McDonald's

How McDonald’s Really Makes Money? Do you know that it is also a Real Estate Company?

During recessions, consumer behavior tends to change in fairly predictable ways. The hardest-hit businesses are, of course, the most unnecessary. Travel and tourism, leisure and hospitality, and manufacturing. Other companies actually stand to benefit. Like, fast food. Stomachs don’t respond to economic downturns, but smaller bank accounts do opt for cheaper alternatives, which is why chains like Burger King and Wendy’s often perform better than average during recessions. From 2008 to 2010, for example, while other businesses closed or downsized, Subway, added nearly 6,000 new locations. KFC added around 300 in roughly the same period. One company, however, stands out as the clear fast food winner of 2008: McDonald’s. That year, it continued its 55-month long streak of same-store sales increases with even better performance than before the recession, while opening 600 new locations, and with an impressive 29% return on equity.

Some of this is for obvious reasons: During that time, consumers were simply eating cheaper food. But there’s also another reason McDonald’s is what some analysts call “recession-proof”: McDonald’s is, first and foremost, a real estate company.

McDonald’s – a real estate company

Glancing at its 2019 balance sheet, one number, in particular, should grab your attention: $39 billion. That’s the current value of all its property and equipment before it reports depreciation. That would technically make it the fifth-largest real estate holder in the world, measured by total assets. Cover the name ‘McDonald’s’, and this might look like the financial statement of any other boring big-name real estate developer.

Like Burger King and Subway, the company was able to grow so fast and reach so many countries around the world through franchising. 85% of its restaurants are owned by someone who essentially ‘leases’ the McDonald’s name and brand, in exchange for a considerable fee. What makes the company so unique is that, unlike other similar fast-food giants, McDonald’s makes the majority of those franchise revenue from rents, not burgers.

To be more precise, in 2019, 7.5, or 64%, of its 11.6 billion dollars in franchise fees came in the form of rent.

How it works?

Because McDonald’s has decades of experience buying and selling properties, it knows the precise ingredients of a successful location. It shops around usually for intersections between two high-traffic roads and buys space in whichever corner has the most parking. The ideal space is around 50,000 square feet, 4 and a half thousand for building space. The intersection should also have traffic lights. It then buys the property with long-term fixed interest rates. Its huge existing property holdings provide it with the most favorable deals. Then, when someone applies to operate their own McDonald’s location, they sign with the company a Franchise Agreement — stipulating nearly every detail of how the business will operate — from how the burgers are cooked, to the hours of operation.

For example, they can only purchase from an approved supplier, who may or may not be the best or cheapest option. The franchisee — that is, the local owner — generally makes a total upfront investment of $1-2 million for a single location, including an initial down payment paid in cash, one-time franchise fee of $45,000, and a percent royalty of every month’s revenues. These, usually 20-year contracts, also have the unusual but highly consequential stipulation that the restaurant be located at that specific address — the one McDonald’s, the corporation, just bought.

Risks

In other words, McDonald’s instantly has a tenant, and one who will always pay above-market rates. Depending on the value you attribute to good location scouting. You might characterize this as a valuable service, or, a ruthless business tactic. Indeed, one franchise union found that the average franchise tends to pay an average of 6-10% of its sales in rent. While McDonald’s franchisees pay 8.5-15%. And if a location fails to perform as expected, McDonald’s can simply find a new franchisee for that location after the contract has expired, or sell the land to someone else entirely, likely at a significant profit.

Why do franchisees agree to these stringent requirements?

Simply put: because it’s seen as an incredibly safe investment. The advantage of this model is that while the absolute numbers are abnormally large. The fees, the initial startup costs, and even the annual revenues — the odds of success are relatively high.

For example, the average location makes $2.7 million in sales every year, with a respectable but not incredible, all-things-considered, $154,000 in final take-home profit. But precisely because McDonald’s is so demanding, can it be such a solid investment. Sure, applicants have to meet high standards to become franchisees and once they do, they have little control over their own business. But all these factors also reduce their risk.

While other franchises may have fewer requirements, they also come with greater risk. The owner of a McDonald’s can be pretty sure they’re qualified for the job, have a good location, and are meeting customer’s standards. Because otherwise, they wouldn’t be allowed in the first place.

McDonald’s trains its franchisees in what it calls “Hamburger University”. The company’s internal system of teaching business owners all the skills and knowledge they need. For McDonald’s, the benefits of owning property are far greater than just an additional source of revenue.

McDonald’s business model

It’s no exaggeration to call it an entirely different business model: It understands that real estate is a far better business than hamburgers. The first reason is just a function of American tax law. Which offers heavy tax breaks for depreciation, even while that same property may increase in value over time. The biggest advantage is the long-term stability of property prices. Along with Walmart, McDonald’s was one of the only two stocks in the Dow Jones Industrial Average to increase in value in 2008.

It’s also one of the 60 or so members of the so-called “Dividend Aristocrats”. Stocks that have increased their dividends annually for 25 consecutive years. Recessions are only a welcome opportunity to buy up discounted properties. When things are truly catastrophic — like during a pandemic. The real estate model outsources risk to franchisees. Who are contractually obligated to pay a minimum amount of rent regardless of sales.

All of this is reflected in the upward trend of franchised McDonald’s locations. And downward trend of the few remaining company-operated locations. If anything, McDonald’s is actively trying to remove itself from the fast food industry. But this naturally raises a question: If McDonald’s makes a huge portion of its profits in the form of rent. And managing real estate is a fairly separate skill from creating new McThings. Why not split-off the real estate holdings into a new company?

Why?

Do that, and you have a very stable, active, and profitable real estate investment trust. One immune from the variability of fast food and/ changing consumer appetites. A group of investors suggested this very idea in 2015. The company, however, decided not to, believing that its property model is what makes it unique. And that its remarkable efficiency is a function of doing both.

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