As interest rates soared out of control, the ambitious growth plans of Arkansas Waffles Inc., a chain of family restaurants, might well have been shelved until better times arrived. The business, based in Jacksonville, Ark., had opened its first 24-hour restaurant in 1971, and the owners were eager to continue penetrating their market by constructing a network of similar units throughout their statewide franchising territory. But by 1981, rates on long-term mortgages for commercial properties were creeping to 17% and higher, far more than most businesses would even dream of paying.
"The cost of financing should never be out of line with the economics of the business you're in," says R. Bert Alexander, president of Arkansas Waffles.
Yet even in 1981, when commercial mortgage rates reached their high-water mark, Alexander and his partner, Charles Menser Jr., the company's secretary/treasurer, managed to open two new restaurants without a hitch, thanks to a creative financing technique that kept the rate they paid -- and their own capital requirements for the business -- to a minimum. Through a series of sale-leaseback transactions, the two entrepreneurs have built Arkansas Waffles into a chain of 14 restaurants with combined 1982 revenues of about $7 million.
While four of the company's properties are owned by Alexander and Menser, the remainder have been sold to private investors with whom Arkansas Waffles has negotiated 20-year leases at fixed rates several percentage points below the prevailing mortgage rates. When rates hit 18% in 1981, for instance, "we signed lease agreements for at least seven points less," Alexander says.
By definition, the use of sale-leasebacks limits the amount of equity the company will build in the land and restaurants. But this doesn't bother the principals, who see their primary business goal as running a chain of restaurants featuring "good food fast," with enough profits to support growth of at least three new restaurants a year. "Doing that," says Menser "is worth more to us than accumulating real estate."
The sale-leaseback technique is hardly new. For decades many businesses including service and manufacturing concerns, have used the mechanism as a way to conserve working capital or, perhaps cash in on real-estate holdings when money is needed elsewhere. And while it is true that periods of high interest rates and inflation often provide added incentives for businesses like Arkansas Waffles to sell property and then lease it back, financial experts say that the arguments for sale-leasebacks continue to be compelling when rates are down for businesses that are growing. With lower rates, the sale-leaseback still lets owners of capital-intensive companies sink their limited equity into working capital needed to run the business, where the anticipated return on assets is more attractive.
"The sale-leaseback is a way of renting money," explains Menser. "We see the restaurants and the real estate as two separate businesses. We've left our credit lines open to finance equipment and other things." Without having to tie up capital -- amounting to about $250,000 per restaurant -- in land or buildings, Alexander adds, "we can concentrate on becoming a bigger operating company."
Alexander, a former savings and loan executive now living in Memphis, and Menser, an Atlanta-based certified public accountant, got started in the restaurant business in 1971 when they purchased a franchise to operate Waffle House restaurants in Arkansas from Waffle House Inc. of Atlanta. As a franchisee, Arkansas Waffles receives the specifications for constructing the 1,800-square-foot restaurants, along with management advice for running the business profitably. But when it comes to sources of capital, Alexander and Menser, who own some 90% of the Arkansas company, have always been left to their own devices. From the very beginning, notes Alexander, "we knew we could rely on the sale-leaseback."
Arkansas Waffles didn't waste any time before arranging its initial sale-leaseback to finance its first restaurant. A commercial landowner in Hot Springs, Ark., was interested in repurchasing the half-acre parcel complete with the new building, and he agreed to offer a 20-year lease. Four subsequent properties were retained jointly by Alexander and Menser for themselves. While those properties generate attractive personal tax benefits, the decision to sell the others to private investors wasn't difficult. To begin with, the company needed outside capital, and, says Alexander, he and Menser "didn't need all that depreciation."
On a typical sale-leaseback deal, Arkansas Waffles seeks an appropriate site and develops the restaurant with a total budget of about $250,000. Prices for commercial half-acre parcels in prime locations, notes Menser, sometimes run as high as 40% of total costs. An investor -- usually an individual, a family, or a trust -- is identified ahd committed even before construction begins. And unlike a financial institution, which is apt to finance only about 75% of the cost of a property, Arkansas Waffles has found investors who have been willing to purchase the properties outright, resulting, in effect, in 100% financing.
"The investor knows exactly what he's getting," says Menser. "We build it and sell it to him at a prearranged price." The cash proceeds are used to pay off the construction loan and all other costs. A major objective throughout the process is keeping development costs as low as possible and making sure the sale price is no higher than the expenses Arkansas Waffles incurs during development (including financing, legal, and engineering fees). That way, says Menser, rent payments can be held to a minimum.
At each restaurant, the rent Arkansas Waffles pays varies according to what the commercial mortgage rate may have been at the time the lease was signed. But in each instance, Alexander and Menser claim, there are monthly cash-flow benefits amounting to hundreds of dollars versus what the mortgage payment would have been if the property were owned by the company. Whereas a 10% lease on $250,000 would require monthly payments of about $2,100 a 14%, 20-year mortgage, for example, would cost $2,590 monthly, Menser explains.
As far as taxes are concerned, leasing has consequences that are different from ownership. Instead of deducting the interest expense of the mortgage and depreciating the cost of the building (without the land) over 15 years, as it would if it were the owner, Arkansas Waffles, as a tenant, treats 100% of its rent payments as tax-deductible business expenses. Since the long-term leases aren't unlike debt obligations, the company describes them in a footnote to its audited financial statements.
For investors in the properties, the key incentives are 20-year leases paying relatively attractive fixed yields, depreciation on the building cost, and whatever future value there is in the property. But, at times, Arkansas Waffles has offered another lure, too. A few years ago, to keep its lease rates low when mortgage rates were going through the roof, the company offered investors a sweetener, consisting of a small percentage of restaurant revenues over a fairly substantial volume. The company, in effect, agreed to pay investors a bonus if the location was a real winner. In the future, Menser notes, the company would like to find willing investors without having to offer such extra benefits.
For the next several years, Arkansas Waffles wants to continue to add at least three new restaurants a year. And although the company evaluates its financing alternatives each step of the way, the chances are that at least one or two of the new restaurants planned for 1983 will be financed with sale-leasebacks. Beyond that, the future game plan, Menser says, will be influenced fundamentally by the level of commercial mortgage rates and whether they fall below 12% or so. "While we can't expect to get money as cheaply as General Motors," he concedes, "we're always looking for the best deal for Arkansas Waffles."