Rye & Roses Bakehouse: Underwriting a Second Location With a Competitor Arriving
Rye & Roses Bakehouse operates one profitable store with $1.1 million in annual revenue, a 62% contribution margin, and $340,000 in annual fixed costs. The owner is evaluating a second location two miles away in a redeveloping shopping district. Projected first-year revenue is $780,000; rent is $4,800 per month on a five-year lease; incremental labor is $180,000 per year; utilities, insurance, and maintenance add $45,000; and build-out costs $85,000, depreciated straight-line over seven years. The owner's market study suggests 15% of the new store's sales would otherwise have gone to the existing store, and that the existing store can absorb the lost volume without reducing its fixed costs. The landlord offers three months of free rent in year one. A competing bakery has announced it will open 0.8 miles from the proposed site in nine months.
1. Compute incremental annual contribution, steady-state profit, break-even revenue, and the margin of safety. Then compute the year-one figures with the rent concession.
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Incremental revenue = $780,000 x 0.85 = $663,000. The 15% haircut is $117,000 of sales that would have been rung at the existing store, and because that store's fixed costs do not fall when volume leaves, the contribution on those sales is genuinely lost.
Incremental contribution = $663,000 x 0.62 = $411,060.
Steady-state incremental fixed costs: rent $57,600 + labor $180,000 + other $45,000 + depreciation ($85,000 / 7 = $12,143) = $294,743.
Steady-state profit = $411,060 - $294,743 = $116,317 per year. Break-even revenue = $294,743 / 0.62 = $475,392, giving a margin of safety of ($663,000 - $475,392) / $663,000 = 28.3%.
Year one with the concession: rent falls to $43,200, fixed costs to $280,343, profit to $130,717, and break-even revenue to $452,166.
Cash payback on the $85,000 build-out, using profit plus depreciation of $128,460, is about 7.9 months, but that assumes the projection is met immediately, which a new store will not do.
2. Evaluate the competitive and lease risks. Should the owner sign now to secure the site?
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Two risks dominate and both are asymmetric, because rent is fixed while revenue is a projection.
Competitor risk: a bakery opening 0.8 miles away in nine months will pull from the same trade area, and its arrival lands exactly when the new store is still building a customer base. Run a downside. Revenue down 20% to $624,000 gives incremental revenue of $530,400, contribution of $328,848, and profit of only $34,105, a 3.7% operating margin that one rent escalation erases. At a 30% shortfall the store loses money. That is the case to underwrite, not the base case.
Lease risk: five years at $57,600 is a $288,000 fixed obligation that survives regardless of traffic. The three months of free rent is worth $14,400, about 12% of one year's profit, and should not drive the decision.
Signing early to beat a competitor inverts the logic: the competitor's arrival is a reason to negotiate harder, not to commit faster. Ask for a co-tenancy or sales-based kick-out clause, a tenant-improvement allowance, or percentage rent in years one and two. Validate demand first with a 90-day pop-up or shared-kitchen test in the trade area, and model cannibalization as permanent rather than recaptured.
3. The owner can fund the $85,000 build-out from cash or with a seven-year loan at 8.5%. Which should be chosen, and on what basis?
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A $85,000 seven-year loan at 8.5% amortizes to roughly $1,346 per month, or about $16,155 per year. Pre-financing cash flow is profit of $116,317 plus depreciation of $12,143, or $128,460. With the loan, free cash after debt service is about $112,305. Paying cash leaves $128,460 of cash flow but consumes $85,000 of reserves.
The loan's true cost is 8.5% on money the owner keeps. That is cheap relative to the 21%-plus implicit cost of stretching supplier terms, so financing is not the problem here. The question is what the reserve is for. If the existing store is the cash engine and $85,000 would drop reserves below roughly six months of fixed costs, the loan is the better choice because it preserves a buffer for a soft quarter or a competitor response, and the second location has a competitor arriving within the year.
The counterargument is stacking fixed obligations: the lease is $57,600 a year and debt service is $16,155, for $73,755 of committed cost before a single hour of labor. If reserves are genuinely surplus and the existing store throws off steady cash, paying cash is cheaper and simplifies the downside. Decide on the reserve test, not on the interest rate alone.