McDonald’s | How Real Estate Saved it from Failure

McDonald’s was on the path to failure.

You may know Ray Kroc made McDonald’s what it is today, but he cannot take all the credit. There was another man, Harry Sonneborn, who should receive the credit for the company still being around.

In the early days of McDonald’s, the parent company was struggling to make a profit. In his first deal with the McDonald brothers, Ray Kroc was trying to build an empire off a 1.4% cut of a 15-cent hamburger.

But the brothers and Ray were not doing as well as the early franchisees.

Ray had open stores across America, but he was only able to breakeven. He unsuccessfully tried to negotiate a larger split with the brothers, so he sought out loans to help him scale and cover expenses.

But banks refused to him loan money even though he was part of a growing franchise. The problem, he did not own any assets.

Something had to change.

Harry Sonneborn then entered the picture, and it changed the course of McDonald’s forever.

Ray Kroc hired Harry Sonneborn in 1956 to serve as President of the company. Sonneborn immediately convinced Kroc that he needed assets, and the real money was in real estate.

In the 2016 film “The Founder” starring Michael Keaton as Ray Kroc, Sonneborn (played by actor B.J. Novak) famously tells Keaton’s Kroc,

“You’re not in the burger business. You’re in the real estate business. You don’t build an empire off a 1.4% cut of a 15-cent hamburger. You build it by owning the land upon which that burger is cooked. What you ought to be doing is buying up plots of land and then turning around leasing said plots to franchisees, who, as a condition of their deal, should be permitted to lease from you and you alone.”

Sonneborn came up with the idea for the company to own the land and building underlying each franchise restaurant and then leasing that land and building to the franchisee. Because this freed franchisees from funding the land and property, this business model attracted more franchisees and led to the explosive growth of McDonald’s.

The real estate operations became so substantial that it was spun off into a separate subsidiary named McDonald’s Franchise Realty Corp.

McDonald’s initially charged franchisees markups of 20 percent of lease costs, but it eventually increased this to 40 percent. Sonneborn wasn’t done. To further fuel growth, Sonneborn had the idea to take out mortgages to acquire the land and building – exploiting the power of leverage to multiply acquisitions, franchises, and in the end, revenue.

This model ensured steady cash flow for the company as long as the restaurants stayed in business. Even if a restaurant failed, the company could sell off the land and building to cut its losses.

This model exists to this day with real estate revenue accounting for 35% of the company’s annual revenue, which exceeded $21 billion in 2018.

In saving McDonald’s, Sonneborn pulled out all the stops in the commercial real estate investing playbook.

Here’s how this strategy contributed to McDonald’s growth and wealth:

Cash Flow – Cash flow from its leasing activities allowed McDonald’s to reinvest profits to acquire other properties. Cash flow is the ultimate arrow in the ultra-wealthy and institutional investor’s quiver for creating wealth.

Unlike traditional asset classes like stocks and bonds that rely solely on appreciation for returns on investment, cash-flowing investment properties generate consistent profits from leases that can be used to acquire more properties. You get the picture. Growth can be exponential as Sonneborn and McDonald’s proved.

Appreciation – Sonneborn knew that appreciation would be key to securing the company’s financial future. He was right. McDonald’s present-day real estate holdings represent $37.7 billion on its balance sheet, about 99% of all of the company’s assets.

These strong financials give McDonald’s the added benefit of negotiating the lowest loan rates and best terms available – rates and terms other borrowers only dream of – further padding the company’s pockets by lowering its borrowing costs.

Real estate appreciation is essential because even while prices fluctuate over time, in the long-run real estate values have historically always gone up – and always far ahead of inflation.

Tax Benefits – By owning the land and building, McDonald’s reaped all the tax benefits for itself. Tax benefits such as depreciation enhance the real rates of return on real estate investments, putting more money in McDonald’s pockets and boosting its bottom line.

McDonald’s reported $1.39 billion in depreciation in 2016. That’s a lot of tax savings.

Better Risk-Adjusted Returns – Because real estate is not correlated to the stock market, it offers diversification and potentially higher returns when compared to mutual funds, stocks, and bonds. Real estate has the highest risk-adjusted returns of any asset class historically.

Leverage – Through leveraging bank financing, Sonneborn was able to expand its real estate holdings and McDonald’s operations by multiples. Conventional and unconventional real estate financing allows investors like McDonald’s to leverage their investment capital (generated from cash flow) to acquire multiple properties instead of just one, allowing for accelerated wealth creation and growth.

Diversification – By diversifying its revenue stream by adding real estate across multiple geographic locations, McDonald’s shielded itself from downturns in specific markets. Revenue drops from layoffs in Pittsburgh could be absorbed by the other thousands of franchises across the world.

As the franchisor, McDonald’s created the master model for many to follow, and some would say Harry Sonneborn was a genius for turning around McDonald’s. It only took someone to see the value of investing in assets.

In the end, Ray Kroc bought out the McDonald’s brother with the leverage he created by owning the real estate.

It’s not always about owning the operations but what’s beneath the business that is the key to income and wealth.