When specialization is a risk

Why specialty product types cannot receive the same leverage in a real estate deal.

Tim Milazzo
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We received a financing request recently for a property rented to Dutch Bros Coffee. Living in the Northeast, I had never heard of it, but apparently it’s a coffee brand taking the West Coast by storm and, at 379 locations, now holds the mantle for “largest privately held drive-through coffee chain in the United States”. They’ve done a great job of branding, from their logo down to the distinctive style of their drive-through locations. They’ve been cleaning up the market.


The branding is so strong, they even have their own custom lego set!

It seems like a great business that’s growing fast.

So what is there to fear in developing or buying a property whose revenue is secured by a long term lease to Dutch Bros?

How lenders see property specialization

Look again at the above pictures of a Dutch Bros drive-through. While the lego set may be a fun gift for the coffee lover in your life, I want you to notice something. It’s distinctive because it’s different. While the building is a bit reminiscent of local bank branches that have double-sided drive-throughs under canopies, the building itself is much narrower. There’s enough room for a simple kitchen that makes coffee, and for patrons to line up inside, outside, or from their car. That’s it. The building would not be able to be converted to a bank without serious construction work, and quick-serve restaurants wouldn’t have enough square footage to lease something like this either.

Either the Dutch Bros succeeds and renews their lease, or this building would sit vacant. There’s not much of a case in between for a real estate investor. I guess you could try to rent it to a different coffee purveyor?

I’m not saying that Dutch Bros is at immediate risk of a default — that would be silly. By all indications, we’ll see many more of these sprouting up across the country in the next few years.

But it’s not crazy to think a Private-Equity retail brand somewhere could get out over their skis and face financial trouble, is it? The whole private equity model is predicated on growing businesses as fast as possible using as much debt as they can handle. While a 2018 investment by TSG Consumer Partners has added fuel to the company’s balance sheet in the service of growth, investment from major private equity players does not always come without a price. And we’ve seen way too many retail company implosions in recent years to forget what happens when a huge retail brand becomes insolvent.

A lender always has to ask “What if?”. Their job is to manage risks. Bankers are paid handsomely for it.

Long story short on the Dutch Bros loan request that came to StackSource: there are several powerhouse lenders that offered great rates and terms to the owner of the property, but at much lower leverage than is typical for standard NNN retail properties rented out to strong tenants. The owner was actually the developer of the property, who had used a very high LTC construction loan to build it out for Dutch Bros, and is now “stuck” in that development loan (at a high interest rate) because the refinancing options won’t be able to pay it off entirely. He’ll need to sell the property or provide more of his own cash to exit that loan.

You better believe that the construction lender will remember this next time a Dutch Bros construction deal comes their way. Lenders hate facing a refinancing risk where the borrower’s ability to exit their loan is in question.

Where special meets common

The more specialized a property is, the less leverage you can expect to access.

There are certainly more common “specialty” property types out there that will face similar treatment from lenders as the coffee example above, because the structure is often tailored too far to the current tenant to be attractive to other tenants without construction work, and/or because the total pool of potential replacement tenants is thin. They are:

  • Car Washes
  • Auto care centers
  • Stadiums
  • Certain Student Housing assets
  • Funeral homes
  • Greenhouses
  • Amusement parks
  • Specialized medical facilities
  • Power generation
  • Religious facilities
  • Youth sports centers

If you are investing in one of the property types above, or something even less common, don’t assume that the same debt will be available as a property that has wider appeal to potential tenants.

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