Development

Joining Forces

Co-Branded California Development Matches Up McDonald's With Union 76.

Editor's note: As co-branded retail developments increasingly become widespread, more commercial real estate professionals are considering them in their own communities. This case study examines one broker's 10-year odyssey to help develop a co-branded project in downtown Stockton in California's fast-growing San Joaquin Valley.

Stockton, Calif., is just one of many cities whose downtowns are making a comeback. Over the last five years, $45 million in private and $50 million in public investment has been focused on downtown redevelopment projects.

In June 1991, a developer made a proposal for a co-branded freeway-service redevelopment on the edge of downtown Stockton. Co-branded retail enterprises typically are two separate retail businesses sharing a single building. They are designed to allow customers interior access between the businesses in order to strengthen drawing power.

Stockton, with a population of 260,000, is the center of a county with 550,000 people. A co-branded freeway-service center on the edge of a rebounding downtown seemed like a lucrative and logical project. A best-use analysis determined that businesses catering to the freeway traffic and surface traffic would generate the most optimal return; thus, gas and fast food were chosen as the desired retail types.

The project soon became known as Stockton Gateway, the first private development project bringing new businesses into the downtown area in 20 years.

Out of the Gate The project site is at the western entrance to downtown Stockton. Located where Interstate 5 and Highway 4 merge, the Lafayette Street offramp drops travelers into the heart of downtown. More than 100,000 cars, both freeway and surface traffic, drive past this site daily, making it an attractive and easily accessible location. Developers and the city considered the area around the site to be ground zero for redevelopment.

However, the location was rife with blight. Cheap hotels and run-down, single-room-occupancy apartments with vacant storefronts and broken signage all were part of the visual first impression to those entering the city and affected which retailers might want to locate there.

In 1992, the city started looking for a master developer for the site, so it sent requests for proposals to all property owners on the block to give them the first chance at the redevelopment opportunity.

First Commercial Real Estate & Advisory Services submitted the freeway-service development on behalf of Paul Mariani, a property owner and owner of Mariani's Men's and Boys' Clothing located on the south end of the block. Mariani's store would not be affected by the proposed demolition.

The city and an out-of-town economic consulting group conducted a best-use analysis of alternative developments for the site, including an office building, hotel, housing project, and the proposed co-branding deal. Both concluded that the co-branded development was the most viable option for the site.

In 1993, the city approved the freeway-service development proposal. The developer signed an agreement that gave it exclusive rights to negotiate a purchase agreement for the site. Over the next three years, the project was refined, and a limited liability company, Stockton Gateway LLC, was formed to develop the property.

In July 1996, the city entered into a disposition and development agreement with Stockton Gateway. This agreement set forth all of the duties of the developer/buyer and the city/seller, prior to relocation, demolition, and transfer of the property.

The development experienced its first major delay when one of the property owners in the proposed demolition site refused to relocate his business. After unsuccessful negotiations, the city and the property owner eventually went to court to resolve the stalemate in an eminent domain trial. The judge ruled in favor of the city and a demolition date was set.

Choosing the Brands A provision in the disposition and development agreement required the developer to secure a major oil company and national restaurant within six months of signing the agreement. Marketing the site to oil companies and national fast-food operations that could be interested in an urban, highway-service location commenced immediately.

Unfortunately, most major fast-food operations declined the site, concerned about the area's appearance, public safety, and economics, even though the market appeared to be underserved and the site had great exposure and access to the new cross-town freeway. Initially, a national pizza chain was interested in the site, but it didn't work out.

An agreement was negotiated with a major oil company to relocate its existing downtown station to the Gateway site. The station was only a block north of Gateway, but its current freeway exposure and ingress/egress for the site was not optimal. However, a few months later, the oil company changed its mind and told the developer that it would not relocate, but instead expand and rebuild on its existing site.

Fortunately, the developer also had received a fueling supply proposal from a Union 76 supplier. When the original deal fell through, the Union 76 supplier was eager to give Stockton Gateway a supply agreement. “With Union 76's out-of-the-box management style, we felt that we could put a deal together that would be beneficial for all the partners in this substantial development,” says David Atwater, field operations manager for Van De Pol Enterprises in Stockton, the fuel supplier that negotiated the agreement.

Thus, Union 76 became the major oil company for the project. Because one member of Stockton Gateway was a long-time owner and operator of two full-service gas stations and car washes, the developer decided to become the Union 76 operator.

Industry research suggests that hamburgers and gas are the best tandem co-branding. Thus, the decision was made to continue to research major hamburger chains.

By mid-1999, the city's redevelopment department had purchased all the properties and relocated on-site businesses, and the city was ready to commence demolition. The development encountered another unexpected delay when two underground storage tanks were uncovered at the beginning of demolition. The county's environmental health agency removed the tanks and tested the site for contamination. Luckily, no contamination was found, and demolition continued.

The demolition phase was an ideal time to contact the major hamburger chains again to show that the project was real and that the timing for the development was around the corner. The developer contacted McDonald's real estate representatives to schedule a meeting.

With the rundown buildings gone, the site took on a different feel. McDonald's was interested enough to gather data on the site and surrounding area. By November 1999, the company entered into a preliminary written agreement with Stockton Gateway that spelled out shared expenses — such as surveys, environmental studies, and zoning assessments — and McDonald's began a more formal site study.

McDonald's presented its Stockton market area map, showing the boundaries from which it expected to draw customers. But, the developer felt that the geography did not accurately identify the real market area potential. The developer conducted its own independent study, called the Stockton Gateway travel time study. The purpose of this study primarily was to identify and support a much larger geographic market area, which would influence potential volume projections.

The McDonald's real estate representatives incorporated the developer's travel time study with their own data to build a market case to present to management. After receiving positive feedback, the real estate representative proceeded with due diligence investigations, which included an impact study (which concluded that the new McDonald's restaurant would have very little negative impact on the sales of the other McDonald's in the area) and sales-volume projections.

Executing a McLease Stockton Gateway's lease agreement with McDonald's is a long-term ground lease. Although McDonald's prefers to purchase property, if it can't, it will enter into a long-term ground lease — typically for 20 years with options to extend. In co-branded projects, McDonald's typically pays an 8.5 percent return to the property owner based on the land's market value with a base rent increase every five years.

Just about everything in a McDonald's co-branding agreement is unique as far as leases go. The lease reads more like a joint venture agreement than a traditional lease agreement, with terms and format fairly rigid but fair in the balance between lessor and lessee.

For instance, because McDonald's has approved the site under the condition of it being a co-branded development, the co-brand operator, Union 76, must comply with certain conditions, such as operating hours and limitations on selling on-site prepared foods. Under the lease, Union 76 only can sell foods that have been prepared off site, such as deli sandwiches. Because the primary entrance into McDonald's is through the service station's food mart, a minimum 4-foot-wide path from the front door of the food mart to the restaurant must remain clear.

Also included in the ground lease are business terms pertaining to shared development cost. The two users share all of the site work, often on a 50-50 basis. The cost of the co-branded building, referred to in the lease as the common building, is shared proportionately based on percentage of occupancy. The service station operator pays for all of the fueling component, canopy, islands, underground fueling lines, tanks, and related equipment, just as the restaurant operator pays for 100 percent of the restaurant furniture, fixtures, and equipment. Freeway signage, which alone will cost $130,000 for the Gateway development, is split 50-50.

“We really enjoy the co-brand concept,” says Dave Lamm, McDonald's manager of unique real estate development. “It provides for a sharing of development costs, which is beneficial to both parties, and it increases the retail uses on the property.” In this instance, co-branding allowed for redevelopment of a property that otherwise might have been passed over, he says. “The shared costs and the shared risks make this a viable project.”

Although more rent might be possible from another chain, Stockton Gateway, as the developer and operator of the service station, felt that the dynamics of the McDonald's image, volume potential, site layout consulting, and construction project management assistance more than would offset potentially higher rent from another restaurant chain.

Laying It Out On paper, the Stockton Gateway development is fairly standard as far as co-branded layouts are concerned. The site fronts on three streets and is composed of about 61,400 square feet. The common building is around 6,500 sf, with McDonald's occupying 3,800 sf and the Union 76 cashier/food mart occupying 2,700 sf. Both businesses share rest-rooms that are located in the transition area between them.

The Gateway development's building architecture is unique. Although fast-food restaurants and service stations usually come from a cookie-cutter mold, Stockton Gateway, with its Spanish mission architecture, resembles the Hotel Stockton, a turn-of-the-century, mission-style hotel located in Stockton's downtown.

A typical McDonald's restaurant — traditional or co-branded — may be 22 feet to 24 feet high. The three towers of the Stockton Gateway building are each 32 feet high. The Gateway building has no red and white tile, nor is there a red banding stripe on the building. Instead, the body color is cinnamon, with deep-fired, brown, clay-like tiles; clay-barrel roof tiles are variegated browns and reds tying into the design.

“The Stockton Gateway project came to us with an exterior design concept already approved by the city of Stockton,” Lamm says. “Because the project was owned and developed by our co-brand partner, and because of the unique characteristics of the redevelopment project, we agreed to deviate from our standard design criteria.”

Although the zoning provided no restrictions on sign height, the city had discretion over signage. Some of those involved in the deal didn't want a tall freeway sign, which caused another delay during the design. To resolve the issue, the city and the developer held public hearings and ultimately compromised on a 70-foot-tall freeway sign.

With approval from the city on the site layout and building design, architects from McDonald's drew up the construction plans that ultimately would be submitted to obtain the proper building permits.

Initially, the plan was to use a particular general contractor that was recommended by the McDonald's corporate office and the McDonald's franchisee. Additionally, the developers would work with a separate contractor that specialized in underground improvements for service stations.

Unfortunately, the project cost came in over budget and the general contractor was unable to lower its bid. The developer requested a competitive bid from another general contractor with experience in constructing both buildings and service stations. The second bid came in within budget primarily because of the contractor's ability to combine all elements of the project under one contract.

The project broke ground in mid- March, and the buildout from start to finish is expected to be completed, per contract, within 100 days. Stockton Gateway looks forward to the completion and grand opening of the businesses by summer.

Kevin Dougherty, CCIM

Kevin Dougherty, CCIM, is president of First Commercial Real Estate & Advisory Services in Stockton, Calif., and is the managing member of Stockton Gateway LLC. Contact him at (209) 461-6400 or kdougherty@ccim.net.

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