So McDonald’s doesn’t make their money from selling burgers.
Does that really surprise you?
A lot of us don't realize that McDonald’s isn't really a burger-flipping restaurant chain. Well, it is, but not purely. Peel back the layers and you’ll find that the corporate entity is actually one hell of a real estate company. Former McDonald’s CFO, Harry J. Sonneborn, is even quoted as saying, “we are not technically in the food business. We are in the real estate business. The only reason we sell fifteen-cent hamburgers is because they are the greatest producer of revenue, from which our tenants can pay us our rent.”
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The fast food giant came from humble beginnings. The McDonald brothers, sons of Irish immigrants, first opened up a hot dog stand in 1937 in Pasadena before venturing out to open their first restaurant. By 1953 they had seen some success using an assembly line method of burger preparation. They'd already started franchising the system, but not the atmosphere or name of their restaurant.
Meanwhile, a milkshake machine salesman named Ray Kroc had taken notice of the brother’s restaurant concept after selling them 8 of his machines. Ray could see the massive potential and quickly partnered with the McDonald brothers, serving as a franchising agent. After six years of working with the McDonalds and finding their ambition ultimately falling short of his own, he elected to buy them out and became the owner of McDonald’s Corporation in 1961.
Franchising is a model by which fast food chains can expand quickly and efficiently by using the money of small investors. Ray Kroc perfected new franchising techniques, increasing the corporation’s size while maintaining strict control of its products. Around this time is when CFO Sonneborn came up with the strategy that McDonald’s continues to use today.
Instead of making money by selling supplies to franchisees or demanding huge royalties…the McDonald’s Corporation became the landlord to its franchisees.
They bought the properties and then leased them out – at large markups. In addition to that regular income, the corporation would take a percentage of each shop’s gross sales.
Today McDonald’s makes its money on real estate through two methods. Its real estate subsidiary will buy and sell hot properties while also collecting rents on each of its franchised locations. McDonald’s restaurants are in over 100 countries and have probably served over 100 billion hamburgers. There are over 36,000 locations worldwide, of which only 15% are owned and operated by the McDonald’s corporation directly. The rest are franchisee-operated.
During the 2008 recession, McDonald’s leaned heavily on this facet of their business as they capitalized on an anemic property market – buying up more of the land and buildings where it operates. The company owns about 45% of the land and 70% of the buildings at their 36,000+ locations (the rest is leased).
It’s a brilliant strategy. Being able to collect on rents helps insulate them from the ups and downs of the business of flippin' burgers. You have to make rent after all.
In 2014, the McDonald’s corporation made $27.4 billion in revenues, of which fully $9.2 billion came from franchised locations and the rest ($18.2 billion) was from company-operated restaurants.
Hold up, we can hear you saying “The majority of their revenue came from company-operated restaurants, a full two-thirds!” Yep, but what about the profit margins?
It costs way more money to run your own store than it does to sit back and collect cash.
McDonald’s keeps close to 82% of all their franchise-generated revenue versus only 16% of its company-operated restaurant revenue. So who’s really contributing more to the bottom line?
Of that $18.2 billion generated by company-operated stores in 2014, the corporation keeps just $2.9 billion. Of the $9.2 billion coming from franchisees, the corporation keeps $7.6 billion.
In 2014 McDonald’s made 4.75 billion dollars in net income (sweet profit dollars). Essentially we could say that 82% of every dollar in profit is generated by a franchisee. That’s an intense statement about a “burger company”.
It’s because of the unique makeup of McDonald’s (and the fact that the business is struggling on a whole) that investors are pressuring the company to spin off its land and buildings into a separate entity. Revenues in 2014 were down from year-ago levels and 2015 looks to be even more depressed than 2014 but if you considered just the real-estate portion of the business, McDonald’s suddenly becomes way more exciting.
Imagine a company with $40 billion dollars’ worth of real estate assets (before taking depreciation into account) and yearly revenues of $9 billion, of which nearly $4 billion is profit. That’s the McDonald’s real estate investment trust (REIT). Not bad right?
To put those numbers into further perspective, this fictional REIT would represent over 40% of McDonald’s current market cap while bringing in 80% of its profits.
McDonald’s is a great example of how diversification helps to not just grow a business’s income but also lower its financial risks. McDonald’s is both a fast food and real estate business. As a fast food company, it doesn’t just operate its own restaurants, it also franchises the brand. By franchising the brand, they’re able to achieve much larger economies of scale because other companies or entrepreneurs finance the expansion of the brand into many other places all over the world. They’re also able to earn more income via higher margins since the income they earn from the percentage of sales of their franchisees don’t require them to spend for operating those franchised branches.
Relying on income from franchises alone can be rather risky. Why? Franchise agreements aren’t forever and as such, they can end. What happens if many franchisees terminate their agreement? However unlikely, it’s still a business risk and by continuing to build and operate company owned branches, they are able to mitigate potential effects of such a risk.
Being in the real estate business also helps McDonald’s earn more income and somewhat diversify its portfolio. Buying properties and leasing them to franchisees is a very clever way of effectively doubling the income earned from franchisees! And for the other properties they don’t lease out to franchisees, they can always rent them to someone else or simply flip them for a profit.
They may, however, need to come up with new ways to keep in step with their industry’s current developments if this diversified portfolio is to continue being profitable.
McDonald’s has been struggling for a while now to compete against fast-casual joints like Chipotle and Shake Shack. They used to hold the promise of good fast-food but now the food is neither fast, nor good. In fact, in 2014, the average drive-thru wait time was over three minutes (the longest it has ever been in about 15 years).
The rot has started to set in, and unless the company pivots quickly and efficiently…they might see themselves left behind. Consumer’s tastes have changed and unless McDonald’s proves itself agile enough to adapt with the times, you might see the company get cannibalized for some time yet.
Maybe they should just go full Donald Trump and become a full-fledged real estate empire. They're already considering increasing the percentage of franchised restaurants so it’s clear that the leadership at the company is leaning in that direction anyway.