Why the REIT idea isn't dead for McDonald's

McDonald’s (MCD) last week brushed aside some investors’ calls to spin off its valuable real estate. The company said the switch would diminish the bonanza it enjoys from franchisee-generated income. Um, OK. But just wait until the next time the burger chain runs into trouble. Then a real estate deal will look a lot more attractive.

We’ve seen this movie before. The last time there was a big push to cash in on the properties, by putting them into a real estate investment trust, or REIT, things were unsettled at McDonald’s. Count on it: That day will dawn again.

Why? Fast food, especially of the hamburger-centric variety, is under fire as so-called healthy eating gains cachet and fast casual dining draws appeal with its superior food. Add in the fact that the company has taken on too much debt, partly to pay for time-honored shareholder-pleasing moves like hiking dividends by 5% in the fourth quarter.

Right now, things seem to have improved at Mickey D’s. After more than two years of slumping same-store sales (those open at least 12 months), new Chief Executive Officer Steve Easterbrook produced a turnaround in the third quarter, with a 0.9% increase in the U.S. —4% when you factor in foreign operations. Easterbrook, who took over in March, cut costs and rolled out all-day breakfast, which has proved to be popular.

And that record gives McDonald’s the confidence to stay the course and retain ownership of its vast real estate empire: over 36,000 restaurants, with almost 30,000 of them operated by franchisees.

The franchisees pay rent and royalties to McDonald’s. By the reckoning of Restaurant News, McDonald’s garners 83% profit margin from franchisees, about five times what company-owned stores provide. That’s because the franchisees shoulder such capital costs as equipment and signs, and ship the company all that cash in rent and royalties.

As mighty as McDonald’s is, the company goes through periodic rough patches. Lately, it’s competition from fast casual dining chains, like Chipotle Mexican Grill (CMG) and Shake Shack (SHAK), which typically enjoy double-digit comparable sales growth.

Ever since concerns about healthier eating arose in the last 20 years, McDonald’s has found itself stuck in self-created quagmires as it tried to win over critics. In the 1990s, it trotted out the McLean Deluxe, a 91% fat-free beef patty. It bombed. So did initiatives such as pizza, fajitas and pasta.

More recently, the public has taken a fancy to fast-casual restaurants because they emphasize quality, whereas fast-food outlets like McDonald’s specialize in value. Over the past few years, McDonald’s sought to change that perception through a spate of new menu offerings—a misbegotten strategy that did little more than bollix up the kitchen as it coped with increased complexity.

In 2013, for instance, the company debuted a spicy dish called Mighty Wings, deep-fried chicken wings that it hoped would be a smash. Customers didn’t agree, and the chain ended up with 10 million pounds of unsold chicken.

The first time the idea of a REIT surfaced was in 2005, when McDonald’s was going through a restructuring that involved closing underperforming stores and a switchover from opening new units to squeezing more from existing locations. The death of CEO James Cantalupo sent the company reeling. The stock was in the doldrums.

Along came hedge fund manager William Ackman of Pershing Square Capital—now best known as the nemesis of nutrition supplement company Herbalife (HLF)—who unveiled an elaborate plan to convert two-thirds of McDonald’s company-operated units into a REIT. Since they generated less cash than did the franchisee-operated segment, the reasoning was that transforming them into a publicly traded entity would double McDonald’s worth for investors.

McDonald’s snubbed Ackman’s plan, and in a few years, once the stock revived again, he sold his stake.

Last March, another hedge fund guy, Larry Robbins of Glenview Capital, proposed a similar scheme, although on an even grander scale involving more of the stores. Going the REIT route would unlock $20 billion trapped in McDonald’s real estate, he calculated. The stock rallied on the news.

The trouble for Robbins is that his timing was off. First, the sudden positive earnings news gave management cover to spurn his idea. When the company rejected a REIT conversion last week, its chief administrative officer, Peter Bensen, said McDonald’s wanted to concentrate “on the operational turnaround without the added complexity, uncertainty and potential disruption of a real estate transaction.”

Second, with the Federal Reserve about to raise interest rates, REITs look less viable these days. Because they depend on lots of borrowing, these vehicles do not tend to do well amid climbing rates.

Nevertheless, all is not well in McDonald land. There is no assurance that Easterbrook’s turnaround—the latest in a long skein of them—will keep going, given the allure of fast-casual dining and the other headwinds.

Plus, the company is sinking deeper into debt to pay for an additional $10 billion it plans to give investors by next year, in the form of sweeter dividends and stock buybacks. As a result, Standard & Poor’s downgraded the chain to triple-B-plus from A-minus.

So don’t count out a McREIT.