Restaurant operators often need to know the approximate value of their restaurant business and/or real estate and personal property, even if they are not currently contemplating a sale of the business. Knowledge of value becomes important for a variety of reasons. Some of the reasons include refinancing of the real estate; dissolution of a partnership or sale of stock representing a majority or minority interest in the business; a divorce settlement; property tax protest; insurance settlement after a fire or natural disaster; and settlement of an estate upon the death of an owner.

Restaurant value can be separated into at least three components, which include the value of the business (business enterprise value), the value of the personal property (furniture, fixtures, and equipment), and the value of the real estate. Real estate value can be broken down further to leased fee value (value to the landlord of the lease encumbering the property), leasehold value (the value of the tenant’s interest in the lease), and the value of the fee simple ownership interest in the real estate. In the United States, approximately one-half of the restaurants occupy a leased building and land, and slightly less than one-half own the building and land.

Business Value Of A Restaurant

The above table shows a statement of income and expense for a hypothetical restaurant.

In this example, the value of the leasehold interest in the real estate has been removed by subtracting rent paid to the landlord from income. The remaining earnings before income taxes, depreciation, and amortization (EBITDA) equal $290,500. This is the cash flow available to cover a return of and on the investment in personal property, and a return to the business component of the going concern value of the restaurant. The return requirements for the non-real property components are typically significantly higher than the return to the land and building. As the net income allocated to the personal property and business is received by the business owner after all occupancy costs have been paid, including rental income attributable to the land and improvements, the risk of the operator is significantly higher than that of the landlord.

Capitalization rates for a restaurant operator’s invested capital typically fall into one of three ranges: for an efficient, profitable operation with new equipment, good location, and expectations of strong annual growth in revenue, a capitalization rate of 13% to 19% is appropriate. Stable, mature restaurants with a track record of steady cash flows, but annual growth in sales attributable to inflationary menu price increases, may use cap rates ranging from 15% to 25%. Capitalization rates for restaurant businesses with declining revenue may range from 20% to 30%. The following table indicates the value range for the hypothetical restaurant business based on the three scenarios listed above. The values shown include the depreciated value of personal property, which must be subtracted from the total capitalized value to isolate the business value.

The personal property within a restaurant consists of its furniture, fixtures, and equipment. On average, restaurant equipment has a useful life of ten years. In the example above, we will assume that the original value of the furniture, fixtures, and equipment was $800,000 and it is now seven years old, or 70% depreciated. On a straight-line basis, the value in use of this personal property would be:

If the personal property were to be sold at auction or in a liquidation of the business, it might sell for $0.05 to $0.10 on the dollar of original cost.

Subtracting the depreciated value in use of the furniture, fixtures, and equipment from the three values indicated in the table above, the value of the business ranges from $836,000 to $1,576,000.

There are other variables to consider in the valuation of the restaurant business, such as the immediate need for capital improvements, which may also need to be deducted from the capitalized value of the business and personal property. This approach uses only one year of cash flow, which does not account for future variation in cash flow. However, the above method of valuing your restaurant business will give you a “ball park” indication of value.

Estimating the Value Of Land And Improvements

It also can be important to value a restaurant's real estate and improvements, i.e., the building, landscaping, and parking lot. Restaurant improvements are typically designed to accommodate a specific concept or type of restaurant, and may require extensive remodeling to suit the needs of a different owner or tenant if the original restaurant operator vacates the property, even if the improvements continue to be used as a restaurant. The value of the improved site and restaurant building components may be higher or lower than the original cost to purchase and prepare the site and build a restaurant building, depending on the age of the improvements and whether the building is occupied by an operating restaurant business.

Appraisers of restaurant real estate normally consider three approaches to value: the cost approach, the sales comparison approach, and the income approach. Each approach has strengths and weaknesses depending on the age and condition of the improvements and whether the building is occupied by an operating restaurant or is vacant. The cost approach is used to estimate the cost of purchasing a site suitable for restaurant development and building a restaurant on the site, including the cost of landscaping the site and paving the parking lot. The sales comparison approach considers recent sales of restaurant properties that are comparable to the subject restaurant property in location, size, and brand affiliation (if the restaurant was in operation at the time of sale). Adjustments are made to the sales prices of the comparables to account for differences between the comparables and the subject property. The income approach considers the actual or projected rental income that could be generated by a restaurant business occupying the building.

Cost Approach

The first method of valuing restaurant real estate presented is the cost approach. New restaurant buildings and the underlying land are often purchased by individual investors or REITs (Real Estate Investment Trusts) at a price that reflects the cost of purchasing a vacant parcel of land and constructing, and equipping, a chain-affiliated restaurant on the site. Investors often prefer chain-affiliated restaurants because chains have a track record of past success and ample financial data upon which the investor can base the decision to purchase. Typically, investors purchase restaurants in order to lease them to operators. These sale/leaseback transactions are considered financing vehicles, as opposed to arm’s-length real estate sales transactions. The purchase price is negotiated based on the rate of return required by the investor and the amount of rent the operator of the restaurant business can afford to pay, based on the sales expected to be generated by the restaurant business operation. The price paid is an “investment value” rather than a “market value” because the terms of the purchase are tailored to meet the requirements of an individual investor, and are not necessarily a reflection of what a “willing buyer and willing seller” would agree to in an open market.

Because a new restaurant building is usually designed with a specific concept in mind, it is appraised as a “going concern.” The appraiser of restaurant real estate most often will provide the client with an opinion of the “value in use” of the property operating as a specific brand or concept. “Value in use” for a restaurant is based on the premise that the value of restaurant real estate is dependent on the restaurant business producing a revenue stream great enough to cover the return of and return on capital invested in the land and improvements. Until such time as the restaurant operation reaches a stabilized level of revenue, the highest value indication, when a building is new, is often derived using the cost approach, and is identified in the industry as the “full value” of the land and building.

After a restaurant property is four years old, the cost approach begins to lose its validity. Restaurant properties are purchased in the re-sale market for two main reasons including anticipation of rental income in the future to the owner of the property (rent to the landlord), and occupancy by an owner/operator of the restaurant. The income approach carries more weight than the cost approach for these properties.

Sales Comparison Approach

A second method of valuing restaurant real estate is the sales comparison approach, or market approach, which attempts to value the subject restaurant real estate based on the selling prices of similar properties. This approach is the least reliable of the three valuation approaches when applied to restaurant real estate, because it is almost impossible to find a sale of a restaurant property that is truly comparable to a subject property. This is true even if the comparable’s concept and chain-affiliation are the same as the subject property and the comparable is in the same geographical area as the subject property. Many subjective adjustments must be made to the sale prices of the comparable restaurants to arrive at an indication of value for the subject property. Typically, the appraiser makes adjustments to comparable sale prices for differences in conditions of sale, location, access, visibility, and volume of business generated by the restaurant compared to the subject property. However, it is very difficult, if not impossible, for the appraiser to truly identify what was going on in the minds of the buyer and seller when they were making their purchase and sale decisions. This is the greatest weakness of the sales comparison approach.

In addition, allocating the sale price between real estate, personal property, and business value is always problematic. Nevertheless, the sales comparison approach is used by appraisers to derive capitalization rates to be applied in the income approach to value, and to provide a range of values for the subject property that can be used as a test of reasonableness for the values indicated in the cost approach and the income approach.

Allocations of sale prices are problematic because business value can make a significant difference in the sale price of an operating restaurant. For example, say that two identical quick-service restaurant buildings (same square footage and seating capacity) are situated on pads of similar size in front of a neighborhood shopping center. One of the restaurant buildings is occupied by a McDonald’s restaurant, and the other building is owned by an independent restaurant operator and is called “Fred’s Tacos.” The McDonald’s property sells for $1,800,000 and the Fred’s Tacos property sells for $750,000. Assuming both restaurants are in operation at the time of sale, the sale price represents a “value in use,” which may be higher or lower than the “market value” of the real estate if it were to become vacant. The difference in sale price may be attributed to business value over and above the value of the land, improvements, and FF&E. Note that this is an important consideration in valuing restaurant property for ad valorem property tax purposes, as an assessor is typically instructed to exclude business value so that only the value of the real estate, and in some states personal property, is taxed.

Income Approach

A third approach to valuing restaurant real estate is the income approach. In this approach, the appraiser assumes that the property is rented to the restaurant operator at a market rent, even if the property is owned by the operator and no rent is paid. This assumption is made in order to isolate the income to the land and building from income attributable to the investment in furniture, fixtures and equipment (personal property), and the return to the restaurant operator for taking the risk of running a business (business value). The economics of the restaurant business dictate that an operator cannot pay more than 8% of gross revenue in occupancy costs and still have an adequate return of and on the investment in FF&E, and an equitable return on the capital invested in the operation of a restaurant business.

Typically, rent on the land and building ranges from 5% to 8% of the gross sales of the restaurant. There may be different variations, such as 5% of food sales and 8% of beverage sales, but overall rent should be in this range if the restaurant operation is to be successful over the long-term. There are exceptions to this range, as in the case of a food court in a retail mall. Percentage rent in a food court can be as high as 10%, or $40 to $80 per square foot per year, but this is mitigated by the large volume of customers generated by the mall retailers and the fact that the restaurant operates in a small space and shares a large dining area with the other operators in the food court.

Valuing the land and building in use as a restaurant requires knowledge of market rent for similar type properties in the restaurant’s neighborhood. If there is no lease encumbering the property, the appraiser assumes that the restaurant is leased at a market rent. If the property is encumbered by a long-term-lease at below market rent, with no additional rent based on a percentage of the restaurant’s sales, the value of the land and building may be negatively impacted.

If the operating restaurant is paying rent based on a minimum rent plus a percentage of gross sales, the income approach to value may indicate a value for the subject real estate, which is higher than the cost to buy the land and build a restaurant on it. On the other hand, if the restaurant has ceased operation and is no longer a going concern, the “going dark” value of the vacant restaurant building may be far lower than the “value in use” when the restaurant was in operation.

When the income approach is used to value the land and improvements of a proposed restaurant, the value derived depends heavily on the projection of the restaurant’s stabilized gross revenue estimated by the appraiser. Because the real estate’s “value in use” is directly related to the potential revenue generated by the restaurant, the indication of value is only as reliable as the projected restaurant food and beverage sales. The projection of stabilized gross sales can be estimated with relative confidence in the case of a chain-affiliated restaurant with a past operating history in multiple locations. However, projecting revenue for a new restaurant concept requires experience in the restaurant business supported by market research in the area where the restaurant is to be built.

The combined “value in use” of the land and restaurant building can be approximated by capitalizing the net income stream that would flow to a hypothetical landlord, after the deduction of vacancy and credit loss, and management expense, assuming the building and land is leased to the restaurant operator at market rent. The key determinant in calculating the value of the subject property is the selection of an appropriate capitalization rate. For example:

Annual food and beverage sales	$3,200,000
Multiplied by rent percentage	7.0%
Annual rent (Potential Gross Income)	$   224,000
Less: Vacancy& Credit Loss @ 3%	-    $6,720
Effective Gross Income	$   217,280
Less: Management Expense @ 2%	$       4,346
Net Rental Income	$   212,934

Net Rental Income ÷ Capitalization Rate = Value of the Land & Building
$212,934    ÷   9.5%  =	$2,241,410
$212,934    ÷ 10.0%  =	$2,129,340
$212,934    ÷   0.5%  =	$2,027,943

As shown in this example, a one-percentage point difference in the capitalization rate results in an approximately $213,000 difference in value. This emphasizes the importance of choosing a capitalization rate that is derived from the market by analyzing comparable sales and interviewing buyers and sellers who are actively involved in the market for restaurant real estate investments.

Complex Valuation

After each of the three approaches to value has been considered, the appraiser reconciles the three indications of value, or range of values, to reach a conclusion of value for the subject property. The weight given to each approach to value may vary depending on many factors including the age of the improvements, whether the property is vacant or occupied, the length of time the restaurant has been in operation, the credit worthiness of the restaurant operator, and the availability of comparable sales of similar restaurant properties. In conclusion, the valuation of restaurant real estate and business value is complex and dependent on many variables. In this article, I have attempted to explain, in simple terms, the methodology used by an appraiser experienced in valuing restaurant real estate and the business value.