March 21, 2006

Assessment Evaluation of Restaurants

By Patrick O'Connor, MAI

Abstract
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.