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INVESTORS BEWARE OF A DEVELOPER SHELL GAME

Sep 23, 2012
Article #154
Author: Mel Jones

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SellingRestaurants has sold nearly 500 restaurants since 2004. In this time I’ve seen a lot of shady transactions and unethical business deals. One of the classic ones I’ve seen is where a developer builds retail space and then goes out an purchases a second rate franchise to place in the retail center. The developer does this for two reasons. First it gets the blood flowing in the center.  Second, it creates a baseline rent.

The rent though is often at the top of the market if not higher.  So you may say so what!

Unless one understands the math behind valuing a commercial piece of real estate, the innocent investor would be blind to what just happened.

Here is the math:

Assume the real market rent for this type of center is $24/year.  Just down the street there is another center getting $40, but of course it is a much stronger center.  To a out-of-town investor they likely wouldn’t know this.

The developer builds a center with 30,000 rentable retail Sq. Ft. He puts a franchise in the center that takes 5,000 Sq. Ft. and charges $40/Sq. Ft+NNN.  Everyone else follows suit and pays $40/Sq. Ft.  The landlord gets all this on long-terms leases.

So this center now has NNN rents of $1.2 million.  The capitalization rates today are in the 7.5% range, placing the value of this center at $16,000,000.

Now, let’s put the normal rents into the equation of $24/Sq. Ft. making the NNN rent $720,000 and placing the value at $9.6 million. Now some could argue the capitalization rate should be higher since the center isn’t the most desirable, but I’ll ignore that for purposes of illustrating how the developer cheats innocent and often new commercial real estate investors – particularly out-of-state investors.

So in this illustration the developer by playing the old buy a franchise and place it in their own center as the anchor has increased the value of the property by more than $6 million. Of course this is not sustainable. It may have cost the developer $1 million to put the restaurant in the spot and perhaps a bit more to make it look like the rent is being paid for an innocent investor, but what the heck, he/she is up $5 million+ on the deal.

The developer then sells the property to out-of-state investor groups who don’t know better and with the premise that the leases are good, the tenants are paying and all is happy in wonderland.

The deal is closed.  A few months later the defaults start. And suddenly the investors get killed. But hey, the developer walked away smelling like a rose!

So the moral of the story is be very careful for this trick that is often played by developers. The best way to avoid it is to demand revenue/sales numbers from each of the retail operators. Take them to a knowledgeable CPA – KNOWLEDGEABLE IS THE KEY WORD DON’T THINK ALL CPA’S ARE THE SAME, THEY AREN’T! – to make sure the sales support the rents.

In one deal I recently completed for an investor who got taken like by this trick, there was a local franchise – 26 stores in Arizona – that filled the space and the franchisor had purchased the land and built the building and rented it to themselves for $25,000 a month.  The investor was from Oregon. He thought he was buying an income stream of $25,000 a month. Not too long after he closed escrow the tenant defaulted and walked from the property. The new landlord took a year to lease it out at $10,000 a month, OUCH!

I’ve seen a lot of these, so don’t think this is an exception to the rule.  It isn’t. There are dishonest people out there looking to steal your money. Be careful.  Call me. You’ve worked hard for your money.  So be smart!

                                                                                                                                                                                                                                                      

Mel Jones is one of the premier restaurant brokers in the nation having published hundreds of articles on buying and selling a restaurant and bar business, selling thousands of restaurants in CA., WA and AZ and building one of the most copied business models in the brokerage industry.  Mel started SellingRestaurants in 2004 with the one simple concept, give the buyers the information they need to make intelligent buying decisions without being pestered by a broker or hiding information, prepare the business for market by researching key details that make or break deals and educate the buyer on the buying process to create an intelligent buyer.  Prior to SellingRestaurants, Mel was a Chief Financial Officer for Universal Music Group, the largest music company in the world.  There he participated in more than $11.5 billion of merger and acquisition transactions.  He also work for top companies such as Nestle Foods, USA. He hold a Bachelors in Business Administration Finance as well as attened Law School at Gonzaga University.  Give Mel a call at 480.274.7000 or e-mail him at [email protected] if you have any questions. 

 

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