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Assessment Evaluation of Restaurants

March 21, 2006

Assessment Evaluation of Restaurants

By Patrick O'Connor, MAI
Many restaurant owners have been shocked to learn that they are unable to sell or lease their restaurant property for an amount equal to its tax assessment value. The market value of a recently built restaurant is usually less than its construction cost. When an owner attempts to set a sales price or lease rate, he is unable to recoup his costs. Excess property taxes result from improper use of the cost approach to market value.

The cost approach is an excellent valuation methodology for some types of new properties. It works better for properties that can be utilized by a large number of users without alteration as opposed to special-use properties. Apartment complexes are an example of properties where multiple users can use the same property with few, if any, alterations. Restaurants are a category where extensive renovations are typically required to convert a restaurant from use by one operator to use by another operator. This is particularly true where chain restaurants are involved. For example, how much would it cost to convert a restaurant built for McDonald's to be used by Pizza Hut?

Randy Dishongh, of the Mason Jar Restaurant Group, recently purchased a 8,250 square foot restaurant that has been used by another operator and altered for use by his firm. It cost $400,000 ($48.48 per square foot0 to convert the restaurant. Phil Kensinger, of Kensinger & Company, recently purchased an 8,000 square foot restaurant that cost $300,000 ($37.50 per square foot) to convert his tenant's requirements. Kensinger reports, "improvement in a restaurant built-to-suit often has little or no value to a successor tenant."

Part of the business value developed by restaurants is dependent upon a distinctive architecture that is recognizable to restaurant patrons, who believe they can expect a reliable quality of food and service for a set price at this establishment. It is important to restaurant operators that all operating units have this recognizable architecture. It is the primary reason large restaurant operators such as McDonald's, Pizza Hut, and Whataburger have distinctive restaurant design with distinctive signage.

Signage is a good example of one of the high-cost conversion items. McDonald's golden arches are distinctive and well serve the purpose of announcing to its patrons the presence of the McDonald's restaurant. However, they are not easily converted for use by another restaurant, perhaps not even with extensive conversion costs. The same is true for changing the elevation (exterior appearance), interior layouts and redoing the interior finish.

The unique architecture of chain restaurant facilities makes it difficult to convert a facility built for one chain to use by another chain. It costs less to convert them from use by a major chain to a local nonchain operator. Examples of national chains with distinctive architecture include: McDonald's, Pizza Hut, Burger King, Taco Bell, Long John Silvers, Pizza Inn, Jack in the Box and Whataburger.

Definitions Determine Methodology
The first steps in determining the proper valuation methodology includes, reviewing a series of definitions, determining how they apply to restaurants, and reviewing the laws that apply in your jurisdiction. However, continual refinement is essential to the growth of the appraisal profession. A current economic definition of market value is stated as follows:

The most probable price, as of a specified date, in cash, or in terms equivalent to cash, or in other precisely revealed terms for which the specified property rights should sell after reasonable exposure in a competitive market under all conditions requisite to a fair sale, with the buyer and seller each acting prudently, knowledgeably, and for self-interest, and assuming that neither is under undue duress. (The Appraisal of Real Estate, 20th ed., published in 1992 by The Appraisal Institute)

The following definition has been agreed upon by agencies that regulate federal financial institutions in the United States, including the Resolution Trust Corporation (RTC):

The most probable price which a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price in not affected by undue stimulus. Implicit in this definition is the consummation of a sale of a specified date and the passing of title from seller to buyer under conditions whereby:

  1. buyer and seller are typically motivated
  2. both parties are well informed or well advised, and acting in what they consider their best interests
  3. a reasonable time is allowed for exposure in the open market
  4. payment is made in terms of cash in the United States or in terms of financial arrangements comparable thereto
  5. the price represents the normal consideration for the property sold unaffected by special or creative financing or sales concessions granted by anyone associated with the sale. (USPAP, 1992 edition)1
Use Value. The value a specific property has for a specific use.2

Investment Value. The specific value of an investment to a particular investor or class of investors based on individual investment requirements; distinguished from market value, which is impersonal and detached. See also market value.3

Liquidation Value. The most probable price which a specified interest in real property is likely to bring under all of the following conditions:

  1. Consummation of a sale will occur within a severely limited future marketing period specified by the client.
  2. Actual market conditions are those obtained currently for the property interest appraised.
  3. The buyer is acting prudently and knowledgeably.
  4. The seller is under extreme compulsion to sell.
  5. The buyer is typically motivated.
  6. The buyer is acting in what he or she considers his or her best interests.
  7. A limited marketing effort and time will be allowed for the completion of a sale.
  8. Payment will be made in cash in U.S. dollars or in terms of financial arrangements comparable thereto.
  9. The price represents the normal consideration for the property sold, unaffected by special or creative financing or sales concessions granted by anyone associated with the sale.
This definition can be modified to provide for valuation with specified financing terms. (The above definition, proposed by The Appraisal Institute Special Task Force on Value Definitions, was adopted by The Appraisal Institute Board of Directors, July 1993.) See also disposition value; distress sale; forced price; and market value.4

How to Apply Market Value to Restaurants
The balance of this article is focused on determining and evaluating market value for a restaurant. Market value is the type of valuation performed in Texas. Value in use, or use in value, is the value a property has to a specific user as opposed to the value in the open market. Investment value is the value an investment has for a specific class of investors. In restaurant valuations, the investment value of a restaurant with a long-term guaranteed by a high credit tenant may be dramatically different from market value of the property without the long-term lease and guarantee. Liquidation value is distinguished from market value primarily by a brief marketing period. The valuation methodology discussed herein pertains to market value instead of value in use, investment value or liquidation value. The market value of the restaurant real estate should be distinguished from the sale of a going-concern. When an operating restaurant is sold it may involve the sale of real estate, FF&E (furniture, fixture, and equipment), business value, and inventory. The following are definitions for real estate, business value and going-concern value.

Real Estate. Physical land and appurtenances attached to the land, e.g., structures. An identified parcel of tract of land, including improvements, if any. See also real property.5

Business Value. A value enhancement that results from items of intangible personal property such as marketing and management skills, an assembled work force, working capital, trade names, franchises, patents, trademarks, contracts, leases, and operating agreements. See also going concern value.6

Going-concern Value. The value created by a proven property operation; considered as a separate entity to be valued with a specific business establishment; also called going value. See also business value.7

When a restaurant is sold, a bulk price for these four classes of assets (real estate, FF&E, business value and inventory) will typically be negotiated. During the business negotiation, each party may give some thought to the different items but is typically focusing more on the net cash flow generated by the restaurant and the market value of that income stream. When the attorneys and accountants become involved, it will be necessary to allocate the purchase price to real estate, FF&E, business value and inventory. Federal income tax ramifications may affect the allocation between these items. Many investors will attempt to maximize depreciation for federal tax purposes. This will involve maximizing the allocation to building values, FF&E, and inventory. Investors typically attempt to minimize the value allocated to land and business value.

When confirming comparable sales, it is essential to determine which of these elements are involved. The final set of definitions to be reviewed is fee simple estate and leased fee estate:

Fee simple estate. Absolute ownership unencumbered by any other interest or estate, subject only to the limitations imposed by the governmental powers of taxation, eminent domain, police power, and escheat.8

Leased fee estate. An ownership interest held by a landlord with the rights of use and occupancy conveyed by lease to others. The rights of the lessor (the leased fee owner) and the leased fee are specified by contract terms contained within the lease.9

There are three primary distinctions between fee simple estate and leased fee estate for the purposes of our analysis: 1) contract rent paid versus market rent which could be achieved, 2) the term of the lease, and 3) the strength of the lease guarantor. A tenant may agree to pay an above market rental rate to induce a landlord to invest capital to build a restaurant that has a distinctive architecture necessary to operate his business and maintain a brand image. McDonald's could not maintain their brand image if they simply leased restaurants built by others, which were not successful locations for the first operator. A diverse set of restaurant elevations would diffuse the brand image developed by their advertising.

The primary reason that some of the restaurant rental rates are at an above market level is the cost of converting a restaurant from use by one operator to use by another restaurant operator. Many restaurant operators view the landlord's capital expenditure of tenant improvements as a loan being repaid over the life of a lease. According to Randy Dishongh, of the Mason Jar Restaurant Group, "landlords expect to receive tenant improvement costs returned over the leased term along with a 10% to 12% return on funds advanced." Discussions with other restaurants, investors and operators indicate that the yield on tenant improvements may range from 10% to 20%, depending on the level of expenditures, their uniqueness and the financial strength of the lessee.

Although 10% to 20% may seem like a high rate of return for a real estate investor, an equity investor in a restaurant business would expect a higher level of return for this capital. Therefore, it is prudent for the real estate operator to in effect borrow the tenant improvement costs from the landlord and repay them with an above market rent as compared to raising additional equity.

Choosing the Correct Approach to Valuation
The final step in our analysis is to review the three traditional approaches to valuation: cost, sales comparison and income. The cost approach involves adding the market value of the land to depreciated value of the improvements. The subjective portion is determining depreciation of the improvements in a market value appraisal. Deducting the cost to change the exterior elevation, interior layout, interior finish and signage is one approach to determining depreciation resulting from the unique requirements of each restaurant operator. Other items, which might be considered, are the leasing commission paid to a third-party leasing agent and rent loss until the property is leased.

These costs can be considerable. Another approach to determining total depreciation in a restaurant is to analyze recent sales and allocate the sale price between land and improvements. If the replacement cost of the improvements is estimated and physical depreciation is deducted, the balance of the depreciation may be a good indicator of the depreciation due to the cost of conversion.

None of the traditional forms of depreciation describe precisely depreciation due to conversion of a restaurant. According to the Appraisal Real Estate, 11th ed., published by The Appraisal Institute, "Functional obsolescence is caused by a flaw in the structure, materials, or design that diminishes the function, utilities and value of the improvement." Curable functional obsolescence is defined as follows: "An element of accrued depreciation; a curable defect caused by a flaw in the structure, materials or design." A second approach would be to treat the costs of conversion leasing and rent loss in the same manner as deferred maintenance since it is a necessary expense to prepare the restaurant for a new restaurant operator.

The sales comparison approach is a direct and easily understood valuation tool. With restaurants, due to the number of elements of value (real estate, business value, FF&E and inventory) involved in a sale, the sales comparison approach requires more detailed research to prepare an accurate valuation. It is critical to perform detailed research to separate the value of the real estate, business value, FF&E, and inventory when reviewing comparable sales. Since the allocation of these items is often made by lawyers and accountants to maximize federal income tax depreciation, it may not be reasonable to use the allocation established by the buyer and seller in preparing a real estate appraisal. Since adequate information may not be available to properly allocate value for the real estate when a going-concern restaurant is sold, it may be appropriate to use this information as a comparable sale. Further, the time involved to estimate the business value, inventory, real estate and furniture, fixture and equipment values may be a more detailed and complex analysis than the appraisal of the subject restaurant.

Selecting appropriate sales, which involve only real estate, is the most important step in preparing the sales comparison approach. It is often practical to separate the other elements of a going-concern restaurant sale from the real estate value. Sale of a restaurant building where a restaurant is no longer being operated reflects the true value of the real estate provided adequate time to market the property is available.

Improper application of the income approach can result in an unreasonable value. The most common pitfall when valuing a restaurant for tax purposes in Texas is to consider the contract rent being paid as market rent. This contract rent in most cases involves compensation for tenant improvements. This repayment of the cost of tenant improvements is often a significant portion of the contract rent.

The second major item, which sometimes distorts the valuation of the fee simple estate when a restaurant is leased, is the effect of the long-term lease to a creditworthy tenant. When valuing the fee simple estate when a restaurant is leased is the effect of the long-term lease to a creditworthy tenant. When valuing the fee simple estate, the appraiser should use market rent, market vacancy, market expenses and a market capitalization rate. If local practice involves valuing the fee simple estate, the income using capitalization rate for a creditworthy tenant.

Conclusion
The most important step in correctly valuing restaurants for tax purposes is determining which type of value should be utilized. There are significant differences between the market value, value in use and investment value for the same property. There are often significant differences between the market value of the leased fee estate and the fee simple estate. Calculations of the appropriate value can then be performed using relevant data. However, controversy over proper valuation of restaurants will likely be an active topic of discussion well into the future.



1 The Appraisal Institute, The Dictionary of Real Estate Appraisal, 3d ed., (The Appraisal Institute, 1993, pp. 222-223).
2 The Appraisal Institute, The Dictionary of Real Estate Appraisal, 3d ed., (The Appraisal Institute, 1993, p. 383).
3 The Appraisal Institute, The Dictionary of Real Estate Appraisal, 3d ed., (The Appraisal Institute, 1993, p. 190).
4 The Appraisal Institute, The Dictionary of Real Estate Appraisal, 3d ed., (The Appraisal Institute, 1993, pp. 210-211).
5 The Appraisal Institute, The Dictionary of Real Estate Appraisal, 3d ed., (The Appraisal Institute, 1993, p. 292).
6 The Appraisal Institute, The Dictionary of Real Estate Appraisal, 3d ed., (The Appraisal Institute, 1993, p. 44).
7 The Appraisal Institute, The Dictionary of Real Estate Appraisal, 3d ed., (The Appraisal Institute, 1993, p. 160).
8 The Appraisal Institute, The Dictionary of Real Estate Appraisal, 3d ed., (The Appraisal Institute, 1993, p. 140).
9 The Appraisal Institute, The Dictionary of Real Estate Appraisal, 3d ed., (The Appraisal Institute, 1993, p. 204).


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