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

At first glance, it might appear as if trendy restaurants are opening up every week, but in reality name-brand restaurants dominate the market. While independent restaurants have dropped in total number of locations, major chains continue to eat up the market share by opening up more than a thousand combined locations last year.

In recent years, casual dining tenants have become some of the most secure and prosperous investments in the net leased world for several reasons. First, unlike most national concepts in the market today, casual dining tenants typically report store sales illustrating their overall success at each location. Second, most

leases tend to offer very favorable lease terms which include strong rental increases and zero landlord responsibilities. Finally, casual dining restaurants are often well-located so it’s difficult and expensive to relocate.

In 2010, the big five of casual dining were all trading roughly 150 - 200 bps higher than where they are currently. Even in today’s market, where most net lease properties are experiencing a stabilization of their cap rates, casual dining rates are still compressing much less than we’ve seen in recent years. In fact, the gap between corporate guaranteed deals compared to franchisee guaranteed deals is smaller than ever before.

CASUAL DINING

DENNY'SCHILI 'S

IHOPBUFFALO WILD WINGS

APPLEBEE'S

THE BIG FIVE: APPLEBEE'S, CHILI 'S, DENNY'S, IHOP, AND BUFFALO WILD WINGS

With most other STNL tenants, we see a large disparity in new construction cap rates compared to the average cap rate as a whole, typically 150-200 basis points. However, with the casual dining restaurants this disparity is much smaller, roughly 75 basis points. The biggest decline in cap rates over the past several years has been Denny’s and IHOP, which were trading in the 8.00% cap rate ranges. Now they are in the low 6.00% range and sub 6.00% range for new construction deals. Applebee’s, Chili’s and Buffalo Wild Wings paint similar pictures on a much smaller scale as we have seen cap rates fall roughly 75 -100 bps in the last 5 years.

AVERAGE CAP RATES

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2%

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6%

8%

%

%

%

201620152014201320122011

10%

CREDIT RATINGSDENNY'S: N/ACHILI'S: BBB-

BUFFALO WILD WINGS: N/A IHOP: N/AAPPLEBEE'S: N/A

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 teamsin place to develop their own restaurants from the groundup. However, on the franchisee level, there is often a lackof capital on hand and general experience to constructtheir own locations. This provides a great opportunity foractive real estate developers to step in and provide thenecessary expertise and capital to help operators expandtheir business.

NEW STORE OPENINGS

0 20 40 60 80 100

2012

2013

2014

2015

2016

NEW STORE OPENINGS

AVERAGE CAP RATES

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

Due to the increase in sale-leasebacks and new development, total 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, 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 and extract value for the next 40 years.

TOTAL TRANSACTIONS

97

32

75 15

66

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.

$160K $180K $200K $220K$140K$120K$100K$80K$60K

AVERAGE RENTS

AVERAGE RENTS

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

# OF TRANSACTIONSIN THE LAST 3 YRS

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.

CAP RATE CORRELATION

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Applebee's

IHOP

Buffalo Wild Wings

Chilli's

Denny's

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2015

2016

$160K $180K $200K $220K$140K$120K$100K$80K$60K

3

0%

2%

4%

6%

8%

Applebee's

IHOP

Bu�alo Wild Wings

Chilli's

Denny's

201620152014201320122011

10%

2% 4% 6% 8% 10%0

5

10

15

20

25

30Applebees

IHOP

BWW

Chilli's

Dennys

Applebee's

IHOP

Bu�alo Wild Wings

Chilli's

Denny'sL

EA

SE

TE

RM

S (

YR

S)

CAP RATE

CAP RATE CORRELATION

The outlook for casual dining remains solid, especially for the big five, Buffalo Wild Wings, Applebee’s, IHOP, Denny’s and Chili’s. The short-term market is projected to remain aggressive for average cap rates and as more people get comfortable with franchisee guaranteed deals, cap rates should continue to drop for most sale-leasebacks. As cap rates for long-term leases stay historically low, we expect sale-leasebacks will provide a bump in transaction volume. Corporate deals will still

trade at a premium compared to franchisee deals, though the gap is shrinking and should continue to do so. Investors should be aware of the rent-to-sales ratio and the effects a downturn in the economy could play for their overall investment. When tenants rely on developers for expansion, rent is typically assigned higher to produce a higher resale value. Due to this inflation, margins are already thin for new development deals and operators might find

themselves in trouble. If they cannot hit their projections or experience a downturn in the economy, this could cause a ripple effect for additional locations. When combined with the rent increases typically included in a basic lease, the occupancy to sales ratio could hit a dangerous point. Once this ratio reaches 10%, tenants would seek rent concessions from their landlords, reducing the rent in the base term or option period to remain afloat.

FUTURE OUTLOOK

FOR MORE INFORMATION REGARDING CASUAL DINING PLEASE CONTACT:

CALVIN SHORTcalv in .short@matthews.com310.919.5770

CHUCK EVANSchuck.evans@matthews.com310.919.5841

DATA SOURCE:COSTAR & RCA

DENNY'SCHILI 'S

IHOPBUFFALO WILD WINGS

APPLEBEE'S

Overall, the restaurant market is far less saturated for fast casual tenants than casual dining and quick service restaurants, leaving 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 openings increasing year over year. Panera Bread has opened about half as many stores since 2012, which may be in part due 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 markets using in-depth algorithms to predict potential profitability at new sites. In addition, both tenants lease the vast majority of their stores and often contract build-to-suit developers for new construction. Panera Bread franchisees contribute to about 50% of the system-wide expansion.

NEW STORE OPENINGS

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 RATINGSCHIPOTLE: N/A

PANERA: N/A FAST CASUAL

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2012

N E W S T O R E O P E N I N G S

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 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 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.

TOTAL TRANSACTIONS

28

63

AVERAGE CAP RATESWhen 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.

When comparing new construction transactions to the overall industry, the data shows that 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.

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20162015201420132012

AVERAGE CAP RATES

* 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

CHIPOTLEPANERA

$160K $180K$140K$120K$100K$80K

Panera Bread pays a much higher rent in comparison to Chipotle mainly due to the fact that they operate in much larger footprint stores. While average rent for Panera Bread is about $30,000 higher than the average rent for a Chipotle, their stores are also about 1,500 SF larger. Taking this into account. The data shows that in actuality, Chipotle is paying average rent per square foot at about a $7.00 premium to Panera Bread. Another factor contributing

to Panera Bread’s higher average rent per unit are the percentage rent clauses that often show up in their leases. These clauses call for the tenant to make rental payments based on sales in excess of a specific amount. This lease structure works as a huge benefit to the landlord as they are able to monitor the store’s performance, one of the biggest indicators to of a unit’s security.

Many factors play into the cap rate associated with a fast casual transaction. Location, store sales, lease structure, rent increases, and guarantee are a few. However, the data suggests a strong correlation between lease term remaining and cap rate. As lease term diminishes, cap rates rise.

For Panera Bread, there is about a 125 bps spread between average cap rates on leases with over 10 years remaining in comparison to leases with under ten years remaining. The good news for investors is, typical leases include rental increases between 5-10% every five years that help offset the spread in basis points and work as a hedge

against inflation. Chipotle leases experience a similar trend throughout their term that is more or less significant dependent upon their lease type. Leases on a NN structure will see a steeper rise in cap rates over time, and therefore a greater loss in value. Ground lease investments will experience a more stable value throughout the length of lease term.

In examining the data there are a few notable outliers. Factors that affected cap rates and caused them to fall out of trend with the vast majority of the tenant’s market include direct competition in the area, less seasoned operators, and substandard demographic markets.

AVERAGE RENT

CAP RATE CORRELATION

4% 5% 6% 7% 8%

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20CHIPOTLEPANERA

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

FUTURE OUTLOOK

FOR MORE INFORMATION REGARDING FAST CASUAL PLEASE CONTACT:

CALVIN SHORTcalv in .short@matthews.com310.919.5770

BRIANNA BURGESSbr ianna.burgess@matthews.com310.919.5825

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 Pie Five Pizza experience sales growth in the double digits. Chicken concepts like Wingstop, 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.

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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.