MATTHEWSA COMMERCIAL REAL ESTATE PUBLICATION AT THE INTERSECTION OF INNOVATION AND INFORMATION

With Fast Casual concepts biting at the opportunity to take down their competitors in both the QSR and Casual Dining space, it is clear that the top brands in the QSR space have continued to find ways to innovate while mid-range concepts are struggling to keep pace with trends such as healthy and organically sourced foods.

McDonald’s two prong attack to bounce back from recent decline has been easy customization and all-day breakfast. They rolled out a day-long morning menu while also implementing the “Create Your Taste” kiosk program. Burger King has continued to improve system-wide sales numbers and AUVs have had a boost with the company putting in place cost-cutting measures and shutting down under-performing stores. Regarding their food offerings, Burger King has pushed to emphasize the cleanliness and freshness of their top items and has thus far stayed away from full menu overhauls. Taco Bell’s recent introduction of a breakfast menu and collaboration with Doritos to create unique offerings has allowed the company to continue years

of success. KFC has seen continued system-wide sales drop despite renovation initiatives and strong marketing. Dunkin’ Donuts has had steady growth with a strong push to expand by 1000+ stores in three years. The company has pushed West and recently re-entered the California market. Starbucks is arguably the most innovative of the group as they continue to push on new products, new store design, and layouts, as well as expanding their scope of business.

We have seen a consistent trend of cap rates stabilizing across the board for the tenants of all three categories. The QSR segment specifically has historically had more aggressive cap rates across the board relative to credit exposure. In the past 12-18 months, we have not seen significant cap rate drops which may indicate a maturing real estate cycle. Grade A tenants with top real estate locations continue to trade new record cap rates, where stabilized product in tertiary markets have seen slight increases in cap rates due to increased supply.

CREDIT RATINGS:MCDONALDS - BBB+BURGER KING - B+ JACK IN THE BOX - N/A

YUM! BRANDS (TACO BELL & KFC) - BBSTARBUCKS - A-DUNKIN DONUTS - N/AQSR

MCDONALDSBURGER KING

TACO BELLKFC

STARBUCKS

DUNKIN DONUTS

JACK IN THE BOX

McDonald’s continues to be the darling from an investment standpoint even with its recent struggles financially. Coming in a close second, Starbucks has recently aggressively pursued multiple store designs with an STNL build. Even with sometimes difficult lease language, Starbucks’ momentum and positive perception have clearly resonated with NNN investors. Taco Bell and Dunkin’ Donuts come in next with strong national perception and a solid model driving investor interest. The primary reason why Taco Bell and Dunkin’ Donuts see slightly higher cap rates is leases have a much higher franchisee credit to corporate credit ratio. Burger King and KFC round out the group with a high number of franchisee leases and some growth concerns.

In the grand scheme of the retail NNN market, all six tenants have remarkably strong cap rates – especially considering franchisee QSR deals trading similarly to other product types with corporate backing and investment grade credit.

0 100 200 300 400 500 600 700

2012

2013

2014

2015

2016

$70K $80K $90K $100K $110K $120K $130K $140K

4%

5%

3%

6%

7%

2012 2013 2014 2015 2016

McDonald’s, Taco Bell, Dunkin’ Donuts, and Starbucks have had strong domestic store growth as shown in the adjacent charts. The majority of Taco Bell and Dunkin’ Donuts’ growth has been focused domestically, whereas McDonalds and Starbucks have also had continued expansion in international markets (international figures not shown).

Burger King and KFC have seen net neutral to net negative growth as the brands have focused on improving existing stores and AUVs. Both Burger King and KFC introduced aggressive brand goals to bump store presentation and sales. Burger King has seen a significant jump in AUVs with strategic closures of under-performing locations as well as effective cost cutting measures.

Average rents for QSRs are going to be most strongly correlated to potential and actual store performance. Brands with lower AUVs will naturally be able to afford less rent. Tenants in this space focus less on rent or square feet and more on rent to sales ratios. One major outlier to the trends mentioned is McDonald’s. Although McDonald’s has one of the highest AUVs in the industry, they tend to also have rents either inline or lower than their competitors. One of the major reasons they can sustain this trend is the cap rate spread between McDonalds and their competitors.

NEW STORE OPENINGS

AVERAGE RENT

AVERAGE CAP RATES AVERAGE CAP RATES

AVERAGE RENT

NEW STORE OPENINGS

* BARS REPRESENT AVG CAP RATES* LINES REPRESENTS AVG CAP RATES FOR NEW CONSTRUCTION

# O F T R A N S A C T I O N SI N T H E L A S T 3 Y R S

Unsurprisingly, the data shows that as lease term burns off, cap rates tend to rise. Cap rates from 20 to 15 years do not change significantly. Cap rates begin a larger increase once you break the 10-year mark and begin to be much less predictable and are generally much higher once term drops below 5 years. Exit caps for these sites as term runs low will depend heavily on a specific property’s rent levels as compared to market rent, store performance levels, property condition, and real estate fundamentals. Luckily for the majority of QSR investors, rent over a 15 to 20-year lease term nearly all have set increases, which help offset inflation. This is contrary to product types such as Drug Stores and select types of Auto Stores and Dollar Stores which traditionally have not had rental increases.

CAP RATE CORRELATION

The traditional fast foods: McDonalds, Burger King, Taco Bell, and KFC have similar transaction numbers trends across the board. Although Burger King, Taco Bell, and KFC have similar turnover ratios given their total US domestic unit count, McDonalds has double the transactions than its closest competitor, Burger King, and shows the lowest turnover rate.

This lack of supply certainly could have a downward pressure on McDonald’s cap rates. The breakfast duo as seen on the chart have significantly less transaction volume and can possibly be attributed to a few factors. Starbucks first and foremost has only recently begun expanding aggressively into the STNL space and has still yet to build up its inventory in this product space. Dunkin’ Donuts is also often in inline locations, but two additional factors: a high degree of franchisee ownership and low broker penetration may explain the lower rates of turnover in the tenant product type.

TOTAL TRANSACTIONS

521

578

181539

454

169148

MCDONALDSBURGER KING

TACO BELLJACK IN THE BOX

KFC

STARBUCKS

DUNKIN DONUTS

3% 6% 9% 12% 15%0

5

10

15

20

25

30

LE

AS

E T

ER

MS

(Y

RS

)

CAP RATE

Data source: Costar & Real Capi ta l Analyt ics*Al l 2016 data is year to date

The future of the Quick Service Restaurant Industry is undoubtedly strong. Even with Federal and State governments passing legislation to increase minimum wage, commodity prices increasing, and a healthy food trend that is clearly here to stay, the QSR industry specifically has shown the innovation and adaptability required to survive. There will certainly be some concept casualties along the way, but the QSR industry has sustained considerably well as compared to its Casual Dining cousins.

As a product type, QSR restaurants tend to have some of the strongest real estate fundamentals in the retail industry. With concepts generally

requiring solid demographics, strong traffic counts, and often times hard corner locations – owners of QSR properties have solid fundamentals even when properties require re-tenanting or redevelopment.

Risks that investors should keep in mind are unsustainable rent loads, tenant remodeling and renovation. With the majority of strong brands heavily incorporating comprehensive remodeling strategies into their overarching goals, landlords will often find tenants with expiring franchise agreements that will require significant levels of investment to keep locations open. This will require landlords to either put up large upfront TI costs, agree

to temporary rent abatements, or rent reductions.

With the overall real estate cycle coming to maturity, any institutional investors, franchisees, or developers looking to capitalize on their properties after maximizing value in the next 3-5 years should strong consider selling their properties sooner rather than later. Financial markets across the board have been propped up with historically low interest rates for a sustained period of time. As those rates begin to rise, the record-breaking low cap rates will begin to rise with them.

FUTURE OUTLOOK

FOR MORE INFORMATION REGARDING QSR PLEASE CONTACT:

GARY CHOUgary.chou@matthews.com310.919.5827

KEVIN CHANGkevin.chang@matthews.com310.919.5828

WESLEY CONNOLLYwesley.connol ly@matthews.com949.432.4512

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Matthews REIS Disclaimer 2016

This publication has been produced by Matthews Retail Group, Inc. solely for information purposes and the information contained has been obtained from public sources believed to be reliable. While we do not doubt their accuracy, we have not verified such information. No guarantee, warranty or representation, expressed or implied, is made as to the accuracy or completeness of any of the information contained and Matthews REISTM shall not be liable to any reader or third party in any way. This publication is not intended to be a complete description of the markets or developments to which it refers. All rights to the material are reserved and cannot be reproduced without prior written consent of Matthews REISTM.