What Is A Good Price To Free Cash Flow Ratio Starbucks Coffee – What Commercial Real Estate Investors Should Know

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Starbucks Coffee – What Commercial Real Estate Investors Should Know

Company summary

Starbucks Coffee, sometimes called Fourbucks Coffee, is the largest coffee chain in the world. Three partners: Jerry Baldwin, Zev Siegel and Gordon Bowker opened their first store in 1971 at Pike Place Market on the Seattle waterfront to sell high quality coffee beans and equipment. In 1982, Howard Schultz, the current chairman and CEO, joined the company as director of marketing. He was impressed by the popularity of espresso bars in Italy after traveling to Milan in 1983. Returning to the US, he convinced the founders of Starbucks to sell both coffee beans and espresso drinks. However, the idea was rejected, so he left the company and in 1985 founded the Il Giornale cafe chain. In 1987, Howard Schultz and Il Giornale bought Starbucks for $3.8 million and renamed the Il Giornale coffee shops Starbucks and turned it into the Starbucks you know today. The company went public under the symbol SBUX on June 26, 1992 at $17 per share with 140 stores. Since then, the stock has split 5 times. As of May 2008, SBUX is trading at around $16, down from a high of $39.43 in November 2006.

Starbucks opened its first overseas store in Tokyo, Japan in 1996. The company currently has around 16,000 stores, employs 172,000 partners, AKA employees as of September 2007 in 44 countries. It has annual sales of over $10 billion, and its most recent quarterly revenue was $2.526 billion. About 85% of Starbucks’ revenue comes from company-operated stores.

Starbucks does not franchise its business and has no plans to franchise in the foreseeable future. In North America, most stores are run by companies. You may see some Starbucks stores inside Target, major supermarkets, college campuses, hospitals, and airports. These stores are operated under licensing agreements to provide access to properties that would not otherwise be available. Starbucks receives licensing fees and royalties from these licensed locations. At those licensed retail locations, workers are considered employees of that particular retailer, not Starbucks. As of 2008, it has 7,087 company-operated stores and 4,081 licensed stores in the US. Internationally, there are 1,796 company-operated stores and 2,792 joint-venture or licensed stores in 43 foreign countries. The pace of expansion is slowing as the company plans to open 1,020 stores in the US in 2008, down from 400 stores in 2009 compared to 1,800 stores in 2007. In addition, it also plans to close 100 stores in 2008.

Risks for real estate investors

Starbucks buildings continue to be a popular investment for many investors. When considering investing in real estate used by Starbucks, you must understand the following risks of your investment:

  1. Sensitivity to recession: a hungry man can survive on a Big Mac and fries, but he can live without a four-dollar Frappuccino. This means that Starbucks is very vulnerable to economic downturns as seen in 2007 and 2008 compared to Burger Kings and McDonald’s. This could be the main reason why sales at US stores open at least a year are expected to decline by a mid-single-digit percentage, the first decline ever. This prompts Howard Schultz to return as CEO. The company plans to double its marketing spend to $100 million in 2008 to boost sales. She has started an aggressive coupon campaign offering free drinks every Wednesday until May 28, 2008. This may be a sign of desperation. On April 22, 2008, Starbucks cut its outlook for the year, citing a weak economy.
  2. Calories and sugar: Starbucks drinks are high in sugar and calories, which consumers are increasingly concerned about due to the explosion of obesity and the diabetes epidemic in the US. For example, its Blended Strawberries & Crème Frappuccino® has 120 grams (over 1/4 lb) of sugar and 750 calories in a 24 oz Venti size. If it becomes a trend for consumers to decide to cut back on sugary drinks or follow a low-carb diet, Starbucks’ revenue will be affected.

  3. Competition: McDonald’s, Wendy’s and Dunkin Donuts now also offer espresso at lower prices to compete with Starbucks. It will capture some of Starbucks’ revenue, especially from cost-conscious shoppers. Starbucks’ current prices are already quite high; it is very difficult for Starbucks to raise prices in the near future without affecting traffic in its stores.

  4. High cost business model: although Starbucks’ profit margin is high because it pays an average of $1.42 per pound for unroasted coffee, its business is very labor intensive like any other food business. One store requires 10-20 employees. All qualified part-time and full-time associates in the US and Canada receive a benefits package consisting of a stock option plan, 401k with matching company, medical, dental and vision insurance. Starbucks was named the 7th best company to work for in the US in 2008 by Fortune magazine’s employee survey. What is good for employees is not necessarily good for employers. These benefits are usually only available to key employees or managers in the restaurant industry. Historically, the cost of these health benefits has been rising faster than the rate of inflation. In the long run, they may have a negative impact on Starbucks’ income. If Starbucks doesn’t perform well, it could be under pressure as a public company to close more stores.

  5. Special purpose building: A stand-alone Starbucks building is a special purpose building designed specifically for Starbucks. If Starbucks decides not to close or not renew the lease, it is difficult to re-lease the property. Few tenants are willing to pay a high rent like Starbucks. It is difficult to use it as a fast food restaurant due to its relatively small square footage. In addition, it does not have a commercial kitchen. Once Starbucks vacates it, the property’s value will most likely drop.

Starbucks’ real estate business

Starbucks divides the US and Canada into 17 real estate areas, each with its own store development office to develop markets in its area. Developers constructed detached buildings approximately 1,800 SF with walk-through on a high-visibility, high-traffic location. After the territorial office approves the location, Starbucks typically signs a 10-year NNN agreement with 2 five-year options where the landlords are responsible for the roof and structure. All leases typically have a corporate guarantee, meaning Starbucks will continue to pay rent in the event it has to close the store. A lease often has a 10% rent increase every 5 years. Rents range from $1.65/SF in retail in Utah to $5.84/SF in New York. This rent survey is based on rents at only 30 Starbucks properties, 18 of which are freestanding, on the market for sale across the US as of April 2008.

A Starbucks location with minimal store closing options

During tough times, such as 2008 when sales are declining, Starbucks will try to cut costs and close underperforming stores. Since a real estate investor is considering investing in a Starbucks building, you don’t want to invest in a property that will be closed in the future.

Location—— 1 mile——3 miles——-AHI/yr—–Size (SF)—-Base Rent/yr—Rent/SF /month –Price—–Cap(%)

Ohio……………296……..2609………$88375….1613……… $58,590……….. $3.03………. $868K…….6.75

Florida………..9186……55270……$68595…..1816………$75,000……. ….3.44 dollars……….1.2 million dollars………6.10

Georgia………5717……57201…..$143936….1750………$74,000………. 3 $.52……….$1,091……..$6.75

Mississippi….188……..4923……..$77372…..1816………$112,184………$5 ,15 ……….1.558 million dollars…..7.2

Texas………….5944…..40970…….$75043…..1752………$92,914….. ……$4.42……….$1.327M….7.00

Table 1: Rent comparisons for stand-alone Starbucks buildings

Location——SBUX rent/yr—SBUX Size—SBUX rent/SF/mo—Other tenant size—Rent/SF/mo—Difference

California…….$30096……..1248 SF…..$2.01…………………. ..1245 SF……$2.50…………-19%

Kansas……….$43200……..1600 SF….$2.25………………. ..1600 SF……………..$1.33…………68%

Utah……………$38568……..1950 SF…..$1.65…………. …. ……..1200 SF……………..$1.86…………-11%

New Mexico..$92004………2000 SF….$3.83……………………. 2500 SF.. ……………..$1.92…………100%

New York…….$125004……1785 SF….$5.84…………………. 2819 SF ……………….$2.75…………112%

Table 2: Rent differential in multi-tenant Starbucks retail centers

Since Starbucks doesn’t release sales revenue for a specific location, you’ll just have to make a good guess. Based on annual revenue and the number of stores operated by Starbucks, the average annual revenue per store is approximately $1 million. Furthermore, if the annual rent-to-income ratio is less than 10%, there is a high probability that the location is profitable. For example, if the base rent for a Starbucks in Ohio is $58,590, then the annual revenue should be greater than $585,590. In addition to choosing a store in a good location (see the article titled “What ‘Location’ Means in Commercial Real Estate” by this author) and cap rates, you should consider the following:

  1. Densely populated area: more people means a larger customer base and thus more revenue. Starbucks in FL, GA and TX in Table 1 show more promise. Note: the author tries to be sensitive by not revealing the exact locations.
  2. Low rent: Starbucks in MS pays $112,184 for base rent. To be reasonably profitable, it must have an annual revenue of $1.12 million. However, since there are only 188 people within 1 mile and a population of 4,923 within 3 miles of the store, it is less likely that the store will ever generate that revenue. Additionally, Starbucks pays $5.15/SF, which is very high compared to only $3.52/SF in fast-growing, high-income, densely populated GA with a population of 57,201 within a 3-mile radius and an average household income of (AHI) of over 143K USD/year. It’s hard to understand how a Starbucks in MS could be an indispensable location in an area with only 188 people within a 1 mile radius of the property! Although it offers the highest cap of 7.2%, this property appears to be a good investment, but actually has the highest risk of bad results and could be closed in the future. Alternatively, Starbucks could try to renegotiate the lease at a lower rent during tough times. Although Starbucks has not yet asked for a rent reduction, it is not surprising if Starbucks does so in order to improve its bottom line in the future. Either way, the value of the property will fall.

  3. Rent premium: while most Starbucks properties are freestanding with 100% occupancy, you may see a Starbucks in a small multi-unit strip center with several other tenants. It usually occupies the end unit with a walk-through and is therefore expected to pay a premium compared to the adjacent unit. However, most of the time, Starbucks pays a significantly higher rent. For example, in Table 2 it pays $5.84/SF compared to just $2.75/SF of a tenant in a neighboring unit in downtown New York, or 112% more. In this strip mall, if the rent for the unit occupied by Starbucks is reduced (due to closing or lease renegotiation), the value of the mall will be significantly reduced. You certainly do not want to invest in this property.

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