the innovation being asked of the operator (and the price tags that are following)?
Certainly that is one factor. The legacy owner/operators are getting older and not necessarily interested in renovations and innovations that cost significant amounts of money that they may never recover. If other family members are not interested in continuing the business, the increased valuation of the business and the real property provides an exit opportunity.
Where are the 1031 exchange buyers and where are they buying?
Many are west coast buyers buying in the Midwest and other more favorably valued real property areas. Real property located on the west coast is trading at very strong cap rates (capitalization rate: dividing a property’s net operating income by the current market value). Real property in the Midwest and other areas of the country are trading at, what appear to west coast buyers to be, more attractive cap rates (less cost).
What are 1031 sellers investing in?
Utilizing 1031 Exchange techniques typically allows the taxpayer to upgrade the type of real property they are purchasing. They may purchase quick-service properties from strong operators. However, quick-service restaurant owner/operators that own their real estate may be trading for upgraded properties. Typically these properties will also be net lease (NNN) properties. They look at C-stores, car washes, industrial spaces such as Amazon fulfillment centers, FedEX distribution centers, etc. The hope is to find real property with strong tenants in good locations that require no or very little management from the exchange buyer.
Are rising interest rates a potential downer?
So far, there has not been much effect from rising interest rates. I believe there will be a dampening 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 trade and have to find a replacement property. Should interest rates continue to rise resulting in softer sales (pricing power drops) the need for replacement properties may drop.
More broadly, how could all of this reshape the franchise market in quick service?
As more legacy owners sell out of quick service, this will further accelerate the consolidation of the sector into the hands of larger, well-capitalized operators. In many cases, these operators have the resources both to expand the brand’s footprint by developing more stores and to invest in the renovation and innovation that the brands are requiring.
Who stands, potentially, to gain the most from the movement?
While all of the parties win, the legacy owners have a way to cash out, the new buyers expand their holdings and the franchisors get further store development and innovation. But the real winner ultimately, is the consumer. They get new and newly renovated stores that promote the latest brand innovations.
Andrew W. Lapin is a Shareholder with Robbins DiMonte and has over 35 years of experience practicing in the areas of real estate, business franchise, business transactions, banking & finance, and labor & employment. His clients include entrepreneurial business owners, franchise owner/operators, real estate investors, developers and syndicators. He can be reached at 312-456-0372 or firstname.lastname@example.org.