MATTHEWSA COMMERCIAL REAL ESTATE PUBLICATION AT THE INTERSECTION OF INNOVATION AND INFORMATION DENNY'S CHILI'S BUFFALO WILD WINGS IHOP APPLEBEE'S CASUAL DINING

THE BIG FIVE: APPLEBEE'S, CHILI'S, DENNY'S, IHOP, AND BUFFALO WILD WINGS At first glance, it might appear as if trendy restaurants leases tend to offer very favorable lease terms which are opening up every week, but in reality name-brand include strong rental increases and zero landlord restaurants dominate the market. While independent responsibilities. Finally, casual dining restaurants are often restaurants have dropped in total number of locations, well-located so it’s difficult and expensive to relocate. major chains continue to eat up the market share by opening up more than a thousand combined locations last year. In 2010, the big five of casual dining were all trading roughly 150 - 200 bps higher than where they are In recent years, casual dining tenants have become currently. Even in today’s market, where most net lease some of the most secure and prosperous investments properties are experiencing a stabilization of their cap in the net leased world for several reasons. First, unlike rates, casual dining rates are still compressing much most national concepts in the market today, casual less than we’ve seen in recent years. In fact, the gap dining tenants typically report store sales illustrating between corporate guaranteed deals compared to their overall success at each location. Second, most franchisee guaranteed deals is smaller than ever before. 2016

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NEW STORE OPENINGS Of all the casual dining concepts, Buffalo Wild Wings is developing the most sites per year, both in major metropolitan areas as well as smaller, tertiary markets. In their development outlook for 2016, they expect to open 40-45 corporate locations and 35-40 franchised locations. On the corporate level, casual dining brands have teams in place to develop their own restaurants from the ground up. However, on the franchisee level, there is often a lack CREDIT RATINGS BUFFALO WILD WINGS: N/A of capital on hand and general experience to construct DENNY'S: N/A IHOP: N/A their own locations. This provides a great opportunity for CHILI'S: BBB- APPLEBEE'S: N/A active real estate developers to step in and provide the necessary expertise and capital to help operators expand their business.

AVERAGE CAP RATES AVERAGE CAP RATES With most other STNL tenants, we see a large disparity 10% in new construction cap rates compared to the average 8%% cap rate as a whole, typically 150-200 basis points. However, with the casual dining restaurants this 6%% disparity is much smaller, roughly 75 basis points. The biggest decline in cap rates over the past several years 4%% has been Denny’s and IHOP, which were trading in the 8.00% cap rate ranges. Now they are in the low 6.00% 2% range and sub 6.00% range for new construction deals. Applebee’s, Chili’s and Buffalo Wild Wings paint similar 0% pictures on a much smaller scale as we have seen cap 2011 2012 2013 2014 2015 2016 rates fall roughly 75 -100 bps in the last 5 years. * BARS REPRESENT AVG CAP RATES * LINES REPRESENTS AVG CAP RATES FOR NEW CONSTRUCTION TOTAL TRANSACTIONS 32 Due to the increase in sale-leasebacks and new development, total 75 15 transaction volume is rising for all casual dining brands. In addition, sale- leasebacks provide an alternative form of financing for remodels, new store development, or allows an operator to use the funds on something else. Given how aggressively these casual dining brands are trading, 66 franchisees are taking advantage of the current market conditions. Rather than using typical bank loans to fund future expansion, they are signing tenant and landlord friendly leases and selling the real estate to a third party investor. Therefore, this allows franchisees to control the real estate 97 and extract value for the next 40 years. # OF TRANSACTIONS IN THE LAST 3 YRS AVERAGE RENTS

Of the big five, Denny’s and Chili’s have consistently assigned the lowest rents in the casual dining sector. With Denny’s, low store sales and B grade locations are contributing factors to the cheap rent. On the other hand, Chili’s prefers to sign ground leases in which they own the leasehold interest and lease the underlying dirt. Due to their rapid store growth, Buffalo Wild Wings assigns the highest rent of nearly $170,000. It is important for operators, developers, and landlords to examine the rent to sales ratio at each individual location; typically, you want to see the tenant in the 6% - 8% range. Also remember, true occupancy cost is significantly higher than simply the NOI and can differ significantly from state to state.

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Data source: Costar & Real Capital Analytics *All 2016 data is year to date Applebee's 2016 3 4 IHOP 2015 Buffalo Wild Wings $60K $80K $100K $120K $140K $160K $180K $200K $220K 2014 Chilli's

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2012 DENNY'S 020406080 100 120 CAP RATE CORRELATION CHILI'S 30 BUFFALOApplebee's WILD WINGS Applebees 10% IHOP Applebee's 25 APPLEBEE'SIHOP IHOP 8% IHOP 20 Bu alo Wild Wings BWW Bu alo Wild Wings Chilli's 6% 15 Chilli's Chilli's Denny's 4% Denny's 10 Dennys LEASE TERMS (YRS) LEASE 2% 5

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The data clearly shows that as guaranteed lease terms burn off, the cap rates at which an owner can sell their asset rises. Generally, there is only a slight drop off in cap rates for leases with 15 and 10 years remaining on the initial term; which makes these deals so attractive to investors. Additionally, there are fixed rental increases in leases which, as mentioned previously, will help counteract the slight increase in cap rate when the lease term burns off. In analyzing the data, the largest drop off occurs when the remaining initial lease term dips below 10 years.

One of the largest differences with casual dining tenants compared to the industry as a whole is the number of outliers. We see significantly more comparable sales at varying cap rates because the security of the lease isn’t just tied directly to the term remaining and credit of tenant. However, casual dining cap rates depend heavily on the store performance and overall location. Some of these concepts can still sell at a very low cap rate, with little remaining term if there is a proven track record of success at the site.

FUTURE OUTLOOK The outlook for casual dining trade at a premium compared to themselves in trouble. If they cannot remains solid, especially for the big franchisee deals, though the gap is hit their projections or experience a five, Buffalo Wild Wings, Applebee’s, shrinking and should continue to do downturn in the economy, this could IHOP, Denny’s and Chili’s. The short- so. cause a ripple effect for additional term market is projected to remain Investors should be aware of the locations. When combined with the aggressive for average cap rates rent-to-sales ratio and the effects rent increases typically included in a and as more people get comfortable a downturn in the economy could basic lease, the occupancy to sales with franchisee guaranteed deals, play for their overall investment. ratio could hit a dangerous point. cap rates should continue to drop for When tenants rely on developers for Once this ratio reaches 10%, tenants most sale-leasebacks. As cap rates expansion, rent is typically assigned would seek rent concessions from for long-term leases stay historically higher to produce a higher resale their landlords, reducing the rent in low, we expect sale-leasebacks value. Due to this inflation, margins the base term or option period to will provide a bump in transaction are already thin for new development remain afloat. volume. Corporate deals will still deals and operators might find

FOR MORE INFORMATION CALVIN SHORT CHUCK EVANS DATA SOURCE: REGARDING CASUAL DINING [email protected] [email protected] COSTAR & RCA PLEASE CONTACT: 310.919.5770 310.919.5841 The fast casual concept is one of the fastest growing segments in the restaurant industry. Combining attributes of both quick service and casual dining restaurants, Chipotle and Panera Bread are viewed by many as segment trailblazers driving the concept’s popularity and targeting health conscious customers. Research shows that Chipotle and Panera Bread are two of the most highly sought after tenants in the net leased market, reflected by their compressed cap rates. However, over the last few years, we have experienced the steep decline in cap rates year over year begin to subside for Chipotle, and even rise for Panera Bread.

That being said, the two major fast casual brands have maintained a strong emphasis on steady expansion over the last three years that will continue through the remainder of 2016 with Chipotle and Panera Bread opening a projected 220-235 stores and 90-100 stores respectively. While Chipotle has seen a slight increase in restaurant openings year over year, Panera Bread has shown a subtle decline since 2013. On the contrary, Chipotle has experienced a decline in sales growth over the last three-quarters that will likely continue for the foreseeable future, while Panera Bread has maintained growth. With new fast casual tenants gaining popularity every day, the biggest opportunity for developers and investors are with tenants on the rise. Brands like Blaze Pizza and Zoes Kitchen, that have a strong customer following, plans for vast expansion, and have experienced extreme sales growth over the last few quarters are tenants to keep an eye on.

CREDIT RATINGS CHIPOTLE: N/A FAST CASUAL PANERA: N/A

NEW STORE OPENINGS Overall, the restaurant market is far less saturated for fast casual tenants than casual dining and quick service restaurants, leaving 2016 segment leaders like Chipotle and Panera Bread ample opportunity for expansion. Since 2011, Chipotle has opened over 1000 stores, with their unit growth averaging about 12% annually and new store 2015 openings increasing year over year. Panera Bread has opened about half as many stores since 2012, which may be in part due 2014 to their heavy focus on converting their current locations to the new, technologically advanced Panera 2.0 concept. Both brand’s development strategies aim to incorporate both new and existing 2013 markets using in-depth algorithms to predict potential profitability at new sites. In addition, both tenants lease the vast majority of 2012 their stores and often contract build-to-suit developers for new construction. Panera Bread franchisees contribute to about 50% of 0 50 100 150 200 250 the system-wide expansion. NEW STORE OPENINGS AVERAGE CAP RATES 8%

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AVERAGE CAP RATES When comparing the average cap rate data of Chipotle to Panera Bread it is clear that the market perceives Chipotle as a more secure investment. Since 2012, Chipotle properties have consistently traded at an annual average cap rate 25-100 bps below the average cap rates of Panera Bread, with the exception of 2014. Chipotle’s lower average cap rates can be attributed to their system-wide corporate guarantee and abundance of ground leases, ultimately increasing the security of an individual asset. Chipotle’s average cap rate data doesn’t follow any particular trend year over year. Average cap rates for Panera Bread trend down until 2014 but have been trending up over the last two years, which seems to be attributed to more franchise properties on the market.

CHIPOTLE When comparing new construction transactions to the overall industry, the data shows that PANERA cap rates on new construction transactions are an average of 25 – 35 bps lower for Panera Bread. For Chipotle, on the other hand, new construction deals traded about 15 bps higher than the overall industry from 2011-2013, which may be a result of the company’s strategy to target smaller or more economically diverse communities. Ultimately, like most other net leased assets, average cap rates for both Chipotle and Panera Bread will depend most often on the length of the original lease term being negotiated, whether 10-15 for Panera Bread or 10, 15 or 20 for Chipotle. What makes these deals so attractive to both private and institutional investors is that both offer strong hedges against inflation in the form of fixed rental increases every 5 years throughout both the initial lease term and option periods.

TOTAL TRANSACTIONS Looking at the data, Panera Bread trades about twice as often as Chipotle despite the fact that Chipotle has more total stores. This is in part because a much larger portion of Chipotle units are in-line or end-cap locations 28 which were not included in our data. With less than 100 total transactions for Chipotle and Panera Bread combined, economics might suggest that the limited supply of fast casual product on the market is driving the demand for each tenant and resulting in compressed cap rates. That being said, the data suggests the total number of transactions year over 63 year for each tenant is rising. While there have been about 15 single tenant Chipotle’s on the market in 2016, only a few have transacted, which may hint to a market push back in cap rate expectation. # OF TRANSACTIONS IN THE LAST 3 YRS $80K $100K $120K $140K $160K $180K

AVERAGE RENT Panera Bread pays a much higher rent in comparison to to Panera Bread’s higher average rent per unit are the Chipotle mainly due to the fact that they operate in much percentage rent clauses that often show up in their leases. larger footprint stores. While average rent for Panera These clauses call for the tenant to make rental payments Bread is about $30,000 higher than the average rent for a based on sales in excess of a specific amount. This lease Chipotle, their stores are also about 1,500 SF larger. Taking structure works as a huge benefit to the landlord as they this into account. The data shows that in actuality, Chipotle are able to monitor the store’s performance, one of the is paying average rent per square foot at about a $7.00 biggest indicators to of a unit’s security. premium to Panera Bread. Another factor contributing

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CAP RATE CORRELATION Many factors play into the cap rate associated with a fast against inflation. Chipotle leases experience a similar casual transaction. Location, store sales, lease structure, trend throughout their term that is more or less significant rent increases, and guarantee are a few. However, the dependent upon their lease type. Leases on a NN structure data suggests a strong correlation between lease term will see a steeper rise in cap rates over time, and therefore remaining and cap rate. As lease term diminishes, cap a greater loss in value. Ground lease investments will rates rise. experience a more stable value throughout the length of lease term. For Panera Bread, there is about a 125 bps spread between average cap rates on leases with over 10 years remaining In examining the data there are a few notable outliers. in comparison to leases with under ten years remaining. Factors that affected cap rates and caused them to fall out The good news for investors is, typical leases include of trend with the vast majority of the tenant’s market include rental increases between 5-10% every five years that help direct competition in the area, less seasoned operators, offset the spread in basis points and work as a hedge and substandard demographic markets.

Data source: Costar & Real Capital Analytics *All 2016 data is year to date FUTURE OUTLOOK The fast casual segment remains the fastest growing concept in the restaurant industry, and while the future is bright, we may have passed the peak in sales growth for the two golden tenants. Millennials seem to be the driving force behind consumer desire for the concept that embodies quality food at affordable prices in a timely manner. In 2016, we have seen new pizza concepts Blaze Pizza, MOD Pizza, and Pizza experience sales growth in the double digits. Chicken concepts like , Zoes Kitchen, and Raising Cane’s are also taking the market by storm. While sales continue to grow year over year and we are seeing more and more concepts gain popularity, overall percentage growth seems to be stabilizing.

Chipotle is in the middle of one of their most difficult operating years to date. In Q4 of 2015 E. coli bacteria was linked to Chipotle restaurants in 14 states. Restaurant closures and deterred interest from consumers adversely affected system- wide sales. Over the last three-quarters, same-store sales have declined approximately 14%, 29%, and 23%. While there’s no doubt the brand will recover, in order to make up for their loss in revenue, the company may be cutting operational costs and pacing their expansion, posing a threat for units with high rental rates. In addition, Panera Bread’s focus on launching their 2.0 platform throughout the system is not inexpensive. In fact, the average cost of conversion per unit has been slated between $65,000 and $125,000. While this is an investment corporate stores can handle, for some franchisees it will be necessary to cut expenses elsewhere, and rent is a high possibility.

Most opportunity in the fast casual market lies outside the two most prominent tenants. Every brand starts somewhere, and brands like Blaze Pizza and Zoes Kitchen that are experiencing rapid growth in both sales and number of units, present a good opportunity to investors, franchisees and developers. Ultimately, for investors with strong Panera Bread units, there is potential for value appreciation with the company roll out of delivery options and a stronger digital platform. Unfortunately for Chipotle investors, with market push back and cap rates stabilizing, assets on long-term leases are likely at their peak in value today.

FOR MORE INFORMATION CALVIN SHORT BRIANNA BURGESS REGARDING FAST CASUAL [email protected] [email protected] PLEASE CONTACT: 310.919.5770 310.919.5825 Matthews REIS Disclaimer 2016

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