How McDonald’s really Makes Money

Thanks to Skillshare for sponsoring this video. The first 1000 people to use the link in thedescription can watch my course and thousands of others with a free trial of SkillsharePremium. During recessions, consumer behavior tendsto 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 BurgerKing and Wendy’s often perform better than average during recessions. From 2008 to 2010, for example, while otherbusinesses 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 clearfast food winner of 2008: McDonald’s. That year, it continued its 55-month longstreak 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: Duringthat time, consumers were simply eating cheaper food. But there’s also another reason McDonald’sis what some analysts call “recession-proof”: McDonald’s is, first and foremost, a realestate 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 propertyand equipment before it reports depreciation. That would technically make it the fifth-largestreal estate holder in the world, measured by total assets. Cover the name ‘McDonald’s’, and thismight look like the financial statement of any other boring big-name real estate developer. Like Burger King and Subway, the company wasable to grow so fast and reach so many countries around the world through franchising. 85% of its restaurants are owned by someonewho essentially ‘leases’ the McDonald’s name and brand, in exchange for a considerablefee. What makes the company so unique is that,unlike other similar fast-food giants, McDonald’s makes the majority of those franchise revenuefrom 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. Here’s how it works: Because McDonald’s has decades of experiencebuying and selling properties, it knows the precise ingredients of a successful location. It shops around usually for intersectionsbetween 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 trafficlights. It then buys the property with long-term fixedinterest rates. Its huge existing property holdings provideit with the most favorable deals. Then, when someone applies to operate theirown McDonald’s location, they sign with the company a Franchise Agreement — stipulatingnearly 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 anapproved 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, includingan initial down payment paid in cash, one-time franchise fee of $45,000, and a percent royaltyof every month’s revenues. These, usually 20-year contracts, also havethe unusual but highly consequential stipulation that the restaurant be located at that specificaddress — the one McDonald’s, the corporation, just bought. In other words, McDonald’s instantly hasa tenant, and one who will always pay above-market rates. Depending on the value you attribute to goodlocation scouting, you might characterize this as a valuable service, or, a ruthlessbusiness tactic. Indeed, one franchise union found that theaverage franchise tends to pay an average of 6-10% of its sales in rent, while McDonald’sfranchisees 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. So, why do franchisees agree to these stringentrequirements? Simply put: because it’s seen as an incrediblysafe investment. The advantage of this model is that whilethe absolute numbers are abnormally large — the fees, the initial startup costs, andeven the annual revenues — the odds of success are relatively high. For example, the average location makes $2.7million 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 standardsto 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 prettysure they’re qualified for the job, have a good location, and are meeting customer’sstandards, because otherwise, they wouldn’t be allowed in the first place.

McDonald’s trains its franchisees in whatit calls “Hamburger University” — the company’s internal system of teaching businessowners all the skills and knowledge they need. For McDonald’s, the benefits of owning propertyare far greater than just an additional source of revenue. It’s no exaggeration to call it an entirelydifferent business model: It understands that real estate is a far better business thanhamburgers. The first reason is just a function of Americantax law — which offers heavy tax breaks for depreciation, even while that same propertymay increase in value over time. The biggest advantage is the long-term stabilityof property prices. Along with Walmart, McDonald’s was one ofthe 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 ofthe so-called “Dividend Aristocrats” — stocks that have increased their dividends annuallyfor 25 consecutive years. Recessions are only a welcome opportunityto buy up discounted properties. When things are truly catastrophic — likeduring a pandemic — the real estate model outsources risk to franchisees — who arecontractually obligated to pay a minimum amount of rent regardless of sales. All of this is reflected in the upward trendof franchised McDonald’s locations and downward trend of the few remaining company-operatedlocations. If anything, McDonald’s is actively tryingto remove itself from the fast food industry. But this naturally raises a question: If McDonald’smakes a huge portion of its profits in the form of rent, and managing real estate isa fairly separate skill from creating new McThings, why not split-off the real estateholdings into a new company? Do that, and you have a very stable, active,and profitable real estate investment trust — one immune from the variability of fastfood and/ changing consumer appetites. A group of investors suggested this very ideain 2015. The company, however, decided not to, believingthat its property model is what makes it unique, and that its remarkable efficiency is a functionof doing both. Now that you know the secrets of how one ofthe world’s great companies truly makes its money, you might be interested in puttingthis new information to use with great Skillshare courses like “Investing 101”, which teachesyou the basics of how stocks, ETFs, and index funds, work. Or learn how to build a business on YouTube,starting with my new course where I explain, step-by-step how I make my thumbnails andmarket my videos. I also give you a complete walkthrough ofhow I created this thumbnail.

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